1. Topic 9: aggregate demand and aggregate supply
Exchange rates

2. 4.1.8 Exchange rates Students should be able to:
Define exchange rate systems (floating; fixed and managed)
Distinguish between revaluation & appreciation and between devaluation & depreciation of a currency
Analyse factors influencing floating exchange rates
Analyse government intervention in currency markets through foreign exchange transactions and the use of interest rates
Evaluate competitive devaluation/depreciation and its consequences
Evaluate the impact of changes in exchange rates (the current account of the balance of payments (Marshall- Lerner condition and J curve effect); economic growth and employment/unemployment; rate of inflation; FDI flows)

3. Microeconomics Topic 1: The Economic Problem
Definitions
Microeconomics Topic 1: The Economic Problem
Exchange rates are ________________________
__________________________________________
Floating exchange rates means that _________ and supply determine the rate at which one currency exchanges for another. E.g.
Fixed exchange rates are where a country’s exchange rate is fixed in relation to, say the US $
Fixed exchange rates can only be changed by the central bank in agreement with other countries usually mediated through the IMF.
E.g. Danish Krona fixed to the _______

4. Definitions: managed exchange rates
Microeconomics Topic 1: The Economic Problem
Managed exchange rates imply that the monetary authorities control the exchange rate through the buying and selling of the country’s currency on the foreign exchange market and through changes in ____________ rates.
Day-to-day the market sets the rate but occasionally the Central Bank may intervene e.g. Switzerland (______) or Japan (_____)

5. Appreciation versus revaluation
Microeconomics Topic 1: The Economic Problem
Appreciation and depreciation are the terms used under a system with _________ exchange rates to describe increases and decreases in the value of a country’s currency in relation to other currencies.
Revaluation and devaluation are the terms used under a system with _________ exchange rates to describe increases and decreases in the value of a country’s currency in relation to other currencies determined by the country’s central bank.

6. Appreciation and revaluation
Microeconomics Topic 1: The Economic Problem
Appreciation/revaluation means that the value of the pound, in terms of other currencies, has ___________
For example, if the value changes from £1 = $1.50 to £1 = $1.70 then the £ has become stronger and _______ dollars are required to buy £1.
With an appreciation/revaluation, even though a good may still be priced at £10, it now costs Americans $___ instead of $___, therefore ___________ demand for UK exports.
Remember SPICED!

7. Depreciation and devaluation
Microeconomics Topic 1: The Economic Problem
Depreciation/devaluation means that the value of the pound, in terms of other currencies, has _____________
For example, if the value changes from £1 = $1.50 to £1 = $1.40 then _____ pounds are required to buy $1.
With a depreciation/devaluation, even though a good may still be priced at £10, it now costs Americans only $___ instead of $___, therefore ______________ demand for UK exports.

8. What determines the exchange rate?
Microeconomics Topic 1: The Economic Problem
The exchange rate will be determined by the supply of, and demand for, the currency which depends on:

9. Relative interest rates and inflation rates
Microeconomics Topic 1: The Economic Problem
• If UK interest rates rise (relative to other countries) then demand for £ increases (currency appreciates)
• Purchasing power parity theory of exchange rates states that exchange rates in the long-term change in line with inflation rates between economies.
Define the term purchasing power parities (2 marks)

10. The current account and net investment into the UK
Microeconomics Topic 1: The Economic Problem
Demand or supply?
The current account: UK exports create a ________ for sterling whereas imports into the UK create a _______ of sterling on the foreign exchange market; therefore, an increasing trade surplus would cause an increase in the value of sterling
Net investment into the UK: FDI into the UK creates a ________ for sterling whereas UK investment abroad creates a _________ of sterling; therefore, an increase in FDI from abroad would cause the value of sterling to rise

