Exchange rate

Exchange rate

Value of one currency expressed in terms of another

When we

Export more and import less- AD increases (shifting to the right)

Import the same at higher costs- SRAS increases (shifts to the left)

If demand for imports is inelastic, we would still import the same quantity at a higher cost

Impact on unemployment

Greater demand for exports can increase the demand for labour, required to produce the additional output being demanded from us by other companies

Fall in the value of the pound

Increasing AD leads to higher economic growth in the short run

Also it becomes cheaper for foreign firms to set up and invest in the UK economy

But more difficult for them to export to the UK

Impact on BOP

Increased demand for exports as they’re cheaper

Reduced demand for imports- more expensive

Elasticity of demand for imports/ exports will determine the extent of the impact

More elastic demand = more sensitive to changes in price/ value of currency

Floating exchange rate

Exchange rate that is set purely by the forces of demand and supply, and free from government intervention

Forces include:

Demand:

Exports of goods and services, speculation, inflows of hot money

Supply:

Imports of goods and services, speculation, outflows of hot money

Hot money- where investors save money in countries with high interest rates

Advantages

Automatic adjustment of BOP- weaker currency makes exports more price competitive, which helps to improve the BOP deficit

Flexibility- government isn’t trying to maintain a particular exchange rate, which can be expensive and constrictive

Low requirement to hold large foreign exchange reserves- floating exchange rate system doesn’t require to hold large reserves