Flashcards in Unit 4: Chapter 3 - Exchange rates and the balance of payments Deck (102):
What do exchange rates express?
The value of one currency against another
What is the interaction between different currencies?
A derived demand
What is the effect of a fall in the value of the pound against the dollar?
The price of British goods becomes cheaper because Americans have to sacrifice fewer dollars to purchase the same amount of British goods
What does a fall in the exchange rate lead to?
Demand for a currency increasing as there is a movement along the demand curve
What is Sterling's average rate measured by?
The Sterling Trade Weighted Index - it is weighted to reflect the relative importance of different countries in terms of UK trade
Why does the Sterling Trade Weighted Index get criticised?
The weights get adjusted too infrequently and changes to the pattern of UK trade take too long to be included in revised weightings
What was the effect of the criticisms of the Sterling Weighted Trade Index?
It led to a new version of the index which an adjust more rapidly to changes in trade patterns
Where does the equilibrium exchange rate occur?
Where the demand of pounds = supply of pounds i.e. where the demand and supply curves intersect
What is the role of the foreign exchange markets?
If there is a shortage or surplus of pounds, then the role of the foreign exchange markets would be to equate the demand for pounds with the supply for pounds
What do pounds go through when they need to be transferred to another country?
The foreign exchange
When do the demand and supply curves for a foreign currency shift?
If a factor other than price changes
How does inflation cause a change in the exchange rate?
A rise in UK inflation relative to other countries would make UK goods less competitive and this would shift the demand curve for pounds inwards
How do interest rates cause a change in the exchange rate?
A rise in UK interest rates will shift the demand curve for pounds outward because UK financial assets would become more attractive i.e. hot money
How do incomes cause a change in the exchange rate?
A rise in incomes in other countries would increase demand for UK exports and this would shift the demand curve for pounds to the right
How does GDP cause a change in the exchange rate?
An increase in GDP in other countries would cause demand to shift out
How do tastes cause a change in the exchange rate?
If it was perceived that foreign goods were of higher quality than British goods then this would shift the supply curve of pounds to the right
How does speculation cause a change in the exchange rate?
Fluctuations are caused by speculation which is people trying to earn a profit by buying and selling currencies by predicting which way market forces will move
What is the acronym which shows the impact of a change in value of a currency on exports and imports?
SPICED - strong pound imports cheap exports dear
What is a depreciation?
When the exchange rate falls - the value of one currency is lowered against others
What is an appreciation?
When the exchange rate rises
What should be the fundamental determinant of exchange rates and what interferes with this?
The fundamental determinant should be the demand for a country's exports but domestic interest rates also have an impact
What is the effect of the exchange rate depreciating?
This will lead to a fall in export prices and this should result in an increase in demand for exports, the extent to which this is the case will depend upon the foreigners' price elasticity of demand for British goods, the price of imports will also rise and thus have a positive effect on growth as AD = C + I + G + (X - M)
What can the exchange rate be affected by?
Policy decisions which are made outside the UK
What should growth due to the exchange rate depreciating lead to?
A reduction in unemployment however this assumes that there are no capacity constraints or skills shortages in the export sector
What will a rise in the prices of imports lead to?
A rise in inflation because some of the goods in the RPI will be imported, the extent to which this is the case will depend upon the share of imports in the representative consumer's basket of goods
What is a floating exchange rate?
Allows the exchange rate to move freely according to changes in demand and supply for the currency - there is no government intervention to help meet other policy objectives
What are managed floating exchange rates?
It is a floating exchange rate in the foreign exchange rates markets but it is subject to intervention from time to time by the monetary authorities
Why might monetary authorities intervene in the exchange rate?
A central bank may try to depreciate the exchange rate in order to improve the balance of trade in goods and services, reduce the risk of a deflationary recession or to rebalance the economy away from domestic consumption towards exports and investment
What is the exchange rate mechanism?
It has an allowed range for the exchange rate to be in - if it moves beyond this range the government would be obliged to act i.e. they could buy up a currency or raise interest rates by shifting demand to the right
What was the point of the exchange rate mechanism?
To reduce inflation
What is a fixed exchange rate?
This occurs when countries peg their currency against another's; the central bank would commit itself to managing the demand and supply for a currency to ensure the fixed exchange rate is maintained
What impact would trying to maintain a stable exchange rate have?
Could be at the expense of domestic stability as the central bank alters policy such as interest rates to maintain the peg
What is the balance of payments?
A record of transactions between one country and the rest of the world
What are the two main accounts that the balance of payments is split into?
The current account and the capital account
What is the equation for the balance of payments?
current account balance + capital account balance + net errors and omissions = zero
What are the four things that the current account is made up of?
