the exchange rate - a-level economics

8/13/2019 The Exchange Rate - A-level Economics

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Exchange Rate Policy and SystemsMeasuring the exchange rate

Exchange rates are expressed in various ways:

o Spot Exchange Rate - the spot rate is the exchange ratefor a currency at current market prices. This isdetermined by the FOREX market on a minute-by-minutebasis on the basis of the flow of supply and demand.

o Forward Exchang e Rate - a forward rate involves thedelivery of currency at a specified time in the future at anagreed rate. Companies wanting to reduce risks fromexchange rate volatility can buy their currency forwardon the market.

o Bi-lateral Exchange Rate - the rate at which onecurrency can be traded against another. Examplesinclude: $/DM, Sterling/US Dollar, $/YEN or Sterling/Euro

o Effecti ve Exchange Rate Index (EER) - a weighted index of sterling's value against a basket ofcurrencies the weights are based on the importance of trade between the UK and each country.

o Real Exch ange Rate - this is the ratio of domestic price indices between two countries. A rise in thereal exchange rate implies a worsening of competitiveness for a country.

Exchange rate systems

A country can decide the type of exchange rate system that they want to follow.

System Main Characteristics Recent UK History

Free FloatingExchangeRate

The value of the pound is determined purely by demandand supply of the currency

Trade flows and capital flows affect the exchange rateunder a floating system

No target for the exchange rate

No intervention in the market by the central bank

Rare for pure free floating to exist

Sterling has floated since the UK suspendedmembership of the ERM in September 1992

The Bank of England has not intervened toinfluence the pounds value since it becameindependent

ManagedFloatingExchangeRate

Value of the pound determined by market demand forand supply of the currency

Some currency market intervention might be consideredas part of demand management (e.g. a desire for aslightly lower currency to boost export demand)

Governments normally engage in managedfloating if not part of a fixed exchange ratesystem.

Managed floating was a policy pursued in theUK from 1973-1990

Semi-FixedExchangeRates

Exchange rate is given a specific target

The currency can move between permitted bands offluctuation on a day-to-day basis

Interest rates are set at a level necessary to keep theexchange rate within target range or directintervention in the FOREX marketRe-valuations are seen as a last resort

The UK operated a semi-fixed system fromOctober 1990 - September 1992 when amember of the ERM

Sterling eventually forced out of the ERM by awave of speculative selling
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Fully-FixedExchangeRates

The exchange rate is pegged

No fluctuations from the central rate

System achieves exchange rate stability but perhaps atthe expense of domestic stability

A country can automatically improve its competitivenessby reducing its costs below that of other countries knowing that the exchange rate will remain stable

The Bretton Woods System which lasted from1944-1972 was a fixed rate system wherecurrencies were tied to the US dollar

Trade-weighted index value for sterling in the foreign exchange market, daily valueUnited Kingdom Effective Exchange Rate Index

Source: Reuters EcoWin

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The sterling effective exchange rate index is shown in the chart above. After a period of relativestability in 2004-06 sterling first appreciated by around 5-7% in 2006-07 and then started todepreciate rapidly from the summer of 2007 onwards. From peak to trough at the start of 2009 theexchange rate index fell by 30%, one of the biggest depreciations in the UKs recent economic

history. The pound fell sharply against most but not all currencies; the depreciation was mostnoticeable against the US dollar and versus the Euro.

Sterling has rebounded in the foreign exchange markets in the first half of 2009.

The Case for Floati ng Exchange Rates

The main arguments for adopting a floating exchange rate system are as follows:

1. Reduced need for currency reserves : There is no exchange rate target so there is littlerequirement for the central bank to hold big reserves of gold and foreign currency to use inofficial intervention in the markets

2. Useful instrument of economic adjustment : For example depreciation can provide a boostto exports and therefore stimulate growth during a recession and when there is a risk ofdeflation.
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3. Parti al automatic correction for a trade deficit : Floating exchange rates can help when thebalance of payments is in disequilibrium i.e. a large current account deficit puts downwardpressure on the exchange rate, which should help exports and make imports relatively moreexpensive. Much depends on the price elasticity of demand and supply of exports and theprice elasticity of demand for imports see the later section on the Marshall-Lernercondition and the J-curve effect .

