Reflective exercise: an increase in the exchange rate – always good news?
1
Scenario
‘The pound has improved today on the foreign exchange market’ is a common
media comment when the pound sterling appreciates. This exercise explores
whether if the pound appreciates it is always good news for industry and the
economy.
Throughout this exercise we consider changes form the point of view of the £. An
increase/rise in the exchange rate is, for example, going from £1:1.4€ to £1:1.6€.
Section 1: Setting the framework for investigating this question
A
a
b
c
d
Tick however many of the following you think are correct
A company in Germany charges €10 for its good. If the
exchange rate increases from £1:€1.3 to £1:€1.5 this will make this
good more expensive in England and reduce the demand for the
good.
A company in Germany charges €10 for its good. If the
exchange rate increases from £1:€1.3 to £1:€1.5 this will make this
good less expensive in England and increase demand for the
good.
A company in the UK charges £10 for its good. If the exchange
rate increases from £1:€1.3 to £1:€1.5 this will make this good less
expensive in Europe and increase demand for the good.
A company in the UK charges £10 for its good. If the exchange
rate increases from £1:€1.3 to £1:€1.5 this will make this good more
expensive in Europe and reduce demand for the good.
feedback page 4
B Which of the following are true?
Tick however many of the following you think are correct
a
In macroeconomic models we are concerned with the quantity
of exports and imports.
b
In macroeconomic economic models we are concerned with the
export revenue and import expenditure (i.e. price x quantity).
c
If the exchange rate rises export revenue falls and import
expenditure rises.
d
If the exchange rate rises import expenditure rises but export
revenue can rise or fall.
e
If the exchange rate rises export revenue rises but import
expenditure can rise or fall.
feedback page 4
Copyright: Embedding Threshold Concepts Project
26/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective exercise: an increase in the exchange rate – always good news?
2
C Tick however many of the following you think are correct
Hint: You need to consider a relevant macroeconomic model.
a
If the economy is in recession, with high levels of unemployment,
the increase in the exchange rate is likely to make this worse.
b
An increase in the exchange rate can be expected to improve
the situation if the economy has high levels of unemployment.
c
If the economy is booming, with increasing inflation, the increase
in the exchange rate is likely to make this worse.
d
If the economy has high inflation the increase in the exchange
rate is likely to improve the situation.
feedback page 5 or 6
D
a
b
c
d
e
Tick however many of the following you think appropriate
The UK inflation is 2% per year, while Euroland is inflating on
average by 5% over the same period. If the exchange rate rises
by 3% over the same period this will reduce the demand for UK
exports.
The UK inflation is 2% per year, while Euroland is inflating on
average by 5% over the same period. If the exchange rate rises
by 3% over the same period this will increase the demand for UK
exports.
The UK inflation is 2% per year, while Euroland is inflating on
average by 5% over the same period. If the exchange rate rises
by 3% this will have no effect on the demand for UK exports.
If UK inflation is lower than that of our trading partners, in the long
run we would expect the £:€ exchange rate to rise.
If UK inflation is lower than that of our trading partners, in the long
run we would expect the £:€ exchange rate to fall.
feedback page 5 or 6
Copyright: Embedding Threshold Concepts Project
26/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective exercise: an increase in the exchange rate – always good news?
3
Section 2: ‘The pound has improved today on the foreign exchange market’ is
a common media comment when the pound sterling appreciates. Is the
appreciation of the pound always good news for industry and the economy?
Use what we have covered in section 1 in answering this question. Draw a diagram
to show the economic model behind your answer.
------------------------------------------------------------------------------------------------Your answer…
You can continue your answer on another sheet if needed…
feedback page 7
Copyright: Embedding Threshold Concepts Project
26/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective exercise: an increase in the exchange rate – always good news?
4
Feedback Section 1: Setting the framework
A
The answer is best considered by using a small amount of arithmetic. It is important
always with exchange rates carefully to work out which currency is important for
which decisions. The table below gives the information from the question and then
works out the price in the other currency (£s for imports and €s for exports). The
appreciation changes the incentives to buy goods from home and abroad. It will
make imports less expensive in England and increase demand: (b) is correct. For
exports the appreciation will make the good more expensive abroad and reduce
the demand for the good: (d) is correct.
