exchange rates

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Appreciation

-occurs when the value/price of one currency increases against another/all others

-CAUSES:
Increase in d of £

Decrease in s of £

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depreciation

-occurs when the price/value of one currency decreases against another/all others

CAUSES:

increase in supply of £

Decrease in d of £ on forex

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impact of depreciation on c/acc BOP

-current account:

                        X                                 M

P                      

C

D

V

-value of X increase

-value of M decrease

ceteris paribus, current account deficit decreases

-makes it easier to achieve BOP equilibrium as lesser inflows on financial account make it easier to achieve BOP eq

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Marshall Lerner condition

-following depreciation, current account deficit only decreases if combined PED of X and M was greater than 1

-(must be price elastic for this to decrease deficit)

-if PED of X and M are inelastic, UK current account deficit will deteriorate

-small % increase in X would be purchased but at less total value (as they are cheaper)

-no fall in M meaning value of M rises

therefore, deficit could rise

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J curve effect

-depreciation in exchange rate causes deterioration of the current account in the short term (inelastic demand)

-long term, demand becomes more price elastic and the current account improves

-linked to Marshall Lerner condition

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J curve short term

-fall in price of X will cause a small % rise in QD

-rise in price of M causes small % fall in D for M- value of M rises

- If demand is inelastic following a depreciation, the current account deficit will worsen

-short term: firms and consumers may have contracts requiring them to keep buying good

-higher price of M will be incentive for domestic firms to increase production, but this will take time

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J curve long term

- demand for X and M will become more price elastic 

- therefore, a fall in price of X will cause a bigger % rise in QD (bigger rise in value of X)
-when demand for X is elastic, the value of X rises and current account position improves

-if d for M is price elastic, there will be a bigger % fall in d for M (total spending on M falls-increase in Ad).
-contracts end or change and consumers discover alternatives, making PED more elastic

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Eval of J curve

-current account depends on consumer spending and the rate of econ growth

-also depends on consumer spending in foreign countries (d for X)

-depends on inflation (depreciation can cause imported inflation which reduces the competitiveness of X)

-firms may engage in insurance policies to hedge against exchange rate movements

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impact of appreciation on c/acc BOP

-current account on bop

                       X                              M

P

C

D

V

-as value of X falls and M rise the c/acc deficit on BOP will increase (ceteris paribus)

-makes it difficult to achieve BOP equilibrium, as greater inflows of finances (bigger surplus on financial account) needs to be attracted

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Marshall Lerner and appreciation

-following appreciation, current account deficit will only increase if combined PED of X and M was greater than 1 (marshall Lerner condition)

-if PED of X and M are inelastic, the UK C/acc deficit may actually decrease

-same imports purchased at less total value (cheaper) and same/slight reduction in X, but inflow of currency may increase, meaning the deficit would fall

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Inverse J curve effect

-even if PED of X and M are elastic in the long run, it is likel that the PED of X and M would be inelastic in the short run due to fixed contracts and imperfect information

-therefore, c/acc deficit likely to decrease in the short run before increasing in the long run (info gaps filled and contracts renegotiated), creating an inverse J curve effect

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Appreciation and econ growth

-decrease due to decrease in X and increase in M (ceteris paribus)

-negative multiplier and negative accelerator may be caused, impacting growth

-following a withdrawal from the circular flow of income, through subsequent withdrawals, there is a multiplied decrease in National Income, greater than the value of the original withdrawal

-as Samuelson said that changes in investment are directly linked to NI, a decrease in injections into the circular flow (decrease in X) and increase in withdrawals (M) creates a negative multiplier- REAL GDP falls in % terms triggering an accelerator- decreases more injections (in the form of investment)- multiplier effect continues (TIME LAG)

-size of negative output gap would increase

-although unlikely (e.g. other factors influence AD and policy response, ebb and flow of exchange rates in reality) could be a danger of hysteresis if combined with a fall in confidence and paradox of thrift

-effect depends on level of spare capacity when AD decreased

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Appreciation and econ growth EVAL

-if PED of X and M are inelastic then the Marshall Lerner isn't fulfilled, therefore AD may not fall and may increase

-other factors influence AD 

-as imports are cheaper following the appreciation, raw materials can be purchased at a lower price, lowering the COP - beneficial to net importers

-capital equipment and tech purchased from abroad becomes cheaper (long run benefits) as according to Schumpeter, tech is a key driver of econ growth

-current account deficit may indicate a high standard of living and now imported consumer goods are cheaper living standards may rise again.

