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

Exchange Rates Different Types of Exchange Rate Systems Currencies matter! Changes in the external value of one currency against another can have important effects on variables such as the volume of exports and imports, domestic production, profits and jobs, the rate of inflation and international competitiveness. Movements in a currency affect both the demand and supply-side of economies deeply integrated in the world economy and open to large-scale trade and capital flows. 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…

TASK Write a news article explaining what has happened to the £, why this has happened and what the impact is going to be

Bilateral exchange rate The rate at which one currency can be converted into another

Floating 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?

Exam Practice With reference to Extract 1, analyse two reasons why the value of the real, Brazil’s currency, has appreciated. (8)

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.

Purchasing power parity

The Big Mac Index This index, devised by The Economist, calculates how many units of a local currency are needed to purchase a Big Mac. Exchange rates can then be adjusted according to how much local currency is required. http://www.economist.com/content/big-mac-index

Managed 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.

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

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 1. Avoid Currency Fluctuations. 2. Stability encourages investment. 3. Keep inflation Low.

Disadvantage of Fixed Exchange Rates 1. Conflict with other objectives. 2. Less Flexibility. 3. Join at the Wrong Rate.