Theme 4 - exchange rates

Question 1

what are exchange rates

Answer 1

the price of one currency in terms of another

Question 2

how are floating exchange rates determined

Answer 2

by demand and supply market forces

Question 3

why might a currency appreciate

Answer 3

1. increase in relative interest rates
   - eg if the UK raises its interest rates relative to the US, it becomes more attractive for investors to save in pounds rather than dollars
   - higher IR draw in hot money inflows, where investors shift funds to take advantage of higher returns
   - increased demand for pound, appreciation
2. Speculation on pound appreciation
   - speculators may anticipate a rise in the pound, perhaps due to projected economic growth or better trade
   - investors may start buying pounds, expecting the value to increase
   - increased demand in the short term can drive up the pounds value
3. increased FDI
   - an increase in FDI, eg international companies setting up facilities or buying assets,raises demand for the pound
   - when foreign investors purchase assets in the uk, they need to convert their currency into pounds, increasing its demand
4. Rises in incomes abroad
   - consumers may import more UK goods and services, demands for UK exports rises, and so does the demand for pounds, as buyers need pounds to pay for British goods and services
   - increased exports drive up demand for the pound and cause it to appreciate
5. Increase in International Competitiveness
   - Improved UK competitiveness, perhaps due to lower unit labor costs (ULC), low inflation, or increased investment in productive capacity, boosts demand for UK goods globally.
   - As UK goods become more competitively priced or higher quality, global demand for UK exports increases, which requires purchasing pounds.
   -This increased demand for pounds appreciates its value, strengthening it against the dollar.

Question 4

why might a currency depreciate

Answer 4

1. decreasing IR
   - lower IR means holding pounds become less attractive for investors
   - reduce the rate of return, hot money outflows as investors seek higher returns in other countries
   - they exchange the pound for other currencies, increasing its supply causing a depreciation
2. Speculation anticipating a pound depreciation
   - if speculators anticipate a depreciation, they may begin selling pounds in favour of more stable currencies
   - this increases supply of the pound causing it to depreciate
3. Firms moving out of the UK
   - If a firm relocated out of the UK, they may sell off assets and convert pounds to foreign currencies, reducing demand for pounds
   - a shift of business and capital out of the UK can signify lower economic growth, leading to further declines to investor confidence
   - lower business activity and capital outflows can increase supply of the pound and cause it to depreciate
4. Increase in domestic incomes
   - rising incomes may increase demand for imports
   - higher import demand increases the demand for foreign currencies while increasing the supply of pounds on the FOREX market
   - as more pounds are sold to purchase foreign currencies, the pounds value falls

Question 5

what is a fixed exchange rate

Answer 5

a system where the currency’s value is pegged to another currency or basket of currencies
- and maintained through government intervention

Question 6

if a fixed exchange rate is too strong, what does a government do

Answer 6

they sell currency reserves and buy foreign currencies, as it would increase the supply of their currency and lower their exchange rate

Question 7

if a fixed exchange rate is too weak, what does a government do eg assume UK has a fixed er

Answer 7

• they use their foreign currency reserves to buy up more of the pound, increasing demand for the pound and increases ER

Question 8

words to use when talking abt fixed exchange rate

Answer 8

devaluation
evaluation

Question 9

negative consequences of a currency appreciation

Answer 9

• lower AD, SPICED, but good for firms who import raw materials, SRAS shifts left as costs of raw materials decrease, decreasing cost push inflationary pressures

