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Highers Economics The sterling exchange rate Does a fall in the pound matter? The sterling exchange rate Does a fall in the pound matter?

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Presentation on theme: "Highers Economics The sterling exchange rate Does a fall in the pound matter? The sterling exchange rate Does a fall in the pound matter?"— Presentation transcript:

1 Highers Economics The sterling exchange rate Does a fall in the pound matter? The sterling exchange rate Does a fall in the pound matter?

2 What’s been happening? A brief history What’s been happening? A brief history

3 Background –Flexible and fixed exchange rates –Depreciation and appreciation –Devaluation and revaluation The sterling exchange rate –Multiple exchange rates –Exchange rate index Long-term movements Background –Flexible and fixed exchange rates –Depreciation and appreciation –Devaluation and revaluation The sterling exchange rate –Multiple exchange rates –Exchange rate index Long-term movements

4 $ / £ $ / £ exchange rate and £ exchange rate index: 1976–2009

5 $ / £ $ / £ exchange rate and £ exchange rate index: 1976–2009

6 $ / £ Index 2005=100 $ / £ exchange rate and £ exchange rate index: 1976–2009

7 $ / £ Index 2005=100 $ / £ exchange rate and £ exchange rate index: 1976–2009

8 Background The sterling exchange rate Long-term movements Long-term movements between dollar and euro Background The sterling exchange rate Long-term movements Long-term movements between dollar and euro A brief history

9 Fluctuations between the euro and the dollar

10 Background The sterling exchange rate Long-term movements Long-term movements between dollar and euro The fall in the pound: 2008–9 Background The sterling exchange rate Long-term movements Long-term movements between dollar and euro The fall in the pound: 2008–9 A brief history

11 Depreciating sterling 2008–9 Source: based on data in Statistical Interactive Database (Bank of England )

12 Depreciating sterling 2008–9 Source: based on data in Statistical Interactive Database (Bank of England )

13 Depreciating sterling 2008–9 Source: based on data in Statistical Interactive Database (Bank of England )

14 What causes the exchange rate to rise or fall? A tale of demand and supply What causes the exchange rate to rise or fall? A tale of demand and supply

15 Exchange Rates Determination of exchange rates –the equilibrium exchange rate Determination of exchange rates –the equilibrium exchange rate

16 $ price of £ Q of £ Determination of the rate of exchange

17 $ price of £ D by USA Q of £ Determination of the rate of exchange

18 $ price of £ QSQS S by UK Q of £ D by USA QDQD ba Excess supply of pounds leads to a depreciation. Determination of the rate of exchange

19 QSQS QDQD d $ price of £ S by UK Q of £ c D by USA Shortage of pounds leads to an appreciation. Determination of the rate of exchange

20 Exchange Rates Determination of exchange rates –the equilibrium exchange rate Determination of exchange rates –the equilibrium exchange rate –what causes a depreciation? shifts in currency demand and supply –what causes a depreciation? shifts in currency demand and supply

21 € / £ S1S1 D1D1 Floating exchange rates: movement to a new equilibrium Q of £

22 € / £ S1S1 D1D1 D2D2 Q of £ Floating exchange rates: movement to a new equilibrium

23 € / £ S1S1 D1D1 S2S2 D2D2 Q of £ Floating exchange rates: movement to a new equilibrium

24 Exchange Rates Exchange rates & the balance of payments –Current account Exports (+) and Imports (–) Government transfers: inward (+); outward (–) Income flows: inward (+); outward (–) –Capital account –Financial account Direct investment: inward (+); outward (–) Portfolio investment: inward (+); outward (–) Other financial flows: inward (+); outward (–) Reserves: drawing on (+); building (–) –Net errors and omissions Exchange rates & the balance of payments –Current account Exports (+) and Imports (–) Government transfers: inward (+); outward (–) Income flows: inward (+); outward (–) –Capital account –Financial account Direct investment: inward (+); outward (–) Portfolio investment: inward (+); outward (–) Other financial flows: inward (+); outward (–) Reserves: drawing on (+); building (–) –Net errors and omissions