11. Quantitative easing and state of the economy
Microeconomics Topic 1: The Economic Problem
Demand or supply?
• quantitative easing – since QE has the effect of increasing money ___________, it is likely that this will cause a depreciation in the country’s exchange rate.
• state of the economy - e.g. slow down in the economy is likely to cause a fall in confidence and a decrease in FDI and less ____________ for the currency hence value of the currency will fall

12. How might the exchange rate be managed?
Microeconomics Topic 1: The Economic Problem
• changing interest rates – if the central bank wishes to increase the value of the country’s currency, it would _________ interest rates, so making it more attractive for foreigners to place cash balances in the country’s banks
• intervention on the foreign exchange market – if the central bank wishes to increase the value of the country’s currency then it would buy its own currency. (This is called “foreign currency transactions” under “Government intervention in currency markets” on your syllabus)

13. Impact of interest rates on value of currency
Microeconomics Topic 1: The Economic Problem
Impact of interest rates on value of currency

14. Impact of a slump in exports on value of currency
Microeconomics Topic 1: The Economic Problem
Impact of a slump in exports on value of currency

15. Microeconomics Topic 1: The Economic Problem
Hot money
Microeconomics Topic 1: The Economic Problem
• Hot money is money that is moved by its owner __________ from one form of investment to another.
The aim is to take ________________ of changing international _______________ rates or to gain ______________ short-term returns on investments.
advantage exchange high quickly

16. Gaining competitive advantage
Microeconomics Topic 1: The Economic Problem
• Some countries try to gain competitive advantage by taking measures to ___________ the value of their currencies.
However, if several countries do this then any advantage would disappear quickly. Consequently, there might be a decline in world trade if countries pursued such a policy – as happened in the 1930s.
(This is called “competitive devaluation/depreciation and its consequences” on your syllabus)

17. Impact of changes in exchange rates
Microeconomics Topic 1: The Economic Problem
An appreciation/revaluation of a country’s currency would have the reverse of the above effects.

18. Impact of changes on the current account
Microeconomics Topic 1: The Economic Problem
• A depreciation or devaluation will __________ the competitiveness of a country’s goods and services by causing a fall in the foreign currency price of its exports and an ___________ in the domestic price of its imports.
However, there will only be an improvement in the current account of the balance of payments if the sum of the PEDs for exports and imports is greater than 1.
This is called the Marshall-Lerner condition.

19. Short run impact of changes on the current account
Microeconomics Topic 1: The Economic Problem
But, the impact on the current account may be different in the ____________run than in the long run.
In the short run there might be a ____________ in the ______________ account of the balance of payments because the demand for imports might be price ______________ if firms have stocks or if they are tied into contracts; and the demand for exports might be price ____________ because consumers take time to adjust to the new, lower, prices.

20. Long run impact of changes on the current account
Microeconomics Topic 1: The Economic Problem
But, in the long run demand for exports and imports is likely to become ___________ price elastic so the significance of the above factors disappears.
This difference in short-run and long-run effects is often referred to as the J curve effect.

21. Microeconomics Topic 1: The Economic Problem
J curve effect

22. Impact of changes on economic growth and employment
Microeconomics Topic 1: The Economic Problem
• Economic growth and employment/unemployment: an increase in the competitiveness of a country’s goods and services following a depreciation (or devaluation) should result in a _________ in unemployment as demand for the country’s goods and services ______________

23. Impact of changes on inflation and FDI
Microeconomics Topic 1: The Economic Problem
• Rate of inflation: the price of imported raw materials and manufactured goods will __________ following a depreciation/devaluation.
This could have inflationary consequences, why?
But its impact on individual producers depends on their reliance on imports and/or exports
• FDI flows: following a depreciation/devaluation it would be cheaper for global companies to invest in the country so FDI might _____________ .

24. Microeconomics Topic 1: The Economic Problem
Exam question: 12 marks
Microeconomics Topic 1: The Economic Problem
• Assess the possible effects of the fall in the external value of the rupee on the Indian economy
(12).
(remember the syllabus “Impact of changes in exchange rates”…)