1. Lower Growth and Potential Current Account Deficit
   - An appreciation makes exports more expensive and imports cheaper for domestic consumers.
   - Higher export prices can reduce demand for UK goods abroad, while cheaper imports increase domestic consumption of foreign products.
   Impact: This can lead to a decrease in net exports , reducing aggregate demand and slowing economic growth.
2. Increased Unemployment in Export Industries
   - Export industries face reduced demand as their goods become more expensive internationally.
   - Firms in sectors like manufacturing and services that rely heavily on exports may experience falling revenues and profits due to decreased international competitiveness.
   - These firms may lay off workers or downsize to cut costs, increasing unemployment in export-focused industries, especially in regions heavily dependent on these sectors.
3. Increased Unemployment in Domestic Industries
   - Appreciation also makes imported goods cheaper for domestic consumers, increasing competition for local producers.
   - Domestic industries, particularly those producing substitutes for imported goods, may see declining sales as consumers shift towards cheaper imported alternatives.
   - Lower domestic demand for locally-produced goods can lead to job losses in affected industries, further driving up domestic unemployment and reducing output in these sectors

Question 10

benefits of a currency appreciation

Answer 10

1. Lower Inflation
   - Appreciation reduces the price of imports, which lowers overall price levels in the economy.
   - Cheaper imported goods put downward pressure on domestic prices, especially for imported raw materials, components, and finished goods.
   - Lower inflation benefits consumers, as their purchasing power increases.
2. Cheaper Imports and Increased Living Standards
   - Appreciation makes foreign goods and services more affordable, which can improve consumers’ living standards.
   - Consumers have access to a wider variety of goods at lower prices, allowing households to buy more with the same income.
   - Increased affordability of imports can improve living standards, especially for lower-income households. However, if domestic industries are outcompeted by cheaper imports, job losses in affected sectors may offset these gains.
3. Potential Efficiency Gains for Domestic Producers
   - Increased competition from cheaper imports can incentivize domestic firms to become more efficient.
   - Facing stiffer competition, firms may be driven to reduce costs, improve product quality, or increase productivity to retain market share.
   - This pressure can lead to efficiency gains, benefiting the economy in the long run. However, firms that are unable to compete may face closure, leading to short-term job losses and adjustment costs before efficiency improvements take hold.

Question 11

benefits of a depreciation

Answer 11

• Increased Employment in the Export Industry
• A depreciation in the currency makes exports cheaper and more competitive internationally.
• Foreign consumers are likely to demand more UK goods and services due to lower relative prices, increasing sales for exporters.
• As export demand rises, firms in the export sector expand, creating more jobs and reducing unemployment in this sector, which can stimulate overall economic growth.
• Increased Employment in the Domestic Industry Generally
• A weaker currency makes imported goods more expensive, leading consumers to buy more domestically produced goods as substitutes.
• Higher demand for local goods and services drives production in domestic industries, encouraging businesses to hire more workers to meet this demand.
• This shift supports job creation across various sectors, reducing overall unemployment and possibly raising wages as firms compete for labor, boosting local spending and domestic economic activity.

Question 12

drawbacks of a currency depreciation

Answer 12

• Higher Inflation (Demand-Pull and Cost-Push)
• Depreciation can lead to higher inflation through both increased import costs (cost-push) and higher aggregate demand for exports (demand-pull).
• Cost-push inflation arises as firms face higher costs for imported raw materials and components, which can lead them to raise prices to maintain profitability. At the same time, increased demand for exports raises overall demand in the economy, contributing to demand-pull inflation.
• While inflationary pressure can erode purchasing power, especially impacting low-income households, mild inflation can encourage spending and reduce the real burden of debt. However, if inflation rises too quickly, it can create instability, reducing the currency’s value further and potentially leading to a self-reinforcing depreciation cycle.

Question 13

what are purchasing power parities

Answer 13

a measure of the price of specific goods in different countries and is used to compare the absolute purchasing power of the countries’ currencies

Question 14

why is the real exchange rate useful for economists

Answer 14

because it actually takes into account changes of costs and prices

Question 15

what does the real exchange rate tell us

Answer 15

the purchasing power parities between 2 countries

Question 16

in theory, if exchange rates are over/undervalued, what should happen

Answer 16

floating - they should self adjust to reflect PPPs - eg if the dollar is overvalued in comparison to the pound, US citizens may spend more on imports and the pound would appreciate and self adjusy
fixed

Question 17

in reality, what happens to an over/undervalued currency

Answer 17

speculation -
- Traders in foreign exchange markets anticipate adjustments in overvalued or undervalued currencies.
- If a currency is seen as overvalued, speculators may sell it in anticipation of a fall in its value. Conversely, if a currency is undervalued, speculators might buy it expecting an appreciation.
- This speculative trading exerts pressure on the currency to correct toward its true value, leading to a potential depreciation for overvalued currencies or an appreciation for undervalued ones.

