9. Exchange Rates: Consequences and Evaluation

AD and SRAS Effects of a Strong and Weak Exchange Rate

Strong Exchange Rate - Decrease in AD, Increase in SRAS

Weak Exchange Rate - Increase in AD, Decrease in SRAS

Pros of a Weak Exchange Rate

Focus on AD Chain

Increased Growth and Living Standards

Decreased Unemployment

Increased Current Account Balance

Inward FDI

Cons of a Weak Exchange Rate

SRAS Chain

Increase in Inflation and Interest Rates

Decrease in Living Standards

Domestic Producer Inefficiency

Increase in Foreign Debt Burdens

Evaluation for Weak Exchange Rates

Marshall-Lerner Condition

Incomes Abroad

Incomes at Home

Protectionism

Output Gap

Firm Reaction to Higher Costs

Size/Duration of Depreciation

Pros of a Strong Exchange Rate

SRAS Chain

Decreased Inflation and Interest Rates

Increase in Living Standards

Increase Domestic Producer Efficiency

Decrease in Foreign Debt Burdens

Cons of a Strong Exchange Rate

AD Chain

Decrease in Growth and Living Standards

Increase in Unemployment

Decrease in the Current Account Balance

Outward FDI

Evaluation for Strong Exchange Rates

Elasticities

Incomes Abroad

Incomes at Home

Output Gap

Firm Reaction

Size/Duration of the Appreciation

Pros of a Fixed Exchange Rate

Exchange Rate Stability

Domestic Producer Efficiency

Some Changes Possible

Less Currency Hedging - Less Speculation

Cons of a Fixed Exchange Rate

Loss of Monetary Policy Autonomy - Interest Rates are only there to maintain the exchange rate

Large Need for Currency Reserves - Money could be spent more productively elsewhere in the economy

Evaluation of a Fixed Exchange Rate

PPP - Overvalued = Speculation, Undervalued = Could be seen as protectionist

Retaliation

Lack of Competitiveness - Can’t use cheap exports from weaker currency, so could be chronically uncompetitive unless firms are hyper-efficient

Pros of a Floating Exchange Rate

Monetary Policy Autonomy

Less Need for Currency Reserves

Benefits of Exchange Rate Changes - Often happens when the economy needs it

Automatic Correction of Current Account Imbalances - Deficit can put downward pressure on the exchange rate and surplus can put upward pressure on the exchange rate

Less Speculation on PPP reflected

Cons of a Floating Exchange Rate

Exchange Rate Volatility - Can take away confidence in that exchange rate which can harm growth, trade and FDI

Pros of a Managed Exchange Rate

Benefits of Exchange Rate Changes

Exchange Rate Stability

Cons of a Managed Exchange Rate

Unintended Consequences of Interest Rate Changes

Cons of Exchange Rates Changes (e.g. cons of stronger or weaker exchange rates)

Retaliation

Risk of Speculative Attacks

What is a Monetary/Currency Union

An agreement between two or more countries to share a common currency, single monetary policy and often use a shared central bank

Advantages of a Monetary/Currency Union

Non-Fluctuating Exchange Rate

Reduced Costs from Absence of Currency Conversion

Increased Business Confidence

Currency More Stable Against Speculation

Prices Between Countries are Easier to Compare

Disadvantages of Monetary/Currency Union

Loss of Monetary Policy Autonomy

No Potential for Countries to Alter their Exchange Rates - Cannot Influence Trade

Cost of changing currency is very high

Lack of a Fiscal Union