Balance of trade in goods, balance of trade in services, income and transfers
What does the balance of trade in goods involve?
Visibles - this looks at the value of imports and the value of exports of goods
What are exports?
Goods that are made by the domestic companies and sold abroad - they appear as a positive entry into the balance of payments as they bring money into the country
What are imports?
Imports are goods made abroad and sold to people in the domestic market - they appear as a negative entry into the balance of payments as money leaves the country
What does the balance of trade in services involve?
Invisibles - this looks at the value of imports and the value of exports of services
What does income involve in the balance of payments?
This is made up of income earned by domestic citizens who own assets overseas; it includes profits, dividends, interest, rent and wages
What do transfers in the balance of payments involve?
Usually money transfers between central governments such as grants, could also be foreign aid, people sending payments abroad to family members (remittances) or donations to international organisations or aid agencies - essentially you get nothing in return
What does the capital account record?
Flows of long-term and short-term international transactions in financial and physical assets
What do long-term flows include?
The purchase of assets such as factories
What do short-term flows include?
Portfolio investment, short-term bank loans and deposits, and changes in official reserves
What does the capital account also take into account?
It includes loans e.g. shares and government bonds, and savings
What is the effect of a country running a current account surplus on the capital account?
This gives them the scope to run a capital account deficit as they can use some of their foreign exchange reserves to invest overseas
Why does the sum of the two accounts that make up the balance of payments not always equal zero?
Balance of payment statistics come from a variety of resources, time lags exist in their compilation and unlawful attempts are made to evade taxes
How can the current account be unaffected by changes in the exchange rate?
The effect can balance out if appreciating against one currency and depreciating against another
What may a government try and do if the current account is in persistent deficit?
Governments could try to depreciate the currency by perhaps lowering interest rates
What is the effect of the price of the pound falling against other currencies?
The price of imports will rise in pounds; this will lead to a fall in the sterling value of imports (assuming that domestic demand for imports is elastic) and there will be a reduction in the foreign price of UK goods and services thus increasing demand for our exports
Why could depreciation generating imported inflation be problematic?
This is not serious if it is a once and for all increase in prices but if it starts a cost-push inflationary spiral, then the increased competitiveness achieved by the depreciation will be eroded away
What does the effect of a depreciation on the current account depend on?
The elasticities of demand for imports and exports
What does the Marshall-Lerner condition state?
A depreciation will only have a positive effect on the current account if the sum of the elasticities of demand for imports and exports is more negative than -1 e.g. -2
What is the condition for a depreciation to have a positive effect on the current account?
The combined demand for imports and exports needs to be price sensitive in order for the depreciation to be successful
What does the Marshall-Lerner condition not take into account?
Supply conditions e.g. in a full employment situation it may not be possible to cope with the increased demand for both exports and import-competing goods therefore the benefits of the depreciation may not be fully realised
What does the Marshall-Lerner condition imply?
The only price determines the demand for goods and services but there are a variety of non-price factors that can affect demand for imports and exports e.g. quality, design after-sales service
When may a depreciation of a currency not improve the current account?
If the country is not performing well on non-price factors
Why do trade adjustments take time even though the exchange rate fluctuates rapidly?
Those engaged in foreign trade may take time to adjust to the prevailing exchange rate
Why do trade adjustments take time in terms of contracts?
Some import contracts may not expire for some time and it may take time for foreigners to adjust to cheaper import prices
What is the effect of people not adjusting quickly to a depreciation?
This may lead to the current account worsening before it improves as we have to pay higher prices for a given quantity of imports
Why do trade adjustments take time in terms of supply?
Supply is inelastic in the short-run i.e. can't start selling more exports immediately
What does trade adjustments taking time imply in terms of the Marshall-Lerner condition?
It implies that the Marshall-Lerner condition may not apply in the short term since the demand for imports and exports is inelastic but may apply in the longer term when exporters and importers adjust to the new relative exchange rate
What are trade imbalances?
The difference between the value of exports and imports over a certain period
What is a positive balance known as?
A trade surplus as X > M
What is a negative balance known as?
A trade deficit
What can happen to fix a deficit if the cause of it is cyclical (due to a rise in growth)?
A downward movement in the trade cycle ought to push the current account back into surplus
What does a persistent problem on the current account reflect and what measures may be taken to try and fix this?
It can reflect a lack of UK competitiveness and measures such as training and investment would need to be implemented to improve this
Why is a structural deficit more problematic than a cyclical deficit?
Supply-side policies take time to be effective and a cyclical deficit should improve once the economic cycle adjusts to slower growth
What are the causes of current account deficits?
