Exchange rates and international trade

• what is the balance of payments?

  a set of accounts that shows economic transactions between a country and the rest of the world
• what are financial inflows?

  treated as credits or positive entries
• what are financial outflows?

  treated as debits or negative entries
• what is a country's current account?

  flows of goods and services, cross border incomes associated with the international ownership of financial assets and current transfers between residents and non residents
• what is a country's financial account?

  shows how the countrys finances its borrowing from the rest of the world (current account deficit) or how the country is lending to the rest of the world (current account surplus)
• how to balance the balance of payments?

  a. when all the components of the balance payments account are taken together, the balance of payments should exactly balance.

  b. when the statistics are complied, a number of errors occur, to correct for this a net errors and omissions item is included.

  c. a balance of payments deficit or surplus is used to refer to just one part of the accounts, typically the current account balance.
• what is an exchange rate?

  the price of one currency in terms of another, its the external value of a currency. In a floating exchange rate system the rate is determined by market forces. In a fixed exchange rate system the government intervenes to maintain the external value of the currency.
• what are changes in the exchange rate in a floating system?

  an increase in the exchange rate is an appreciation. a fall is a depreciation
• what are the changes to the exchange rate in a fixed system?

  If the rate at which its fixed is increased, this is a revaluation. If lowered its a devaluation.
• whats a floating exchange rate system?

  determined by market forces, mainly demand and supply. there is no government intervention
• what are advantages of a floating exchange rate system?

  • automatically adjusts so that supply equals demand.
  • no need for central bank to keep foreign reserves.
  • government can pursue its own domestic policies e.g., adjusting interest rates.
  • prevents imported inflation.
  • possibly reduces speculation
• what are disadvantage's of a floating exchange rate system?

  • causes instability which deters investment and trade.
  • can lead to inflation
  • speculation on future movements can lead to major changes in the rate.
  • governments aren't forced to control their economies
• why is it a disadvantage that a floating exchange rate system can cause inflation?

  domestic inflation makes goods less competitive, leading to a fall in the demand for the currency and a fall in the exchange rate. this makes goods more competitive again but also more expensive so will lead to cost push inflation
• how does fiscal policy work in a floating exchange rate system?

  less effective, measures are undermined by changes in financial flows
• how does monetary policy work in a floating exchange rate system?

  more powerful. A reduction in interest rates can boost spending within the economy, but it also leads to outflows of currency, this will lead to a fall in the value of the currency which boosts exports leading to a further increase in aggregate demand.
• whats a fixed exchange rate system?

  government will intervene to maintain the exchange rate.

  • if the price of the currency is about to fall, the government may increase demand by buying its own currency or increasing interest rates.
  • if the price of the currency is about to increase, the government may sell its own currency or lower interest rates.
• what are advantages of a fixed exchange rate system?

  • provides stability for firms and households, encourages trade and investment.
  • acts as a constraint on domestic inflation
  • in theory they prevent speculation as theres no point because the value of the exchange rate is fixed.
• why is a fixed exchange rate system acting as a constraint on domestic inflation an advantage?

  if a country has higher inflation than its trading partners then its goods/services will become uncompetitive, forcing firms to control their costs to compete
• what are disadvantages of a fixed exchange rate system?

  • a government must have enough foreign currency reserves to intervene to maintain the price of its currency.
  • goods and services may be uncompetitive if the exchange rate is fixed at a too high rate.
  • the gov must make intervention a priority, this may mean implementing policies that damage the domestic economy.
• how does a fiscal policy work in a fixed exchange rate system?

  its effective. if the government tries to deflate the economy through higher taxes and less spending this reduces aggregate demand and spending on imports. Lower demand will also reduce the demand for credit and may lead to lower interest rates. Lower interest rates lead to capital outflows which reinforces the contractionary fiscal policy.
• how does a monetary policy work in a fixed exchange rate system?

  becomes more difficult. any change in the interest rate is liable to lead to inflows/outflows of currency
• what is the demand for sterling?

  refers to the desire to change other currencies into pounds in order to spend on UK goods and services, save in UK banks/financial institutions (long term capital movement) and speculate on the currency in the hope that the pound will become more valuable in the future (short term capital movement)
• what can increase the demand for pounds?

  UK goods and services are demanded more. UK interest rate increases, there will be greater desire to save to earn higher rates of return. People think the value of the pound will rise in future so buy now
• what is the elasticity of demand for pounds?

  if the pound falls in value, the price of UK goods and services in foreign currency also falls so demand for UK goods will increase:

  • the extent of the increase in the quantity of pounds demanded depends on the price elasticity of demand for UK goods/services.
  • the more elastic the demand for UK goods/services, the more elastic the demand for pounds
• what is the supply for pounds?

  refers to the desire to change pounds into other currencies in order to buy overseas goods/services, travel abroad, save in overseas financial institutions and speculate on foreign currency in the hope it will increase in value.
• what is the elasticity for the supply for pounds?

  if the UK exchange rate falls, price of imports in UK currency increases, this will reduce the amount of imports which are brought.

  • if demand for imports is inelastic, the total amount spent on imports will increase and the supply of pounds is downward sloping.
  • If the demand for imports is elastic, then when their price rises in pounds the total amount spent on them falls.
• what can increase the supply of pounds?

  • overseas interest rates increase so saving abroad becomes more attractive.
  • overseas goods are demanded more
  • people think the pound will fall in the future so they sell it now
• What is a current account deficit?

  Country spending more on foreign goods/services than is being spent on their goods/services. In the long run this could indicate problems with the competitiveness of a country's industries.
• how does a current account deficit effect a floating exchange rate system?

  the external value of the currency falls, making exports competitive again
• how does a current account deficit effect a fixed exchange rate system?

  the deficit may be offset by inflows on the capital account or the gov will have to intervene to buy up excess currency. this cannot continue indefinitely as the country will run out of foreign currency reserves
• what are policies to reduce a balance of payments deficit?

  expenditure switching and reducing
• whats expenditure switching?

  attempts to make imports relatively expensive compared to exports by import controls and reduce the exchange rate
• whats expenditure reducing?

  attempts to reduce spending throughout the economy by increase tax, cut gov spending, increase interest rate
• what are policy packages?

  may be necessary to use a combination of policies to cure a balance of payments deficit.

  • a depreciation will result in consumers switching from imports to exports, but if UK industry is at or near full capacity it will lead to inflation.
  • therefore the gov may deflate the economy using expenditure reducing policies at the same time as allowing the currency to depreciate leading to expenditure switching.
• what is international competitiveness?

  refers to the ability of a country to provide goods and services which provide better value than their overseas rivals. this depends on:

  • productivity, unit costs
  • state of tech & research and development
  • investment in capital equipment
  • quality of design and production
  • entrepreneurship
  • exchange rate
• what are 5 policies to improve international competitiveness?

  1. lower interest rates to stimulate investment
  2. tax incentives for r&d and investment
  3. help entrepreneurs to start up and survive
  4. encourage the sharing of ideas and best practice
  5. reduce protectionist barriers to stimulate competition