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
negative consequences of a currency appreciation
- 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
- 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. - 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. - 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
benefits of a currency appreciation
- 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. - 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. - 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.
benefits of a depreciation
- 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.
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.
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