Effect of appreciation on quantity sold of goods
Imports
Exports
ER
Price €s
Price £s
Price £s
Price €s
£1: €1.3
€10
£7.69
£10
€13
£1: €1.5
€10
£6.66
£10
€15
Result
Lower price, Higher demand
Higher price, Lower demand
B
In macroeconomic models (such as the circular flow of income,
income/expenditure and AS/AD models we are concerned with expenditures, so (b)
is correct not (a).
To consider (c), (d) and (e) we have to consider what happens to expenditures in
£s. For exports it is simple, since the price stays the same (or goes down a little if
exporters try to keep up sales) and quantity goes down, the revenue must fall. But
for imports it is more complicated. The quantity increases, but the price in £s goes
down. This means import expenditure can rise or fall: thus (e) is correct.
However, for simplicity we will assume for the rest of this exercise that the import
expenditure rises.
Copyright: Embedding Threshold Concepts Project
26/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective exercise: an increase in the exchange rate – always good news?
5
Feedback Section 1 (cont) Intermediate
C
As we have seen in the earlier parts, an appreciation of the exchange rate leads to
a fall in export revenue and may increase import revenue. If the economy is in
recession this further reduces aggregate expenditure (aggregate demand) in the
economy as injections fall and withdrawals rise (and there will be a multiplier effect
that increases the effect). Output and employment will be reduced. The recession
deepens as in diagram (i): thus (a) is correct. If the economy is booming, with
increasing inflation, the decrease in aggregate demand will help reduce the
inflationary pressure (as in diagram (ii)): (d) is correct.
Diagram 1: expenditure changes
E
E=Y
E1 is the original level of expenditure
E2 includes the decrease in exports
and increase in imports
YF is full employment level
E
E=Y
E1
E1
E2
Y2
Y1 YF
Y
E2
YF Y2
Y1
(i) Economy in recession
(ii) Economy with inflation
Deflationary gap increased
Inflationary gap reduced
Y
D
Here we have to work out the overall effect on prices by examining the relative
inflation rates and then the exchange rate change.
UK
Euro
Relative
Exchange rate
Overall
inflation
inflation
inflation
change (£:€)
2%↑
5%↑
3%↑ (5-2) 3%↑
No change
The prices in Euroland are going up by 3% more per annum than in the UK. Other
things being equal this means UK exports are becoming relatively cheaper. If
nothing happens to the exchange rate UK exports have become more competitive
and more will be sold. If, however, the exchange rate appreciates by 3% this will
increase the price of UK exports to compensate for the inflation differential: thus (c)
is correct.
(d) is also correct and we can approach this through demand and supply analysis.
If our inflation rate is lower than our competitors, this will increase the demand for our
exports which will increase the demand for £s. It will also decrease the demand for
imports, which will probably reduce the supply of pounds. This, other things being
constant, will increase the exchange rate.
Copyright: Embedding Threshold Concepts Project
26/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective exercise: an increase in the exchange rate – always good news?
6
Feedback Section 1 (cont) Basic
C
Circular Flow of Income
Exports Down
Less Injections
Imports Up
More Withdrawals
S
T
Fall in consumption
I
G
Firms
Households
Fall in income
The increase in the exchange rates leads to:
• less exports, which is an injection. This lowers incomes as jobs are lost in
companies that export and this reduces consumption
• more imports, which is a withdrawal. This also leads to less consumption as
disposable incomes fall.
There is a multiplier effect with the reduction in consumption.
If the economy is already in recession this will deepen it. Thus (a) is correct.
If the economy is booming, with increasing inflation, the decrease in
aggregate demand will help reduce the inflationary pressure. Thus (d) is also
correct.
D
Here we have to work out the overall effect on prices by examining the relative
inflation rates and then the exchange rate change.
UK
Euro
Relative
Exchange rate
Overall
inflation
inflation
inflation
change (£:€)
2%↑
5%↑
3%↑ (5-3) 3%↑
No change
The prices in Euroland are going up by 3% more per annum than in the UK. Other
things being equal this means UK exports are becoming relatively cheaper. If
nothing happens to the exchange rate UK exports have become more competitive
and more will be sold. If, however, the exchange rate appreciates by 3% this will
increase the price of UK exports to compensate for the inflation differential: thus (c)
is correct.
(d) is also correct and we can approach this through demand and supply analysis.
If our inflation rate is lower than our competitors, this will increase the demand for our
exports which will increase the demand for £s. It will also decrease the demand for
imports, which will probably reduce the supply of pounds. This, other things being
constant, will increase the exchange rate.
