Pack 8 pg57

Question 1

floating exchange rate

Answer 1

• When governments allow the exchange rate to be determined by market forces and there is no attempt to influence the exchange rate.

Benefits:
- flexibility: beneficial as a change in the exchange can help overcome issues, such as the pound falling following the financial crisis and the Brexit vote, helping to increase exports and growth.
- robust system: does not need to keep their exchange rate at a set level and therefore is not prone to collapse

However:
- more volatile and so less stability to promote trade - so forward contracts to provide more stability

Question 2

appreciation and depreciation

Answer 2

• Appreciation: where the exchange rate increases or gets stronger.
• Depreciation: where the exchange rate decreases or gets weaker.

Question 3

Factors Influencing Floating Exchange Rates

Answer 3

• determined by demand and supply
  Demand for the Currency:
• when economic agents purchase currency
• derived demand - only purchasing for specific uses, e.g buying exports
  Example:
• a UK firm exports their goods to the US market.
• US consumer demands pound to purchase UK goods by supplying dollars.

supply of the currency:
- affected when economic agents sell the currency.
- Supply of a currency will increase in order to demand another currency, such as to purchase imports.
Example:
- UK citizen wants to import goods from the US
- UK consumer supplies pound in order to get the dollars they need to purchase US goods.

Question 4

factors affecting the demand for the currency in the context of the UK pound

Answer 4

• Changes in Exports: increase in sale of exports = higher demand for pound as foreigners need to be purchased in pounds
• Inflation: lower inflation = ceteris paribus exports more competitive = higher demand for currency
• Economic Growth and FDI: when an economy is growing fast, foreign investors may purchase UK firms or share in UK companies; both increase the demand for pounds.
• Interest Rates: interest rates high = hot money flow into UK to gain interest = higher demand for pound
• Purchasing Government Bonds: foreign investors look to purchase as safe investment = higher demand for pounds
• Speculation: if believe pound will rise in value will buy them to then sell

Question 5

changes in supply of the currency

Answer 5

• Change in Imports: higher imports = UK citizens need to supply pounds in order to gain dollars
• UK Inflation: higher inflation = imports more attractive = increase supply of pounds
• Economic Growth and FDI: faster economic growth abroad = UK investors may purchase shares in foreign companies, so need to supply pounds
• Interest Rates: high interest rates abroad = hot money flows out of UK to gain higher interest
• Purchasing Government Bonds abroad
• Speculation: if believe fall in value of pound will sell it for another currency

Question 6

fixed exchange rate

Answer 6

• rate of exchange between at least two currencies, which is constant over time
  Benefits:
• Provides stability: facilitates trade = growth/employment knock on effects
• Encourage financial discipline in a country: policymakers must control inflation/maintain international competitiveness as exchange rate cannot fall to correct these issues

However:
- historically less robust and have broken down due to speculative pressure
- significant costs to maintaining a fixed exchange rate system, needing to raise interest rates to maintain currency’s value or raising taxes to reduce imports

Question 7

revaluation and devaluation

Answer 7

• only for for fixed exchange rate system
  Revaluation: where a fixed exchange rate is increased, making the currency stronger.

Devaluation: where a fixed exchange rate is decreased, making the currency weaker.

Question 8

Use of foreign currency transactions to manage exchange rates

Answer 8

(a) Foreign Currency Transactions:
- could attempt to increase the value of the exchange rate by purchasing their own currency
- increase demand for currency = higher value
- also reduce value by selling it to increase supply (can be done by central banks as have gold/currency reserves)

However:
- reserves not infinite and only small fraction of global money markets
- also issues with trying to devalue exchange rate as requires central banks to sell currency, either has to borrow money it sells or can print it (inflation)

Question 9

use of interest rates to manage exchange rates

Answer 9

• Higher interest rates will attract hot money into the country in order to take advantage of greater returns.
• This will increase the demand for the currency.
• There may also be lower supply as existing investors are less willing to move money abroad.
• Higher interest rates should slow down consumption and investment, as well as economic growth.
• Lower economic growth will mean ceteris paribus lower imports and therefore a lower supply of pounds on foreign markets.

