exchange rates Flashcards
Macroeconomic effects of a depreciating currency on AD
- 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
- In long run as firms are more competitive without effort- reduced incentives to cut costs - declining productivity - declining supply -excess demand - rising prices
Macroeconomic effects of a depreciating currency on inflation
-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)
Macroeconomic effects of a depreciating currency - less attractive to migrant workers
-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
Macroeconomic effects of a depreciating currency - increases the value of debt denominated in a foreign currency
-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
Broader eval points about currency depreciation
- 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 - The openness of a country to trade - more open to trade will be more affected than closed countries
What is an exchange rate
Value/price of one currency in terms of another currency
What causes exchange rates to change
- In order to purchase imports: imports are typically bought in the currency where that good is produced - demand for the foreign currency will rise
- 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
- 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
- inflation rates, high inflation leads to depreciation, domestic consumers purchase imports
- Speculation
Factors influencing floating exchange rates
- Inflation
- Speculation - if currency set to appreciate in future demand will increase now thus appreciate the currency now
- Gov finances - high level of debt risk - investors lose confidence so sell their holdings of bonds - currency depreciate
- Current account deficit - need to attract foreign capital inflows - depreciates currency
- International competitiveness - increased demand for exports leads to an appreciation of the currency
Gov intervention in currency markets - interest rates
-An increase in interest rates relative to other countries makes investments in the country more attractive - receive a higher rate of return - increases demand for the currency causing an appreciation - hot money flows
Gov intervention in currency markets - QE
-Stimulate economy when standard monetary policy is no longer effective - inflationary effects - reduced purchasing power - depreciation as goods are more expensive
Gov intervention in currency markets - foreign currency transactions
-Buying and selling foreign currency to manipulate the domestic currency
-China kept large reserves of the US dollar by purchasing government bonds in order to undervalue the yuan
Consequences of competitive depreciation/devaluation
- Makes exports cheaper and imports more expensive leading to export-led growth
- Inflation increase from increase in AD and higher costs of raw materials being imported
- current account deficit may improve
- Can plan investments as they will not be affected by harsh fluctuations
- Could be costly to hold large reserves of foreign currency
- Inelastic exports will not increase significantly
-Depends on position of economy for main trading partners - if in a recession demand is likely to be low
Factors affecting the supply and demand for a currency
- goods people want to buy
- desire to invest
- tourism
- placing money in domestic or foreign banks
- speculation
Impact of changes in exchange rates -