4. Less opportunity for currency speculation : The absence of an exchange rate target mightreduce the risk of currency speculation. Speculators tend to attack currencies where agovernment is trying to maintain an exchange rate out of line with economic fundamentals.

5. Freedom (autonomy) for domestic monetary policy : The absence of an exchange ratetarget allows policy interest rates to be set to meet domestic objectives such as controllinginflation or stabilising the economic cycle. Countries locked into a single currency systemsuch as the Euro do not have the same freedom to manage interest rates to meet their mainmacroeconomic aims.

The Case for Fixed Exchange Rates

The main arguments for adopting a fixed exchangerate system are as follows:

1. Trade and Investment: Currency stabilitycan promote trade and investment becauseof less currency risk. Overseas investors willbe more confident that the returns from theirinvestments will not be destroyed by violentfluctuations in the value of a currency.

2. Some flexibility permitted: Someadjustment to the fixed currency parity ispossible if the economic case becomesunstoppable (i.e. the occasional devaluation or revaluation of the currency if agreement canbe reached with other countries). Some countries are tempted to engage in competitivedevaluations.

3. Reductions in the costs of currency hedging : Businesses have to spend less on currencyhedging if they know that the currency will hold its value in the foreign exchange markets.

4. Disciplines on domestic producers: A stable currency acts as a discipline on producers tokeep their costs and prices down and may encourage attempts to raise productivity and focuson research and innovation. In the long run, with a fixed exchange rate, one countrys inflationmust fall into line with another (and thus put substantial competitive pressures on prices andreal wages)

5. Reinforcing gains in comparative advantage : If one country has a fixed exchange rate withanother, then differences in relative unit labour costs will be reflected in changes in the rate ofgrowth of exports and imports. Consider the example of China and the United States. Forseveral years China pegged the Yuan against the dollar. Until July 2005 the exchange ratewas fully fixed; since then the Chinese have allowed only a gradual depreciation of the dollaragainst the Yuan. Most estimates indicate that the Chinese currency is persistentlyundervalued against the dollar. This makes Chinese products cheaper than they wouldotherwise be and has led to a surge in import penetration from China into the US. This hasled to numerous calls from US manufacturers for the Chinese to be persuaded to switch to afloating exchange rate or to adjust their currency by appreciating against the dollar.

Competitive devaluations Competitive devaluations occur when a country deliberately intervenes in foreign exchange marketsto drive down the value of their currency to provide a competitive boost to demand and jobs in their
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export industries. They may also try to do this when faced with the threats of a deflationary recession. Another reason is to entice extra foreign investment into a currency.

For nations with persistent trade deficits and rising unemployment a competitive devaluation of theexchange rate can become an attractive option - but there are risks. One is that devaluing anexchange rate to avoid deflation or inject extra demand into export industries can be seen by othercountries as a form of trade protectionism that invites some form of retaliatory action . Cutting theexchange rate makes it harder for other countries to export their goods and services hitting theircircular flow.

One of the reasons often cited as to why the 1930s Great Depression lasted so long was thatcountries acted independently to protect their own interest by undermining their currencies. Ultimatelya competitive devaluation provides only a temporary boost to competitiveness. And a policy ofholding down an exchange rate can be costly.

For many years the International Monetary Fund (IMF) has tried to help countries coordinate theirtrade and foreign exchange policies in order to prevent repeated devaluations. The 1976 revision of

Article IV of the IMF charter was written to avoid "manipulating exchange rates...to gain an unfaircompetitive advantage over other members."

