Presentation on Exchange rates and their impact on macro objectives

1. Exchange Rates
EdExcel AS Economics 2.6.2

2. Sterling against the US Dollar
0.5
0.52
0.54
0.56
0.58
0.6
0.62
0.64
0.66
0.68
0.7
Jan
14
Feb
14
Mar
14
Apr
14
May
14
Jun
14
Jul
14
Aug
14
Sep
14
Oct
14
Nov
14
Dec
14
Jan
15
Feb
15
Mar
15
Apr
15
USD/£(sterling)exchangerate
The chart shows the monthly average value for sterling against the $
The UK operates
with a floating
exchange rate –
the external
value of the
currency is
determined
purely by market
forces of supply
and demand for
a particular
currency
Source: Office for National Statistics

3. Sterling against the Euro
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.
0.7
0.72
0.74
0.76
0.78
0.8
0.82
0.84
Jun
'15
May
'15
Apr
'15
Mar
'15
Feb
'15
Jan '15 Dec
'14
Nov
'14
Oct
'14
Sep
'14
Aug
'14
Jul '14 Jun
'14
May
'14
Apr
'14
Mar
'14
Feb
'14
Jan '14
Exchangerate
Source: Office for National Statistics

4. Fixed and Floating Exchange Rates
Floating Exchange
Rates
• Value of currency
determined purely by
demand and supply
• No need for intervention
by the central bank
Fixed exchange
Rates
• Exchange rate is pegged
• Occasional realignments
e.g. usually a devaluation

5. Currency Market Analysis: Higher Interest Rates
Value of
currency
Quantity of currency traded
Demand
Supply
Rise in interest rates
Currency more
attractive for investors
Attracts inflows of hot
money
Causes outward shift
in demand
Currency appreciates
P2
P1

6. Currency Market Analysis: Slump in Exports
Value of
currency
Quantity of currency traded
Demand
Supply
Recession in
trading partner
Causes fall in
export sales
Worsening of
trade balance
Inward shift of
currency demand
Currency will
depreciate
D2
P1
P2

7. Data on the UK Exchange Rate over recent years
Source: HM-Treasury Databank
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

8. The Sterling Exchange Rate and UK Exports & Imports
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
20
40
60
80
100
120
140
160
60
70
80
90
100
110
120
130
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Sterling Exports (RHS) Imports (RHS)
Sterling exchange rate index,
2005 = 100
The sterling exchange rate
depreciated by more than
20% during 2008.
Source: Office for National Statistics

9. How a Lower Currency can affect Macro Objectives
Changes in the exchange rate affects demand for exports and
imports, real GDP growth, inflation, business profits and jobs
Inflation
• A fall in a currency leads to a rise in import prices
• Causes a rise in cost-push inflationary 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

10. Economic Effects of a Currency Depreciation
This will have an effect on a number of economic indicators
Domestic production  Trade deficit  Domestic jobs 
Changes in import and export prices will affect demand
Import sales will CONTRACT Export sales will EXPAND
When the pound depreciates against the US dollar
It makes UK import prices RISE It makes UK export prices FALL

11. Will an Exchange Rate Depreciation improve the BoP?
Time period after
depreciation
Trade
surplus
Trade
deficit
Currency
depreciation
here
Trade deficit may
grow in initial
period after
depreciation
Net improvement
in trade provided
certain conditions
are met
The diagram below shows the “J Curve effect” – it shows the time
lags between a falling currency and an improved trade balance

12. The Marshall Lerner Condition
The Marshall Lerner condition states that a depreciation /
devaluation of the exchange rate will lead to a net improvement in
the trade balance provided that the sum of the price elasticity of
demand for exports and imports > 1
Ped for exports Ped for imports
Sum of price
elasticity
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

13. Evaluating the Effects of a Currency Depreciation
In theory a depreciation of the exchange rate provides a boost to
aggregate demand and economic growth ....but this depends on..
1. The length of time 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 elasticity of demand is important i.e.
will there be a large change in demand for exports & imports?
5. The size of any second-round multiplier and accelerator effects
6. When the currency movement takes place – i.e. Which stage of
an economic cycle (recession, recovery etc)

14. A currency appreciation makes
exports more expensive & is likely
to lead to an inward shift of AD
Real GDP
GPL1
Y1
AD1
AS
Y2
AD2
GPL2
GPL
The Effects of a Currency Appreciation
Real GDP
GPL1
Y1
AD1
AS1
Y2
AD2
GPL2
GPL
AS2
Y3
GPL3
A currency appreciation makes
imports cheaper & likely to cause
an outward shift of AS

15. Effect of a Currency Appreciation on Imports
Appreciation of
currency
Rise in external
purchasing power
• £1 buys more Euros/S
Cheaper to import
goods and services
Rising demand for
imports
• Depends on elasticity of
demand for imports
Worsening of the
trade balance
• Trade deficit may rise
Fall in aggregate
demand
• Because of rising
leakages from circular
flow
Evaluation points
1. Price is not the only
factor affecting the
UK demand for
imported goods and
services
2. An appreciating
currency also leads to
lower costs of
imported raw
materials and energy
which will help to
restore
competitiveness
3. Demand for imports
may be price inelastic
(Ped <1) at least in
the short term.

16. The Exchange Rate and Unemployment
• An exchange rate appreciation causes a
slower growth of real GDP because of a fall
in exports (a reduced injection) and a rise in
demand for imports (an increased leakage
in the circular flow). Net trade may worsen.
• A reduction 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
negative multiplier effect on the economy.
• Some industries are more exposed than
others to currency fluctuations – e.g.
sectors where a high % of output is
exported and where demand is price
sensitive (i.e. price elastic)

17. Exchange Rates
EdExcel AS Economics 2.6.2