Exchange rates + Balance of payments Flashcards
exchange rate
define
the value of one currency expressed in terms of another
what is a floating exchange rate system?
exchange rates are determined by market forces, with no govt. or central bank intervention
currency appreciation
define
an increase in the value of a currency
currency depreciation
define
a fall in the value of a currency
causes of appreciation and depreciation
- foreign demand for exports
- domestic demand for exports
- investment (inward and outward)
- speculation
- changes in income of trading partners
- changes in domestic income
- relative inflation rates
- relative interest rates
- central bank intercvention (use of foreign currency reserves)
- remittances
consequences of appreciation and depreciation
- currency appreciation can be expected to result in a decrease in net exports
- currency depreciation can be expected to lead to an increase in net exports
effect of currency depreciation on the rate of inflation
deamnd-pull AND cost-push
Demand-pull inflation:
- makes exports cheaper and imports more expensive, thus increasing net exports
Cost-push inflation:
- makes imports more expensive, resulting in a leftward shift of the SRAS curve, resulting in cost-push inflation
effect of currency appreciation on the rate of inflation
deamnd-pull AND cost-push
Demand-pull inflation:
- reduces demand-pull inflationary pressures due to a decrease in net exports
Cost-push inflation:
- makes imports less expensive, resulting in a rightward shift of the SRAS curve, lowering inflationary pressures
effect of depreciation on economic growth
Depreciation increases net exports, increasing AD, thus causing an increase in real GDP.
HOWEVER, depreciation also leads to a leftward shift of the SRAS curve (cost-push inflation), which puts downward pressure on real GDP.
SO, GDP depends on which of the 2 effects is stronger: the upward effect due to AD or the downward effect due to the decrease in SRAS.
effect of appreciation on the current account balance
Appreciation will cause imports to increase and exports to fall. If a country has an excess of imports over exports (‘trade deficit’), its deficit is likely to become larger after a period of time. If it has excess of exports over imports to begin with (‘trade surplus’), its trade surplus is likely to become smaller.
effect of appreciation on economic growth
Appreciation reduces net exports, reducing growth of real GDP.
effect of depreciation on the current account balance
Likely to cause imports to decrease and exports to increase. If a country has an excess of imports over exports (‘trade deficit’), its deficit is likely to become smaller after a period of time. If it has excess of exports over imports to begin with (‘trade surplus’), its trade surplus is likely to become larger
effect of depreciation on foreign debt
Depreciation lowers the value of the domestic currency, causing the value of the foreign debt to increase.
effect of appreciation on foreign debt
Appreciation causes the value of the foreign debt to fall.
effect of depreciation on living standards
Depreciatiopn causes imported goods to become more expensive, so residents become worse off, and travellers abroad find their holidays have been made more expensive.
effect of appreciation on living standards
If a currency appreciates, standards of living are likely to increase. Prices of imported goods fall, imports become cheaper, and travellers abroad will find the cost of travelling to decrease.
effect of depreciation on unemployment
Depreciation increases net exports and therefore AD, which causes a fall in cyclical unemployment if the economy is in a recessionary gap.
HOWEVER, depreciation may lead to cost-push inflation, which involves lower real GDP due to the decrease in SRAS, hence an increase in unemployment.
SO, the overall effect depends on which of the 2 effects is stronger: the upward effect due to the increase in AD or the downward effect due to the decrease in SRAS.
effect of appreciation on unemployment
Appreciation reduces exports and hence AD, creating a recessionary gap and therefore cyclical unemployment.
methods the central bank uses to maintain a fixed exchange rate
- using official reserves
- increasing interest rates
- borrowing from abroad
- efforts to limit imports
currency devaluation
define
if the currency value is higher than what can be maintained through intervention, the govt. may change it to a new, lower value
currency revaluation
define
if the currency value is lower than what can be maintained through intervention, the govt. may change it to a new, higher value
Degree of certainty for stakeholders
floating vs fixed exchange rates
Fixed:
High degree of certainty.
Floating:
Uncertainty because stakeholder cannot know what the value of the currency will be in the future.
