3.2 C Effects of high/low exchange rates (and what governments tend to do about them)

1. 3.2 C Effects of high/low exchange rates (and what governments tend to do about them) Chapter 23 Pages 287-289

2. Learning Objectives • Evaluate the possible economic consequences of a change in the value of a currency, including the effects on a country’s • inflation rate, • employment, • economic growth and • current account balance. • Examine the possible consequences of overvalued and undervalued currencies. [what type of exchange rate “regime” is assumed?]

3. In regard to ImportsWhen the a currency depreciates… Trading partners’ currency is more expensive in the FOREX. • Thus their imports are more expensive. • The good news is that this makes domestic producers more competitive against higher priced imported final goods. • The bad news is that this makes imported inputs/raw materials more expensive for those industries that depend upon them – thus they become more expensive and less competitive.

4. In regard to ExportsWhen the a currency depreciates… Domestic currency is less expensive compared to the trading partners’ currency, • Thusexports are less expensive for them. • This improves our eXport (receipts) and thus these industries will grow • Furthermore, the world price for exports, in terms of the domestic currency, actually increases. Summary effect when a currency depreciates, on: • inflation rate, • employment, • economic growth and • current account balance.

5. Low or depreciating Exchange Rates: Pros vs. Cons Advantages • Greater employment in export industry • Greater employment in domestic industry • GDP increases • Positive effect on BoP Disadvantages • Cost of production increases due to more expensive imported raw material – thus decreasing AS • Thus cost push and Demand Pull inflation • Long term: worsening competitiveness

6. Pros vs. cons of a high /appreciating exchange rate • Downward pressure on inflation because… • More unemployment because…. • Good for consumers because…

7. 3.2 D LO: Compare and contrast a fixed exchange rate system with a floating exchange rate system, with reference to any of four major factors. Pages 290-292

8. Floating Exchange Rates: Advantages • “stabilises” current account deficit/surplus. • If too many inflows/outflows in the overseas sector occurs, this imbalance adjusts the exchange rate automatically to counteract that change. • But – regardless of how the CA is changing, International flows of money in the capital account may affect the exchange rate, and thus worsen the current account unintentionally. • No need to employ monetary policy (interest rates) nor “much” buying/selling foreign reserves.

9. Disadvantages of Floating Rates Short term volatility: fluctuations are painful for firms due to uncertainty. Ruins firms if they persist at high levels (and depress growth). If exchange rates remain too low, inflation may “set in” Smaller economies are more vulnerable to large flows of investment funds (“hot money”) due to speculation or fearful events.

10. Advantages of a fixed exchange rates • The main advantage is predictability and certainty for firms. • Any undesirable effect of low or high valuation of the currency may be controlled. • In particular, growth can be increased. How? • There is less risk of currency speculation • However, if everybody knows the country doesn’t have the foreign reserves to “prop up” the currency, it can fail quite dramatically. How?

11. Disadvantages of fixed exchange rates • Loss of freedom to set monetary policy. Why? • Financing current deficits from foreign investment: • Foreign ownership increases • Investment income outflows increase • Selling of foreign reserves – these can run out. • Imposing barriers on imports – but at what cost?

12. Big Extension: the PPP The theory of purchasing-power parity (PPP) says that, in the long run, exchange rates should move towards levels that equalise the prices of a basket of goods and services in different countries—ie, a dollar should buy the same everywhere. Therefore, if US$1 = NZ$1.5, then a basket of goods costing US$240 in USA should cost $NZ360 in New Zealand. Consider the most recent Economist Bigmac index, and an interesting article on the Starbucks index.

13. Bigger Extension: How the USA’s policy of QE strains currency valuations around the world. Read the start of a discussion at the NY Times, and search that newspaper for more. Here is an excerpt from the article QE, currencies and creditors that I have posted on my blog: “The gut feeling that I have been expressing for a while is that the currency set-up is unsustainable and QE only adds to that sentiment. Can the world’s largest economy and debtor nation follow a consistent policy of devaluation, and thus penalising its creditors?”

14. Biggest Extension: a new currency system? Read the interesting article from the Economist Is there a better way to organise the world’s currencies? “American officials blame China’s refusal to allow the yuan to rise faster. The Chinese retort that the biggest source of distortion in the global economy is America’s ultra-loose monetary policy—reinforced by the Federal Reserve’s decision on November 3rd to restart “quantitative easing”, or printing money to buy government bonds (see article)… The underlying truth is that no one is happy with today’s international monetary system—the set of rules, norms and institutions that govern the world’s currencies and the flow of capital across borders.”