AS Economics (Macro)

putiflatwi
Epi
.

Chapter 8: Exchange rates

IÑ-aualusEnteeaal_aes_
Nominal exchange rate

It is the price of one currency in terms of another. OR The esteemed value

fore currency
interns
ifanother .

Trade weighted exchange rate

It is an index measure of the value of currency against a basket of currencies, with each
currency assigned a weight depending on its relative importance in terms of trade with that
country.

Real effective exchange rate

𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 (𝐶𝑃𝐼)

Nominal exchange rate x
𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 (𝐶𝑃𝐼)

( measures a currency’s purchasing power of other country’s goods)

Exchange rate systems

É¥nedER→
ER
Managed Float

Floating market -

F- Rsetbythe
-

1- combo of floating
-

ER set by gout S refined limits

fokesifdemandd
"
-
tower dapper
" set to regulate
supply Ssi OER
fluctuations
between

float
>

BE which it can

ERM

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 Dieeuaudfoekso
ERA
- we relationship b/w F- R&B ,

D.rs '

>
QRS
i

ER supplyfRs@
SRs

F-Rd Srs
+ve relationship b/w

Qrs
Free floating exchange rate

Free floating exchange rate is left on the foreign exchange market as it works on the principles
of demand and supply. Changes in demand and supply directly affect exchange rates in such a
regime.
Demand for any currency is downward sloping as it is negatively related with exchange rate
changes, while supply of the currency is upward sloping as it is positively related to changes in
exchange rate.

Equilibrium exchange rate

A
Sec
The changes in the exchange rate
are due to the changes in the
demand and supply of the
ER
currency in a floating exchange
rate system.
Die
a.
Factors affecting demand and supply of a currency

Factors shifting demand to right Factors shifting supply to right

• Demand for exports (goods and
services) increases, it can lead to
foreigners demanding more of local
currency
• Investment prospects in local country
rise, it causes people to invest more in
local country which increases demand
for local currency as local currency is
needed for investment by foreigners
• Savings from abroad increase in local
country, causing people to demand
more local currency
• Positive speculation: when it is expected
that the price of the currency will rise in
the future, people increase demand for
local currency
• Demand for imports (goods and
services) increases, it leads to locals
buying more foreign currency and in
turn selling local currency so supply rises
• Investment prospects abroad rise,
causing locals to invest more abroad,
increase demand for foreign currency
and hence increasing supply of local
currency to buy foreign currency
• Savings in foreign countries rise from
local country, causing supply of local
currency to rise to buy foreign currency
• Negative speculation: when it is
expected that the price of the currency
will fall in the future, people start selling
local currency, increasing its supply

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 Fined Fined
Floating
↑ ↑ Mooting ↑
.

ER↑ Appreciation/ Revaluation ER↓ Depreciation/Devaluation

When a currency becomes expensive, this is
normally caused when the demand of local
currency increases and its supply decreases.
Rise in exchange rate by govt in fixed ER
regime is called revaluation
E.g. In 2010, $1 = Rs 150
When a currency becomes cheap, this is
normally caused when the demand of
currency decreases and its supply increases.
Fall in exchange rate by the govt in fixed ER
regime is called devaluation
E.g. In 2010, $1 = Rs 150
01
§,E=%so¥i:p .

In 2011, $1 = Rs 160, here dollar is In 2011, $1 = Rs 160, here the rupee is

appreciating depreciating
Eik £ S,
S'
Sz
↑ D↑/S↓ ERI →
er ,
D↓/s↑
Dz ER ! ↓
D
D, D. '

Qcc

Fixed exchange rate: it is the government or a central

bank of a country that sets and keeps a fixed rate of
currency known as official exchange rate.

A central bank can keep its exchange rate fixed through 2 tools:

• Buying and selling Foreign exchange reserves

• Interest rates
$
If there is an appreciating pressure Sz
on currency i.e rise in demand or

%
decrease in supply , central bank - - - - - - - - - - - ± --
- - - Crout
can buy foreign reserves by selling
local currency which would Jgction
increase the supply of local OER •

currency or decrease in interest

rate which would lower the
demand hence the appreciating
pressure would be then
normalized as the exchange rate
would come back to the fixed
exchange rate.
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 51 52
If there is an depreciating pressure
on currency i.e. decrease in
demand or increase in supply ,
central bank can sell foreign
reserves by buying local currency
OER •

which would increase the demand

of local currency or increase in
② Gove D
.
. . .
. . ._ . . . .
. .
- -- - -
-
-

interest rate which would increase

2
the demand and normalize the action
exchange rate. D,

Pros and cons of floating exchange rate

Advantages
• The exchange rate automatically
adjusts, moving current account
position to equilibrium /eliminating
deficits or surpluses.
• No need for the central bank to keep
reserves, foreign currencies/gold can
be used for other purposes.
• Governments can pursue other
objectives more easily e.g., changing
Disadvantages
• May cause instability of value of
currency which could discourage trade
and investment.
• May cause speculation, causing
movements in value which lead to
current account deficits and surpluses.
• May cause imported inflation in case of
depreciating pressures on currency.

