Threshold Network Exercise: how is the exchange rate affected by inflation?
1
Scenario
A country has a floating exchange rate and its inflation rate is higher than its trading
partners.
Why we would expect the country’s exchange rate to depreciate?
In doing this you should:
(1) Consider an economic framework or model that you think is going to be useful.
Draw an appropriate diagram.
(2) Identify three important economic concepts from the list below you would use in
answering this question and explain why they are important in this context.
Exports
Incentives
The multiplier (cumulative causation)
Demand and supply
Withdrawals
Prices
Social costs
Imports
Supply
Scarcity
(In the list there are concepts that are irrelevant and concepts that are useful. Some are arguably
more useful than others. Although there are some ‘wrong’ answers there is not just one ‘correct’ one.
Our feedback highlights our choice of three concepts but you will find we use others on this list as well.
In making your choice try to discard the irrelevant and consider what you think is the most important
amongst the others and why.)
feedback page 2
Copyright: Embedding Threshold Concepts Project
04/09/08
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.
Threshold Network Exercise: how is the exchange rate affected by inflation?
2
Feedback
First we have to decide what economic framework, or model, to use.
We are concerned with the market for foreign exchange and how the exchange
rate, that is the price of £s in terms of another currency, is changing. Therefore
demand and supply is the appropriate framework.
Using this framework:
1. We start from an initial equilibrium. In figure 1 the initial equilibrium is at an
exchange rate of £1:$1.5 and at N1. The actual numbers are just for illustration.
2. We then consider what may be shifting and why. Here we have to consider the
effect of the inflation on demand and supply. If the UK is inflating faster relative to
our competitors:
- our exports will increase in price relative to our competitors. This leads to less
demand for our exports at the current exchange rate as there is an incentive to
switch to other providers. To pay for our exports, people abroad demand £s, so
this leads to a fall in demand for the £ (D1 to D2) on the foreign exchange market.
- our imports will decrease in price relative to home-produced goods so we will
demand a greater quantity of imports at the current exchange rate. To pay for
our imports, we demand foreign currency and this means we supply £s
(remember the graph is in £s). If import demand is elastic this will leads to an
increase in the supply of pounds (S1 to S2) on the foreign exchange market.
Figure 1: The foreign exchange market
Unlike in most markets,
in the foreign exchange
market many of the
same factors shift
demand and supply, so
that both move at
once.
↑
Appreciation
S1
Exchange rate
S2
£1:$1.5
£1:$1.4
D1
D2
N2
N4 N1
N3
Numbers of pounds (£s)
3. The shifts in the demand and supply mean that we are no longer at equilibrium at
the initial exchange rate of £1:$1.50, but there is an excess supply of N2 to N3. This
leads to a fall in the exchange rate to the new equilibrium at £1: $1.4.
Our choice of important concepts you could have identified are in bold. The
following are not useful here: the multiplier, withdrawals, social costs and scarcity.
Copyright: Embedding Threshold Concepts Project
04/09/08
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.
Threshold Network Exercise: how is the exchange rate affected by inflation?
Reflection In your explanation:
1.
Did you correctly label the axis of your diagram?
Why is this important?
2.
Did you recognise that both demand and supply
are affected?
3.
Did you shift the curves correctly?
4.
Did you use your diagram in your answer by referring
to the labelled changes?
5.
Do you understand why the inflation led initially to
shifts in the demand and supply of £s, rather than
movements along these curves, although it is the
prices of exports and imports that are changing?
Copyright: Embedding Threshold Concepts Project
Yes
3
Partly No
04/09/08
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.
Threshold Network Exercise: how is the exchange rate affected by inflation?
4
Notes for lecturers
Objectives of the exercise and prerequisites
The threshold network exercises are designed to help students recognise the
importance of economic concepts and modelling. They are concerned with how
economics uses a range of concepts (in a connected web) in answering applied
questions and getting students to recognise which concepts are important and how
they relate to each other in the specific context.
Learning Focus: Developing understanding of the workings of the foreign exchange
market and the real exchange rate. A stress is on getting the students to
appreciate the need to use an appropriate economic model.
The exercise does not draw attention to the Marshall-Lerner conditions; it purely
states that we will assume imports as elastic. We did not want to introduce this
complication, feeling the exercise was complicated enough, but you may like to
draw attention to it in developing the answer,
Threshold Concepts pivotal to this learning are economic modelling and price
incentives.
Prior Knowledge Required:
Some prior knowledge of the demand and supply of foreign exchange.
Timing
We would suggest that this exercise is likely to take students around 20 minutes to
complete. It may be undertaken individually or in groups. This timing does not allow
for any presentation by students of their findings.
Copyright: Embedding Threshold Concepts Project
04/09/08
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.