25 € / £ S1S1 D1D1 Q of £ Floating exchange rates: movement to a new equilibrium Supply = B of P –ve items Demand= B of P +ve items

26 € / £ S1S1 D1D1 S2S2 D2D2 Q of £ Floating exchange rates: movement to a new equilibrium Supply = B of P –ve items Demand= B of P +ve items

27 UK Balance of Payments Source: Based on Times Series Data (National Statistics)

28 Exchange Rates Exchange rates & the balance of payments Causes of a depreciation

29 € / £ S1S1 D1D1 S2S2 D2D2 Q of £ Causes of a depreciation rise in aggregate demand fall in interest rate change in inflation rate inward investment less attractive speculation against depreciation

30 Why did the exchange rate fall last year and into this? Was it the credit crunch? Why did the exchange rate fall last year and into this? Was it the credit crunch?

31 Causes of the falling pound Credit crunch worse in UK than in many other countries –Financial services sector larger in the UK than elsewhere Potential detrimental effect on services part of current account –Recession potentially deeper Interest rates fell further in the UK Interest rates would remain lower in the UK for longer Credit crunch worse in UK than in many other countries –Financial services sector larger in the UK than elsewhere Potential detrimental effect on services part of current account –Recession potentially deeper Interest rates fell further in the UK Interest rates would remain lower in the UK for longer

32 Central bank interest rates

33 Causes of the falling pound The carry trade

34 The Carry Trade Borrowing at low interest rates and then using it to buy assets that earn higher rates. In foreign exchange markets, the carry trade involves borrowing money in a currency of a country where interest rates are low and exchanging it for another currency where the country pays higher interest rates.

35 Causes of the falling pound The carry trade –UK has had long-term current account deficits Thus relatively high interest rates –Other countries, e.g. Japan and Switzerland, have had current account surpluses Thus relatively low interest rates –People borrowed from Japan and deposited in the UK, pushing the £ up and the ¥ down This made the UK’s current account deficit worse! –UK has had long-term current account deficits Thus relatively high interest rates –Other countries, e.g. Japan and Switzerland, have had current account surpluses Thus relatively low interest rates –People borrowed from Japan and deposited in the UK, pushing the £ up and the ¥ down This made the UK’s current account deficit worse!

36 The Carry Trade Currencies of deficit countries appreciated, making their goods less competitive thereby worsening their current account deficit. Between 1996 and 2006, the average current account deficits as a % of GDP for the USA, the UK and Australia were 4.0, 1.8 and 4.4 respectively. The US dollar appreciated by 9.8 per cent, sterling by 27.7 per cent and the Australian dollar by 3.8 per cent over the same period.

37 The Carry Trade Currencies of surplus countries depreciated, making the their goods more competitive and further boosting their current account surpluses. Between 2004 and 2006, the Japanese yen depreciated by 10.4 per cent, the Swiss franc by 2.3 per cent and the Swedish krona by 4.3 per cent.

38 Causes of the falling pound The unwinding of the carry trade –Credit crunch caused sort-term financial flows to decrease –Currencies of deficit countries (e.g. UK, USA) began to depreciate Currencies of surplus countries (e.g. Japan, Switzerland) began to appreciate. –This was made worse by speculation The unwinding of the carry trade –Credit crunch caused sort-term financial flows to decrease –Currencies of deficit countries (e.g. UK, USA) began to depreciate Currencies of surplus countries (e.g. Japan, Switzerland) began to appreciate. –This was made worse by speculation

39

40 Causes of the falling pound Role of speculation –Stabilising and destabilising speculation Stabilising speculation Role of speculation –Stabilising and destabilising speculation Stabilising speculation

41 Stabilising speculation: initial depreciation er 1 Exchange rate Quantity of sterling O er 2 D2D2 a S1S1 D1D1 Speculators believe that the depreciation to er 2 is only temporary. S2S2 c S3S3 D3D3 b er 3

