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AS Econs

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Published in: Business Strategy
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Tan C / Kuching

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  1. Il Page EXCHANGE RATE The price of one currency in terms of another currency/ external value of a money. External value of currency —Exchange rate Internal value of currency- what currency can by in its own country. Depends on price level EXCHANGE RATE SYSTEM Floating Prices determined by market forces of supply and demand Increase-Appreciation Decrease-Depreciation TYPES Nominal Exchange rate Price of one currency in terms of another Bilateral rates Fixed Government intervenes to maintain the price of the currency value Increase- Revaluation Decrease - Devaluation Traded weighted exchange rate The price of one currency against a basket of currencies- based on the relative importance in trading terms for the country of each. Multilateral exchange rate Real effective exchange rate A currency's value in terms of its real purchasing power A fall in country's exchange rate would be expected to make exports more price competitive BUT if the country experiencing a relatively high inflation rate, import prices may actually be increasing.
  2. DEMAND AND SUPPLY OF CURRENCY Demand Increase if Good s/services demanded more —may due to increase in quality(higher added value) Domestic interest rate increases More attractive to save People think the value will increase in future. Buy low sell high (Speculate on making profit ) 2 Page Supply increases if Demand for foreign goods increases Foreign interest rate increases People think domestic currency will drop IN FREE MARKET Graph: CAUSES OF : Depreciation Reduction in number of exports sold abroad Reduction in number of foreign investors Interest rates drops Increase supply of domestic currency Appreciation Reduction in consumption of imports. Reduction in number local investors invests in overseas. Interest rates rises Decrease in supply of domestic currency
  3. IMPACTS OF : Depreciation 1. Domestic manufacturers become more competitive due to the demand for export increases. 2.1nflation Cost passed to the consumers(extend depends on the elasticity) 3. Increase demand of Factors of Production Unemployment rate drops 4.BOP deficit replaced by surplus (refer J- curve effect) 13 Page Appreciation 1. Domestic consumers switch to imported goods. So, the import expenditure increases and export revenue decreases. 2. Unemployment rate increases due to falls in demand for domestic labour force Economic Effects of a Currency Depreciation When the pound depreciates against the US dollar It makes UK import prices RISE It makes UK export prices FALL Changes in import and export prices will affect demand Import sales will CONTRACT Export sales will EXPAND This will have an effect on a number of key economic indicators Domestic production Trade deficit Domestic jobs
  4. A currency appreciation makes exports more expensive & is likely to lead to an inward shift of AD 4 Page The Effects of a Currency Appreciation Y2 Y3 A currency appreciation makes imports cheaper & likely to cause an outward shift of AS GPL GPLI GPL2 1 1 1 AS GPI GPLI GPL2 1 1 1 ASI AS2 ADI ADI GPL3 1 1 1 AD2 Yl Real GDP 1 1 1 1 1 AD2 1 Yl Real GDP Marshall-Lerner Condition and J Curve The Marshall-Lerner condition states that a real devaluation (or a real depreciation) of the currency will improve the trade balance if the sum of the elasticities (in absolute values) of the demand for imports and exports with respect to the real exchange rate is greater than one, Exportsped+lmportsped > 1 J Curve A country's trade balance experiences the J-curve effect if its currency becomes devalued. At first, the country's total value of imports (goods purchased from abroad) exceeds its total value of exports (goods sold abroad), resulting in a trade deficit. But eventually, the currency devaluation reduces the price of its exports. Consequently, the country's level of exports gradually recovers, and the country moves back to a trade surplus. In short run The demand of imports and exports are inelastic In long run The demand of imports and exports tend to be elastic
  5. Firms/Consumers are reluctant to change so will keep purchasing the same product /raw materials in short run. So, when export price drops, the export revenue falls. When import price rises, the import expenditure increases. So, BOP deficit increases Rationale behind J-Curve Page 5 Firms /Consumers switch to the cheaper alternatives (e.g local substitute) in long run So, when the export price drops, the quantity demanded increases, total export revenue increases. When import price rises, the quantity demanded decreases, total import expenditure decreases. So, BOP deficit decreases Immediately following the depreciation or devaluation of the currency, the volume of imports and exports may remain largely unchanged due in part to pre-existing trade contracts that have to be honoured. Moreover, in the short run, demand for the more expensive imports (and demand for exports, which are cheaper to foreign buyers using foreign currencies) remain price inelastic. This is due to time lags in the consumer's search for acceptable, cheaper alternatives (which might not exist). Over the longer term a depreciation in the exchange rate can have the desired effect of improving the current account balance. Domestic consumers might switch their expenditure to domestic products and away from expensive imported goods and services, assuming equivalent domestic alternatives exist. Equally, many foreign consumers may switch to purchasing the products being exported into their country, which are now cheaper in the foreign currency, instead of their own domestically produced goods and services Current account surplus Current account deficit J CURVE Time
  6. 6 Page Impact of Currency Depreciation Economic Effects of a Currency Depreciation When the pound depreciates against the US dollar It makes UK import prices RISE It makes UK export prices FALL Changes in import and export prices will affect demand Import sales will CONTRACT Export sales will EXPAND This will have an effect on a number of key economic indicators Trade deficit Domestic production Domestic jobs