Switzerland intervenes to drive their currency low er

Euros per Swiss Frnace, ECB Reference Rate, Daily FixingEuro - Swiss Franc Exchange Rate


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Attempted devaluation

The Swiss Central Bank has opted to intervene directly in the currency exchanges. This is the first time aleading central bank has intervened in the foreign exchange markets since Japan sought to weaken the yen in2004. And it is the first official intervention in the markets by the Swiss since 1995 although they have triedverbal intervention in the past in an attempt to talk the currency down.

At times of global economic uncertainty investors look for assets and currencies that hold their value and offer asafe haven - gold and the Swiss Franc fit neatly into this category and the result has been strong demand forFrancs driving it higher against the Euro. For the Swiss National Bank an appreciating currency represents aninappropriate tightening of monetary conditions during an economic slowdown and they have decided to enterthe market and use Swiss Francs to buy other foreign currencies. This will lead to an outward shift in themarket supply of Swiss Francs and an outward shift in the demand for Euros.

The Swiss franc had risen some 6 percent against the euro since December and some 10 percent against arange of currencies in trade-weighted terms since the credit crisis broke in 2007. Official policy interest ratesare already at zero and the Swiss economy (which is heavily export dependent) is facing the worst recession

for 30 years and a serious risk of price deflation.Source: Tutor2u economics blog, March 2009

The Swiss franc has continued to appreciate in value against the Euro since this blog was written


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Currencies in Europe: The European Exchange Rate Mechanism II

Local exchange rates to the Euro, daily valuePegging to the Euro - Estonia and Latvia


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Fix or float? Decisions about which exchange rate system to choose are important for most of the countriesinside the European Union. The UKs brief membership of ERM from 1990 to 1992 was the closest the countrycame to embracing Economic and Monetary Union (EMU). In the years that followed the UK pounds ERM exit,it has floated freely against the euro and Britain. In reality the chances of the UK joining the Euro Zone in theshort term are remote. However, following the launch of the euro in January 1999 ERM II was created for EUmember states that had not yet joined the euro.

ERM II is designed to ensure exchange rate stabilit y between the euro and prospective members of thesingle currency. Each ERM currency is given a central exchange rate against the euro with a maximumfluctuation band of +/-15%. Once a currency has been in ERM for two years without any devaluation outsidethe permitted band, it meets one of the key convergence criteria for entering the Euro Zone. If a countryscurrency is close to falling outside the permitted bands the European Central Bank (ECB) and the central bankof the country affected will intervene by buying and selling currency to try to stabilise the exchange rate.Interventions of this kind are only for short term exchange rate problems not in circumstances where forexample the currency is clearly overvalued (similar to the UK in 1992).

When ERM II came into being in 1999 there were only two members, Denmark (which like the UK has an optout from the euro) and Greece. However, the latter joined the euro in 2001. Denmarks fluctuation bands for itscurrency the Krone are only +/- 2.25% for a central rate against the euro and hence its monetary policy is tiedstrongly to the ECB.

In recent years several countries have been in the ERM, Slovenia, Malta, Cyprus and Slovakia, but they havenow all joined the euro and are no longer in the ERM. Along with Denmark there are only three other countriescurrencies in the ERM II; Estonia, Lithuania and Latvia. Indeed Estonia has pegged her exchange rate to theEuro since the Euro was launched in 1999. Latvia locked into the ERMII at the start of 2005. Countries hopingto join the ERM in the next couple of years are Hungary (2010), Bulgaria (2010) and Romania (2011). But thecurrent recession and credit crunch has hit many eastern European economies hard and some of theseprovisional dates may be a little over ambitious.

An anomaly is the position of Sweden which has decided to stay out of ERM even though it is technicallycommitted to euro membership by the terms of its membership in 1995. If the euro continues to expand itsmembership most EU countries will pass through ERM membership at some stage as the opt out afforded tothe UK and Denmark is not available to new members.

Adapted from EconoMax, author Robert Nutter


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What determines the value of a currency?

