4.5 Exchange Rates

Question 1

What is a “Floating” exchange rate?

Answer 1

A type of exchange rate system where the market forces of supply and demand determine the exchange rate

Question 2

What is appreciation and what causes it?

Answer 2

An increase in the value of a currency. Caused by an increase in demand or a decrease in supply.

Question 3

What is depreciation and what causes it?

Answer 3

A decrease in the value of a currency. Caused by a decrease in demand or an increase in supply.

Question 4

What are some factors that increase currency demand (leading to appreciation)?

Answer 4

• Increase in foreign demand for exports of g+s
• Lower inflation leading to increase in foreign demand for exports
• Increase in inward investment
• Higher interest rates leading to more inward financial investment

Question 5

What are some factors that decrease currency demand (leading to depreciation)?

Answer 5

• Decrease in foreign demand for exports of g+s
• Higher inflation leading to a decrease in foreign demand for exports
• Decrease in inward investment
• Lower interest rates leading to less inward financial investment

Question 6

What are some factors that decrease currency supply (leading to appreciation)?

Answer 6

• Decrease in domestic demand for imports of g+s
• Lower inflation leading to a decrease in domestic demand for imports
• Decrease in outward investment
• Higher interest rates leading to less financial investment by domestic residents in foreign countries

Question 7

What are some factors that increase currency supply (leading to depreciation)?

Answer 7

• Increase in domestic demand for imports of g+s
• Higher inflation leading to an increase in domestic demand for imports
• Increase in outward investment
• Lower interest rates leading to more financial investment by domestic residents in foreign countries
• Increase in outflow of remittances

Question 8

What is the impact of APPRECIATION on “Economic Growth”?

Answer 8

Net exports decrease, causing a left shift in AD (as exports become more expensive, and the incentive to import is greater! X fall, M increase, (X-M) falls!)
Negative economic growth

HOWEVER,
Whether it’s good or bad depends on the stage of the business cycle:
- INFLATIONARY GAPS - this is good! fall in AD reduces inflationary pressure

Question 9

What is the impact of APPRECIATION on “Unemployed”?

Answer 9

AD falls, increase in unemployment

HOWEVER,
Wages may have a tendency to fall as demand for the labour decreases,
this could lead to a fall in costs of production, and therefore labour intensive industries will have access to cheaper labour (AS shifts outwards)

Question 10

What is the impact of APPRECIATION on “Inflation”?

Answer 10

Inflation is controlled as AD is falling (demand pull inflation falls)

HOWEVER,
The threat of the deflation is based on the business cycle

Question 11

What is the impact of APPRECIATION on “Living Standard”?

Answer 11

Increase in living standards of living,
AD decreases, cost of living decreases, imports increase

Question 12

What is the impact of APPRECIATION on “Indebtedness”?

Answer 12

Indebtedness falls, less domestic currency is needed to pay the same debt

Question 13

What is the impact of DEPRECIATION on “Economic Growth”?

Answer 13

Depreciation reduces the incentive for consumers to import, whereas foreign countries are more likely to import as the products become cheaper to buy,
therefore X increases, M falls, and (X-M) Increases, causing an AD shift and thus economic growth.

HOWEVER,
Economic growth depends on how reliant an economy is on imports. As imports become more expensive, if an economy heavily relies on imports, they will have to keep importing,
this causes M to increases and will decrease the net exports, potentially causing a fall in economic growth.

Question 14

What is the impact of DEPRECIATION on “Unemployment”?

Answer 14

Due to an outward shift in AD, the rate of unemployment decreases. Cyclical unemployment decreases due to economic growth

HOWEVER,
Due to higher inflation some companies may be incentivized to move geographic locations increasing structural unemployment

Question 15

What is the impact of DEPRECIATION on “Inflation”?

Answer 15

Due to the outward shift in demand the price level increases, so an increase in inflation (demand-pull) inflation occurs

HOWEVER,
If there is a lot of spare capacity and unemployment in the economy, then AD can shift outward without inflation (Keynesian economics)

Question 16

What is the impact of DEPRECIATION on “Living Standard”?

Answer 16

Because inflation increases, the purchasing power of the consumer within the economy falls. Furthermore, the price of imports rise and they switch to domestic producers which leads to limited choice.

HOWEVER,
Living standard of those who were unemployed may increase as they are no longer dependent on government benefits and are employed

Question 17

What is the impact of DEPRECIATION on “Indebtedness”?

Answer 17

Debts in foreign countries require more domestic currency to be paid off.