Copyright: Embedding Threshold Concepts Project
26/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective exercise: an increase in the exchange rate – always good news?
7
Feedback Section 2: The approach of economics
What is the effect on exports and imports?
The immediate effect is, other things being constant, that UK companies will find it
harder to export and face stiffer import competition. The easiest way to explain this
is if we assume the exporter charges the same price in pounds as we did in 1A. The
appreciation of the exchange rate will increase the foreign price of exports,
reducing demand. The exporter’s revenue falls. On the other hand, UK consumers
will find imports cheaper and buy more (though as we mentioned in 1B the total
amount paid for imports may decline – we will continue to assume (as we did there)
that demand is elastic and import expenditure increases for simplicity).
What is the effect on the economy?
In examining the macroeconomic economy, we should not simply assume that
other things are constant as there are important ‘knock-on’ effects. Importantly,
decreases in exports and increases in imports will decrease aggregate demand as
we considered in section 1B. If the economy is already in recession this will damage
the situation further, reducing output and employment (with a multiplier effect). If
however, the economy is booming, the reduction in aggregate demand will help
reduce the inflationary pressures. The diagram in section 1C applies here.
How does inflation affect the situation?
Initially, we were ignoring any effect of inflation on export and import prices.
However, prices may already be changing through inflation as we explored in
section 1C. Indeed, the appreciation of the £ may be the result of inflation in the UK
being lower than in our trading partners. If the appreciation did not take place, UK
exporters would become more competitive as their prices would be lower abroad.
The rise in the exchange rate may simply maintain the real exchange rate, which is
the exchange rate adjusted for inflation differentials. The concept of purchasing
power parity suggests that in the long run we can expect prices, at least of traded
goods, to be on average the same in different countries when translated through
the exchange rate to a common currency.
So, in summary, what is our answer to the question?
There is no simple answer to whether an appreciation is good news. From an
exporter’s view the immediate effect is bad; while from the consumer’s view it is
good as imported goods have lower prices. Looking at it from a wider
macroeconomic perspective, it depends on whether the economy is in a recession
(when it is bad) or suffering from inflation (when it is good), and whether it takes us
closer to the purchasing power parity rate or away from it.
Reflection
1.
2.
Yes
Partly
No
Do you understand why a fall in the £ could be good
news?
Do you understand why we need to relate to a model of
the economy in answering this question?
Copyright: Embedding Threshold Concepts Project
26/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective exercise: an increase in the exchange rate – always good news?
8
Notes for lecturers
Objectives of the exercise and prerequisites
Learning Focus: The effect of exchange rate changes on imports and exports and
how these changes have different effects on the economy in different
circumstances.
Threshold Concepts that are of importance to this learning are interaction between
markets, incentives and economic modelling (particularly equilibrium).
Prior Knowledge Required
Students need to have covered a basic model of the macroeconomy and a brief
introduction to exchange rates.
In order to allow this exercise to be used with different groups of students (e.g.
business students as well as those taking an economic award), or at different
junctures in a module, the feedback is available at two levels for you to choose:
(a) for students who have only covered the circular flow of income and a
general introduction to the idea of the multiplier (labelled basic).
(b) for students who have covered the income/expenditure model (labelled
intermediate).
The second page of the feedback to section 1 differs depending on which diagram
is used.
You may prefer students to use the AD/AS model, but you will have to add your own
feedback for this.
We have explained what we mean by a ‘rise’ or ‘increase’ in the exchange rate at
the start of this exercise. However, you may want to draw students’ attention to this,
as maintaining a consistent point of view in terms of the currency/economy is
something that some students have difficulty with.
Sequencing and timing
1. The exercise is likely to take over 30 minutes if fully completed in class time.
2. The feedback to section 1 should be given to students before they attempt
section 2.
3. The exercise can be completed without the complication of considering
inflation if section D is not used. The feedback on inflation in section 2 will
need to be deleted in this case.
4. The exercise does discuss that import expenditure may fall or rise with an
increase of the exchange rate (because we have found that students are
confused between quantities, prices and expenditures). However, we do
assume for the rest of the exercise that import expenditure rises with an
increase in the exchange rate. Discussion of the Marshall–Lerner conditions
can follow on from this exercise.
Copyright: Embedding Threshold Concepts Project
26/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.