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AS Macroeconomics / International Economy

Exchange Rates

This chapter looks at the currency markets where the value of one currency against another is determined on a daily basis

• The exchange rate measures the external value of sterling in terms of how much of another currency it can buy. For example - how many dollars or Euros you can buy with £5000.

• The daily value of the currency is determined in the foreign exchange markets (FOREX) where billions of $s of currencies are traded every hour.

• The global currency markets are open 24 hours a day allowing businesses, banks, individuals to trade in the currencies that they need.

Recent trends in the exchange rate

The UK operates with a floating exchange rate system where the forces of market demand and supply for a currency determine the daily value of one currency against another. If, for example, overseas investors want to buy into sterling to take advantage of higher interest rates on offer in UK bank accounts, they will swap their own currencies for pounds. This causes an increase in the demand for sterling in the foreign exchange markets, and in the absence of other offsetting factors, this will force sterling higher against other currencies.

How does a change in the exchange rate influence the economy?

Changes in the exchange rate can have a powerful effect on the macro-economy affecting variables such as the demand for exports and imports; real GDP growth, inflation and unemployment – but as with most variables in economics, there are time lags involved.

• The scale of any change in the exchange rate.
• Whether the change in the currency is short term or long term.
• How businesses and consumers respond to exchange rate fluctuations – the concept of price elasticity of demand is important here.

Advantages of an appreciation in the currency

• Cheaper imports for consumers: A high pound leads to lower import prices – this boosts the real living standards of consumers at least in the short run – for example an increase in the real purchasing power of UK residents when travelling overseas or the chance to buy cheaper computers or motor vehicles from the United States or Europe.
• Lower costs for producers: When the sterling exchange rate is high, it is cheaper to import raw materials, component parts and capital inputs such as plant and equipment – this is good news for businesses that rely on imported components or who are wishing to increase their investment of new technology from overseas countries. A fall in import prices has the effect of causing an outward shift in the short run aggregate supply curve. And if a country can now import more productive technology, the LRAS curve may shift out.
• Lower inflation: A strong exchange rate helps to control the rate inflation because domestic suppliers now face stiffer international competition from cheaper imports and will look to cut their costs and prices accordingly in order not to suffer from a loss of international competitiveness. Cheaper prices of imported foodstuffs and beverages will also have a negative effect on the rate of consumer price inflation.
• If inflation is lower, then interest rates will be lower than if the exchange rate was weaker – and cheaper money will eventually stimulate higher consumer spending and capital spending in the circular flow

Disadvantages of a Strong Pound

• Increase in the trade deficit: The lower price of imports leads to consumers increasing their demand and this can cause a large trade deficit. Exporters lose price competitiveness because they will find it more expensive to sell in foreign markets and face losing market share – this can damage profits and employment in some sectors and industries.
• Slower economic growth: If exports fall, this causes a reduction in aggregate demand and reduces the short-term rate economic growth as measured by the % change in real GDP. Some regions of the economy are affected by this more than others. In the North east for example, manufacturing industry accounts for over 28% of regional GDP whereas the percentage for the UK as a whole is just 19%.
• If exports fall, then so will business confidence and capital investment – because investment is partly dependent on the strength of demand

Showing the effects of currency movements using AD-AS analysis

Changes in the exchange rate have quite a powerful effect on the economy but we tend to assume ceteris paribus – all other factors held constant – which of course is highly unlikely to be the case

• Counter-balancing use of fiscal and monetary policy: For example the government can alter fiscal policy to manage the level of AD and the Bank of England has the flexibility to change interest rates (e.g. lower interest rates if they felt that a high exchange rate was damaging export sectors and causing much lower inflation)
• Low elasticity of demand: In the short term, the effects of exchange rates on export and import demand tends to be low because of low price elasticity of demand
• Business response to the challenge of a high exchange rate: Businesses can and do adapt to a high exchange rate. There are several ways in which industries can adjust to the competitive pressures that a strong pound imposes. Some of the options include:
• Cutting their export prices when selling in overseas markets and therefore accepting lower profit margins to maintain competitiveness and market share
• Out-sourcing components from overseas to keep production costs down
• Seeking productivity / efficiency gains to keep unit labour costs under control or perhaps trying to negotiate a reduction in pay levels
• Investing extra resources in new product lines where demand is price inelastic and less sensitive to exchange rate fluctuations. This involves producing products with a higher income elasticity of demand, where non-price factors such as product quality, design and effective marketing are as important in securing orders as the actual price

London is the major centre for foreign exchange trading in the world economy – the market is nearly wholly screen based and billions of dollars worth of currencies is traded every hour