Exchange Rates - Macroeconomic Effects of Currency | tutor2u Economics
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Exchange Rates - Macroeconomic Effects of Currency Fluctuations

  • Levels: AS, A Level
  • Exam boards: AQA, Edexcel, OCR, IB

Changes in the external value of a currency can have important effects on a number of macroeconomic outcomes and objectives

Effects of a Currency Appreciation - revision video

Impact of a currency appreciation - revision video

Effects of a Currency Depreciation - revision video

Effects of a currency depreciation

The Exchange Rate and Inflation:

The exchange rate affects the rate of inflation in a number of direct and indirect ways:

  • Changes in the prices of imported goods and services – this has a direct effect on the consumer price index. For example, an appreciation of the exchange rate usually reduces the price of imported consumer goods and durables, raw materials and capital goods.
  • Commodity prices: Many commodities are priced in dollars – so a change in the sterling-dollar exchange rate has a direct impact on the UK price of commodities such as oil and foodstuffs. A stronger dollar makes it more expensive for Britain to import these items.
  • Changes in the growth of exports: A higher exchange rate makes it harder to sell overseas because of a rise in relative prices. If exports slowdown (price elasticity of demand is important in determining the scale of any change in demand), then exporters may choose to cut their prices, reduce output and cut-back employment levels.
Changes in the sterling exchange rate can affect the rate of consumer price inflation

Bank of England research for the UK economy suggests that 10% depreciation in the exchange rate can add up to 3% to the level of consumer prices three years after the initial change in the exchange rate. But the impact on inflation of a change in the exchange rate depends on what else is going on in the economy.

The Exchange Rate and Unemployment

  • An exchange rate appreciation causes a slower growth of real GDP because of a fall in net exports (reduced injection) and a rise in the demand for imports (an increased leakage in the circular flow).
  • A reduction in demand and output may cause job losses as businesses seek to control costs. Some job losses are temporary – reflecting short term changes in export demand and import penetration. Others are permanent if imports take up a permanently higher share of the domestic market. Thus a higher exchange rate can have a negative multiplier effect on the economy.
  • Some industries are more exposed than others to currency fluctuations – e.g. sectors where a high percentage of total output is exported and where demand is highly price sensitive (price elastic)

What are some of the Macroeconomic Benefits of a Weaker Currency?

  • A fall in a currency is an expansionary monetary policy and can be used as a counter-cyclical measure to stimulate demand, profits, output and jobs when an economy is in recession or slowdown
  • It ought to bring about an improvement in the balance of trade and, through higher export sales, drive an expansion of output in industries that serve export businesses – this is known as the ‘supply-chain’ effect.
  • Economists at Goldman Sachs have estimated that a 1% fall in the exchange rate has the same effect on UK output as a 0.2 percentage-point cut in interest rates. On this basis, the 25% decline in sterling in 2008 was equivalent to a cut in interest rates of between 4 and 5%. Without the depreciation in sterling at this time, the recession in the UK would have been much deeper.

In brief, a cheaper currency provides a competitive boost to an economy and can lead to positive multiplier and accelerator effects within the circular flow of income and spending.

Depreciation of also has the effect of increasing the value of profits and income for a country’s businesses with investments overseas. And it is a boost to tourist and farming industries.

For farmers in Europe, CAP payments are made in Euros, so a lower sterling/Euro exchange rate increases the sterling value of farm subsidies for farmers in Britain.

Some of the benefits of a weaker currency happen in the near term; but there are also some potential gains in the medium term. For many years the UK economy has been criticized for over-consumption and under-investment with the economy being unbalanced and too dependent on borrowing.

Sterling exchange rate versus the US dollar

Evaluation – What are the Limits of a Currency Depreciation to solve Economic Problems?

Not all of the effects of a cheaper currency are positive – here are some downsides and risks:

  • A weak currency can make it harder for the government to finance a budget deficit if overseas investors lose confidence. When investors take their money out, this is known as capital flight

A weak currency also makes it harder to pay for a trade deficit that is owed to overseas creditors

  • Depreciation increases the cost of imports – e.g. rising prices for essential foodstuffs, raw materials and components and also imported technology. This can cause an inward shift of SRAS (and has inflationary risks) and might also affect long-run productive potential.
  • Weak global demand can dampen the beneficial effects of a lower currency – it is then harder to export when key markets are in recession and overseas sales are falling
  • If the price elasticity of demand for exports and imports is low, a depreciation of the exchange rate may initially cause a worsening of the balance of trade in goods and services. This is known as the J-Curve Effect

Exchange rates and balance of payments adjustment - The ‘J-Curve’ effect

  • In the short term depreciation may not improve the current account of the Balance of Payments
  • This is due to the low price elasticity of demand for imports and exports in the short term
  • oInitially the quantity of imports will remain steady because contracts for imported goods will have been signed. Export demand will be inelastic in response to the exchange rate change
  • Earnings from exports may be insufficient to compensate for higher spending on imports.
  • The balance of trade may worsen and this is known as the ‘J-Curve’ effect
  • Providing that the elasticity of demand for imports and exports are greater than one, then the trade balance will improve over time. This is known as the Marshall-Lerner condition.
Can you find a relationship here between the exchange rate and the UK balance of payments?

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