[58 IR ↑
interest rates to influence inflation
to
keep ER from ↓ → co B ↑→ I ↓ → output ↓ → warp↑ ,

to
↳ Eg of how
uneuip is compromised just fined ER .

Pros and Cons of Fixed Exchange Rate

Advantages Disadvantages
• May be a greater degree of certainty • Need to keep reserves, to intervene to
and stability, may promote trade and protect the exchange rate, involves an
investment. → Risk ↓ opportunity cost.
• May be less speculative and debt • Exchange rate may not be set at an
depreciating
burden.especially ifthere ispressure
a
appropriate level, if too high will discourage
der
ing
on

•
-

Lessens imported inflation in case of countries .

depreciating pressure on currency that
is avoided by fixed exchange rate
(especially in developing countries)
• Keeps a country’s external debt burden
in check
exports, if too low may increase import
prices causing inflation.
• Policies taken to maintain the exchange
rate may conflict with other objectives e;g;
raising the interest rate may increase
unemployment / reduce economic growth

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 How does
floating
a ER
automatically
correct a
/
CAS CAD ?

CAD__:-(X - M)
Cfflow of money outflow of money)
<

CAD →
✗ am →

c. As
→ × - M→D①→_DT
→
ERT →
-
y①TP⑤^→ca⇐ .

Wolf : -
Form mostly
reserves arefor used

eternal debt
eg inputs
foreign paymentsetc
,

aid
payments
.

,
Note: How does floating exchange rate automatically correct current account deficit and
surplus?

Current account deficit is when the value of imports is greater than the value of exports that
means the demand for exports is less than the demand for imports so as a consequence the
demand for local currency would decrease too while its supply would increase. The exchange
rate would decrease as its supply exceeds its demand so the prices of the exports would
decrease in the international market while the prices of imports would increase due to low
exchange rate . this will eventually increase the demand for our exports in the foreign market
as other nations would now start buying our exports due to their low prices hence decreasing
the demand of imports sideways. So after some time when the exports demand would increase
and the demand for the imports would decrease than automatically after some time the
current account deficit will improve and go toward the surplus . this is how floating exchange
rate works and affects the current account balances.

Causes of exchange rate Appreciation and Depreciation

Depreciation
• When the domestic interest rate is less
than the foreign interest rate, locals
save in foreign banks which cause the
supply of local currency to rise and
foreigners tend to save less in local
banks which then decreases the
demand of local currency which leads
to exchange rate depreciation
• If domestic inflation is greater than
foreign inflation which leads to higher
prices of local goods and comparatively
low prices of foreign produced goods
which would then lead to decrease in
demand of exports and increase in the
demand of imports. Hence demand of
local currency decreases and supply of
local currency increases hence causing
exchange rate depreciation.
• If Domestic investment prospects are
less than foreign investments locals
would invest abroad hence increasing
the supply of local currency and
foreign investment also decrease
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Appreciation
• When the domestic interest rate is
more than the foreign interest rate
hence locals would save in local banks
which would reduce supply of local
currency and foreigners would tend to
save more in local banks which then
increase the demand of local currency
which leads to exchange rate
appreciation
• If domestic inflation is less than foreign
inflation which leads to higher prices of
foreign goods and comparatively low
prices of locally produced goods which
would then lead to decrease in
demand of imports and increase in the
demand of exports. Hence demand of
local currency will increase and supply
of local currency would increase hence
causing exchange rate appreciation.
• If Domestic investment prospects are
greater than foreign investments,
locals would invest locally hence
decreasing the supply of local currency
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 which then leads to decrease in
demand of local currency which would
then lead to exchange rate
depreciation.
• It can be due to negative speculation of
local currency which would lead to
decrease in demand of local currency
and increase in the supply of foreign
currency hence causing exchange rate
depreciation.
• If there is domestic economic growth
peoples purchasing power would
increase and then there would be an
increase in demand of imports which
would lead to rise in the supply of local
currency and consequently exchange
rate depreciation.
• If there is recession in trading partners,
there would be decrease in exports
which would then lead to decrease in
demand of local currency which would
then lead to Exchange rate
depreciation.
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and foreign investment also increase
which then leads to increase in
demand of local currency which would
then lead to exchange rate
appreciation.
• It can be due to positive speculation of
local currency which would lead to
increase in demand of local currency
and decrease in the supply of foreign
currency hence causing exchange rate
appreciation.
• If there is domestic recession peoples
purchasing power would decrease and
then there would be an decrease in
demand of imports which would lead
to decrease in the supply of local
currency and consequently exchange
rate appreciation.
• If there is economic growth in trading
partners, there would be an increase in
exports which would then lead to
increase in demand of local currency
which would then lead to Exchange
rate appreciation.
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① www.GERI-I?gTf?Fi-Ysn-aimg-meoae
www.T/saimgsm- foreign baidu.YEKD.at/SuT
→
€¥ → ER to