Question 18

how do economists see if currencies are reflecting purchasing power parities or not

Answer 18

by using the big mac index
- The price of a Big Mac is noted in the local currency in each country.
- Usually, the U.S. dollar is used as the base currency. The local price of a Big Mac is then compared to its price in the U.S.
- If the price of a Big Mac is higher than in the U.S. (after converting to USD), the currency is considered overvalued.
If it is lower, the currency is undervalued.

Question 19

advantages of a floating exchange rate

Answer 19

1. No need for currency reserves
   - eliminates the need for governments to hold large reserves of foreign currencies.
   - In a fixed exchange rate system, governments must maintain reserves to manage the currency’s value.
   - With floating rates, the currency’s value is determined by market forces, reducing reliance on reserves.
   - This saves financial resources for other public spending priorities or investments, enhancing economic efficiency.
2. Freedom for domestic monetary policy
   - Floating exchange rates allow countries to freely use monetary policy to achieve domestic objectives like controlling inflation or supporting growth.
   - Central banks in a floating rate regime can adjust interest rates without worrying about maintaining a currency peg, which might otherwise conflict with local economic goals.
   - Greater flexibility in monetary policy supports economic stability by allowing governments to address domestic needs directly.
3. Partial automatic correction for a current account deficit
   - A floating exchange rate can help correct a current account deficit.
   - A country with a deficit will likely see its currency depreciate, making exports more competitive and imports more expensive.
   - Over time, this can improve the balance of trade by reducing the deficit, helping to bring the current account back into equilibrium. UNLIKELY
4. Reduced risk of currency speculation
   - A floating exchange rate reduces the incentive for speculative attacks on the currency.
   - In a fixed exchange rate system, speculators might buy or sell a currency in large amounts to profit from expected changes in the peg. However, in a floating system, the value is market-driven and can adjust more naturally, reducing speculation.
   - This leads to greater financial stability by reducing the likelihood of sudden currency crises, especially in emerging markets with open economies.

Question 20

disadvantages of floating exchange rate

Answer 20

• Floating exchange rates can lead to high levels of currency volatility.
• Since the value of a currency is determined by market forces, exchange rates can fluctuate significantly in response to changes in investor sentiment, speculation, or external shocks. This is especially true during times of economic instability or uncertainty.
• Exchange rate volatility can create uncertainty for businesses, particularly exporters and importers, as they face unpredictable costs and revenues. This can discourage trade and investment and lead to potential losses on international transactions.

2. Self-Correction of Trade Deficits is Unlikely
   - Floating exchange rates do not guarantee self-correction of trade deficits.
   - Although theory suggests that a currency should depreciate in response to a trade deficit, boosting exports and reducing imports, this effect may be limited by factors like speculation, capital flows, and investor confidence. Often, these external factors have a stronger influence on currency demand and supply than trade alone.
   - Persistent trade deficits can continue, as currency depreciation may not adequately address the root causes of the imbalance. As a result, the economy may still face issues such as increased debt, dependence on foreign investment, or reduced foreign reserves, affecting long-term economic stability.

