Exchange rates changes

How does a reduction in the exchange rate affect exports and imports?

• A reduction in the exchange rate makes exports cheaper, increasing their demand (assuming price elasticity).

• Imports become more expensive, which reduces demand for foreign goods.

• This improves the current account balance, reducing a deficit.

• However, it can lead to inflation as imported raw materials become pricier, raising production costs (cost-push inflation).

What is the Marshall-Lerner condition?

• The Marshall-Lerner condition states that a devaluation of currency will only improve the balance of trade if the sum of the price elasticities of demand for exports and imports is greater than or equal to 1.

• If the demand for both exports and imports is sufficiently elastic, the trade balance will improve after a devaluation.

What is the J-curve effect?

• The J-curve effect occurs when a currency is devalued.

• Initially, the trade deficit worsens because imports become more expensive, causing their total value to rise.

• Over time, exports increase, and the trade deficit improves, leading to a J-shaped curve in the trade balance over time.

How do exchange rates affect Aggregate Demand (AD)?

• An appreciation in the exchange rate makes imports cheaper and exports more expensive, likely leading to a decrease in AD as demand for domestic goods falls.

• A depreciation increases exports, boosting AD, as domestic firms can increase sales abroad.

• The magnitude of the effect depends on inflation rates and the price elasticity of demand for goods.

How do exchange rate changes affect firms?

• A depreciation in the exchange rate makes UK exports more price competitive. Firms can reduce prices in the export market or maintain prices to increase profit margins.

• If UK goods are inelastic in demand, the impact of the exchange rate change on sales may be minimal.

• If firms import raw materials, a weaker pound increases production costs, which can hurt profitability unless contracts are fixed.

How do exchange rate changes affect FDI?

• A depreciation in the currency reduces production costs and wages in the country, making it more internationally competitive.

• This is likely to attract more Foreign Direct Investment (FDI) as firms seek to take advantage of lower costs.

How does a depreciation of the exchange rate affect inflation?

• A depreciation of the currency is likely to be inflationary because imports become more expensive, increasing production costs (cost-push inflation).

• As aggregate demand rises from increased exports, upward pressure on the average price level can occur.

What is the Eurozone?

• The Eurozone is a monetary union where member countries use the Euro as their common currency.

• It is more economically integrated than a customs union and free trade area.

• It involves shared monetary policies, including the same interest rates set by a central authority, like the European Central Bank (ECB).

What are the convergence criteria for joining the Eurozone?

• Budget deficit: No more than 3% of GDP.

• Government debt: Must be below 60% of GDP.

• Inflation: Must be below 1.5% of the three lowest inflation countries.

• Government bond yield: Must be within 2% of the lowest yields in the Eurozone to ensure exchange rate stability.

What is needed for an optimal currency zone?

• Real convergence: Member countries must respond similarly to external shocks or policy changes.

• Flexibility: Product and labour markets must be flexible to absorb shocks, which could include geographical and occupational mobility of labour and price and wage flexibility.

• Fiscal transfers may help balance regional economic imbalances.

How does the fixed exchange rate in the Eurozone affect countries?

• Eurozone countries cannot devalue their currency to restore competitiveness if they face a current account deficit.

• Economic decline in the Eurozone can negatively affect countries like the UK, especially if the Eurozone is a major trading partner.

What are the benefits of the Euro in terms of currency stability?

• The Euro reduces speculative shocks and gives currency stability.

• This stability encourages investment and promotes economic growth.

• The absence of currency exchange fees simplifies travel and trade across member countries.

What are the advantages of being part of the Eurozone?

• Increased currency stability, leading to more certainty and investment potential.

• Reduced administrative costs, including lower fees and less red tape for businesses and tourists.

• Lower interest rates due to Germany's monetary credibility, potentially encouraging more investment and job creation.

What are the disadvantages of the Eurozone?

• Labour mobility is limited due to language barriers, and economic differences between countries mean a common monetary policy may not work for all.

• Fixed exchange rates prevent countries from adjusting their currency to meet their own economic needs, such as boosting exports.

• Member states lose some sovereignty over their monetary policies, having to cooperate with weaker economies.

• The one-off cost of joining the Euro involves changing labels, prices, and other infrastructure, which can be significant.