Theme 4 - exchange rates Flashcards
what are exchange rates
the price of one currency in terms of another
how are floating exchange rates determined
by demand and supply market forces
why might a currency appreciate
- 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 - 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 - 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 - 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 - 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.
why might a currency depreciate
- 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 - 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 - 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 - 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
what is a fixed exchange rate
a system where the currency’s value is pegged to another currency or basket of currencies
- and maintained through government intervention
if a fixed exchange rate is too strong, what does a government do
they sell currency reserves and buy foreign currencies, as it would increase the supply of their currency and lower their exchange rate
if a fixed exchange rate is too weak, what does a government do eg assume UK has a fixed er
- they use their foreign currency reserves to buy up more of the pound, increasing demand for the pound and increases ER
words to use when talking abt fixed exchange rate
devaluation
revaluation
disadvantages of a currency appreciation
Exports become more expensive
A stronger currency makes the country’s goods and services more expensive for foreign buyers.
As a result, demand for exports may decrease.
This can lead to a decline in export revenue, affecting businesses reliant on international markets.
This could harm industries like manufacturing and agriculture that depend on export demand.
Negative impact on competitiveness
An appreciation makes domestic products less competitive in the global market.
Foreign competitors’ products become cheaper in the domestic market.
This leads to reduced demand for domestically produced goods.
This can hurt the profitability of local firms and increase the risk of business closures.
Impact on tourism
A stronger currency makes it more expensive for foreign tourists to visit the country.
This reduces the number of tourists and spending in the country’s tourism industry.
Businesses in hospitality, retail, and leisure sectors may see reduced sales.
This could lead to job losses or lower income for people employed in tourism-related sectors.
Deflationary pressure
An appreciation can reduce the cost of imported goods.
This may lead to deflation or lower inflation, reducing the overall price level.
If deflation occurs, consumers may delay purchases, expecting prices to fall further.
This can reduce overall demand in the economy, potentially leading to a slowdown in economic activity.
Adverse impact on the current account
A stronger currency worsens the current account balance.
As exports fall and imports increase due to cheaper foreign goods, the trade deficit can widen.
A persistent deficit can put downward pressure on the currency in the long run, leading to more volatility.
This can affect the country’s external debt and foreign reserves, leading to potential economic instability.
benefits of a currency appreciation
- Reduced Imported Inflation
With an appreciation in the exchange rate, imported raw materials and finished goods become cheaper.
This leads to lower costs for businesses that rely on foreign inputs, reducing inflationary pressure.
As the cost of production for firms decreases, firms may pass these savings on to consumers in the form of lower prices.
This can lead to greater purchasing power for consumers, benefiting overall economic welfare.
- FDI hot money inflows
A stronger currency signals economic stability and confidence, making the country more attractive to foreign investors.
Capital inflows, both in terms of foreign direct investment (FDI) and portfolio investments, increase.
This leads to greater capital availability for domestic businesses and government projects.
The influx of capital can spur economic growth and improve infrastructure.
- Potential Efficiency Gains for Domestic Producers
A stronger currency can lead to cheaper imports, increasing the demand for foreign goods.
While this may initially worsen the trade balance, it could encourage competition and drive domestic producers to improve efficiency.
This may lead to a long-term improvement in the competitiveness of domestic industries.
As industries become more competitive, they can improve their productivity and export potential.
Imports Become Cheaper
An appreciation of the currency increases its value relative to other currencies.
This makes foreign goods and services cheaper for consumers and businesses.
The reduced cost of imports leads to lower prices for consumers and businesses.
This can boost consumer welfare and reduce inflationary pressures.
benefits of a depreciation
Increase in export competitiveness: When a country’s currency depreciates, it makes its goods and services cheaper for foreign buyers. This increases demand for exports, leading to a rise in the value of export revenue.
This leads to an increase in AD (aggregate demand).
This boosts economic growth, as higher export sales increase national income.
The increase in AD can lead to higher employment in export-driven industries, raising wages and living standards.
The increase in economic growth strengthens business confidence, leading to more investment and job creation in the long run.
Reduction in trade deficit: Depreciation makes imports more expensive, reducing demand for imported goods and services.
This leads to a reduction in the trade deficit, as the higher cost of imports encourages consumers to buy domestic products instead.
The decrease in imports helps to improve the current account balance, stabilizing the economy.
This reduction in imports allows for a greater focus on domestic industries, boosting local production and jobs.
Over time, the reduction in the trade deficit can lead to a healthier and more balanced economy.
Boost to domestic industries: As the value of a currency falls, it makes domestically produced goods and services more competitive in the international market.
This encourages firms to invest more in production and innovation to meet increasing demand.
More investments help industries grow, leading to job creation and productivity improvements.
The expansion of domestic industries contributes to higher GDP growth rates and a stronger economy.
The improvement in industrial performance can lead to increased tax revenues, which can be used to fund public services and further economic development.