In floating exchange rate systems, the market value of a currency is determined by the demand forand supply of a currency. Most currency dealing is purely speculative but trade and investmentdecisions also have a role to play. Some of the key factors that can affect a currency are as follows:

1. Trade balances countries that have strong trade and current account surpluses tend(ceteris paribus) to see their currencies strengthen as money flows in from exports of goodsand services and investment income.

2. Foreign direct investment an economy that attracts high net inflows of capital investmentfrom overseas will see an increase in currency demand

3. Portfolio investment much currency trading is used to finance cross-border portfolioinvestment, for example investors putting funds into stocks and shares, government bondsand property. Strong inflows of portfolio investment from overseas can cause a currency toappreciate

4. Interest rate differentials - if UK interest rates are higher than rates on offer in othercountries then ceteris paribus we expect to see an inflow of currency into UK banks and otherfinancial institutions. The higher the interest rate differential, the greater is the incentive forfunds to flow across international boundaries and into the economy with the higher interestrates. Countries offering high interest rates can expect to see hot money flowing across thecurrency markets and causing an appreciation of the exchange rate.

US dollars per 1, daily closing exchange rate; US and UK official policy interest rates (%)Dollar-Sterling and Interest Rate Differentials

Source: International Monetary Fund

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There are inevitable risks in shifting funds across international markets. What might happen to thecurrency if you leave $200,000 worth of cash in a UK bank account? What happens to the value ofyour investment if sterling depreciates against the US dollar? What are the risks in exchanging a

similar value of US dollars and putting it into the UK stock market or into government bonds?Investors often consider the risk-adjusted relative rate of return from different financialinvestments.


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The Carry Trade

The carry trade refers to a strategy where investors borrow low-yielding currencies and lend high-yielding currencies. For example hundreds of billions of $s have been staked on borrowing inJapanese Yen (where official interest rates have been very low for several years) and lending /investing in countries offering a more attractive interest rate or rate of return - such as New Zealand,Iceland or economies in Eastern Europe.

The big risk in carry trading is that foreign exchange rates are volatile and move sharply in a directionthat wipes out gains made through carry trade speculation to the effect that the investor would haveto pay back more expensive currency with less valuable currency. There is also some evidence thatsome of the explosion in carry-trade activity funded money flowing in sub prime lending in the USA.

Dangers from the Carry Trade (Bob Nutter)

In recent years many speculators have made a financial success of what is known in the moneymarkets as the carry trade. The carry trade involves speculators borrowing money in one countrywhere interest rates are low and investing that money in another country where either the interestrate is high or asset values are rising. When the speculator repays the low interest loan the profit is

what is left over; making it seem a certain way to make money without really trying.Origins in Japan

The carry trade first became part of global currency dealings in recent years when Japan had verylow or zero interest rates in the 1990s. Japan was in a period of negligible economic growth anddeflation and low interest rates were part of a package of monetary and fiscal policies to get theeconomy moving again. At this time it was thus very cheap to borrow in Japan and interest rateselsewhere were relatively higher.

Per centJapan's Zero Interest Rate Policy


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For example if a speculator borrowed the equivalent of $100,000 in yen at 1% interest and thenconverted the yen into Australian dollars where interest rates were say 5% a profit of $4,000 could bemade in a year. Many carry trade transactions involved much more of an outlay than that and sothere is the potential for a lot of easy money for speculators.

Unfortunately there is a significant risk in the carry trade. The risk for speculators comes with themovements of exchange rates. If, in the above example, the yen had depreciated during the carryperiod this would have led to increased profit.However, an appreciation would mean that a lot of the profit made in Australian dollars would be lostin the exchange transaction as more dollars would then be needed to buy yen. It is the


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unpredictability and volatility of exchange rates that makes the carry trade dangerous for speculatorsand potentially destabilising for the global financial markets.

