Chapter 23
Pages 287-289
1.
Evaluate the possible economic consequences of
a change in the value of a currency, including the
effects on a country’s
inflation rate,
b. employment,
c. economic growth and
d. current account balance.
a.
2. Examine the possible consequences of
overvalued and undervalued currencies.
[what type of exchange rate “regime” is assumed?]
Trading partners’ currency is more expensive in the
FOREX.
 Thus their imports are more expensive.
 The good news is that this makes domestic
producers more competitive against higher priced
imported final goods.
 The bad news is that this makes imported
inputs/raw materials more expensive for those
industries that depend upon them – thus they
become more expensive and less competitive.
Domestic currency is less expensive compared to the
trading partners’ currency,
 Thus exports are less expensive for them.
 This improves our eXport (receipts) and thus these
industries will grow
 Furthermore, the world price for exports, in terms of
the domestic currency, actually increases.
Summary effect when a currency depreciates, on:
a.
b.
c.
d.
inflation rate,
employment,
economic growth and
current account balance.
Advantages
 Greater employment in export industry
 Greater employment in domestic industry
 GDP increases
 Positive effect on BoP
Disadvantages
 Cost of production increases due to more expensive
imported raw material – thus decreasing AS
 Thus cost push and Demand Pull inflation
 Long term: worsening competitiveness
 Downward pressure on inflation because…
 More unemployment because….
 Good for consumers because…
Pages 290-292
1.
“stabilises” current account deficit/surplus.
 If too many inflows/outflows in the overseas sector
occurs, this imbalance adjusts the exchange rate
automatically to counteract that change.
 But – regardless of how the CA is changing,
International flows of money in the capital account
may affect the exchange rate, and thus worsen the
current account unintentionally.
2. No need to employ monetary policy (interest
rates) nor “much” buying/selling foreign
reserves.
1. Short term volatility: fluctuations are painful
for firms due to uncertainty.
2. Ruins firms if they persist at high levels (and
depress growth).
3. If exchange rates remain too low, inflation may
“set in”
4. Smaller economies are more vulnerable to large
flows of investment funds (“hot money”) due to
speculation or fearful events.
The main advantage is predictability and certainty
for firms.
2. Any undesirable effect of low or high valuation of the
currency may be controlled.
1.

In particular, growth can be increased. How?
3. There is less risk of currency speculation
 However, if everybody knows the country doesn’t have
the foreign reserves to “prop up” the currency, it can fail
quite dramatically. How?
Loss of freedom to set monetary policy. Why?
2. Financing current deficits from foreign investment:
1.


Foreign ownership increases
Investment income outflows increase
3. Selling of foreign reserves – these can run out.
4. Imposing barriers on imports – but at what cost?
The theory of purchasing-power parity (PPP) says
that, in the long run, exchange rates should move
towards levels that equalise the prices of a basket of
goods and services in different countries—ie, a dollar
should buy the same everywhere.
Therefore, if US$1 = NZ$1.5, then a basket of goods
costing US$240 in USA should cost $NZ360 in New
Zealand.
Consider the most recent Economist Bigmac index, and
an interesting article on the Starbucks index.
Read the start of a discussion at the NY Times, and
search that newspaper for more. Here is an excerpt
from the article QE, currencies and creditors that I
have posted on my blog:
“The gut feeling that I have been expressing for a while is
that the currency set-up is unsustainable and QE only
adds to that sentiment. Can the world’s largest
economy and debtor nation follow a consistent policy
of devaluation, and thus penalising its creditors?”
Read the interesting article from the Economist Is there a
better way to organise the world’s currencies?
“American officials blame China’s refusal to allow the yuan to
rise faster. The Chinese retort that the biggest source of
distortion in the global economy is America’s ultra-loose
monetary policy—reinforced by the Federal Reserve’s
decision on November 3rd to restart “quantitative easing”,
or printing money to buy government bonds (see article)…
The underlying truth is that no one is happy with today’s
international monetary system—the set of rules, norms
and institutions that govern the world’s currencies and the
flow of capital across borders.”