Highers Economics

1. Highers Economics The sterling exchange rate Does a fall in the pound matter?

2. What’s been happening? A brief history

3. A brief history • Background • Flexible and fixed exchange rates • Depreciation and appreciation • Devaluation and revaluation • The sterling exchange rate • Multiple exchange rates • Exchange rate index • Long-term movements

4. $ / £ exchange rate and£ exchange rate index: 1976–2009 $ / £

5. $ / £ exchange rate and£ exchange rate index: 1976–2009 $ / £

6. $ / £ exchange rate and£ exchange rate index: 1976–2009 Index 2005=100 $ / £

7. $ / £ exchange rate and£ exchange rate index: 1976–2009 Index 2005=100 $ / £

8. A brief history • Background • The sterling exchange rate • Long-term movements • Long-term movements betweendollar and euro

9. Fluctuations between the euro and the dollar

10. A brief history • Background • The sterling exchange rate • Long-term movements • Long-term movements betweendollar and euro • The fall in the pound: 2008–9

11. Depreciating sterling 2008–9 Source: based on data in Statistical Interactive Database (Bank of England )

12. Depreciating sterling 2008–9 Source: based on data in Statistical Interactive Database (Bank of England )

13. Depreciating sterling 2008–9 Source: based on data in Statistical Interactive Database (Bank of England )

14. What causes the exchange rate to rise or fall? A tale of demand and supply

15. Exchange Rates • Determination of exchange rates • the equilibrium exchange rate

16. Determination of the rate of exchange $ price of £ Q of £

17. Determination of the rate of exchange $ price of £ D by USA Q of £

18. Determination of the rate of exchange b a QS QD S by UK Excess supply of pounds leads to a depreciation. $ price of £ D by USA Q of £

19. Determination of the rate of exchange c d QD QS S by UK Shortage of pounds leads to an appreciation. $ price of £ D by USA Q of £

20. Exchange Rates • Determination of exchange rates • the equilibrium exchange rate • what causes a depreciation? • shifts in currency demand and supply

21. Floating exchange rates:movement to a new equilibrium S1 € / £ D1 Q of £

22. Floating exchange rates:movement to a new equilibrium S1 € / £ D1 D2 Q of £

23. Floating exchange rates:movement to a new equilibrium S1 S2 € / £ D1 D2 Q of £

24. Exchange Rates • Exchange rates & the balance of payments • Current account • Exports (+) and Imports (–) • Government transfers: inward (+); outward (–) • Income flows: inward (+); outward (–) • Capital account • Financial account • Direct investment: inward (+); outward (–) • Portfolio investment: inward (+); outward (–) • Other financial flows: inward (+); outward (–) • Reserves: drawing on (+); building (–) • Net errors and omissions

25. Floating exchange rates:movement to a new equilibrium S1 Supply = B of P –ve items Demand = B of P +ve items € / £ D1 Q of £

26. Floating exchange rates:movement to a new equilibrium S1 Supply = B of P –ve items Demand = B of P +ve items S2 € / £ D1 D2 Q of £

27. UK Balance of Payments Source: Based on Times Series Data (National Statistics)

28. Exchange Rates • Exchange rates & the balance of payments • Causes of a depreciation

29. Causes of a depreciation • rise in aggregate demand • fall in interest rate • change in inflation rate • inward investment less attractive • speculation against depreciation S1 S2 € / £ D1 D2 Q of £

30. Why did the exchange rate fall last year and into this? Was it the credit crunch?

31. Causes of the falling pound • Credit crunch worse in UK than in many other countries • Financial services sector larger in the UK than elsewhere • Potential detrimental effect on services part of current account • Recession potentially deeper • Interest rates fell further in the UK • Interest rates would remain lower in the UK for longer

32. Central bank interest rates

33. Causes of the falling pound • The carry trade

34. The Carry Trade Borrowing at low interest rates and then using it to buy assets that earn higher rates. In foreign exchange markets, the carry trade involves borrowing money in a currency of a country where interest rates are low and exchanging it for another currency where the country pays higher interest rates.

35. Causes of the falling pound • The carry trade • UK has had long-term current account deficits • Thus relatively high interest rates • Other countries, e.g. Japan and Switzerland, have had current account surpluses • Thus relatively low interest rates • People borrowed from Japan and deposited in the UK, pushing the £ up and the ¥ down • This made the UK’s current account deficit worse!

36. The Carry Trade Currencies of deficit countries appreciated, making their goods less competitive thereby worsening their current account deficit. Between 1996 and 2006, the average current account deficits as a % of GDP for the USA, the UK and Australia were 4.0, 1.8 and 4.4 respectively. The US dollar appreciated by 9.8 per cent, sterling by 27.7 per cent and the Australian dollar by 3.8 per cent over the same period.

37. The Carry Trade Currencies of surplus countries depreciated, making the their goods more competitive and further boosting their current account surpluses. Between 2004 and 2006, the Japanese yen depreciated by 10.4 per cent, the Swiss franc by 2.3 per cent and the Swedish krona by 4.3 per cent.

38. Causes of the falling pound • The unwinding of the carry trade • Credit crunch caused sort-term financial flows to decrease • Currencies of deficit countries (e.g. UK, USA) began to depreciateCurrencies of surplus countries (e.g. Japan, Switzerland) began to appreciate. • This was made worse by speculation

40. Causes of the falling pound • Role of speculation • Stabilising and destabilising speculation • Stabilising speculation

41. Stabilising speculation: initial depreciation S3 S2 b er3 c er2 D3 D2 S1 a er1 Speculators believe that the depreciation to er2 is only temporary. Exchange rate D1 O Quantity of sterling

42. Speculation • The effects of speculation • Stabilising and destabilising speculation • Stabilising speculation • Destabilising speculation

43. Destabilising speculation: initial depreciation S2 S2 er2 b c er3 D2 D3 S1 a er1 Speculators believe that the depreciation to er2 signifies a trend. Exchange rate D1 O Quantity of sterling

44. Speculation • The effects of speculation • Stabilising and destabilising speculation • Stabilising speculation • Destabilising speculation • Overshooting

45. Depreciating sterling 2008–9 Source: based on data in Statistical Interactive Database (Bank of England )

46. Does the fall in thepound matter? A story ofgainers and losers

47. Gainers and losers • Gainers • Exporters • Foreign currency earnings are worth more £s • Allows exporters to cut foreign currency prices to become more competitive • People with assets denominated in foreign currencies • Property owners • Investors • People with bank accounts in foreign currencies

48. Gainers and losers • Losers • Importers • Increased price of imports • Are these passed on to consumers or absorbed by importers? • People with assets denominated in sterling • Foreign residents • People in this country wishing to invest abroad

49. Overall effects • Helps current account • Exports rise • Imports fall • Helps to aid recovery(rise in aggregate demand) • Possibly inflationary • Greater fluctuations • May cause greater exchange rate uncertainty • May reduce inward and outward investment • Restoration of PPP exchange rate?

50. Bic Mac Prices (July 2009)