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Section 8: Tricky Topics -
Macroeconomics
8.5 EXCHANGE RATES
1 Essay Structure Skills! Organising information – exchange rate questions
For the following sample question, we have started the answer plan with a simple list of
possible points that could be part of the answer. The simple approach would be to write
about as many of those as you can.
However, a better quality approach is to organise those ideas into different headings in
order to have a better structured answer. Your task is to categorise the points listed under
the appropriate headings.
Question 1: Analyse the likely economic impact of further depreciation of Sterling
(6 marks)
Simple list of points: More competitive exports; greater employment; expensive oil; cost-push
inflation; increase in tourism and ‘staycations’; improvements on the FTSE; economic growth;
less availability of hot money/short-term capital; reduction in outsourcing; positive multiplier;
higher value of EU benefits priced in Euros e.g. CAP; risk of capital flight
Better quality approach: categorise these impacts:
Macro Impact e.g. indicators Micro Impact e.g. Global Impact e.g. trade
of performance (growth, businesses/profits, flows, investment flows
unemployment, inflation household
Now your turn!
Question 2: Analyse the advantages of operating a fixed exchange rate system
(9 marks)
Add your own simple list of points here:
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Better quality approach: categorise your advantages:
Category 1 Category 2 Category 3
2 Adding application
Examiners frequently note that the data and context provided in data response questions
is not used effectively by students in their longer exam answers. For this activity, we have
provided you with a short case study, one exam-style question and a student answer.
The student’s economic theory is excellent. However, they have forgotten to include any
data references and will not be awarded any marks for AO2 (application) which will
severely limit their overall marks, because of the use of “levels-based marking”.
Your task is to read through the student’s answer and add in the relevant application.
(10 marks)
The US view on Chinese currency manipulation
Figure A: the value of the Chinese Yuan (CNY) Extract:
against the US$, 2010-2020 In August 2019, US President Trump stated
that the US believed the Chinese government
to be a “currency manipulator”, keeping the
value of the Yuan artificially low in order to
make Chinese exports more price competitive.
This statement was made in the middle of a
“tit-for-tat” protectionist trade war between
the two countries, initiated by President
Trump due to his belief that US manufacturing
was in decline due to development of the
Chinese economy. Following the
announcement, it was expected that President
Trump would use it as a reason to impose
retaliatory tariffs on Chinese goods imported
into the US. However, in January 2020, the US
Treasury announced that the US had reversed
its view and that China was no longer a
currency manipulator. This was because the
Chinese currency had appreciated against the
dollar since August 2019. A US Treasury
spokesperson also said that China had
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committed to refraining from competitive
devaluations.
Question: Analyse one reason why China’s government might have devalued its currency
against the US dollar.
Student answer – please add your relevant application throughout:
A currency devaluation occurs in a fixed exchange regime, when the price of the currency
against another is deliberately lowered, usually by buying the foreign currency. This causes the
supply of the domestic currency to increase on the foreign exchange market, as shown in the
diagram below.
One reason why a government may devalue
its currency is to make its exports more
price competitive. The price paid by
consumers abroad is a combination of the
original domestic price of the good and the
exchange rate. So, ceteris paribus, a weaker
currency causes exports to appear cheaper overseas. If exports are relatively price elastic then
the rise in the quantity of exports sold will cause an increase in export revenue, boosting AD and
short-run economic growth for the exporting country.
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3 Excellent evaluation
In the activity below, we have given you some important analytical points in relation to
the benefits of floating exchange rates, along with some suggested evaluation points that
fit with the APE approach (Assumption – Perspective – Evidence).
Your task is to complete the missing element of APE for each argument.
(If you need some help with the APE approach, look again at the videos which go through
the best technique for essays.)
(10 marks for each)
Question: Discuss the view that floating exchange rate systems are always preferable to fixed
exchange rate systems
Analysis point 1: Add your ‘Assumptions’ evaluation here:
Floating exchange rates
are beneficial for
economies because they
allow, in theory, an
automatic correction of a
current account
imbalance. Suppose an
economy is running a
current account deficit,
so the value of imports is
greater than the value of
exports. With a floating
exchange rate, a rising
value of imports causes
an increase in the supply
of the domestic currency
onto the foreign
exchange market.
Some countries may be happy to run a current account
Similarly, a fall in the
deficit, as it will mean that they have a corresponding
value of exports causes a
financial account surplus (ideally with an inflow of FDI
fall in demand for the
rather than shorter-term capital flows such as hot money)
domestic currency.
and could be importing essential capital goods that will aid
These factors combined
productive potential. This was the case with South Korea in
cause a depreciation of
the 1960s. Such countries may not want their current
the currency. A weaker
account deficit to be automatically corrected, and may
currency makes exports
therefore be keen to have a fixed exchange rate system.
more price competitive
and should, ceteris The UK has a floating exchange rate system, and has run
paribus, increase such a system since it left the Exchange Rate Mechanism in
demand for exports. 1992. It briefly ran a small trade surplus in the mid-1990s
Likewise, imports now but since then the trade balance has been in deficit –
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appear relatively more Sterling’s floating exchange rate has done little to correct
expensive and so the balance. That is partly because of the PED of the UK’s
demand for imports exports and imports (the Marshall-Lerner condition does
should fall. This corrects not seem to apply in the UK) and because other factors,
a current account deficit. such as the UK’s stable investment environment, affect our
exchange rate and balance of payments.