42 Speculation The effects of speculation –Stabilising and destabilising speculation Stabilising speculation The effects of speculation –Stabilising and destabilising speculation Stabilising speculation Destabilising speculation

43 Destabilising speculation: initial depreciation er 1 O S1S1 D1D1 D2D2 a er 2 Speculators believe that the depreciation to er 2 signifies a trend. Exchange rate Quantity of sterling S2S2 er 3 S2S2 D3D3 c b

44 Speculation The effects of speculation –Stabilising and destabilising speculation Stabilising speculation Destabilising speculation The effects of speculation –Stabilising and destabilising speculation Stabilising speculation Destabilising speculation –Overshooting

45 Depreciating sterling 2008–9 Source: based on data in Statistical Interactive Database (Bank of England )

46 Does the fall in the pound matter? A story of gainers and losers Does the fall in the pound matter? A story of gainers and losers

47 Gainers and losers Gainers –Exporters Foreign currency earnings are worth more £s Allows exporters to cut foreign currency prices to become more competitive –People with assets denominated in foreign currencies Property owners Investors People with bank accounts in foreign currencies Gainers –Exporters Foreign currency earnings are worth more £s Allows exporters to cut foreign currency prices to become more competitive –People with assets denominated in foreign currencies Property owners Investors People with bank accounts in foreign currencies

48 Gainers and losers Losers –Importers Increased price of imports Are these passed on to consumers or absorbed by importers? –People with assets denominated in sterling Foreign residents People in this country wishing to invest abroad Losers –Importers Increased price of imports Are these passed on to consumers or absorbed by importers? –People with assets denominated in sterling Foreign residents People in this country wishing to invest abroad

49 Overall effects Helps current account –Exports rise –Imports fall –Helps to aid recovery (rise in aggregate demand) Possibly inflationary Greater fluctuations –May cause greater exchange rate uncertainty –May reduce inward and outward investment Restoration of PPP exchange rate? Helps current account –Exports rise –Imports fall –Helps to aid recovery (rise in aggregate demand) Possibly inflationary Greater fluctuations –May cause greater exchange rate uncertainty –May reduce inward and outward investment Restoration of PPP exchange rate?

50 Country Big Mac prices in local currency Big Mac prices in $ at current ex ratePPP to $ Actual $ exchange rate Under(–) / over(+) valuation against $ USA$3.57 ($1 = $1) 0 UK£2.29$3.69$1 = £0.64$1 = £0.62+3% Euro Area€3.31$4.62$1 = €0.93$1 = € % SwitzerlandCHF6.5$5.98$1 = CHF1.82$1 = CHF % Mexico33 peso$2.39$1 = 9.24 peso$1 = 13.8 peso–33% China12.5 yuan$1.83$1 = 3.50 yuan$1 = 6.83 yuan–49% Bic Mac Prices (July 2009)

51 “The markets have been kindest to British exporters. A year ago the pound was overvalued by more than a quarter on the Big Mac gauge. Now it is close to its fair value against the dollar and looks cheap against the euro. That shift has upset some other EU countries that had relied on selling to spendthrift British consumers. But after years of struggling with an overvalued currency, British firms will feel they deserve a little mercy.” The Economist, July 16 th 2009

52 What of the future?

53 Interest rates –Relative recovery rates in the UK and in the USA, Eurozone and Japan If UK lags behind, relative interest rates could be lower in the UK –Public-sector debt Bank of England may have to raise Bank Rate Re-emergence of the carry trade? –Unlikely in short term –Likely to keep exchange rate low Interest rates –Relative recovery rates in the UK and in the USA, Eurozone and Japan If UK lags behind, relative interest rates could be lower in the UK –Public-sector debt Bank of England may have to raise Bank Rate Re-emergence of the carry trade? –Unlikely in short term –Likely to keep exchange rate low


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