Low labour productivity, antiquated infrastructure (such as rail networks needing to be modernised), high relative wage rates, too much government regulation and interference, a strong exchange rate, the level of domestic AD and the economy's position in the trade cycle, the level of AD abroad in export markets and structural problems with the economy
What does a current account surplus indicate?
What does a current account deficit indicate?
An uncompetitive economy
If a country has a current account deficit, what does this infer about its export incomes and import incomes?
Its export incomes will be insufficient to pay for its import expenditure
What must a country do in order to finance a deficit?
A country must sell off its assets; run down its savings or borrow money
What does a CA deficit do in terms of a country's wealth?
It reduces a country's long term wealth relative to other countries
What should supply-side polices designed to raise the potential of the economy lead to?
Productivity improvements or quality improvements which should lead to a country selling a good at a lower price and one which has higher quality
What is a supply-side policy to correct a current account deficit in terms of taxes?
The government could reduce taxes and welfare benefits in order to increase the incentive to find work or work longer and it will provide an incentive for businesses to cut costs as they get to keep more of their profit
What is a supply-side policy to correct a current account deficit in terms of trade unions?
Passing laws to weaken trade union power may remove obstacles to efficiency such a striking but they also conflict with workers conditions and rights
What is a supply-side policy to correct a current account deficit in terms of privatisation?
Privatisation (whereby nationalised industries are returned to the private sector) could increase efficiency as private firms have a greater incentive to profit maximise and cut costs as failure could result in a take-over or bankruptcy; privatisations also provide governments with a cash injection to help finance the budget deficit
What is a supply-side policy to correct a current account deficit in terms of de-regulation?
De-regulation involves reducing rules and regulations that discourage new competition and so companies are forced to become more efficient to remain competitive; increased competition and innovation should lead to lower prices and better product quality or service
What is the disadvantage of supply-side policies?
They take a long time to have an impact therefore improving international competitiveness can take a long time
How do deflationary policies work?
By reducing the level of domestic aggregate demand: if AD falls then demand for foreign imports should fall, export sales should not be affected as they are determined by AD abroad - if import expenditure falls at a time when export incomes remain constant the result will be an improving current account balance
What can be used to reduce domestic AD?
Contractionary fiscal policy and tight monetary policy
What is the problem with deflating domestic demand?
It can cause unemployment as falling levels of domestic demand might mean firms have to lay off some workers
How can protectionism be used to correct a current account deficit?
Adopting trade policies designed to block out imports can help domestic firms increase their share of foreign markets
What is a tariff and what is its effect?
A tariff is a tax imposed on imported goods and they increase the price of the imported goods and make foreign goods appear poor value for money
What is a quota?
A quota is a physical limit imposed on the amount of goods that are allowed to be sold in the domestic market of the country that has imposed the quota
How can a quota correct a current account deficit?
If the volume of imported goods is restricted domestic producers operating in the same market will have a greater chance of surviving because their domestic market share will to a degree, be protected by the quota
What is an export subsidy?
A sum of money given by the government to the producers of exports that is designed to give the firm a competitive advantage
What can the current account be expressed as?
The difference between national savings and investment
What can a current account deficit reflect in terms of savings?
A low level of national savings relative to investment or a high rate of investment or both
Why might a current account deficit be natural for capital-poor developing countries?
They have more investment opportunities than they can afford to undertake with low levels of domestic savings
Why is the timing of trade significant?
A country could be running a current account deficit now as they import capital equipment but this can be used to produce goods which can be exported in the future therefore they could run a current account surplus in the long run
What is a country building up when it runs a current account deficit?
It is building up liabilities to the rest of the world that are financed by flows in the financial account, eventually these need to be paid back
When may a country's ability to pay back all it has borrowed to finance its current account deficit come into question?
If a country invests its borrowed foreign funds in things that yield no long-term productive gains, then its ability to pay (basic solvency) might be questionable
What does solvency require?
That the country be willing and able to eventually generate sufficient current account surpluses to repay what it has borrowed
What does whether a country should run a current account deficit depend on?
The extent of its foreign liabilities (its external debt) and on whether the borrowing will be financing investment that has a higher marginal product than the interest rate (or rate of return) the country has to pay on its foreign liabilities
Why is caution required in running large and persistent deficits?
The country could experience an abrupt reversal of financing
Why can reversals be disruptive?
Private consumption, investment and government expenditure must be restricted abruptly when foreign financing is no longer available and indeed a country is forced to run large surpluses to repay its past borrowings
Why do weak financial sectors often lead to higher vulnerability to a reversal?
Banks borrow money from abroad and make risky domestic loans
If a deficit reflects an excess of imports over exports, what might it be indicative of?
Competitiveness problems but because the CA deficit also implies an excess of investment over savings, it could be equally pointing to a highly productive, growing economy