Make clear and describe with examples to illustrate understanding J1996 (a) Explain how exchange rates are determined. [15] (b) Discuss why variations in the exchange rate have an important effect upon the economy. [10] Consider the arguments for and against the issue raised in the question This means that you can focus either on depreciation or an appreciation Aspects of economy that must be considered: economic growth, unemployment, inflation, BOP, budget etc Suggested answer: Part (a) 1. Define exchange rate. Its is the external value of one currency against that of another. 2. Show how exchange rates are determined. Exchange rates are determined by the interaction of the supply and demand of an economy’s currency. Demand for a currency arises from the following sources exports of goods and services inflows of direct and portfolio investment pure speculative demand official buying of the currency by the central bank Elaborate on each point Supply of a currency arises from the following sources imports of goods and services outflows of direct and portfolio investment speculative selling of the currency official selling of the currency by the central bank The equilibrium exchange rate is obtained where the demand curve for an economy’s currency intersects the supply curve for the currency (see diagram). 3. Explain why is the equilibrium exchange rate a stable exchange rate. 4. Explain what happen to the equilibrium exchange rate when supply or demand conditions change Important causes of changes in the exchange rate: Balance of payments deficit or surplus (net currency flow from one country to another) Changing interest rates (relative to those available elsewhere) and effect this might have on portfolio flows (i.e international investors seeking the highest rate of return on their money by shifting it into those currencies that offer attractive risk-adjusted interest rates External shocks - e.g. a change in international commodity prices (including oil) Other factors driving the exchange rate’s value: Purchasing Power Parity (PPP) If a country has a high relative inflation rate - we expect to see the exchange rate fall over time to compensate for this. Economic Growth relative to trend - impact on likely interest rate policy of domestic monetary authorities. Fast growing economies where interest rates are likely to move upwards may see their exchange rate appreciate as the speculators move in Supply-side performance of the economy - those countries with fastest long-term growth and productivity will do better in trade performance and this impacts on the exchange rate 5. Explain how exchange rates are determined in other systems (i.e. fixed and managed float). Part (b) Consider an appreciation of the currency. 1. Evaluate the effect of an appreciation on the economy in the areas of: Exchange rate and inflation An appreciation of the exchange rate helps to control cost and price inflation in the economy because: Cheaper to import raw materials, components, finished manufactured products (leading to an outward shift in SRAS shown in diagram below) – this has a direct impact on the Retail Price Index. Prices fall and inflation drops. Good for the economy if the economy is initially suffering from inflation AD AS1 AS2 However, this is bad for the economy if the economy is already facing unemployment and deficiency in aggregate demand because: Tougher for domestic companies to compete with cheaper imports – lower profit margins as businesses have to adjust (less pricing power in their markets) – lower investment, lower employment Slower growth of exports (leading to a slowdown in aggregate demand – possibly the emergence of a negative output gap where actual GDP < potential GDP) A bigger trade deficit represents a net outflow of income from the circular flow of income and spending – national income falls Exchange rate and unemployment An appreciating currency will create a strong incentive for domestic industries to upgrade themselves as firms may respond to high exchange rate by seeking productivity improvements and modernize plant and equipment. However, a higher exchange rate is detrimental because it might threaten employment in industries open to international trade Harder to export goods and services – fall in export orders might lead to plant closures, redundancies etc – use the problems faced by manufacturing industry as an example of that Fall in the relative price of imports will lead to a rise in import penetration into the domestic economy – squeezing domestic output and employment High exchange rate may dissuade some foreign firms from investing in the UK Multiplier effects arising from a fall in aggregate demand Exchange rate and the balance of payments When the exchange rate is strong and rising, we expect to see a worsening in the net balance of trade in goods and services. Increase in the relative prices / fall in the profitability of exporting overseas. Growth of exports likely to slowdown (loss of export market share – may be difficult to recover) Fall in the relative price of imported goods and services – which if consumer demand is strong will encourage a faster growth of import volumes Cheaper for businesses to import capital goods, raw materials and components (including an expansion of out-sourcing of inputs from overseas) Depending on the price elasticity demand for exports and imports, an appreciation of the exchange rate will see a widening of the trade deficit (but in the short run, when the elasticity of demand is low, the trade balance may improve (inverse J curve effect)). DISCLAIMER: This essay is meant only as a guide for students in their revision. It is NOT to be taken as the “perfect” answer and to be memorized wholly.
