AS Exchange rates

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Information about AS Exchange rates

Published on March 14, 2014

Author: HelenRose2



Very simple introduction designed for mixed ability AS students


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. • revision-monetary-policy-and-exchange-rates

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