3.1.5 Exchange rate changes

What happens to exports when the exchange rate falls

exports become cheaper and increase

What condition must hold for exports to rise

demand must be price elastic

What happens to imports when the exchange rate falls

imports become more expensive

How does depreciation affect the current account

the deficit improves

Why can depreciation cause inflation

imported raw materials cost more

What type of inflation can result from higher import costs

cost-push inflation

What is the Marshall–Lerner condition

trade balance improves if export and import elasticities add to at least one

Why might devaluation not improve the trade balance immediately

demand is inelastic in the short run

What is the J-curve effect

trade balance worsens before improving after devaluation

Why does the trade deficit worsen at first after devaluation

imports become more expensive before quantities adjust

Why does the trade balance improve in the long run

consumers switch to domestic goods

What causes the time lag in trade balance adjustment

contracts and inelastic demand

How do exchange rates affect aggregate demand

by changing export and import prices

What happens to AD when the currency appreciates

AD falls

Why does AD fall when the currency appreciates

exports are dearer and imports cheaper

What does a high marginal propensity to import mean

households import even if currency strengthens

How does a weaker exchange rate affect employment

higher exports can create jobs

How can a stronger exchange rate cause job losses

cheaper imports reduce domestic demand

What does SPICED stand for

strong pound imports cheap exports dear

How does depreciation affect firms’ export prices

exports become more competitive

How can firms respond to depreciation

cut prices or increase profit margins

Why might depreciation not raise export sales much

demand may be price inelastic

How does growth in export markets affect export sales

higher confidence raises demand

How does depreciation affect firms that import raw materials

production costs rise

How can firms avoid exchange rate uncertainty

fixed import contracts

Why might firms not improve efficiency after depreciation

higher margins reduce incentives

What is foreign direct investment

capital flows to gain lasting control abroad

How does depreciation affect FDI

lower costs attract more investment

How does depreciation affect inflation through AD

higher exports increase demand

What is the Eurozone

a monetary union using the euro

What is a key feature of a monetary union

shared interest rates

Why are current account deficits a concern in the Eurozone

members cannot devalue

How does a strong pound affect UK tourists abroad

they can buy more

Why did fears of Grexit strengthen the pound

investors saw it as safer

How does a weaker euro affect Eurozone exports

exports become more competitive

Why did Eurozone recession affect UK exports

the EU is a major trading partner

What is an advantage of a common currency

exchange rate stability

How does a common currency benefit firms

lower transaction costs

Why might interest rates be lower in a monetary union

shared monetary credibility

What is a disadvantage of a monetary union

loss of independent monetary policy

Why is labour mobility limited in the Eurozone

language and cultural barriers

Why might a single interest rate be unsuitable

economies differ in performance

What is a cost of joining a currency union

changing prices and systems