Part of the problem relates to what is called uncovered interest parity theory which basically says thateconomies with low exchange rates and low interest rates are likely to see an appreciation of theircurrency in the near future. Similarly high exchange rate and high interest rate economies are likelyto see a fall in their currencies. In this latter case the high current interest rates are to compensatecurrency dealers for the expected fall in the currency.

Thus according to this theory borrowing in a low interest rate currency and investing in a high interestrate currency could cause problems in the future if exchange rates have moved in the waysuggested. Related to this issue is the time when speculators in carry transactions unwind theirinvestments and take the profits. Those that are first to the door generally make good returns, but,as the volume of transactions increase back into the currency where the money was borrowed, it ispossible that the volume of monetary movements will pull the exchange rates in unfavourabledirections for the speculators. The currency being sold will depreciate and the buying currency willappreciate thus progressively reducing the potential gains.

Risks of unstable finance markets

US policy rates (top pane) , Hong Kong property price index (bottom pane)How might low US interest rates affect Hong Kong property prices?

Source: OECD

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There is now renewed concern that the carry trade is going to destabilise the financial markets morethan the yen carry trade did in the 1990s. Some blame the yen carry trade for the Asian Crisisin1997. The fear is that a dollar carry trade could have devastating results unless it is checked.

With Ben Bernanke at the Federal Reserve saying recently that US interest rates are going to stayexceptionally low for an extended period it is now possible to borrow very cheaply in dollars andinvest in some high yielding assets especially in the Far East, e.g. the Hong Kong property marketwhere house prices rose 28% over the last year. The fact that the Hong Kong dollar is pegged to theUS dollar reduces the risk of such carry activity.

The real worry is that the dollar will continue to fall partly because of low interest rates and also thedollars carry trade causing the selling of dollars. In addition the US government may be happy to seea dollar depreciation as it will help revive the US economy. However, a falling dollar can cause globalinflation as many commodities are priced in dollars.

In addition the dollar carry trade could cause asset price bubbles all over the world and this couldfurther destabilise the financial markets. Zhao Qingming, a Beijing-based analyst at ChinaConstruction Bank Corp., said recently that low borrowing costs in the U.S. have spurred a carrytrade with some currencies, notably the Australian dollar after recent rate increases by that nationscentral bank. The carry trades will further drive down the dollars value and fuel commodity prices,Zhao said. The dollars depreciation has also caused excessive liquidity in the global market.


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Will the dollar carry trade cause a global asset bubble that will inevitably burst with direconsequences? Time will tell.

Source: EconoMax, Robert Nutter

Reserve currencies A reserve currency is sometimes called an anchor currency and is a currency that nationalgovernments and other institutions are happy to hold as a key part of their foreign exchangereserves. It also acts as a global pricing currency for many commodities such as gold, oil, wheat andcopper.

For decades the reserve currency of choice has been the US dollar partly because the USA is theworlds biggest economy. For the Americans one of the benefits of this is that the USA can borrowfrom the rest of the world at a slightly lower interest rate because there has been a lengthy queue offoreign investors willing to purchase $ denominated assets such as US Treasury bonds. China forexample has amassed a mountain of foreign exchange reserves arising from their super-charged

trade surpluses. The bulk of their $2 trillion worth of foreign exchange reserves are in dollars and alarge percentage of US government debt is owned by the Chinese the fortunes of the twoeconomies are now closely entwined. China is spooked by the scale of the fiscal stimulus beingintroduced by the Obama administration and the likely size of the quantitative easing that the USFederal Reserve will undertake to drag the US economy out recession. If the worlds supply of USdollars increases at too fast a rate the US dollar will lose value and Chinas huge investments in theUS economy will suffer too.

