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economics

Asked by tbakkar | Feb 1, 2008 | KS3 Level > Economics > Coursework
tbakkar
tbakkar asks:

I have a couple of questions, thanks so much.

If a country were to increase the value of their
currency, how could that improve their economy?

How does the value of currency (the increasing or decreasing of) affect the debt,deficit, CNI, GDP, & GDP per capita and is there a chart that shows these relationships.

Do you know how a country's currency can valuate (the
valuation process- how a currency can increase); how
does that occur?

Thanks so much,

Tony

etutor answers:

There are lots of questions here! I am assuming here that when you refer to the currency value, you mean its EXTERNAL VALUE - in other words, the exchange rate. I have looked at both appreciation and depreciation here, all of it in context of sterling's value against the euro and the dollar. The major effects on the economy are detailed below, though you should be warned they are ften quite complex, and involve a fair amount of theory. I have omitted debt (since there is almost no effect, and in any event I don't know what debt you are referring to), CNI (since I have never heard of it) and GDP per capita (since the effect is the same as on GDP; you simply divide it by population). I have no access to a chart showing the various relationships; you might usefully scan the ONS website.

The Effective Exchange Rate Index (EER) is an index of the value of the £ against a ‘basket’ of international currencies, each weighted according to their significance in the UK’s trade, and is thus a measurement of the overall level of competitiveness of UK goods. A fall in the exchange rate represents an increase in competitiveness, and vice versa.

In a purely floating exchange rate system, the value of a currency against other currencies is determined by changes in the supply of, and demand for the currency on the foreign exchange market. When the demand rises, the value of the currency rises, and vice versa. When the supply rises, the value of the currency falls, and vice versa. The factors that would cause a rise in demand for a currency (say the £) would include: an increase in UK exports of visibles and invisibles (since importers abroad have to buy £ to pay the exporters); an increase in the number of tourists visiting the UK; an increase in overseas direct investment in the UK (multinationals setting up plants here); an increase in speculative currency inflows ('hot money') caused by speculators converting their currencies into £ to take advantage of higher interest rates in the UK, or on expectation of a future increase in the value of the £. Factors that will cause an increase in the supply of the £ (and thus a fall in its value) include: an increase in UK imports of goods and services (since UK importers have to supply £ on the foreign exchange market to buy the foreign currency to pay for the imports); an increase in UK citizens travelling/holdaying abroad; an increase in direct investment by UK companies abroad (particularly in the USA and EU); an increase in speculative currency outflows abroad (due to higher interest rates abroad, fear of a future fall in the value of the £, or even political instability at home).

Changes in the exchange rate have always had significant effects on the UK economy, though for much of the post-war period they were dominated by devaluations of sterling (as in 1949, 1967 and 1992) or long periods of depreciation (for much of the 1970s and at times in the 1980s). A lower £ was traditionally the ‘get out clause’ for much of manufacturing industry, since it represented an artificial boost to competitiveness, and bought a temporary stay of execution from the need to address more fundamental problems of low investment, poor productivity, outdated product ranges and high unit costs. In more recent years, however, sterling has been much more likely to appreciate against the currencies of our major trading partners. The exchange rate is not of course the only factor affecting export and import sales volumes. Relative prices at home and abroad, marketing and distribution networks, perceptions of the quality of products, the position of economies in the business cycles, and the capacity of firms (together with the extent to which they exploit it) are some of the other key determinants.

The rise in the £’s value after 1996 reflected a widespread perception in markets that it had previously been undervalued. Markets were also impressed by the decision, in May 1997, to grant the Bank of England operational independence. This decision, together with the Chancellor’s tough inflation target and new, tighter fiscal ‘rules’, inspired confidence in the UK economy. As the policy objectives of low inflation, high growth and falling unemployment were simultaneously achieved, while nominal interest rates were appreciably higher in the UK than elsewhere, sterling was increasingly seen as a ‘safe haven’. This was particularly the case when the euro proved to be frail in the early months after its launch in 1999. By mid-2001, sterling was 30% above its 1995 level, though its appreciation was chiefly against the euro. In more recent years, much of sterling's appreciation has been against the US dollar rather than the euro; indeed, it is now gently though persistently falling against the euro.

