LS8 - Exchange Rates Flashcards
What is the point of a weighted exchange rate?
- to show how a currency’s value is changing against a country’s trading partners
What is a foreign exchange market split into?
- a spot market for transactions that happen now
- a forward market for transactions that will happen at an agreed time in the future
What determines the exchange rate in a floating exchange rate system?
- the forces of supply and demand
Factors increasing demand for a currency -> currency appreciation
- 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
Factors decreasing demand for a currency -> depreciation (people swap the currency for another)
- fall in interests rate
- speculators anticipate fall
- firms moving away from UK
- increase in incomes domestically
Currency appreciation SPICED
- stronger pound imports cheap exports dear
Negatives of currency appreciation
- lower growth due to potential current account deficit as imports > exports
- higher unemployment in exporting & domestic industries
Benefits of currency appreciation
- 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
Currency depreciation WIDEC
- weaker imports dear exports cheaper
Benefits of currency depreciation
- increased employment in domestic & exporting industries
- increased net trade -> economic growth
Negatives of currency depreciation
- SRAS may shift to the left as firms face higher costs
- higher DP & CP inflation (due to econ growth and SRAS fall)
The Marshall-Lerner condition states that
- a currency depreciation will only correct a current account deficit if PEDx + PEDm > 1
What do economists say happens in the short term when a currency depreciates?
- 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
What effect is a result of net exports being inelastic in the short run?
- the J-Curve effect
The J Curve effect
- 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
J Curve effect diagram
- y axis is current account
- x axis is time
- J curve shows the deficit worsens before it improves