Exchange Rates AQA Economics 3.2.4.1 Sterling against the US Dollar Source: Office for NaTonal StaTsTcs USD / £ (sterling) exchange rate 0.7 0.68 0.66 0.64 0.62 0.6 0.58 0.56 0.54 0.52 0.5 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr 14 14 14 14 14 14 14 14 14 14 14 14 15 15 15 15 The UK operates with a floaTng exchange rate – the external value of the currency is determined purely by market forces of supply and demand for a parTcular currency The chart shows the monthly average value for sterling against the $ Sterling against the Euro Source: Office for NaTonal StaTsTcs 0.84 0.82 Exchange rate 0.8 0.78 0.76 0.74 0.72 0.7 Jun May Apr Mar Feb Jan '15 Dec Nov '15 '15 '15 '15 '15 '14 '14 Oct '14 Sep '14 Aug Jul '14 Jun May Apr Mar Feb Jan '14 '14 '14 '14 '14 '14 '14 The chart shows the monthly average value of the £ against the Euro For example, in November 2014, one Euro bought 80 pence or expressed another way, £1 bought Euro 1.25. Fixed and Floa7ng Exchange Rates FloaTng Exchange Rates Fixed exchange Rates •  Value of currency determined purely by demand and supply •  No need for intervenTon by the central bank •  Exchange rate is pegged •  Occasional realignments e.g. usually a devaluaTon Currency Market Analysis: Higher Interest Rates Rise in interest rates Value of currency Supply P2 Currency more a`racTve for investors A`racts inflows of hot money P1 Causes outward shia in demand Demand QuanTty of currency traded Currency appreciates Currency Market Analysis: Slump in Exports Recession in trading partner Value of currency Supply Causes fall in export sales P1 Worsening of trade balance P2 Inward shia of currency demand D2 Demand QuanTty of currency traded Currency will depreciate Data on the UK Exchange Rate over recent years Sterling Exchange Rate Index Sterling v US Dollar Sterling v Euro Year Jan 2005 = 100 £1 Buys £1 Buys 2007 103.7 2.00 1.46 2008 91.1 1.85 1.26 2009 80.6 1.57 1.12 2010 80.4 1.55 1.17 2011 80.0 1.60 1.15 2012 83.0 1.59 1.23 2013 81.4 1.56 1.18 2014 87.0 1.65 1.24 2015 (May) 91.4 1.55 1.39 Source: HM-­‐Treasury Databank The Sterling Exchange Rate and UK Exports & Imports Sterling exchange rate index,
2005 = 100
Sterling Exports (RHS) Imports (RHS) 130 160 120 140 110 120 100 100 90 80 80 70 60 2003 2004 The sterling exchange rate depreciated by more than 20% during 2008. 2005 2006 2007 2008 60 40 2009 2010 2011 2012 20 2013 2014 2015 Source: Office for NaTonal StaTsTcs This chart tracks the value of the sterling exchange rate index together with an index of the volume of exports and imports of goods and services How a Lower Currency can affect Macro Objec7ves Changes in the exchange rate affects demand for exports and imports, real GDP growth, inflaTon, business profits and jobs Infla7on •  A fall in a currency leads to a rise in import prices •  Causes a rise in cost-­‐push inflaTonary pressure Export demand and trade balance •  Weaker currency makes exports cheaper overseas •  Rising export sales & a stronger trade balance Real GDP and jobs •  Rise in exports and fall in imports will increase AD •  Higher export profits is boost to the labour market Economic Effects of a Currency Deprecia7on 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 sales will CONTRACT Export sales will EXPAND This will have an effect on a number of economic indicators Domes7c produc7on ! Trade deficit " Domes7c jobs ! Will an Exchange Rate Deprecia7on improve the BoP? The diagram below shows the “J Curve effect” – it shows the 7me lags between a falling currency and an improved trade balance Trade surplus Currency depreciaTon here Trade deficit Trade deficit may grow in iniTal period aaer depreciaTon Time period aaer depreciaTon Net improvement in trade provided certain condiTons are met The Marshall Lerner Condi7on The Marshall Lerner condiTon states that a depreciaTon / devaluaTon of the exchange rate will lead to a net improvement in the trade balance provided that the sum of the price elasTcity of demand for exports and imports > 1 Ped for exports Ped for imports Sum of price elas7city Will fall in currency improve the trade balance? Country A 0.4 0.3 0.7 No Country B 1.2 0.7 1.9 Yes Country C 0.8 0.2 1.0 Will leave it unchanged Evalua7ng the Effects of a Currency Deprecia7on In theory a depreciaTon of the exchange rate provides a boost to aggregate demand and economic growth ....but this depends on.. 1.  The length of 7me lags as consumers and businesses respond 2.  The scale of any change in the exchange rate i.e. a 5%, 10%, 20% 3.  Whether the change in the currency is short-­‐term or long-­‐term – i.e. is a change in the exchange rate temporary or likely to persist 4.  How businesses and consumers respond to exchange rate changes – the value of price elasTcity of demand is important i.e. will there be a large change in demand for exports & imports? 5.  The size of any second-­‐round mul7plier and accelerator effects 6.  When the currency movement takes place – i.e. Which stage of an economic cycle (recession, recovery etc) The Effects of a Currency Apprecia7on A currency appreciaTon makes exports more expensive & is likely to lead to an inward shia of AD GPL A currency appreciaTon makes imports cheaper & likely to cause an outward shia of AS GPL AS AS1 GPL1 GPL1 GPL2 GPL2 AD1 GPL3 AD2 Y2 Y1 Real GDP AS2 AD1 AD2 Y2 Y3 Y1 Real GDP Effect of a Currency Apprecia7on on Imports AppreciaTon of currency Cheaper to import goods and services Rise in external purchasing power •  £1 buys more Euros/S Rising demand for imports •  Depends on elasTcity of demand for imports Worsening of the trade balance Fall in aggregate demand •  Trade deficit may rise •  Because of rising leakages from circular flow Evalua7on points 1.  Price is not the only factor affecTng the UK demand for imported goods and services 2.  An appreciaTng currency also leads to lower costs of imported raw materials and energy which will help to restore compeTTveness 3.  Demand for imports may be price inelasTc (Ped <1) at least in the short term. The Exchange Rate and Unemployment •  An exchange rate appreciaTon causes a slower growth of real GDP because of a fall in exports (a reduced injecTon) and a rise in demand for imports (an increased leakage in the circular flow). Net trade may worsen. •  A reducTon in demand and output may cause job losses as businesses seek to control their costs. (cyclical unemployment) •  Thus a higher exchange rate can have a nega7ve mul7plier effect on the economy. •  Some industries are more exposed than others to currency fluctuaTons – e.g. sectors where a high % of output is exported and where demand is price sensiTve (i.e. price elasTc) Exchange Rates AQA 3.2.4.1