however:
- negative effects on growth

Question 10

use of currency controls and borrowing from institutions to manage exchange rate

Answer 10

• Currency Controls: this is where limits are placed on the amount of foreign currency that can be bought
• helps the central bank fix the exchange rate but can lead to corruption and black markets occurring.
• Borrowing from institutions, such as the IMF: as a last resort, countries could borrow from the IMF to fund purchases of their currency in order to maintain their exchange rate. However, the IMF will put conditions on borrowing, such as economic reform

Question 11

impact of exchange rate on current account

Answer 11

• weaker exchange rate = reduce price of exports = increase price of imports
• more internationally competitive so increased export volumes and decreased import volumes as consumers switch to cheaper domestically produced goods
• if demand price elastic = improvement in current account
• lower export price = more than proportional increase in qty demanded = increasing value of exports
• higher import price = more than proportionate fall in demand

Question 12

impact of exchange rate on economic growth and unemployment

Answer 12

• Assuming price elastic demand, the weaker exchange rate will lead to an increase in exports and a fall in imports
• lead to an increase in aggregate demand
• should lead to a reduction in demand-deficient unemployment and a rise in employment
• because there are not only more jobs available in the export sector but also domestic businesses who now face less competition from foreign competition, as import prices rise.
• increased derived demand for workers

Question 13

impact of exchange rate on rate of inflation

Answer 13

• weaker exchange rate will cause arise in inflation as the cost of raw materials will be more expensive due to an increase in the price of imports
• cost-push inflation

Question 14

impact of exchange rate on Foreign Direct Investment Flows

Answer 14

• weaker exchange rate not only makes it cheaper to purchase UK exports in pounds but also UK companies
• weaker exchange rate not only makes it cheaper to purchase UK exports in pounds but also UK companies
• however other factors that affect FDI, e.g access to free trade, tax levels and economic growth

Question 15

consequences of competitive devaluations and depreciations

Answer 15

• When a country deliberately intervenes to drive down the value of their currency to provide a competitive boost to demand and jobs in their export industries
• competitive devaluations or depreciations by one nation are often matched by a similar currency changes of another, as it is seen as a form of protectionism - US accused China of in recent years
• lead to currency wars
• at least, there may be higher inflation for country using this exchange rate policy and greater currency volatility

Question 16

The Marshall Learner Condition

Answer 16

• A fall in an exchange rate will lead to an improvement in the current account as long as the combined price elasticity of demand for exports and imports are greater than 1.
• For exports, it does not matter what value PED is (as long as it is not zero), the UK exporter will always be better off.
• This is because the UK exporter will earn the same amount in pounds for each good sold but also see an increase in exports sold as they are more price competitive. Therefore, in pounds, the value of exports has increased.
• For imports, the price elasticity of demand is more crucial. When the pound falls, the value of UK imports will fall if demand is price elastic but rise if demand is price inelastic. Therefore, an improvement in the current account only occurs when PED for imports is price elastic.

Question 17

J-curve

Answer 17

• a fall in an exchange rate will initially lead to a deterioration in the current account before improving in the long-term
• assumed that the PED for net exports will vary over time
• in short-run demand for exports and import more price inelastic as time to switch their buying behaviour or may be tied into contracts
• so initially even when price of export falls and price of imports rises, unlikely improvement in current account balance
• in long run, demand becomes more price elastic as can now switch to cheaper alternatives
• so when price of exports fall/import prices rise, there will eventually be an improvement in current account balance

Question 18

what other factors do the impact of the exchange rate depend on

Answer 18

impact of a currency deprecation will be greater:
- The shorter the time lags of consumers and businesses to respond
- The more open to free trade an economy is
- The larger and more long-term the exchange rate change is

Question 19

measures of international competitiveness

Answer 19

1. Relative unit labour costs:
   - Cost of employing people divided by total (real) output, compared to other countries
   determined by:
   - Labour costs, such as wage rates, salaries, employment taxes and costs.
   - level of labour productivity
2. Relative Export prices:
   - price of goods sold abroad, compared to other countries
3. Non-price competitiveness:
   - looking at factors such as quality, service, reliability and durability

