AS Macro: Exchange Rates The Exchange Rate The exchange rate is the rate at which one currency can be exchanged for another i.e. £1 buys $1.60 The UK operates with a floa5ng exchange rate – the external value of the currency is determined purely by market forces of supply and demand for a parCcular currency. The Pound against the Euro Britain is outside of the Euro Area in which 19 EU countries share the same currency How Currency Changes can affect Macro Objec5ves Price Stability – i.e. Low Posi5ve Infla5on (CPI Infla5on of 2%) A Sustainable Growth of Real GDP (Na5onal Output) Falling Unemployment / Rising Employment Rate Higher Average Living Standards (na5onal income per capita) Improved Global Compe55veness / Trade Balance (BoP) A More Equitable Distribu5on of Income and Wealth How a Lower Currency can affect Macro Objec5ves Changes in the exchange rate affects demand for exports and imports, real GDP growth, inflaCon, business profits and jobs Infla5on •  A fall in a currency leads to a rise in import prices •  Causes a rise in cost-­‐push inflaConary 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 Deprecia5on 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 key economic indicators Domes5c produc5on ! Trade deficit " Domes5c jobs ! Evalua5ng the Effects of a Currency Deprecia5on In theory a depreciaCon of the exchange rate provides a boost to aggregate demand and economic growth ....but this depends on.. 1.  The length of 5me 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 elasCcity of demand is important i.e. will there be a large change in demand for exports & imports? 5.  The size of any second-­‐round mul5plier and accelerator effects 6.  When the currency movement takes place – i.e. Which stage of an economic cycle (recession, recovery etc) Key evalua5on point Movements in a currency affect the prices of exports and imports, but non-­‐price factors in a market are oaen more significant in determining demand, e.g. quality, design, branding etc. Analysis: The Effects of a Currency Apprecia5on A currency appreciaCon makes exports more expensive & is likely to lead to an inward shia of AD GPL A currency appreciaCon also makes imports cheaper & is 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 AS Macro: Exchange Rates