Question 21

disadvantages of a fixed exchange rate

Answer 21

1. Interest Rate Constraints
   - Fixed exchange rates limit a country’s ability to adjust interest rates freely.
   - Maintaining a fixed rate often requires aligning domestic interest rates with the currency’s value, even if those rates conflict with other macroeconomic objectives.
   - Interest rate rigidity can hinder a government’s ability to manage inflation, employment, and growth targets, creating economic imbalances.
2. High Foreign Currency Reserve Requirements
   - Fixed systems require maintaining substantial reserves of foreign currency to defend the exchange rate.
   - The central bank needs these reserves to buy or sell its own currency as necessary, ensuring the fixed rate holds against market pressures.
   - Accumulating and managing large reserves can be costly, tying up resources that could otherwise support domestic economic development.
3. Risk of Speculative Attacks
   - Fixed exchange rates are vulnerable to speculation if the rate diverges too much from market expectations.
   - If speculators believe the fixed rate is unsustainable, they may sell the currency in anticipation of a devaluation, leading to sharp declines in reserves and eventual currency devaluation.
   - Speculative attacks can destabilize the economy, as seen in currency crises, leading to lost reserves and reduced investor confidence in the economy’s stability.

Question 22

advantages of a fixed exchange rate

Answer 22

1. Decreased Exchange Rate Uncertainty
   - Fixed exchange rates provide greater stability and predictability in international trade and investment.
   - Businesses and investors can rely on stable currency values, which reduces the risks associated with exchange rate fluctuations.
   - This stability encourages more cross-border trade and investment, as firms and investors are more confident in long-term commitments.
2. Some Flexibility Permitted
   - Fixed systems often allow for limited adjustments (e.g., revaluations or devaluations).
   - This managed flexibility enables a country to make adjustments in response to extreme economic pressures without fully abandoning the fixed rate system.
   - These adjustments help stabilize the economy in response to major economic shifts, providing a balance between stability and adaptability.
3. Reduction in Trade Costs (Less Hedging Needed)
   - Fixed rates reduce the need for businesses to hedge against exchange rate risks.
   - By eliminating the costs associated with exchange rate insurance (hedging), firms save on transaction costs and complexity.
   - Lower hedging costs reduce overall trade costs, benefiting businesses and promoting greater international trade.
4. Discipline on Domestic Producers
   - Fixed exchange rates impose a level of discipline on domestic economic policy.
   - Since governments aim to maintain the fixed rate, they are encouraged to pursue policies that control inflation and maintain competitiveness.
   - This can help avoid excessive inflation, benefiting consumers and promoting long-term economic stability.

Question 23

what does the marshall lerner condition state

Answer 23

• that a currency depreciation will only correct a current account deficit if the ped of imports + ped of imports = 1

Question 24

explain the marshall lerner condition

Answer 24

• For the Marshall-Lerner Condition to hold, the demand for exports needs to be elastic, meaning foreign buyers are responsive to the lower prices. For instance, if the UK’s pound depreciates against the dollar, UK exports must increase in volume significantly to offset any price drop in foreign currency terms.
• On the import side, domestic consumers need to cut back significantly on imported goods due to their higher prices. This responsiveness, or elasticity, in reducing import volume is crucial to reduce overall import expenditure.
• In reality, if a country’s exports consist of goods with low elasticity (e.g., essential goods like raw materials or unique luxury items), depreciation might not lead to significantly higher export volumes. Similarly, if imports are essential (like energy), people may still buy them despite higher costs, causing the trade deficit to persist or worsen.

Question 25

what is the j curve

Answer 25

The J-curve describes how a country’s trade balance typically worsens before it improves following a currency depreciation.

Question 26

explain the J curve

Answer 26

• Following a depreciation, imports become more expensive in domestic currency terms, and exports become cheaper for foreign buyers.
• In the short term, contracts and purchasing agreements often lock in prices, meaning that consumers and businesses cannot quickly change their volume of imports and exports. As a result, the value of imports rises immediately (due to higher import prices), while export quantities may not increase right away. This initially worsens the trade balance.
• Over time, as consumers and businesses respond to price changes, demand begins to adjust. Foreign buyers start purchasing more of the country’s now-cheaper exports, increasing export volumes. Meanwhile, domestic consumers and firms start cutting back on more expensive imports, shifting to locally produced goods or alternatives.