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.
• Speculation - If speculators believe the sterling will rise in the future, they will demand more now to be able to make a profit. This increase in demand will cause the value to rise.

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.

Question 7

J-curve effect

Answer 7

the J-curve effect is seen in economics when a country’s trade balance initially worsens following a devaluation or depreciation of its currency. The higher exchange rate will at first correspond to more costly imports and less valuable exports, leading to a bigger initial deficit or a smaller surplus. Due to the competitive, relatively low-priced exports, however, a country’s exports will start to increase. Local consumers will also purchase less of the more expensive imports and focus on local goods. The trade balance eventually improves to better levels compared to before devaluation.