Question 20

Factors influencing international competitiveness

Answer 20

• exchange rates: e.g depreciation in the exchange rate will reduce relative export prices and improve competitiveness
• productivity: Assuming other labour costs remain the same, this will reduce relative unit labour costs and therefore allow a reduction in relative export prices
• wage and non-wage costs: affect unit labour costs/relative export prices
• regulation: lower regulation = lower unit costs = lower export prices
• quality: greater non-price competitiveness
• research and development: improve non-price competitiveness with higher quality products, also mean forms lower unit costs if more efficient production process
• taxation: higher indirect taxation = higher unit costs = lower competitiveness, also could leave less profits for investment in R&D
• levels of inflation: high = high unit costs = high costs of production
• free trade and protectionist policies: tariffs = less competitive

Question 21

benefits of being internationally competitive

Answer 21

• Balance of Payments:
  Current Account: more internationally competitive should lead to an increase in demand for exports and a decrease demand for imports
  Financial account: more incentive for foreigners to invest in internationally competitive companies due to the exports and profit potential from higher competitiveness
• economic growth: higher exports = boost AD and so increase real GDP
• employment: industries become more competitive and are selling more goods and services, they should be more profitable and have the opportunity to expand and grow
• impact on FDI:
  global companies may wish to invest in industries that are internationally competitive due to greater prospects for profits
• impact on the exchange rate:
• selling more exports, selling less imports, more foreign direct investment and the strength of the economy in general will make the exchange rate appreciate
• because there is greater demand for the domestic currency

Question 22

components of the balance of payments

Answer 22

current account
financial account
capital account

Question 23

current account

Answer 23

1. Balance of Trade in Goods: this refers to the difference between the value of goods exported and the value of goods imported.
2. Balance of Trade in Services: this refers to the difference between the value of services exported and the value of services imported.
3. Investment Income (also known as primary income): this comprises income earned by domestic citizens who own assets overseas minus income earned by foreign citizens who own assets in this country. It includes profits, dividends on investments abroad and interest (IPDs).

4.Current Transfers (also known as secondary income): these are usually money transfers between governments (who lend or borrow from each other) or grants, such as those between EU members and the EU.

Question 24

Financial account

Answer 24

1. Direct Investment: includes FDI where investors purchase a controlling interest in a foreign firm or reinvested profits by foreign owned firms. For example, FDI into the UK would improve the financial account.
2. Portfolio Investment: includes investment in shares (where this is less than 10% of the company), as well as investment in government bonds. For example, UK selling shares would lead to an improvement in the financial account.
3. Other investments: any investment other than direct or portfolio, it includes trade credit, loans, purchase of currency and bank deposits. For example, money invested in UK banks from abroad would lead to an improvement in the UK financial account.
4. Reserve assets: foreign financial assets that are available to or controlled by monetary authorities, such as a central bank. These include gold and foreign exchange.

Question 25

capital account

Answer 25

1. The transfer of assets when migrants change nationalities: for example, assuming Roman Abramovich changed his residency from Russia to the UK, then, automatically his assets are transferred and is money flowing into the capital account for the UK.
2. Government transfers, such as debt forgiveness to LEDCs: for example, the UK forgiving debt for Uganda would be money flowing out of the capital account for the UK but money flowing into Uganda’s capital account.

Question 26

impact of Increase in export of UK financial services to China on balance of payments: changes in trade

Answer 26

• money flows into the current account (trade in services): reduce UK current account deficit

Question 27

impact of increase in Foreign Direct Investment in the UK on balance of payments: changes in FDI

Answer 27

• money flows into the financial account: increase UK financial account surplus
• money flows out of current account medium term (foreign company profits): increase UK current account deficit

Question 28

impact of Increase in UK exchange rate due to economic growth on balance of payments: changes in exchange rate

Answer 28

• Money flows out of current account (trade in goods services): Increase UK current account deficit
• More FDI abroad by UK citizens as cheaper to buy foreign firm in pounds (financial account): Decrease UK financial account surplus
• More investment income flows into current account medium term (profits): Reduce UK current account deficit

Question 29

impact of UK forgives debts in LEDCs in Africa on balance of payments - debt forgiveness

