Welcome to Exchange Rates!
Ever wondered why going on holiday abroad is cheaper in some years than others? Or why the price of an imported pair of trainers or smartphone suddenly changes? It all comes down to exchange rates.
In this chapter of AS 2: Managing the National Economy, we will explore what exchange rates are, how they are determined in a floating market, why they go up or down, and how changes in currency value affect the entire national economy. Don't worry if this seems tricky at first—we will break it down step-by-step with easy-to-remember memory tricks!
---1. What is an Exchange Rate?
An exchange rate is simply the price of one currency expressed in terms of another currency.
For example, if the exchange rate is \(£1 = \$1.30\), it means that one British Pound can be exchanged for one US Dollar and thirty cents.
Types of Exchange Rate Systems
Governments can manage their currencies in different ways:
1. Floating Exchange Rate: The value of the currency is determined purely by the market forces of demand and supply in the foreign exchange (forex) market, without direct government or central bank intervention. (The UK uses a floating exchange rate.)
2. Fixed Exchange Rate: The value of the currency is pegged (fixed) to another currency (such as the US Dollar or Gold) by the central bank, which buys and sells currency reserves to maintain the target rate.
3. Managed (Semi-Fixed) Exchange Rate: The currency generally floats according to market forces, but the central bank steps in to buy or sell currency if it rises too high or falls too low.
Quick Review: Key Takeaway
The exchange rate is the price of money. In the UK, we use a floating exchange rate where supply and demand set the price every second of the day.
---2. Determination of Floating Exchange Rates
Since the UK uses a floating exchange rate, the value of the pound (\(£\)) depends on who wants to buy pounds (Demand) and who wants to sell pounds (Supply).
Why do people Demand Pounds?
Foreign buyers need to buy pounds when they want to:
• Buy UK exports (goods and services made in the UK).
• Invest in the UK via Foreign Direct Investment (FDI) (e.g., building a factory in Belfast or London).
• Put money in UK bank accounts to earn higher interest rates (known as "hot money" flows).
• Speculate that the pound will rise in value in the future.
Why do people Supply Pounds?
UK residents need to sell pounds (supplying them to the foreign market) when they want to:
• Buy imports from abroad (e.g., German cars, French wine).
• Travel abroad on holiday (buying foreign currency).
• Invest in businesses or property overseas.
• Move savings into foreign bank accounts where interest rates are higher.
Factors that Shift Currency Demand and Supply
• Interest Rates: If the Bank of England raises UK interest rates, foreign investors move their money into UK banks to get better returns. This increases the demand for pounds (hot money inflow), shifting the demand curve to the right.
• Relative Inflation Rates: If UK inflation is lower than abroad, UK goods become relatively cheaper and more competitive. Demand for UK exports rises, increasing demand for pounds.
• Speculation: If traders believe the pound will rise, they buy pounds now, driving up demand.
• Economic Growth Abroad: If trading partners (like the EU or USA) experience strong economic growth, their consumers buy more UK exports, boosting demand for sterling.
Quick Review: Key Takeaway
High UK interest rates and low UK inflation attract money into the UK, boosting demand for the pound and increasing its price.
---3. Appreciation vs Depreciation
When the value of a currency changes in a floating system, we use two specific terms:
• Appreciation: A rise in the value of a currency against other currencies (e.g., \(£1 = \$1.20 \implies £1 = \$1.40\)).
• Depreciation: A fall in the value of a currency against other currencies (e.g., \(£1 = \$1.40 \implies £1 = \$1.20\)).
Essential Memory Tricks: SPICED and WIDEC
These two mnemonics are essential for your exam toolkit!
S.P.I.C.E.D.
• Strong
• Pound
• Imports
• Cheap
• Exports
• Dear (Expensive)
When the pound appreciates, foreign goods become cheaper for UK consumers, but British exports become more expensive for foreigners.
W.I.D.E.C.
• Weak
• Imports
• Dear (Expensive)
• Exports
• Cheap
When the pound depreciates, foreign goods become more expensive in the UK, but British goods become cheaper and more attractive to buyers overseas.
4. Impact of Exchange Rate Changes on Macroeconomic Objectives
Changes in the exchange rate have major ripple effects across the four main macroeconomic objectives: Economic Growth, Unemployment, Inflation, and the Current Account balance.
Scenario A: A Depreciation of the Pound (Weak Pound - WIDEC)
• Impact on Aggregate Demand (AD): Since exports become cheaper (\(X\) rises) and imports become dearer (\(M\) falls), net exports \((X - M)\) increase. Because \(AD = C + I + G + (X - M)\), overall Aggregate Demand shifts to the right.