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appreciation and unemployment

-cyclical unemployment increases as AD increases- as firms reduces costs they let labour go as labour is a derived demand and less labour is needed than before.

-in exporting manufacturing sector, PED will be elastic, most likely to lay off workers first

-additionally, foreign competition (and imports) in terms of manufactured goods

-negative multiplier creates an increase in cyclical unemployment

-over time a sustained appreciation may cause structural unemployment as manufacturing suffers, adding to the NRU

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Appreciation and un EVAL

-financial sector will remain relatively unaffected, as this is where our comparative advantage lies (PED more inelastic due to expertise and specialisation)

-structural un unlikely to be affect unless deindustrialisation from a lack of competitiveness occurs
           -those who are cyclically unemployed will become structurally unemployed (labour deskilling) which would take significant time

-UK based importers may benefit and take on extra workers

-most importing and exporting firms will not make knee jerk reactions to hiring and firing on the basis of exchange rate fluctuations 

-Time lag on the J curve- fixed contracts

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Appreciation and inflation

imported inflation: the price of imported goods will decrease as they are less expensive to buy from abroad
            -in terms of raw materials this will reduce cost push inflationary pressure

lower domestic demand- UK exports more expensive in terms of foreign currency, decreasing demand for X
-increased demand for M, shifting spending towards M
-decrease in domestic AD, less demand pull pressure

-more incentive to cut costs: manufacturers who export see a decline in competitiveness- provide incentive to cut costs, reducing inflation

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Appreciation and inflation eval

-combined with domestic turndown there could be deflationary pressure
    -only desirable if inflation is below target 2%

-Exchange rate naturally fluctuates and producers may wait before altering prices to a great extent.

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depreciation and econ growth

-AD would increase due to increase in X and decrease in M

+ multiplier and + accelerator may be caused, closing the negative output gap

-effect depends on level of spare capacity when AD increases 

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depreciation and econ growth EVAL

-PED of X and M may be inelastic, therefore AD may not rise

-other factors influence AD (policy response, higher interest rates)

-price of M    after depreciation, raw materials          so COP 

-capital equipment and tech purchased from abroad becomes       expensive, which could have negative long term FX according to Schumpeter, as tech is key driver of economic growth.

-current account surplus - however, there is a lower standard of living, M    , living standards 

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Depreciation and unemployment

-cyclical un     as AD        through positive multiplier

firms employ more workers as demand for products increases (labour is a derived demand)

-if PED is elastic in the export manufacturing sector, it is most likely to increase the number of workers first- little foreign competition, few imports of manufactured goods

-positive multiplier will decrease cyclical un if there is a sustained depreciation 

-NRU decreases as manufacturing improves

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Depreciation and unemployment EVAL

-financial sector will be relatively unaffected as that's where our comparative advantage lies (PED inelastic, specialisation and expertise)

-UK based importers may be negatively affected and begin to lay off workers

-most importing and exporting firms do not make knee jerk reactions to hiring and firing on basis of ER fluctuations

-TIME LAG JCURVE

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Depreciation and low inflation

-price of imported goods will rise as they will be more expensive to buy from abroad

-raw materials increasing will increase cost push inflationary pressure

-increasing domestic demand. UK exports are less expensive in terms of foreign currency 

d for X increases

-increase in X and decrease in M means a rise in AD, more demand pull inflation

-manufacturers who export see a rise in competitiveness have less incentive to cut costs- increasing cost push inflation

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depreciation and inflation EVAL

-inflation is only desirable if inflation is below target 2%

-exchange rate naturally fluctuates and producers may wait before altering prices to a great extent

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