Inflationary pressure reduction: A controlled depreciation can lead to increased domestic production and consumption, mitigating the risk of deflation.
While inflation might rise in the short term, depreciation can help keep the economy moving towards equilibrium by increasing domestic output.
The higher output can offset the initial inflationary pressure, as more goods and services are available to satisfy demand.
It stabilizes the economy, providing a more predictable environment for businesses to plan investments.
Increased tourism: Depreciation of the currency makes a country more attractive to foreign tourists, as their money has more purchasing power.
This leads to increased revenue in the tourism sector, stimulating local economies.
The growth in tourism encourages the development of related industries, such as hospitality and transportation.
The boost in tourism spending can create new job opportunities in the local economy, especially in regions heavily dependent on tourism.
As tourism increases, foreign investment may also rise in the sector, further boosting economic growth.
drawbacks of a currency depreciation
- 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.
- lower fdi
what are purchasing power parities
a measure of the price of specific goods in different countries and is used to compare the absolute purchasing power of the countries’ currencies
why is the real exchange rate useful for economists
because it actually takes into account changes of costs and prices
what does the real exchange rate tell us
the purchasing power parities between 2 countries
in theory, if exchange rates are over/undervalued, what should happen
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
in reality, what happens to an over/undervalued currency
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.
how do economists see if currencies are reflecting purchasing power parities or not
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.
advantages of a floating exchange rate
Automatic Adjustment to Economic Shocks
A floating exchange rate allows for automatic adjustments when there are economic shocks (like a recession or inflation).
This leads to a depreciation or appreciation of the currency.
The depreciation makes exports cheaper and imports more expensive, helping to balance trade.
This adjustment helps the economy to recover and stabilize over time.
Monetary Policy Autonomy
With a floating exchange rate, a country has more control over its own monetary policy.
The central bank can set interest rates without worrying about maintaining a fixed exchange rate.
This allows for more flexibility in responding to inflation or deflation.
It helps the central bank achieve domestic economic objectives such as growth and price stability.
Reduced Need for Foreign Currency Reserves
A floating exchange rate reduces the need for a government to hold large reserves of foreign currencies.
Since the exchange rate is determined by market forces, there is no need for constant intervention.
This allows the country to save money that would otherwise be spent on foreign exchange reserves.
This also reduces the risk of currency crises linked to the depletion of reserves.
Encourages Competitive Markets
A floating exchange rate encourages more competition by allowing market forces to determine the price of currency.
This fosters greater efficiency in international trade and investment.
Businesses and investors are incentivized to seek the most competitive prices and rates.
It helps create a more dynamic economy, as firms respond to changing exchange rates
disadvantages of floating exchange rate
Exchange Rate Volatility
Exchange rates can fluctuate significantly.
This creates uncertainty for businesses engaged in international trade.
It may discourage investment due to unpredictable costs.
Reduced stability could lead to slower economic growth and lower consumer confidence.
Inflationary Pressures
A depreciation of the currency increases the cost of imports.
Higher import prices contribute to overall inflation.
Inflation can erode the purchasing power of consumers.
It may lead to reduced consumer spending and slower economic activity.
Impact on International Competitiveness
A rising currency value can make exports more expensive.
Higher export prices reduce demand for domestically produced goods.
This could harm the country’s trade balance and lead to a larger trade deficit.
It may result in a slowdown in key export-driven sectors of the economy.
Monetary Policy Constraints
A floating exchange rate may limit a government’s ability to control domestic monetary policy.
It may lead to higher interest rates to control inflation caused by a falling currency.
Higher interest rates could stifle investment and reduce economic growth.
The central bank may have less room to maneuver in response to economic shocks.
Speculation and Short-Term Fluctuations
Speculative activities in currency markets can create short-term volatility.
Unpredictable exchange rate movements could lead to market distortions.
Firms and investors may take on higher risks due to these fluctuations.
Excessive speculation could harm long-term economic stability.
disadvantages of a fixed exchange rate
- 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. - 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. - 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.
advantages of a fixed exchange rate
- 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. - 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. - 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. - 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.
what does the marshall lerner condition state
- that a currency depreciation will only correct a current account deficit if the ped of imports + ped of imports > 1
explain the marshall lerner condition
📏 Marshall-Lerner Condition (for Depreciation to improve Current Account)
🔗 A currency depreciates, making exports cheaper and imports more expensive
🔗 Whether the current account improves depends on how responsive demand is (price elasticity)
🔗 The Marshall-Lerner Condition states that the sum of PED for exports + PED for imports must be > 1
🔗 If it is, then export revenue rises more than import spending rises, improving the current account
❌ If Marshall-Lerner Condition is Not Met
🔗 If the sum of elasticities < 1, demand for exports and imports is too inelastic
🔗 Export volumes don’t rise much and import volumes don’t fall much
🔗 Therefore, export revenue falls and import spending rises
🔗 This causes the current account to worsen, especially in the short run 📉
