Exchange Rate Yr12
Part of: AD = I + G + C + (X-M)
(X - M) = net exports
Exchange rate = is the rate of one currency against another currency
E.G
Y1: £1 = $2 £ appreciated over the year against the $
Y2: £1 = $4 = £ got stronger
Y1: £1 = $4 £ depreciated over the year against the $
Y2: £1 = $3 = £ got weaker
Appreciation = refers to an increase in the value of an asset or currency over time.
Deprecation = is the decrease in the value of an asset or currency over time.
Trade balance is the difference between a country's exports and its imports
Trade surplus = occurs when a country's exports exceed its imports during a specific
period.
o Example: If a country exports $500 billion worth of goods but imports only $400
billion, it has a trade surplus of $100 billion.
o It may lead to an inflow of foreign currency, strengthening the country’s
economy.
o However, too much surplus can create trade imbalances globally or cause
political tensions.
Trade deficit = occurs when a country's imports exceed its exports during a specific
period.
o Example: If a country imports $600 billion worth of goods but exports only $450
billion, it has a trade deficit of $150 billion.
o This can lead to borrowing from foreign countries to finance the deficit,
potentially increasing national debt.
o On the positive side, a trade deficit can signal strong consumer demand for
foreign products.
Strong Pound Imports Cheaper Exports Dearer (SPICED)
= Net export deficit
Weaker Pound Imports Expensive Exports cheaper (WPIEEC)
= net exports Surplus
Imports (M) = something that comes into the UK = money flows out of the country
People buy goods from foreign countries and comes to the UK
Exports (X) = something that comes out of the UK = money flows into the country
Foreign people buy goods from the UK, and it leaves
E.G
The quality of the UK goods is better than the quality of the foreign goods
X increase = M decrease = AD increase
Income levels at home go up and income levels abroad go down
X decreases = M increases = AD decreases
Marketing for the UK goods overseas is improved
X increase = M decrease = AD increase
The pound rises against the dollar
X decreases = M increases = AD decreases
Strong £ (SPICED) impact on (X dec - M inc), net exports deficit = AD
decrease
Weak £ (WPIEEC) impact on (X inc - M dec), net exports surplus = AD
increase
Hot money flows = refers to the movement of short-term capital between countries to take
advantage of changes in interest rates and exchange rates.
hot money flows in = IR inc & ER inc
o Interest rates (IR) increase: Higher interest rates in a country makes it more
attractive for foreign investors to save or invest in that country because they can
earn better returns.
o Exchange rate (ER) increases: As foreign investors convert their currency into
the domestic currency to invest, the demand for the domestic currency rises,
leading to an appreciation of the exchange rate.
Hot money flows out = IR dec & ER dec
o Interest rates (IR) decrease: Lower interest rates reduce the incentive for
foreign investors to keep their money in the country, prompting them to move
their funds elsewhere.
o Exchange rate (ER) decreases: When investors withdraw their funds, they sell
the domestic currency, increasing its supply and causing the exchange rate to
depreciate.
When interest rates increase it brings the £ up
Rich investors around the world would like to take advantage of the higher returns from
the uk banks
Will exchange (sell) their currency with the £
Demand of the £ will increase = turns into a stronger £ (APPRECIATE)
When interest rates decrease it bring £ down
Decreases the reward for saving
Sells the £ = more in the market
Turns the £ weaker = loss of value
Demand of £ decreases (DEPRECIATION)
Exchange rate changes impacts
Appreciation – SPICED
If a currency appreciates in value – SPICED
In a diagram if imports are cheaper and the exports are expensive, net exports in the
economy is likely to decrease.
As net export is a component of AD, AD is likely to shift to the left
But if imports are cheap, it means that firms that import raw materials to produce in the
economy are going to benefit from cheaper imports, cheaper commodity prices in terms of
lower import prices, so it will reduce their cost of production.
shifting SRAS to the right, and lower cost push inflation
Analysis
CONS
1. Lower growth – When exports is falling, current account position is likely to
worsen, maybe going to deficit
2. Higher unemployment in exporting industries - Exports is more expensive,
demand for exports decreases
3. Higher unemployment in domestic industries – domestic firms must compete
with cheaper imports from abroad
PROS
1. Lower demand-pull inflation & lower cost push inflation – Good for the
economy
2. Cheaper imports – Good for consumers. Consumers have increase in material
living standards. It is easier to import, so it improves happiness, improve material
standards of living
3. Potential efficiency gains for domestic producers – They can compete with
cheaper imports, domestic firms may look to cut cost elsewhere, look to gain
increased competitiveness to compete, see increase in efficiency gains which, lead
to lower prices in the economy – good for firms, consumers
Depreciation – WPIEEC
If a currency depreciates in value – WPIEEC
Increase AD because net export increases, with imports being more expensive, demand for
imports falls, expenditure on imports falls
Exports will be cheaper, demand for exports rises, revenue generated from exports will go up,
which increases net exports. Leads to increase in growth, causing a reduction in exchange
rate (depreciation in exchange rate).
AD shifts to the right
firms that need to import raw material will see an increase in costs, those imports become
more expensive, increasing the cost of production
shifting SRAS to the left, which could harm the economy
AD graph: main for growth, depending on the economy, whether the economy has a strong
exporting base or not, if it does then then this effect will dominate the SRAS graph
Analysis
PROS
1. Increase in employment- industries that export will see an increase in demand,
therefore will produce, which will require more labour to produce more that extra output
2. Domestic industries – competition falls, imports are more expensive, consumers may
switch to buying domestic goods, increase employment to match the increase in
demand
CONS
1. Higher demand and cost pull inflation
Evaluation
- Consider the extent to which the exchange rate is changed – whether it’s an
appreciation or depreciation, how much the exchange rate risen or fallen
- Consider the pride elasticity of demand for exports and imports – Marshall learner
condition & j-curve
- Consider the restrictions on trade – i,e protectionism may cause restrictions , on weaker
ER – exports are cheaper but if there are trade restrictions put on exports might reduce
some of the benefits