A high and appreciating £ brings with it a number of potential benefits:

It becomes cheaper for firms to import raw materials, energy and components, lowering their unit costs.
It increases the living standards of consumers who now have access to cheaper goods from overseas.
It makes travel and holidays abroad cheaper for UK citizens.
Since all imports are now cheaper, including finished goods, it directly reduces inflationary pressures, and also indirectly if lower costs for firms and lower prices for consumers influence pay settlements in a downward direction.
It also reduces inflationary pressures through its impact on aggregate demand, since the resulting fall in the value of exports (or, more accurately, in export growth) and rise in the value of imports represent a net withdrawal from the circular flow of income.

There are, on the other hand, several potential drawbacks:

Exports become less competitive and exporting companies are likely to see reduced sales and market share; similarly, UK companies face increased competition from imports in domestic markets. This is particularly significant for an open economy such as that of the UK.
The resulting impact on their profit levels causes many firms to search for cost savings, or else to reduce the scale of their operations. Many respond by reducing the size of their workforce, leading to higher unemployment. This in turn reduces the incomes of the unemployed and the resulting fall in aggregate demand has a downward multiplier effect on the level of real output.
The trade deficit will tend to increase as exports (or export growth) fall and imports rise.
Since parts of manufacturing industry are most heavily affected by the appreciation of the currency, regional income and employment differences are likely to become greater.

In reality, an appreciation of sterling may sometimes have little effect, or even a perverse effect:

Much depends upon the scale of the appreciation, the length of time it lasts (or is expected to last), and whether it encompasses all the currencies of the UK’s trading partners.
In practice, larger firms can and often do react by cutting the sterling level of their export prices, hence maintaining sales at the expense of profit margins.
Firms often respond to pressure by introducing measures to increase productivity to lower costs and to ensure survival, or simply exercising greater control over costs. The familiar exercises in ‘outsourcing’ are the most recent example of this approach.
Some firms may choose to focus upon higher value added products that are then sold in markets where demand is more price inelastic, or else search for ‘niche’ markets where demand is income elastic; others may relocate abroad.
in the balance of trade, especially if large numbers of traders are locked into future contracts.

Normally, in the past, high growth in the UK has coincided with a depreciating currency, while low or negative growth (as in 1990-92) has coincided with an appreciating currency. Yet, despite the regular howls of anguish from parts of the manufacturing sector, the high level of sterling did not slow down UK growth until 2005, and then only temporarily. This in part reflects the diminishing influence on the growth rate of manufacturing, which accounts for the greater part (55%) of our exports and which is most affected by exchange rate changes. By 2006, manufacturing’s share of GDP had fallen below 15%, while manufacturing output declined in 2001 and 2002, before experiencing a very modest recovery since then. Meanwhile, apart from a mild dip in 2002 and a more significant fall in 2005, annual GDP growth has generally been at or around 3%. Any adverse effect of currency appreciation on the (X-M) component of the aggregate demand equation has been more than offset by rapidly growing spending by consumers and by the government. Consumer spending is, however, slowing down markedly in 2007/08, and so the growth rate of GDP in the UK is unlikely to exceed 2% in 2008.

Between 2003 and the summer of 2007, there was a small appreciation of sterling, though this disguised two very different trends. While the £ has appreciated against the dollar by more than 30%, at the same time it has depreciated against the euro by about 15%. Sterling’s trend fall against the euro is more important, since our trade with the eurozone is nearly four times greater than that with the USA. Since the autumn of 2007 (when the value of the £ against the US $ exceeded $2) there has been a continuing fall against the euro and a small fall against the $.

