exchange rates

Question 1

Macroeconomic effects of a depreciating currency on AD

Answer 1

1. AD
   -production costs for domestic firms fall relative to those of foreign competitors, making the country’s EXPORTS MORE COMPETITIVE in foreign markets as they are cheaper to buy
   -the domestic firms production should increase, which increases domestic employment - multiplier effect

-Reduce imports as they are now relatively more expensive
-This may encourage domestic production of goods that were previously imported- acting as a protectionist policy

EVAL:
1.-depends on price elasticity of demand of exports and imports
-UK tend to provide services and they compete more on quality rather than price - legal/financial sectors
-Some UK exports are relatively price inelastic and so will not benefit from the depreciating currency

2. In long run as firms are more competitive without effort- reduced incentives to cut costs - declining productivity - declining supply -excess demand - rising prices

Question 2

Macroeconomic effects of a depreciating currency on inflation

Answer 2

-A depreciating currency makes importing raw materials and other factors of production more expensive- leading to higher COP - SRAS shifts inwards
-Increases cost-push inflation
-increases demand pull inflation caused by higher exports

EVAL:
1.Depends on how dependent domestic firms are for imported raw materials - the UK imports over half of its oil - more expensive
2. Extent of cost-push inflation depends on how much other factors are rising (eg wages)

Question 3

Macroeconomic effects of a depreciating currency - less attractive to migrant workers

Answer 3

-With a depreciation of the pound, migrant workers from Eastern Europe may prefer to work in Germany rather than the UK.
-More than 30% of the workers in the food manufacturing industry are from the EU
-UK firms may have to push up wages to keep foreign labour

Question 4

Macroeconomic effects of a depreciating currency - increases the value of debt denominated in a foreign currency

Answer 4

-Especially important for governments and firms in less developed countries who borrow money in another currency
-Face increased cost of borrowing
-However the UK gov is able to borrow money in pounds therefore does not face this risk

Question 5

Broader eval points about currency depreciation

Answer 5

1. Exchange rate only shows value of one currency in terms of another.
   -Depreciation of the pound against the dollar may be offset by the appreciation of the pound against the euro as the currency fluctuates independently - varying IR, inflation.
   -The significance of the depreciation depends on which country it is depreciating against - depreciation against the yuan is more significant than against the Thai Baht - china is a large trading partner
2. The openness of a country to trade - more open to trade will be more affected than closed countries

Question 6

What is an exchange rate

Answer 6

Value/price of one currency in terms of another currency

Question 7

What causes exchange rates to change

Answer 7

1. In order to purchase imports: imports are typically bought in the currency where that good is produced - demand for the foreign currency will rise
2. Individuals or firms require foreign currency to buy financial assets denominated in that currency - shares, properties, bonds - e.g. if interest rates in the USA savers were to rise, investment funds in the UK may buy dollars to switch their savings to american bank accounts - changes in monetary policy affect the exchange rate - hot money flows
3. If a firm engages in foreign direct investment abroad - if a firm sets up a factory in Germany it will need to buy raw materials and pay workers in euros
4. inflation rates, high inflation leads to depreciation, domestic consumers purchase imports
5. Speculation