EXCHANGE RATESUNIT 2 MACROECONOMICS

Rose

The Specification:

• Students need to be able to:• Understand the impact on the current account

(of the BoP) of factors including a change in the exchange rate.

What is the Current Account?

• Current –‘now’ – the short run.• This is opposed to the Capital Account

which is about the future – the long run.• The 4 elements of the Current Account

are: trade in goods (visibles); trade in services (invisibles); transfers & net property income from abroad.

• The last 2 can be ignored at this level.

Back to the Exchange Rate

• This is the price of one currency in terms of another

• Therefore the price of £1 (sterling) is given in $ or Euros etc

• Sterling has a FLOATING EXCHANGE RATE SYSTEM

• This means that the price of £ is determined by market forces – demand & supply

Diagrams can be used for this...

• An increase in the exchange rate is called an APPRECIATION

• This means £1 buys more other currencies – the price has gone up

• Imports will therefore become cheaper and exports more expensive (LESS COMPETITIVE)

On the other hand

• A fall in the exchange rate is called a DEPRECIATION

• This means the currency is worth less so £1 buys less of other currencies

• Consequently exports become cheaper an imports become more expensive

• Changes in the relative prices of imports and exports affect the Balance of Payments

What influences Demand for a currency?

• Relative interest rates• The demand for imports (D£)• The demand for exports (S£)• Investment opportunities• Speculative sentiments• Global trading patterns• Changes in relative inflation rates

These will cause a SHIFT in the demand curve

And Supply?

• Changes in the supply of £ depends on the desire to change £ into other currencies in order to– Buy overseas goods & services– Travel abroad– Save in overseas financial institutions– Speculate on a currency

• Sometimes Governments might choose to control the money supply

To repeat...

• A depreciation in exchange rate should lead to a rise in demand for exports & a fall in demand for imports – the balance of payments should ‘improve’

• An appreciation of the exchange rate should lead to a fall in demand for exports and a rise in demand for imports – the balance of payments should get ‘worse’

BUT!

• The volumes and the actual amount of income and expenditure will depend on the relative price elasticity of demand for imports and exports.

• Clever clogs stuff – the current account will improve provided the PED of Imports + PED of Exports > 1

• This is the Marshall-Lerner condition

So

• One advantage of a freely floating exchange rate is that, in time, the Balance of Payments will always balance so that any deficit or surplus on the current account will automatically disappear.

• This is why a current account deficit is not a cause for concern in the short run.

• The mechanism for this can be shown on a simple flow chart

In the real world

• The exchange rate would be a proper reflection of the purchasing power in each country if the relative values bought the same amount of goods in each country.

• This is Purchasing Power Parity (PPP)

To sum up

• Money can be bought and sold on foreign exchange markets

• Currency markets work 24/7 so can be considered close to perfect markets

• In a free market currencies will float freely• This has advantages for managing the Balance

of Payments.• http://www.slideshare.net/tutor2u/as-macro-

revision-monetary-policy-and-exchange-rates