LS8 - Exchange Rates

Question 1

What is the point of a weighted exchange rate?

Answer 1

• to show how a currency’s value is changing against a country’s trading partners

Question 2

What is a foreign exchange market split into?

Answer 2

• a spot market for transactions that happen now
• a forward market for transactions that will happen at an agreed time in the future

Question 3

What determines the exchange rate in a floating exchange rate system?

Answer 3

• the forces of supply and demand

Question 4

Factors increasing demand for a currency -> currency appreciation

Answer 4

• increase in relative interest rates
• speculators anticipate rise
• increase in FDI - e.g. company setting up in UK have to pay costs in pounds
• rise in incomes abroad - they may purchase from UK
• increase in international competitiveness of domestic exports

Question 5

Factors decreasing demand for a currency -> depreciation (people swap the currency for another)

Answer 5

• fall in interests rate
• speculators anticipate fall
• firms moving away from UK
• increase in incomes domestically

Question 6

Currency appreciation SPICED

Answer 6

• stronger pound imports cheap exports dear

Question 7

Negatives of currency appreciation

Answer 7

• lower growth due to potential current account deficit as imports > exports
• higher unemployment in exporting & domestic industries

Question 8

Benefits of currency appreciation

Answer 8

• lower inflation (DP and CP)
• cheaper imports so a rise in living standards for consumers
• potential efficiency gains for domestic producers as they now have to compete with cheaper imports and therefore cut costs elsewhere

Question 9

Currency depreciation WIDEC

Answer 9

• weaker imports dear exports cheaper

Question 10

Benefits of currency depreciation

Answer 10

• increased employment in domestic & exporting industries
• increased net trade -> economic growth

Question 11

Negatives of currency depreciation

Answer 11

• SRAS may shift to the left as firms face higher costs
• higher DP & CP inflation (due to econ growth and SRAS fall)

Question 12

The Marshall-Lerner condition states that

Answer 12

• a currency depreciation will only correct a current account deficit if PEDx + PEDm > 1

Question 13

What do economists say happens in the short term when a currency depreciates?

Answer 13

• they say that in the SR, the Marshall-Lerner condition is not met as demand tends to be inelastic for both exports and imports
• this may be due to the time taken to adjust to changes currency value
• consumers may not comprehend the currency value change and therefore not change their behaviour accordingly
• it may also take foreign nations time to realise goods from e.g. the UK have become cheaper

Question 14

What effect is a result of net exports being inelastic in the short run?

Answer 14

• the J-Curve effect

Question 15

The J Curve effect

Answer 15

• Economists argue that in the SR, when there is currency depreciation, the Marshall Lerner condition does not hold, as demand tends to be inelastic for both imports and exports so much so that the total elasticity is less than 1 of net exports
• consumers, foreign countries and firms take time to adjust to the fact that exports have changed in price and so continue to buy at the same rate as before

Question 16

J Curve effect diagram

Answer 16

• y axis is current account
• x axis is time
• J curve shows the deficit worsens before it improves