In recent years there has been a shift in holdings of foreign exchange there are now more Euros incirculation than dollars, and the euros role as an international reserve currency is growing. By thefirst half of 2008 the euro accounted for 27 per cent of official foreign reserves, up from 18 per centsoon after its launch. The dollars share fell from 71.2 per cent to 62.5 per cent during the same

period.The two requirements for a currency to have reserve status is credibility of a government that it willnot default on its debt or attempt to debase its currency by printing too much of it. China, India,Russia and Brazil are four emerging economies with growing global power but they are not yet readyto assume the mantle of an economy large enough for their domestic currency to have reservequalities.

Is it ti me for a Tobin Tax?

In recent months, in the wake of the global financial crisis, there has been a revival in support for aTobin tax on foreign currency transactions i.e. when one currency is converted into another.

James Tobin, after whom the tax concept is named, first proposed the idea in 1972 after the collapse

of the Bretton Woods f ixed exchange rate system in 1971. The 1970s, another era of economicinstability, saw the bulk of the major currencies move to a floating exchange rate system where spotrates were determined by market forces. Thanks to the progressive relaxation of exchange controls
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this led to volatile exchange rate movements as speculators moved hot m oney around the financialworld chasing the best short term return.

A speculative attack on a currency can cause an economic crisis as it plunges in value causingpolicy makers to instigate unnecessary interest rate increases to stem the outflow. The UKs ERMexit in 1992 and the Asia Crisis in 1997 are examples of the power of speculators in foreignexchange markets in a globalised financial world.

A Tobin tax would simply impose a tax of less than 1% on currency transactions. The idea would beto reduce the huge speculative flows that can cause a foreign exchange rate to reflect merely shortterm expectations rather than long term fundamentals.

Emerging economies are keen to find ways of controlling boom-bust capital flows , and hope atransaction tax could help dampen the destabilising effect of sharp swings in "hot money" flowing inand out of their countries. Indeed Brazil has already imposed a 2% tax on currency transactions, totry and prevent its currency, the real, from appreciating too rapidly over the coming months.

However, even if a Tobin tax gained widespread agreement internationally, a necessary condition forit to work effectively globally, at what rate would it be set at? A rate as low as 0.005% has been

suggested which would raise over 35bn annually; while a rate of 0.05% could raise up to 400bn.Is there an optimal rate for a Tobin tax? Some economists have suggested that the tax should be seton a sliding scale, with a high tax rate for those who hold currency for the shortest period of time.This would hopefully have the effect the deterring the short term hot money flows that causes suchvolatile swings in currencies.

Another major hurdle for the Tobin tax to surmount is what should happen to the proceeds of the tax?Many foreign exchange transactions are done in London so would this mean that the UK exchequerwould benefit rather disproportionately? Should the tax revenue been pooled by say the IMF andthen used to fund development aid to reduce global poverty? Should countries use these taxrevenues to reduce their fiscal deficits? Many financiers and fund managers dislike the idea of aTobin tax as it might negatively affect equity and bond markets and add to business costs. Will theUK, with its reliance on the financial sector, really be as committed to the tax if there could bepotential damage to the City of London?

In short there is a need for intergovernmental agreement before any real progress can be made.There is certainly a need to set up a global regulatory framework for the banking and financial sector.In addition, with governments in severe debt, a dislike for the financial sector among the public atlarge as well as a feeling that the banks and financial institutions need to give something back aftertheir rescues by the state maybe the time for a Tobin tax has finally come.

Source: EconoMax, Bob Nutter, spring 2010

The scale of global currency transactions

Despite the financial crash in recent years, the Bank of International Settlements has confirmed thatthe UK retained its top spot for leading on global currency transactions. London-based bankshandled 37% of the worlds foreign exchange deals in a three year period to April 2010, followed bythe United States with 18% and Japan with 6%.

Currency transactions grew by 20% in the last three years, with an average daily turnover of $4trillion. This sum is equivalent to the entire output of the global economy being traded around once afortnight on currency markets. This implies that if a Tobin Tax was imposed, it would generate quitethe revenue for governments!

