2.4.4 Exchange rates Flashcards
exchange rates
Price of one currency in terms of another, purchasing power of one currency against anothe
ER and D/S
- Exchange rates are an important instrument of monetary policy. They are influenced by the interaction of demand and supply. (market forces)
- Demand for pounds is created by importers in foreign countries who are buying UK exports and foreign investors wh are using FDI to set up businesses here
- Supply of pounds comes from UK importers and the investors who are setting up businesses abroad, and need to buy foreign currency
- Eg if the UK is selling exports to france, they will sell euros to pay for pounds for purchase, increasing £ demand
- If the UK is purchasing imports from france, we will sell our pounds to purchase euros to pay, increasing the supply for pounds
when the SUPPLY of the pound increases
Eg min budget
- Announcement of unfunded tax cuts, led to market panic
- Traders didnt want to invest in pounds and sold £
- Supply of £ increased and exchange rate and price of P fell –> supply shifts to the right
when DEMAND of the pound increases
- Bank of england 5.25%, ECB 4%
- As the interest rate is higher, return on investment is greater in the UK
- Demand for £ increases, D shifts to the right
- Exchange rate increases
impact of exchange rates on domestic businesses
- The flexibility and variance of exchange rates creates uncertainty
- If the exchange rate rises, domestic businesses will lose competitiveness relative to imports (more foreign goods are being purchased, as the pound is stronger)
- A fall in the exchange rate makes imports more competitive (less foreign goods are being purchased, as the pound is weak in comparison)
- Selling exports in a foreign market that has an undervalued exchange rate can be a problem due to cheaper domestic competition in other countries
what happens when the pound is strong
SPICED
(strong pounds? Imports cheap, exports dear)
£1: $2
£100 → $200
$300 → £150 (dollar worth half of pound)
- Hard for UK firms to compete, as consumers think imports are cheaper/price competitive and it is hard to export as UK goods seem expensive in overseas markets
- BY HOW MUCH → time, SL/LR, elasticity, competition in a market, will consumers care if it is expensive (luxury)
what happens when the pound is weak
WPIDEC
(Weak pounds? Imports dear, exports cheap)
£1: $0.50
£100 is only worth $50
- This is good for UK firms as UK customers think imports are expensive and not price competitive
- Easier to export as UK goods seem price competitve/cheaper in overseas markets
I- T DEPENDS: does the country need a stronger currency or more exports/at home sales
international trade and ER cycle
- Strong £, SPICED
- Imports increase (M) → sell £ to buy other currencies, supply increases
- Exports decrease (X) → demand for £ decrease, as consumers are buying less British goods
- Exchange rates falls/depreciates, WPIDEC
- M decreases, fewer £ sold
- X increases, demand £ increases
- Exchange rate rises/appreciates → cyclical
interpretation of exchange rate data
- Most exchange rates float but a few are pegged → this is to enhance economic stability
- Marked exchange rates have specific reasons → a falling exchange rate implies a gain in competitiveness and a drop indiciates a drop in competitiveness
- Central banks watch exchange rates to lessen fluctuations
how to measure the effectiveness of an exchange rate
- Based on exchange rate index that shows the relative strength of a currency compared to a basket of other currencies
- Currency is valued as a weighted average of currencies of major trading partners, so it is an accurate measure of competitiveness
- This is a useful indicator of the relative strength of a currency, taking into account of all the trading partners currencies
- If the exchange rate index rises, the purchasing power of that current has risen relative to its trading partners → reduce import prices but increases imports prices
