Edexcel A Level Economics A:复习笔记4.1.8 Exchange Rates

• As with any market, if there is excess demand for the currency on the forex market, then prices rise (the currency is worth more)
  • In a floating exchange rate system this is called an appreciation
• If there is an excess supply of the currency on the forex market, then prices fall (the currency is worth less)
  • In a floating exchange rate system this is called a depreciation

• The Central Bank negotiates with the international Monetary Fund (IMF) to fix (peg) their currency to another one
  • Sometimes the peg is at parity e.g. 1 Brunei Dollar = 1 Singapore Dollar
  • Often the peg is not at parity e.g. Hong Kong has pegged its currency to the US$ at a rate of HK$ 7.75 = US$ 1
• A revaluation occurs if the Central Bank decides to change the peg and increase the strength of its currency
• A devaluation occurs if the Central Bank decides to change the peg and decrease the strength of its currency

• This is a combination of the fixed & floating mechanism
• The Central Bank determines the preferred currency value - and then the currency is free to fluctuate within a certain range of this value e.g 0.75%
• If it goes above this range then the Central Bank will intervene by selling its own currency in forex markets so as to increase supply
  • Increased supply of their currency in the forex market decreases the value of the currency & brings it back within the range
• If it goes below this value then the Central Bank will intervene by buying its own currency in the forex market using its foreign reserves (US$, Euros etc.)
  • Increased demand for their currency in the forex market increases the value of the currency & brings it back within the range
• Interest rates can also be used to intervene
  • Raising interest rates appreciates a currency as returns on investment/savings become more attractive to foreigners & they demand local currency
  • Decreasing interest rates depreciates a currency as returns on investment/savings become less attractive to foreigners & they sell their local currency & move their money elsewhere

The Current Account

• Depreciation of the £ causes exports to be cheaper for foreigners to buy & imports to the UK are more expensive
• The extent to which this improves the current account balance depends on the Marshall-Lerner condition
  • This follows the revenue rule which states that in order to increase revenue, firms should lower prices for products that are price elastic in demand
  • If the combined elasticity of exports/imports is less than 1 (inelastic), a depreciation (fall in price) will actually worsen the current account balance
• It is also important to recognise that there is a time lag between the depreciation of the £ and any subsequent improvement in the current account balance
  • This is explained by the J-Curve effect
    • It takes time for firms & consumers to respond to changes in price
    • Once it becomes evident that price changes will last for a longer period of time, firms & consumers switch
    • E.g. a firm in the USA has been importing electric scooters from the UK. If the Euro depreciates, the price of scooters in France becomes relatively cheaper. In the short-term, the USA firm will not switch immediately to purchasing scooters from France as the exchange rate may soon bounce back. They also have a good relationship with their UK suppliers. In the long term they are likely to switch

Economic growth

• Net exports are a component of aggregate demand (AD)
  • A depreciation that results in an increase in net exports will lead to economic growth

Inflation

• Cost push inflation is likely to occur as the price of imported raw materials increases with currency depreciation
• Net exports are a component of aggregate demand (AD)
  • A depreciation that results in an increase in net exports will lead to an increase in aggregate demand
  • This may lead to an increase in demand pull inflation
• An appreciation of the currency will have the opposite effect

Unemployment

• If depreciation leads to an increase in exports, unemployment is likely to fall as more workers are required to produce the additional products demanded
• An appreciation of the currency will have the opposite effect

Living standards

• The impact of a depreciation on living standards can be muted
  •  As imports are more expensive, households face higher prices & less choice, which detracts from living standards
  • Rising exports can decrease unemployment & increase wages/income which means an improved standard of living for some households
• The impact of an appreciation on living standards will be the opposite

Foreign direct investment (FDI)

• Depreciation of a currency makes it cheaper for foreign firms to invest in the country and can increase the FDI
  • The money they have available to invest is worth more when the currency has depreciated
• An appreciation has the opposite effect