Exchange Rates Flashcards
(18 cards)
Exchange rate
The price of one currency in terms of another currency. It reflects the purchasing power that currency has abroad.
What is the impact of exchange rate changes?
If currency falls in value -> WPIDEC, therefore anything brought abroad in another currency such as consumer goods or holidays becomes more expensive
firms relying on imports for their goods -> Costs may rise, leading to higher inflation
Suppose a good is produced domestically be exported to another country with a different currency -> higher demand for your product, exports appear cheaper after appreciation
Monetary union
A group of countries that use the same currency
Depreciation
(Opposite is appreciation) refers to a fall in the value of the currency under a floating exchange rate regime
Devaluation
(Opposite: revaluation) refers to a fall in the value of the currency under a fixed exchange rate regime (decision made by the central bank or government)
Examples of depreciation
Following the Brexit vote, that is the decision to leave the European Union, the British Pound depreciated by about 10%
Following Kwasi Kwarteng’s mini-budget announcements, the British Pound depreciated to its lowest level against the US Dollar since 1985
Effects of depreciation/devaluation
Net trade improvements - WPIDEC. Deceases import demand and increases export demand. This means higher total value of next exports, so net exports rise. AD rises so real GDP grows - can generate the multiplier effect.
“Marshall Lerner” condition. It states that the effects of a depreciation depend on the PED’s of exports and imports. Specifically if the PED of exports and the PED of imports sum to one or more in absolute value, then a depreciation improves the net trade position (value of exports - val of imports).
If Net exports elastic to change in price/exchange rate - only then will val of next exports rise in response to a depreciation. Volume of net exports likely to rise, less clear whether total value of next exports will rise
Increased costs for firms
Increased business costs for firms importing inputs, firms may have inputs from abroad such as raw materials or capital equipment. A depreciation raises import costs and so the SRAS may shift left - depends on how reliant firms are on imports, if they aren’t reliant then they wont need to buy imports and can find substitutes. This may vary from industry to industry and over time e.g. Overtime may be easier to find cheaper substitutes from domestic companies
Increased costs for consumers
Increased costs for consumers that buy imports. In general because a depreciation may increase AD and decrease AS, it is likely to lead to higher inflation
Increased Government Borrowing costs
When borrowing from foreign sources - means there is a greater opportunity cost from any government borrowing - the Gov may have to give up more spending or raise taxes further, now or in the future, to cover increased borrowing. Alternatively the Gov does not have to cover increased borrowing. Depending on the level of borrowing, if borrowing is too high, this could increase interest rates on government debt and the risk of the government defaulting on its debt
Causes of depreciation
Fall of the vale of the currency matters. If the depreciation is because of a fall in the economy’s growth rate. This suggests the deprecation may reflect expectation of weakened economic performance and reduced confidence from business, consumers and investors.
Effects of depreciation
Study by the Bank of International Settlements (BIS) looked at a sample of 44 countries. It found that net trade boosts growth when the currency falls in value and vice versa (“trade effect”)
Another potential effect of a weak currency in terms of a so-called “financial effect” e.g. a weakened currency could reflect reduced confidence, harming investment and making it harder to borrow, depending on the the depreciation. Particularly for some emerging market economies, this financial effect can outweigh the trade effect.
Three main types of Exchange rate system
Floating - market forces (S and D) determine the exchange rate. The UK and the US currently have floating exchange rates.
Fixed - The Gov or central Bank sets a constant exchange rate. Saudi Arabia has a fixed exchange rate system
Managed - the exchange rate is allowed to vary within certain limits
Interventions in currency markets by central banks, such as interest rates changes or buying/selling of foreign currency, allow them to maintain a fixed or managed exchange rate
Who demands currency?
Those who buy exports or invest from abroad into the domestic economy
Who supplies Currency?
Those who need to swap their domestic currency for foreign currency to buy something abroad. E.g Importers, domestic residents investing abroad, governments borrowing in foreign currency and so on.
Central banks can buy or sell currencies in exchange for another, influencing supply and/or demand
Determinants of supply and demand for currency (IR, Inflation…)
> Interest rate domestically relative to other countries - if domestic IR increases relative to interest rates abroad, this means higher returns for international savers in the domestic economy. So these savers move their money into the domestic economy (“hot money inflows”). These savers need to demand the domestic currency to buy domestic assets, so there is a higher demand for the domestic currency, so the currency appreciates.
Higher inflation relative to other countries - if inflation is high domestically relative to other countries, export competitiveness decreases, reducing export demand and export value if export demand is sufficiently elastic. This reduces currency demand leading to deprecation.
High productivity growth relative to other countries - this is likely to reduce inflation relative to other countries, increasing export competitiveness, export demand and hence currency demand
Further Determinants of supply and demand for currency… (economic growth…)
> Economic growth relative to other countries. High economic growth may necessitate increased interest rates to control inflation. Higher IR may increase demand for domestic currency due to hot money inflows. So currency appreciates
Current account deficit/surplus - if a country has a deficit, this means there could be low export demand relative to import demand, which means reduced demand for the currency, so the currency depreciates.
Net investment flows. If there are increased investment inflows into the economy from abroad, this increases demand for the currency
Central banks selling or buying foreign currency - say it sells foreign currency in exchange for demanding domestic currency, this boosts demand for domestic currency and leads to appreciation. This is one way in which central banks can control exchange rate in a fixed or managed exchange rate regime.
Even Further Determinants of Supply and demand for Currency (debt…)
> Risk of Government debt default. If investors believe the government is likely to default, investors sell domestic bonds and in doing so reduce their demand for the currency needed to sell bonds (or increase supply of currency). This means a depreciation in the value of the currency
Expectations about future exchange rates (“speculation”). If traders think the currency is likely to appreciate in the future, traders may buy currency today in order to make a profit. This increases demand for the currency today and may lead to an appreciation today