Source: Tutor2u Economics Blog, August 2010, Mo Tanweer

The Exchange Rate and Inflation:


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The exchange rate affects the rate of inflation in a number of direct and indirect ways:

1. Changes in the prices of imported goods and services this has a direct effect on theconsumer price index . For example, an appreciation of the exchange rate usually reducesthe sterling price of imported consumer goods and durables, raw materials and capital goods.

2. Commodity p rices and the CAP : Many commodities are priced in dollars so a change inthe sterling-dollar exchange rate has a direct impact on the UK price of commodities such asoil and foodstuffs. A stronger dollar makes it more expensive for Britain to import these items.

3. Changes in the growth of UK export s : A higher exchange rate makes it harder to selloverseas because of a rise in relative UK prices. If exports slowdown (price elasticity ofdemand is important in determining the scale of any change in demand), then exporters maychoose to cut their prices, reduce output and cut-back employment levels.

Bank of England research suggests that a10% depreciation in the exchange rate can add up to 3% tothe level of consumer prices three years after the initial change in the exchange rate. But the impacton inflation of a change in the exchange rate depends on what else is going on in the economy.

Exchange rate index (top pane) and inflation (lower pane)Inflation and the Exchange Rate for the UK


95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

0.51.01.52.02.53.03.54.04.55.05.5

P e r c e n t

0.51.01.52.02.53.03.54.04.55.05.5

Consumer Price Inflation

70

75

80

85

90

95

100

105

110

I n d e x

70

75

80

85

90

95

100

105

110

Sterling Exchange Rate Index

Sterlings depreciation during 2008 contributed to rising inflation through higher import prices. A yearbefore, the relative strength of sterling helped to partially cushion the blow of the severe rise in oiland food prices many of which are priced in US dollars.

The Exchange Rate and Unemployment

1. An exchange rate appreciation tends to cause a slower rate of growth of real GDP because ofa fall in net exports (reduced injection) and a rise in the demand for imports (an increasedleakage in the circular flow).

2. A reduction in demand and output may cause job losses as businesses seek to control costs.Some job losses are temporary reflecting short term changes in export demand and importpenetration. Others are permanent if domestic industries move out of some export markets or
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if imports take up a permanently higher share of the UK market. Thus a higher exchange ratecan have a negative multiplier effect on the economy.

3. Some industries are more exposed than others to currency fluctuations e.g. sectors where ahigh percentage of total output is exported and where demand is highly price sensitive (priceelastic)

The 2008 depreciation of sterling

In 2008 the pound fell sharply against a range of currencies. Sterlings weakness was put down toseveral macroeconomic factors:

Steep cuts in official policy rates by the Bank of England

A dramatic weakening of the real economy with growth forecasts being slashed and arealisation that a recession was inevitable. Currency traders decided that the UK economywas more exposed than most to the downturn in the world economy and the unwinding of theproperty bubble.

Linked with the recession - a downgrading of expected real returns from investment in the UK

The macroeconomic benefits of a weaker currency

A fall in the currency represents an expansionary monetary policy and can be used as a counter-cyclical measure to stimulate demand, profits, output and jobs. It ought to bring about animprovement in the balance of trade and, through higher export sales, drive higher demand andoutput in industries that serve export businesses the so-called supply-chain effect .

Economists at Goldman Sachs have estimated that a 1% fall in the exchange rate has the sameeffect on UK output as a 0.2 percentage-point cut in interest rates. On this basis, the 25% decline insterling in 2007-08 was equivalent to an additional cut in interest rates of between 4 and 5percentage points this at a time of domestic and global economic weakness. Without thedepreciation in sterling at this time, the recession in the UK would have been much deeper.

Real National Output Real National Output

Pricelevel

SRAS

AD2

AD1

AD

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SRAS1

LRAS LRAS

Y2 Y1 Y1 Y2

A fall in export demand - lower GDP negative output gap

A fall in the cost of importing raw materials- Increase in GDP reduction in inflation

Pricelevel


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the exchange rate - a-level economics

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