Analysis point 2: This analysis assumes that floating exchange rates result
Under a floating in more predictability. However, fixed exchange rate
exchange rate system, systems can significantly improve predictability for
central banks do not businesses. Businesses can be much more confident about
need to intervene to the prices of their imported raw materials and the price
maintain a particular that they can receive for their exports. This makes their
exchange rate. Instead, cost and revenue streams more predictable, which also
they can focus on other makes profits more predictable. Many businesses rely on
objectives such as the retained profit for funding investment, and so they may
management of inflation be more likely not less likely to invest under a fixed
via interest rate or exchange rate system.
money supply
manipulation. It is not Add your ‘Perspectives’ evaluation here:
possible for central
banks to manipulate all 3
elements of monetary
policy (interest rates,
money supply, exchange
rates). This can usually
create a more stable
economic environment
because interest rate
decisions are more likely
to be made monthly or
at other predictable,
frequent intervals – in
turn this improves
business confidence and
can stimulate
investment, for example. The Eurozone, US, UK and Japan are regarded as the
When the UK ran a fixed world’s leading economic areas in terms of production
exchange rate against levels and development levels. All of these areas operate
the German DM in the floating exchange rate systems. However, they are far from
early 1990s in the ERM, the fastest growing economies – economies such as China,
interest rates could Ethiopia, and India are projected to be the fastest growing
change frequently (even economies in 2018, and these countries all operate fixed
several times a day) exchange rates.
which was too
unpredictable, and
arguably was a major
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factor for tipping the UK
into recession.
4 The chart below shows the value of the UK pound sterling (£) trade-weighted exchange
rate index over a 3-year period from 2016 to 2019.
Explain one reason for the changes in the trade-weighted sterling index that are shown
in the chart.
(4 marks)
Source: [Link]
Write your explanation here:
5 Which one of the following is the most likely cause of this news headline, about the Ted
Baker fashion chain: “Ted Baker cautions on profits amid currency movements”?
A weaker currency is causing Ted Baker’s imports to be more expensive, so
A
raising costs and cutting profits
A weaker currency is causing Ted Baker’s exports to be more expensive for
B
overseas buyers, so reducing overseas sales and cutting profits
A stronger currency is causing Ted Baker’s imports to be more expensive, so
C
raising costs and cutting profits
A stronger currency is causing Ted Baker’s output to be reduced, so they have
D
fewer goods to exports
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SUGGESTED ANSWERS
Question 1: Analyse the likely economic impact of further depreciation of Sterling
Simple list of points: More competitive exports; greater employment; expensive oil; cost-push
inflation; increase in tourism and ‘staycations’; improvements on the FTSE; economic growth;
less availability of hot money/short-term capital; reduction in outsourcing; positive multiplier;
higher value of EU benefits priced in Euros e.g. CAP; risk of capital flight
Better quality approach: categorise these impacts:
Macro Impact e.g. indicators Micro Impact e.g. Global Impact e.g. trade
of performance (growth, businesses/profits, flows, investment flows
unemployment, inflation household
• Greater employment • Expensive oil • More competitive exports
• Cost push inflation • Increase in tourism and • Less availability of hot
• Economic growth ‘staycations’ money/short term capital
• Positive multiplier • Improvements on the FTSE
• Risk of capital flight • Reduction in outsourcing
• Higher value of EU
benefits priced in Euros
e.g. CAP
Now your turn!
Question 2: Analyse the advantages of operating a fixed exchange rate system
Add your own simple list of points here:
May lower inflationary expectations / price stability; increases certainty of revenue for exporting
businesses; increases certainty of production costs for importing businesses; easy target to
understand for policy-makers; can protect a domestic economy; encourages inwards FDI
therefore LR growth; reduces cost of currency hedging
Better quality approach: categorise your advantages:
Macro performance Impact on profits Impact on policymakers
Price stability Certainty over higher revenue Easy-to-understand target
Inwards FDI hence LR growth Certainty over lower costs Protectionism for domestic
Protectionism for domestic economy
economy Reduction in hedging costs
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2.
The application has been added in bold below:
A currency devaluation occurs in a fixed exchange regime, for example China pegs its currency
against the US $, when the price of the currency against another is deliberately lowered, usually by
buying the foreign currency, in this case dollars. This causes the supply of the domestic currency,
the renminbi, to increase on the foreign exchange market, as shown in the diagram below. The
value of China’s currency fell, such that it went from $1 = 6.7RMB to $1 = 7.2RMB, a change of
7.5%.
Diagram: consider changing the axes labels to $1 = RMB, and quantity of RMB
One reason why a government such as China may devalue its currency is to make its exports more
price competitive. The data states that there has been ‘development’ of China’s economy and
this could have pushed up domestic prices, which would make their exports seem less price
competitive if the exchange rate is not controlled. The price paid by consumers abroad is a
combination of the original domestic price of the good and the exchange rate. So, ceteris paribus, a
weaker Chinese currency causes exports to appear cheaper overseas, in particular in the US,
where President Trump is blaming China’s currency action for declining US manufacturing. If
exports, such as manufacturing, are relatively price elastic then the rise in the quantity of exports
sold will cause an increase in export revenue, boosting AD and short-run economic growth for
China.
3.
Analysis point 1 Assumptions evaluation:
A weaker currency has been assumed to boost demand for exports but this may not be the case as
price is not the only factor that determines demand – demand for exports also depends on income
in trading partners, the availability of substitutes, the quality of the exports etc.
Analysis point 2 Perspectives evaluation:
Different central banks will adopt different approaches e.g. the Bank of England has also had to
adopt a policy of Forward Guidance in order to improve confidence over future interest rate
changes; furthermore, some economies with floating exchange rates do not target inflation and
instead target the money supply (e.g. Kenya and Uruguay) which can be highly unpredictable (e.g.
UK in the early 1980s).
4.
The results of the vote in the UK referendum on membership of the EU in 2016 to leave the EU (1
mark) resulted in lower base rate of interest (1 mark) which caused the price of sterling to weaken
(1 mark) as the index has fallen from around 90 to an average of 76 or 77 (1 mark).
5. A