Answer 29

• Less money flowing into UK current account (less interest): Increase UK current account deficit
• Transfer of debt is a transfer of money out of UK capital account: Decrease UK capital account surplus

Question 30

causes of current account surpluses and deficits

Answer 30

1. exchange rate: affect value of exports/imports
2. international competitiveness: determine demand for exports/imports
3. Economic growth and savings: determine levels of income available to import, depending on the marginal propensity to import in the country
4. changes in investment income and transfers: determined by changes in primary income

Question 31

current account deficit problems for the UK

Answer 31

• indicates lack of international competitiveness and decline in manufacturing (car manufacturing)
• caused by excessive consumer debt (damaging as consumer spending dampened citizens pay off debt over time)
• large and sustained and cannot be financed, may find it difficult to find lenders to borrow
• cannot be self-corrected painlessly: if operating fixed exchange rate system problem more severe as exchange rate cannot fall

EV - may not be a problem if:
- used to import capital goods to improve long-term competitiveness
- consumers are living within their means: simply choosing to improve their own welfare and living standards by importing better goods and services
- could be easily financed by other accounts on the balance of payments
- the economy naturally self-corrects the deficit

Question 32

current account surplus problems (taiwan)

Answer 32

• may be beneficial due to positive impact on economy’s circular flow of income, economic growth and employment

However, problems:
- export dependence
- lack of focus on domestic markets: means consumer choice and living standards could be very low
- susceptible to protectionism: others will be in deficit

Question 33

issues of global imbalances

Answer 33

• low interest rates in deficit countries: either lowering interest rates to stimulate growth, or high levels of savings in surplus countries, which allowed interest rate to be low
• bubbles, bust and recessions in deficit
• fall in global demand for exports and recessions in surplus countries: spending on imports fell

other financial crises possibly occurring due to global trade imbalances, such as:
- fluctuating exchange rates
- rise in protectionism

Question 34

business policies to improve competitiveness

Answer 34

• improving the workforce: improve skill through improved training/better recruitment, use of financial/non-financial methods to motivate employees
• investment in capital goods: investing in up to date machinery/tech = lower unit costs
• market research: help identify customer want/needs and develop better products
• relocation of production: offshore products abroad
• research and development: improve production process

however: often increase costs and time lag, also dependent on how well they are implemented relative to competitors

Question 35

government policies to improve competitiveness

Answer 35

supply side policies:
- education and training: boost productivity - lower relative unit labour costs
- improved infrastructure: improve efficiency of businesses through lower transport costs/better internet connections

Market based supply side:
- reduced corporation tax: more profits to invest in capital goods so boost productivity
- promote competition and small businesses: could deregulate to increase competition to drive improvements in innovation/productivity to compete
- but significant time lag

Exchange rate policies:
- reduce value of exchange rate
- however could lead to series of competitive devaluations and currency wars
- also other factors e.g quality impact competitiveness too

Demand side policies:
- lower inflation, to improve price competitiveness and greater stability should encourage businesses to invest
- however, hard to control all factors of macroeconomic environment

Protectionism and trade policies:
- promote free trade/trade blocs
- but risks of trade war

Question 36

policies to reduce current account deficits

Answer 36

Supply side:
- to improve international competitiveness of exports in long run
- spending on education/infrastructure
- however time lag/other side effects (budget)

Contractionary demand side policies:
- reduce AD/incomes to reduce imports
- e.g higher interest rates/taxation
HOWEVER will reduce living standards/rising unemployment/lower income

Decreasing exchange rate:
- competitive devaluation
HOWEVER: impact depends on PED of imports/exports and can lead to retaliation

Protectionist policies:
- reduce imports
- e.g tariffs
- however can distort comparative advantage/lead to retaliation

Question 37

policies to reduce current account surplus

Answer 37

Policies to stimulate domestic spending:
- lower interest rates/taxation
- however hard to encourage spending when saving for a good reason (e.g china)

increasing exchange rate:
- appreciating/revaluing
- e.g increase interest rates to affect hot money flows

remove protectionist policies:
- e.g reduce tariffs
- however, could be job losses in uncompetitive industries and other reasons country may want to protect (e.g retaliation)