Very simple introduction designed for mixed ability AS students

1. EXCHANGE RATES
UNIT 2 MACROECONOMICS
Rose

2. 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.

3. 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.

4. 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

5. 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)

6. 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

7. 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

8. 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

9. 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’

10. 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

11. 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

12. 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)

13. 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.
• http://www.slideshare.net/tutor2u/as-macro-
revision-monetary-policy-and-exchange-rates