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Exchange Rates a2 Notes

The document provides an overview of exchange rate systems, including floating, fixed, and managed float systems, along with their determinants and economic models like Purchasing Power Parity. It discusses the effects of devaluation and appreciation on macroeconomic variables such as aggregate demand, inflation, unemployment, and terms of trade, highlighting the Marshall-Lerner Condition and the J-Curve Effect. Additionally, it addresses the implications of policy interventions and the volatility of hot money flows in the context of exchange rates.

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Ambika Lootawon
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4 views1 page

Exchange Rates a2 Notes

The document provides an overview of exchange rate systems, including floating, fixed, and managed float systems, along with their determinants and economic models like Purchasing Power Parity. It discusses the effects of devaluation and appreciation on macroeconomic variables such as aggregate demand, inflation, unemployment, and terms of trade, highlighting the Marshall-Lerner Condition and the J-Curve Effect. Additionally, it addresses the implications of policy interventions and the volatility of hot money flows in the context of exchange rates.

Uploaded by

Ambika Lootawon
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd

CIE A2 ECONOMICS (9708): EXCHANGE RATES

Focused High-Yield Topic Revision Notes

1. EXCHANGE RATE SYSTEMS & DETERMINATION

EXCHANGE RATE SYSTEMS ECONOMIC MODELS & MEASUREMENT

• Floating Exchange Rate: Determined purely by market • Purchasing Power Parity (PPP): Long-run rate equilibrium
demand ($D$) and supply ($S$) of the currency. where identical goods cost the same across nations.
• Demand drivers: Exports, primary/secondary income
%ΔE ≈ πDomestic - πForeign
inflows, FDI & foreign portfolio inflows.
• Supply drivers: Imports, outward income flows, foreign • Limitations: Ignores trade barriers, transport costs, non-
investment outflows. tradables, and massive speculative capital flows.
• Automatic Adjustment: CA deficit causes currency
• Real Exchange Rate (RER): Measures price
depreciation, restoring price competitiveness automatically.
competitiveness adjusted for inflation:
• Fixed Exchange Rate: Currency value pegged to another
currency or currency basket. RER = (E × PDomestic) / PForeign
• Maintenance: Central bank buys/sells foreign reserves,
adjusts interest rates, or enforces foreign exchange controls. • Effective Exchange Rate (EER): Weighted average index
relative to key trading partners' currencies.
• Managed Float: Exchange rate floats freely within target
bands; central bank intervenes during extreme volatility.

2. DEVALUATION, ELASTICITIES & MACROECONOMIC IMPACT

ELASTICITIES & BALANCE OF PAYMENTS POLICY INTERVENTIONS & TRADE-OFFS

• Marshall-Lerner Condition: Devaluation/depreciation • Hot Money Flows: Highly mobile short-term capital moving
improves the Current Account balance only if: across borders seeking high real interest rates or currency
appreciation. Creates extreme volatility.
| PEDX + PEDM | > 1
• Macroeconomic Conflicts:
• The J-Curve Effect: • Devaluing currency to boost exports risks retaliatory tariffs,
• Short Run: Demand is price inelastic global trade tensions, and demand-pull inflation.
( |PEDX + PEDM| < 1 ). Current Account worsens due to • Raising interest rates to defend currency suppresses
domestic consumption ($C$) and investment ($I$).
sticky trade contracts.
• Long Run: Demand becomes elastic over time; export/
import volumes adjust, moving Current Account into surplus.

MACROECONOMIC IMPACT MATRIX

Economic Variable Impact of Depreciation / Devaluation Impact of Appreciation / Revaluation

Aggregate Demand Rises: Export volume increases, import volume falls Falls: Exports become expensive, imports become
(AD) (X - M) ↑ → AD ↑ cheaper (X - M) ↓ → AD ↓

Inflationary Risk: Higher import costs (cost-push) and Deflationary Pressure: Lower cost of imported raw
Inflation
rising AD (demand-pull). materials and capital goods.

Falls: Stimulates jobs in export-oriented & import- Rises: Domestic producers face stronger foreign
Unemployment
competing domestic industries. competition and lower export orders.

Deteriorates: Relative price of exports falls relative to Improves: Relative price of exports increases relative to
Terms of Trade (ToT)
price of imports. price of imports.

CIE A2 Economics (9708) — Exchange Rates Page 1 of 1

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