AS Monetary Policy

There should be an understanding that changes in the exchange rate can affect the prices of exports and imports, the level of domestic economic activity, as well as the balance of payments on current account. Note: candidates do not need to know about how interest rates and exchange rates are determined. These topics are included in Unit 4.

the rate of one currency expressed in terms of another. E.g. £1 = 1.3 Euros

The value of the currency is determined in the foreign currency markets without government interference

Country A trades only with two countries. 60% of its trade is with country X and 40% with country Y.

Country A trades only with two countries. 60% of its trade is with country X and 40% with country Y.

Freely floating exchange rates Fully-fixed exchange rates Adjustable peg systems Crawling peg systems Semi-fixed exchange rates Managed floating exchange rates The Euro

The spot price or spot rate of a currency is the price that is quoted for immediate settlement, payment and delivery. Trade weighted exchange rate is the value of a currency expressed using an index of a basket of currencies weighted to take account of the amount of trade transacted in those currencies

Exchange rate of the £

A single fixed exchange rate with no permitted fluctuations. The value of a currency is maintained at the agreed rate because the central bank promises to buy and sell currencies at the specified rate.

The Gold Standard C18th, C19th up to 1931 Most of the worlds major currency were on the Gold standard at some point. UK acted as the guarantor

Before 1914 and between 1925 and 1931 the Bank of England would give you ounces of gold for a pound. But not now

Each central bank agreed to buy back their own currency with a fixed amount of gold. This meant that any currency in the scheme would remain worth the same in terms of other countries currencies. If there was any fluctuation in value, it was a simple matter for a firm to sell pounds, buy gold and then use the gold to buy the foreign currency. In this way currencies could only fluctuate in value by as much as it cost to transport gold from one country to another.

Similar to fully fixed but currencies are allowed to devalue or revalue by agreement. E.g. Bretton Woods Agreement

Similar to adjustable peg but small adjustments made regularly (monthly for example). E.g.The European Exchange Rate Mechanism (ERM), which was the precursor to the

Here the Exchange rate is given a specific target but the currency can move within a percentage from the target currency From 1987 until joining the ERM in 1990, The UK shadowed the Deutschmark.

A managed oating rate system is a hybrid of a fixed exchange rate and a flexible exchange rate system. In a country with a managed floating exchange rate system, the central bank becomes a key participant in the foreign exchange market.

Launched 1999 Notes and coins countries have currencies pegged to the Euro – 150 million Africans.

Benefits Lower import prices – boosts real living standards of consumers Increase in real purchasing power of UK residents travelling overseas Cheaper to import raw materials, components and capital inputs Improvement in the terms of trade Helps to control domestic inflation Costs Cheaper imports leads to rising import penetration and larger trade deficit Exporters lose price competitiveness and market share Damages profits and employment in some sectors (e.g. manufacturing) Negative impact on economic growth Some regions affected more than others

Value (purchasing power) of a currency in terms of what it can buy of other currencies Measures the external value of a currencyexternal value of a currency Price determined in the foreign exchange markets Global currency markets are open 24 hours per day Markets are operated by the major banksmajor banks Daily turnover in the currency markets is enormous London is the main centre of global currency dealing Large share of trading is purely speculative

Bi-lateral exchange rate £/ $ or $ / ¥ or £ / Effective Exchange (EER) Sterling's average value against a basket of currencies Weighted against the proportion of trade that the UK does with each country Heavily weighted currencies are the Euro and the dollar Spot Exchange Rate Forward Exchange Rate

Currency traders / speculators make huge sums dealing in very small currency fluctuations Example: Current exchange rate is £1 = $1.50 You expect the value of sterling to rise You spend $600,000 today and buy £400,000 Two months later the pound has appreciated so that £1 = $1.60 You sell the £400,000. You get $640,000 Speculation has led to a significant capital gain The greater the expected profit – the higher the speculative demand for sterling at a given rate of interest (This example ignores transactions costs)

Money is worth what it can earn Example: Money in a UK deposit account earns 6% a year Money in a Euro-based account earns 4% a year Assume that exchange rate expectations between sterling and the Euro are constant Footloose Money will flow out of Euros and into Sterling A positive interest rate differential will lead to an increased demand for sterling in currency markets Sterling appreciates against the Euro. Changes in interest rates will affect the differential and cause changes in hot money flows between currencies

Direct effect on Retail prices of imported goods and services Costs of imported raw materials, components and energy Short term living standards for UK consumers Competitiveness of UK exporters Further impact on Balance of trade in goods and services Net exports and aggregate demand Output, profits, investment and employment in the UK traded goods sector Economic growth in the short / medium term

Variety of strategies for UK businesses in response to strong sterling Cut export prices (lower profit margins) to maintain price competitiveness and hold onto market share Out-source components and raw materials from overseas Seek productivity / efficiency gains to keep unit labour costs under control Move into product lines where demand is more inelastic and less sensitive to exchange rate fluctuations Move production overseas

Government policies to switch production which is being sold domestically to being sold abroad. i.e. a devaluation of the pound makes imports dearer and exports more expensive. (fixed or pegged rate systems) Currency controls (before 1979) stop people taking money abroad.

Gert FröbeHarold Sakate

A policy of reducing the level of aggregate demand so that imports are reduced and exports increased. For example: Increasing interest rates Incomes policy Rationing.

If the exchange rate depreciates – imports are dearer (p1 to p2) price Qs&d p1 p2 D q1 q2 Expenditure on imports falls from (p1 x q1) to (p2 x q2) Ceteris paribus, the BoP current account improves

If the exchange rate depreciates – imports are dearer (p1 to p2) price Qs&d p1 p2 D q1 q2 Expenditure on imports RISES from (p1 x q1) to (p2 x q2) Ceteris paribus, the BoP current account deteriorates

Surplus Deficit Time

the combined price elasticity of demand for imports and exports must be greater than one for improvements to be effected in the balance of payments by a devaluation of the currency.