  7. Page 7 Questions 29 The diagram shows the market for Japanese Yen. st price of Yen in terms of other currencies quantity of Yen What could have caused the change in the supply of Yen from St to S2? A B C D a reduction in the level of international 'investment into Japan a reduction in the level of Japanese tariffs a reduction in the value of foreign goods imported into Japan a reduction in the value of Japanese goods exported 30 To reduce a deficit on the current account of the balance of payments, a government imposes a limit on the foreign exchange its people and firms can purchase. Why may this increase the counW's inflation rate? A B C D Firms may have to purchase more expensive, domestically-produced raw materiåls. Firms may have to sell more of their output on the domestic market. The change in demand for foreqn currency on the foreign exchange market may lead to an appreciation in the exchange rate. The change in supply of the domestic currency on the foreign exchange market may reduce the money supply in tie domestic economy. 28 Demand for imports is often price inelastic in the short term. Over twne, demand tends to become more price elastic. What does this help to explain? A B C D why a fall in the exchange rate causes a deficit on the current account of the balance of payments to increase before decreasing why a fall in the exchange rate causes inflation to rise before falling why a rise in the exchange rate causes a surplus on the current account of the balance of payments to decrease before increasing why a rise in the exchange rate causes the terms of trade to worsen before improving
  8. 8 Page 29 The table shows the number of Jamaican dollars which exchanged for one unit of other currencies in time period 1 and Orne period 2. Jamaican $ time period 1 Barbados $ Guyana $ What might be concluded from the table? 23.19 025 45.78 63.86 Jamaican $ time period 2 23.12 025 45.77 64.37 A B C D There was a decreased demand for Barbados $ by Jamaicans. There was a decreased supply of Guyana $ to Jamaicans. There was an increased demand for IJS$ by Jamaicans. There was an increased supply of LIKE to Jamaicans. 26 A country experiences a devaluation of its currency. Under which circumstances is thes most likely to cause inflation in the country? dependence on price elasticity of price elasticity of c imported raw materials high high Ilow low demand for imports inelastc elastic inelastic elastic demand for elastc inelastic elastic inelastic 26 A country experiences a devaluation of rts currency. Under which circumstances is ths most likely to cause inflation in the country? dependence on price elasticity of price elasticity of c imported raw materials high high low low demand for imports inelastic elastic inelastic demand for exports elastic inelastic elastic inelastic
  9. 19 Page 28 In the diagrami DI 01 and SISI are the initial demand and supply curves of the pound sterling (E) on the foreign exchange market D, price of Es in SUS O st quantity of E What will cause the demand curve to shift to and the supply curve to S2S27 A B C D an appreciation of the pound an increase in LIK interest rates a reduction in the level of UK import tariffs a reduction in the quality of LIK goods 29 In a country the Marshall-Lerner condition for an improvement in the trade balance is satisfied in the long run, but quantities of imports and exports are slow to respond to price changes. The govemment devalues its currency to reduce its trade deficit Which curve indicates the probable behaviour of the trade balance? trade balance 8 c time
  10. | 10 Page 28 Country X trades with only countries, the LISA and Japan. of the country's trade is with the LISA and 10% is with Japan. The original value of the trade-weighted exchange rate index is 100. The value of counÃœy Xis currency against the IJS$ rises by 10%. The value of country X's currency against the Japanese yen rises by 50%. What will be the value of country XTs new trade-weighted exchange rate index? A 114 B 115 c 130 D 160 29 What is most likely to cause a rise in a country's exchange rate? A B C D a fall in its direct taxes a fall in its export orders a rise in its interest rates a rise in its imports 27 With an exchange rate of 30 Thai baht to $IJSI an American export sells in Thailand for 150 baht What change in the exchange rate of the baht would cause the export to sell for 165 baht? A B C D a depreciaton of 10% a depreciation of 15% an appreciation of 10% an appreciation of 15% 28 The diagram shows demand and supply curves of the E sterling against the LIS dollar. s price of E sterling in US dollars s o quantity of Es What is likely to cause a shift in the demand curve from 01 to A B C D an adverse balance of payments in the LIK an increased demand for LIK goods in the LISA an increase in LIK tourists visiting the LISA an increase in LIS interest rates
  11. | 11 Page 30 What is most likely to immediately reduce the deficit on the current account of a counto/s balance of payments? A B C D a cut in its interest rates a rise in its income tax rates cuts in subsidies to domestic industry purchases of its currency by its government 28 Country X trades with only b,vo countries, Nigeria and Malaysia. 80% of the counWy's trade is with Nigeria and 20% is with Malaysia. The original value of the trade-weighted exchange rate index is 100. The value of the country Xs currency against the Nigerian Naira rises by 10%. The value of the country X's currency against the Malaysian Ringgit rises by 50 Yo. What will be the value of country X's new trade-weighted exchange rate index? A 115 B 118 c 130 D 160 29 In the diagram, curves DtDt and SS relate to the demand for and supply of E sterling in the foreign exchange market D price of E sterling s o quantity of E sterling mat may cause the demand curve to shift from DIDI to 02027 1 A B C D an increase in UK interest rates an increase in the price of US goods sold in the UK the removal of UK tariffs against LIS goods the development of LIS substitutes for UK goods

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