Exchange Rates

Question 1

Standard An - SPICED

Answer 1

• If there is a strengthening of the pound relative to other currencies, for example, If the pound appreciates relative to the dollar from £1=$1.30 to £1=$1.50
• Then imports become cheaper and exports become deerer.
• For instance, suppose that UK consumers want to export shortbread from the US (UK’s largest trading partner) and that the price of shortbread is $10 per tin.
• At the exchange rate, £1=$1.30 the cost of importing shortbread in terms of pounds is £7.69 wheras if the exchange rate is £1=$1.50 it is only £6.67, thus demonstrating that imports have become cheaper.
• However, suppose Americans want to import British Tea (UK export) and it is £10 per packet of tea.
• At the exchange rate, £1=$1.30, the export of tea would cost Americans $13 wheras at the exchange rate where, £1=$1.50 it would cost $15 thus demonstrating that exports have become deerer.
• This can then…..(where you go from here largely depends upon the question at hand e.g trade deficit, economic growth?)

Question 2

Standard An - WPIDEC

Answer 2

• If there is a weakening of the pound relative to other currencies, for example, if the pound depreciates relative to the dollar from £1=$1.50 to £1=$1.30.
• Then imports become deerer and exports become cheaper.
• For instance, suppose that UK consumers want to import baseball caps from the US (UK’s largest trading partner) and that the price of a baseball cap is $10 per cap.
• At the exchange rate, £1=$1.50 the cost of importing a baseball cap is £6.67, wheras if the exchange rate is £1=$1.30 the cost of importing a baseball cap is now £7.69, thus demonstrating that imports have become deerer.
• Suppose Americans want to import British Tea and it is £10 per packet of tea. At the exchange rate of £1=$1.50, Americans would pay $15 wheras at the depreciated exchange rate they would only pay $13, thus demonstrating how exports have become cheaper.
• ATQ…..

Question 3

What are some demand-side reasons for changes in the exchange rate?

Answer 3

• Changes in relative interest rates –> if interest rates are relatively higher in the UK, then investors will move their “hot money” into the UK. As a result, in order to invest into the UK, investors have to turn their currency into pounds in order to invest in UK financial institutions. As a result, the demand for the pound rises, shifting demand rightwards from D1-D2. This puts upwards pressure on the price of the pound, thus appreciating the currency.
• Rise in incomes abroad –> if there is a rise in American incomes (UK’s largest trading partner), then the demand for UK exports will rise as Americans are more willing and able to buy UK exports. As a result, in order to do this, they have to convert their dollars to pounds. This increases the demand for the pound shifting it rightwards…..
• Speculation

Question 4

What are some supply-side reasons for changes in the exchange rate?

Answer 4

• Changes in relative interest rates
• Increases in incomes domestically - depreciates the exchange rate
• Speculation

Question 5

What are the advantages of an appreciating exchange rate?

Answer 5

• Imports are now cheaper –> increases material living standards
• Decreases in demand pull inflation in the economy & cost push inflation –> increases international competitveness in the UK.

Question 6

What are the disadvantages of an appreciating exchange rate?

Answer 6

• Lower SR economic growth –> since exports are now more expensive imports are cheaper –> decrease in (X-M)
• Worsening of the current account deficit –> macroeconomic conflict + crowding out effect potentially?
• Increased unemployment in the export industry –> demand for exports falls –> labour is a derived demand –> decrease in employment –> increase in poverty and income inequality.

Question 7

What are the advantages of a depreciating exchange rate?

Answer 7

• Increase in SR economic growth
• Increase in employment in exporting industries
• improvement in the current account deficit –> leading to less crowding out….

Question 8

What are the disadvantages of a depreciating exchange rate?

Answer 8

• Increase in demand-pull & cost push inflation
• decrease in material living standards from higher imports