Weak Exchange Rate

Question 1

State + explain the macro effects of a weak exchange rate.

Answer 1

• Current Account: weak exchange rate - makes M dearer + X cheaper - improves CA balance.
• Growth: if increased (X - M) see higher AD - higher growth.
• Unemployment: low cyclical unemployment - due to higher AD.
• Inflation: demand-pull inflation + cost-push inflation - M dearer - more expensive for firms to import raw materials - drives up CoPs.
• Inward FDI: foreign firms may see this as a good time to I in country if exchange rate is weak, due to start up C being low + when country does set up - will be able to tap into benefits of weak exchange rate to boost X.

Question 2

State + explain the micro effects of a weak exchange rate.

Answer 2

• Higher Costs For Firms + Lower Profits: higher CoPs for firms who M raw materials - lower profit, reduced I, higher P.
• Inefficiency: domestic firms may become inefficient / complacent due to weak exchange rate + diminishing competition - provided that weak exchange rate prevails for a long time.
• Foreign Debt Burdens: for firms + gov who have debt to buy in foregin currency - weak exchange rate makes debt harder to service.

Question 3

State + explain the macro factors that weaken a currency.

Answer 3

• Current Account Deficit: M expenditure is greater than X revenue - implies more S for a currency than D for it - downward pressure on exchange rate. Also, CA deficit that’s wildly unsustainable can mean panic selling of currency - weakening currency.
• Poor Macroperformance: low growth, high unemployment, high rates of inflation, poor state of gov finances. Leads to panic selling of currency due to lack of confidence in how country is doing.
• Lower Interest Rates: provides hot money outflows.
• Quantitative Easing: direct increase in money supply - weakens exchange rate.
• Outward Direct Investment: as firms leave country - sell currency + convert to currency’s they’re moving to - weakening exchange rate.
• Speculation: speculation in FOREX markets that currency will fall - infers sell it now + buy it back if speculators are correct - weakens currency.

Question 4

State + explain the micro factors that weaken a currency.

Answer 4

• Lower Export Demand: lower incomes abroad, movement away in fashion / tastes , etc. Means lower D for currency - weakening it.
• Higher Import Demand: buying in foreign currency - increasing S of domestic currency - weakening value.