Role of foreign currency reserves
floating vs fixed exchange rates
Fixed:
Central bank intervention to maintain a fixed exchange rate requires sufficient supplies of foreign currency reserves.
Floating:
There is no need for central banks to hold foreign currency reserves since there is no need for intervention in foreign markets.
Correction of current account imbalences
floating vs fixed exchange rates
Fixed:
No easy methods to correct imabalances in the balance of payments. External shocks cannot be handled quickly and easily. Persisten current account deficits require large quantities of foreign currency reserves. If these are not readily available, the country must resort to contractionary policies or trade protection. If the current account deficit persists, the country may have to devalue its currency.
Floating:
These can easily adjust automatically to excess demand or supply of the domestic currency, thus bringing about a balance in the balance of payments.
Effects of inflation
floating vs fixed exchange rates
Fixed:
If a country has a rate of inflation that is higher than that of its trading partners, the foreign demand for exports falls as these are less competitive, while demand for imports rise, and the country is likely to develop a current account deficit. However, depreciation cannot be used to correct the deficit, so countries must use fiscal policy to maintain a low and stable rate of inflation.
Floating:
If a country has a rate of inflation that is higher than that of its trading partners, so that the country develops a current account deficit, this can be corrected through depreciation. However, depreciation leads to higher costs of imports, which can create cost-push inflation.
Flexibility offered to policy-makers
floating vs fixed exchange rates
Fixed:
Do not offer flexibility to policy-makers.
Floating:
Offer greater flexibility to policy-makers.
managed exchange rate system
define
exchange rates are supposed to move towards their long-term equilibrium determined by the market; however, central banks periodically intervene to stabilise them over the short term
pegged exchange rate
define
one currency is fixed in relation to another currency, and floats in relation to all other currencies
overvalued currency
define
A currency that has a value too high relative to its equilibrium free market valu. Its exchange rate has been set at a higher level than the equilibrium market exchange rate.
undervalued currency
define
A currency that has a value too low relative to its equilibrium free market value. Its exchange rate is low relative to the one the market would have determined.
pros and cons of an overvalued currency
Pros:
- developing countries can import capital goods and materials at a cheaper price
Cons:
- exports become more expensive
- worsening current account balance
- domestic producers have to compete with artificially low-price imports (leading to negative consequences for domestic employment and resource allocation)
pros and cons of an undervalued currency
Pros:
- exports become less expensive to foreign buyers; some developing countries have used undervaluation as a method to expand their export industries, dxpand their economies and therefore also increase their employment levels
- country gains access to foreign exchange
Cons:
- imports become more expensive domestically
- can lead to cost-push inflation due to higher price of imports
- deemed unfair and a form of protectionism because it distorts prices: may result in retaliation
credits (inflows) represent … for a country’s currency
fill in the blank:
foreign demand OR domestic supply
foreign demand
debits (outflows) represent … for a country’s currency
fill in the blank:
foreign demand OR domestic supply
domestic supply
surplus
in balance of payments
occurs whenever a baqlance of payments has a positive value, meaning that credits are larger than debits (excess of credits)
deficit
in balance of payments
occurs whenever a baqlance of payments has a negative value, meaning that debits are larger than credits (excess of debits)
Does a current account surplus causes appreciation or depreciation?
appreciation
Does a current account deficit causes appreciation or depreciation?
depreciation
implications of a persistent current account deficit
- depreciation exchange rate
- possible need for higher interest rates to attract foreign financial investments, leading to recession
- foreign ownership of domestic assets
- increasing levels of debt
- poor international credit ratings
- painful demand-management policies
- possibility of economic growth
methods to correct a persistent current account deficit
- expenditure reducing policies (reduce AD)
- expenditure switching policies (switch consumption away from imported goods towards domestically produced goods)
- supply-side policies (to increase competitiveness)
implications of a persistent current account surplus
- low domestic consumption
- insufficient domestic investment
- appreciation of the domestic currency
- inflation
- employment
- reduced export competitiveness
What is the Marshall-Lerner condition?
The condition states that a fall in the exchange rate will reduce a current account deficit if the sum of PEDs for exports and imports is greater than 1.