• Economic Growth: Higher AD leads to an increase in real GDP output.
• Unemployment: Domestic firms hire more workers to satisfy higher export demand and replace expensive imports, reducing unemployment.
• Inflation: Risk of higher inflation! This happens in two ways:
1. Demand-pull inflation: Higher \(AD\) puts upward pressure on price levels.
2. Cost-push inflation: Imported raw materials, fuel, and components become more expensive, increasing production costs for firms.
• Current Account of the Balance of Payments: Tends to improve over time as export volumes rise and import volumes fall.
Scenario B: An Appreciation of the Pound (Strong Pound - SPICED)
• Impact on Aggregate Demand (AD): Exports become expensive (\(X\) falls) and imports become cheaper (\(M\) rises), so net exports \((X - M)\) decrease. This slows down Aggregate Demand.
• Economic Growth: Slower GDP growth or potential reduction in output.
• Unemployment: Export industries may cut jobs due to reduced overseas sales.
• Inflation: Helps reduce inflation because imported goods and raw materials are cheaper, keeping costs and consumer prices lower.
• Current Account of the Balance of Payments: Tends to worsen (deficit gets bigger) because cheap imports flood the market while exports struggle.
Summary Table of Macroeconomic Effects
• Depreciation (Weak Currency): Growth \(\uparrow\), Unemployment \(\downarrow\), Inflation \(\uparrow\), Current Account Balance improves.
• Appreciation (Strong Currency): Growth \(\downarrow\), Unemployment \(\uparrow\), Inflation \(\downarrow\), Current Account Balance worsens.
5. Evaluation and Real-World Complications
In economics exams, top marks come from evaluation. Does a currency depreciation always improve the trade balance? Not necessarily!
1. The Marshall-Lerner Condition
A depreciation of the exchange rate will only improve the current account deficit if the sum of the price elasticities of demand for exports and imports is greater than 1:
\(PED_x + PED_m > 1\)
• If demand for exports and imports is price inelastic (\(PED_x + PED_m < 1\)), making exports cheaper and imports dearer actually worsens the trade balance in value terms.
• For example, the UK imports a lot of oil and essential foodstuffs. Even if the pound drops, people must still buy these necessities at higher prices.
2. The J-Curve Effect
Even if the Marshall-Lerner condition holds in the long run, in the short run, a currency depreciation often causes the current account deficit to get worse before it gets better.
Why does the J-Curve occur?
• Short-Run Inelasticity: In the short term, firms and consumers are locked into existing contracts. Importers cannot instantly switch suppliers, so they pay higher prices for imports, worsening the trade deficit.
• Long-Run Elasticity: Over time (6 to 18 months), businesses find cheaper domestic alternatives and foreign buyers notice cheaper UK goods. Demand becomes more price elastic, and the current account balance improves, creating a "J" shape on a graph.
3. Other Evaluative Factors
• Non-Price Competitiveness: Quality, design, reliability, and brand reputation often matter more than price. A German car or an iPhone might still sell well even if the domestic currency appreciates.
• Import Content of Exports: Many UK manufacturers use imported components to make their goods. If a falling pound makes imported parts more expensive, export prices might have to go up anyway!
6. Common Mistakes to Avoid
• Confusing Appreciation with Inflation: Appreciation means the currency's value is rising against other currencies. Inflation means domestic prices are rising (which actually lowers the domestic purchasing power).
• Forgetting Units: Always check which currency has changed. If \(£1 = \$1.30\) moves to \(£1 = \$1.20\), the pound has depreciated, while the dollar has appreciated.
• Assuming Instant Effects: Remember the J-curve! Exchange rate changes take time to affect real export and import volumes.
Final Summary Checklist
\(\checkmark\) A floating exchange rate is determined by currency supply and demand.
\(\checkmark\) High interest rates create "hot money" inflows, increasing demand and causing currency appreciation.
\(\checkmark\) SPICED: Strong Pound = Imports Cheap, Exports Dear.
\(\checkmark\) WIDEC: Weak Pound = Imports Dear, Exports Cheap.
\(\checkmark\) Currency depreciation boosts \(AD\), creates jobs, and risks inflation.
\(\checkmark\) The current account only improves if the Marshall-Lerner condition is met (\(PED_x + PED_m > 1\)), subject to the J-curve short-run lag.