exchange rates

Question 1

Causes of Appreciation in Exchange Rate

Answer 1

• Relatively higher interest rates (attract hot money flows to get better rate of interest on savings)
• Relatively lower inflation rate. Makes UK goods more attractive.
• Current account surplus. Inflows of currency.

Question 2

Effect of an Appreciation in Exchange Rate

Answer 2

• Makes exports more expensive. Therefore quantity of exports falls
• Makes imports cheaper. Therefore quantity of imports rises.
• Fall in aggregate demand and lower economic growth
• Lower inflation (due to lower import prices, lower AD and incentives to cut costs)
• Worsening of current account – i.e. bigger deficit.

Question 3

However the impact of appreciation depends upon:

Answer 3

• Elasticity of demand for imports and exports. Marshall Lerner condition states an appreciation will only worsen current account if PEDX + PEDM >1 (elasticity of demand is greater than 1)
• Other components of AD. An appreciation won’t cause a fall in AD, if consumer spending is growing strongly.
• Time lags. Often demand is inelastic in short term and becomes more elastic over time, therefore an appreciation has more effect over time.

Question 4

Exchange Rate Systems

Answer 4

• Floating exchange Rates – when governments don’t intervene in exchange rates and allow them to be determined by free market forces.
• Fixed Exchange Rates – When government seek to maintain a certain target exchange rate.
• Semi Fixed Exchange Rates – when government allow a small window of exchange rate fluctuation.

Question 5

Advantages of Fixed Exchange Rates

Answer 5

• Provide greater stability for firms involved in trade. E.g. exporters don’t have to fear a rapid appreciation which would reduce their profitability.
• Can help reduce inflation as countries have an added discipline to keep inflation low otherwise the currency would be weaker.
• May reduce speculation if markets believe country will stick to exchange rate

Question 6

Disadvantages of Fixed Exchange Rates

Answer 6

• May lead to exchange rate being overvalued, this can harm exports and economic growth
• To maintain fixed exchange rate may require high interest rates (this may conflict with other objectives such as causing lower growth and higher unemployment)
• UK forced out of ERM in 1992, because markets felt they had joined at wrong rate.