Starter: Recap… Macro effects of a currency depreciation When the pound depreciates against the US dollar It makes UK import prices RISE It makes UK export prices FALL Changes in import and export prices will affect demand Import volumes will CONTRACT Export volumes will EXPAND This will have an effect on a number of key economic indicators Domestic production Trade deficit Domestic employment

Exchange Rates Different Types of Exchange Rate Systems Currencies have important effects on economic variables such as the volume of exports and imports, domestic production, profits and jobs, the rate of inflation and international competitiveness. Different Types of Exchange Rate Systems 1 Free-floating exchange rate 2 Managed floating 3 Fixed exchange rate (fully fixed or semi-fixed) 4 Monetary Union with other countries

TASK…

1. Floating Exchange Rates Under a system of floating exchange rates, demand and supply determine the rate at which one currency exchanges for another. What factors impact the supply and demand for a currency?

When making comparisons between countries which use different currencies it is necessary to convert values, such as national income (GDP), to a common currency. This can be done it two ways: Using market exchanges rates, such as $1 = ¥200, or: Using purchasing power parities (PPPs)

Purchasing power parity The purchasing power of a currency refers to the quantity of the currency needed to purchase a given unit of a good, or common basket of goods and services. Purchasing power is clearly determined by the relative cost of living and inflation rates in different countries. Purchasing power parity means equalising the purchasing power of two currencies by taking into account these cost of living and inflation differences.

2. Managed Floating regimes Managed regimes involve a mixture of free-market forces and intervention. A recent example is the European Exchange Rate Mechanism (ERM), which operated from 1979 to 1999. In this system, currencies were kept inside an agreed band of (+/-) 2.25% for most members. This was achieved by the monetary authorities either raising or lowering interest rates, or by buying or selling currency.

Welcome Back – Revision Question Read the explanation to the left and answer the question on the right

How to influence the exchange rate… Buying and selling currency Changing the interest rate Currency controls Borrowing from IMF Devaluation and revaluation

3. Fixed Exchange Rate This occurs when the government seeks to keep the value of a currency fixed against another currency. e.g. the value of the Pound is fixed at £1 = €1.1

Advantages of Fixed Exchange Rates Avoid Currency Fluctuations. Stability encourages investment Some flexibility (occasional ‘realignments’) mean gov’t can adjust the economy Domestic producers can improve international competitiveness through  costs

Disadvantage of Fixed Exchange Rates 1. Conflict with other objectives. 2. Less Flexibility. 3. Join at the Wrong Rate. Disadvantage of Fixed Exchange Rates 1. Conflict with other objectives. To maintain a fixed level of the exchange rate may conflict with other macroeconomic objectives. · If a currency is falling below its band the government will have to intervene. It can do this by buying sterling but this is only a short term measure. · The most effective way to increase the value of a currency is to raise interest rates. This will increase hot money flows and also reduce inflationary pressures. · However higher interest rates will cause lower AD and economic growth, if the economy is growing slowly this may cause a recession and rising unemployment 2. Less Flexibility. It is difficult to respond to temporary shocks. For example an oil importer may face a balance of payments deficit if oil price increases, but in a fixed exchange rate there is little chance to devalue. 3. Join at the Wrong Rate. It is difficult to know the right rate to join at. If the rate is too high, it will make exports uncompetitive. If it is too low, it could cause inflation. 4. Current Account Imbalances. Fixed exchange rates can lead to current account imbalances. For example, an overvalued exchange rate could cause a current account deficit. See: problems of overvalued exchange rate.

Factors affecting exports and imports What happens to UK exports if the pound falls in value against other currencies UK goods would become cheaper in overseas markets. Demand will rise, and so exports would rise – improving the current account balance What happens to imports if the pound falls in value against other currencies Imported products will be more expensive, so demand will fall and so (the volume of) imports will fall But what happens to the value of imports? Are there any time lags?

Marshall Lerner Condition Following depreciation Exports prices fall, Import prices rise If the PED for exports and imports is low, a depreciation can worsen the trade balance ie Exports = price fall is blue to green on chart to top right, with loss in export earnings -> worse trade balance) If the PED for exports and imports is high, a depreciation will improve the trade balance Given certain assumptions, such as starting at balance on the trade account, the Marshall Lerner Condition states: As long as the sum of the price elasticities of demand for imports and demand for exports (in absolute value) is greater than 1, a devaluation/depreciation will improve the trade balance.

J curve – a depreciation in the currency may initially increase the current account deficit

The J Curve In the short term, a devaluation is likely to lead to a deterioration in the current account position before it starts to improve Due to the inelasticity of imports in the short term… people take a while to change their buying and the immediate effect is to increase the total spent on imports and decrease the total spent on exports

J Curve – what are the assumptions? Are there any time lags involved if a currency falls in value (depreciates)? 2 time lags: In the short term contracts will have been agreed, so the new exchange rate will not apply to all exports and imports. Some will keep existing prices for a while Demand takes time to adjust to new prices. Consumer will not instantly switch from say BMW made overseas to a Jaguar made in the UK Some firms will have already bought the foreign currency they need and so are not immediately affected

Exchange Rate effects on Inflation, Growth and Unemployment INFLATION: Stronger GBP -> Lower Inflation (and vice versa) Why? 1. Fall in Import Prices, 2. Fall in Aggregate Demand as (X-M) falls – note depends on PED for X and M (More elastic = larger change in X and M volumes) ECONOMIC GROWTH: Stronger GBP -> lower Growth Why? as volume of X falls and M increases, GDP will fall, also as X falls/M rises, UK Investment is likely to fall UNEMPLOYMENT: Stronger GBP -> higher Unemployment Why? Lower AD/Output depresses demand for workers, particularly in export sectors