The high value of the £ against the $ has been a mixed blessing for the UK. While it helps to keep down the price of all commodities that are priced in dollars, it continues to erode the competitiveness of UK firms exporting to the USA and to reduce still further the price of US goods competing in our domestic market. Fears that trade will be harmed have been heightened as the larger Asian manufacturing economies, such as China, peg their currencies to the dollar, and so also see their goods become cheaper in overseas markets. Another concern is that the rise in the value of the euro against the dollar will continue to result in weaker demand in the eurozone through its impact on EU exports, thus offsetting some of the benefit of sterling’s depreciation against the euro. This is more significant than sterling’s appreciation against the dollar, since 51.4% of UK exports go to the eurozone, compared with only 14.4% to the USA.

The UK’s current account deficit has increased as a % of GDP from below 2% in 2001 to a record £65 B (4.3%) in 2007. The deterioration in the trading position can be attributed not only to the strength of sterling and supply-side weaknesses, but also to factors that have contributed to weak overseas demand. These include the 1997 Asian crisis, the upheaval in financial markets in 1998, the US recession of 2001-02 (and the downturn since 2007), and sluggish growth in most years in the eurozone. While the traditional surplus on services and the substantial surplus on investment income go some way towards offsetting the deficit in goods, both are extremely volatile and vulnerable, while since 2006 the UK has become a net importer of oil.

Looking now at the effects of a devaluation. Devaluation of the £ against, say, the euro means that there has been a fall in the exchange rate - hence the £ now exchanges for fewer units of the euro. This has the effect of making the price of UK exports to the eurozone cheaper, and the price of the eurozone's goods and services imported into the UK more expensive. This assumes that both exporters and importers adjust the price they are charging in line with the depreciation; they might instead choose to leave prices unchanged. Assuming that the price of exported goods is lowered in line with the depreciation, then more UK goods will be sold in the eurozone. The extent to which the quantity sold increases depends upon the price E of D for UK exports – the greater the value of PED, the greater the % increase in sales of exports. Similarly, the higher price of goods imported from the eurozone reduces the quantity bought here; the greater the value of PED for imports, the greater the % decrease in purchases. The MARSHALL-LERNER THEOREM states that a devaluation/depreciation will improve the current account if the SUM of the PED for X and M exceeds 1. In the short run (perhaps up to 2 years), the UK's current account is likely to worsen before it improves, because of the J CURVE EFFECT. In other words, it takes time for the quantities sold and purchased to respond to the new prices, largely because new markets have to be found and contracts have to be re-negotiated. The reverse of the above analysis applies in the case of a revaluation/appreciation of sterling.

In the case of a depreciation, if the Marshall-Lerner condition is fulfilled, the resulting eventual improvement in the current account represents a net injection into the economy, since (X-M) is part of the Aggregate Demand equation. This will then have a MULTIPLIER effect on output and employment. Much, however, depends upon the DOMESTIC SUPPLY RESPONSE to the increased demand for EXPORTS and for IMPORT SUBSTITUTES. If the economy is operating at or around full employment, or if the AGGREGATE SUPPLY schedule is inelastic, the depreciation will simply result in HIGHER INFLATION, since AD now exceeds AS. In these circumstances, governments will need to deflate the economy in order to ‘make room’ for the increased exports. A depreciation also raises the cost of imported goods and services. This is particularly significant for UK firms that rely on imported energy or raw materials, since it increases their costs, and may therefore result in higher final prices. This is especially if they also find themselves conceding higher pay settlements in response to the higher price of manufactured goods and services from the eurozone, and the increase in the RPI that is the direct result of imported inflation. This would eventually result in the Bank of England raising interest rates to ensure that the inflation target is met, which would have the effect of retarding the growth of the UK economy. Hence, an appreciation of the currency, by contrast, might be seen as a counter-inflationary measure, obliging firms to cut costs in order to remain internationally competitive, and relieving any pressure on the Bank of England to raise interest rates.

All of the above effects are likely to be significant for the UK, as over 50% of UK overseas trade is conducted with the eurozone. The devaluation might also attract more FDI to the UK because of the competitive price advantage, though much would in practice depend upon whether investors saw the devaluation as permanent.

I hope this is helpful.

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Tony
Tony
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