② Domestic Inflation Foreign if Riypmte

→ →
>

D to /Dmt D.at/Su9-ERt
-

→
✗

③ Domestic Inr
prospects < Foreign prospects Inr

→ Into / If 9 → Diet/ Get → ERI

a

→ F- Rt
→ Sect
speculation
-

④ Negative Kamat
⑤ Eco
growth domestic
in
growth → Local

→ Dm 9 → Set → F- Rt
to
⑥ Recession in
trading partners → Foreign incomes
→ D ✗ to → Diet → F- Rt -

Keef

ER"E↳Y☐Ñ
IR : - Interest Rate

LC local
:
currency
-

f- c foreign country
.
: -

S
D Demand : -
supply . =

I : Investment -

✗ : -

anpoet .
M -
-
Import -
Cwsesf_ERaqpaeiahon①IRp7IRe→SUBh/5¥¥→
Days ERM
①
→
T.am#3Dx9/DmaHDuhYsuT
ERR
⑤IBSIPF-sI.at/Ii-#D.cTlsut
→ EAT
^
① frequentation -217cal ER⑨4
⑤ fcognomthiihadigtatuseihcome ,I→DI
→ Di→ERi
⑥ Recession domestically → Income
D
Dmt -55kt → EAT
 > P×↓→D×↑
F- R↓[→Pm↑→Dm↓
Consequences of Exchange Rate Depreciation

Short Run Long Run

Elasticities ( PED) Inelastic
Current account As exchange rate falls the price
of exports falls by a lot but the
demand rises by less due to
demand being inelastic in short
run which leads to decrease in
export revenue. Similarly, price
of imports rises by a lot but the
decrease in demand for imports
decreases by less hence causing
increase in import expenditure.
Hence together with decrease in
export revenue and increase in
import expenditure the current
account deficit worsens.
Aggregate Demand It decreases as current account
deficit worsens.
GDP/Incomes/Employme It falls due to decrease in
nt aggregate demand
Inflation Demand pull fall, cost push rises
J-Curve CAN
+
Elastic
As exchange rate falls the price of
exports falls by less but the
demand rises by a lot due to
demand being elastic in long run
which leads to increase in export
revenue. Similarly, price of imports
rises by less but the decrease in
demand for imports decreases by a
lot hence causing decrease in
import expenditure. Hence
together with increase in export
revenue and decrease in import
expenditure the current account
-55s
deficit becomes better.
It increases as current account
becomes better.
It increases due to increase in
aggregate demand.
Demand pull rises, cost push
remains high

>
#
time

CA v

Marshall-Lerner Condition If the sum of price elasticity of demand of exports and price elasticity
of demand of imports is less than 1 so exchange rate deprecation will
have positive effects in the long run. [PEDX + PEDM > 1]

Hence exchange rate depreciation is good in long run but bad in short run.

of ✗ &
}
M
/
value
NI : -

Qx Qm → volume CA depends
on

✗R / ME →
Value
of ✗ dry

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 F- R↑P×↑→D×↓
↳ Pm↓→Dm↑
Consequences of Exchange Rate Appreciation
Short Run
Elasticities Inelastic
Current account As exchange rate rises the price
of exports increases by a lot but
the demand decreases by less
due to demand being inelastic in
short run which leads to
increase in export revenue.
Similarly, price of imports falls
by a lot but the increase in
demand for imports is by less
hence causing decrease in
import expenditure. Hence
together with increase in export
revenue and decrease in import
expenditure the current account
tick
deficit becomes better.
Aggregate Demand It increases as current account
deficit becomes better.
GDP/Incomes/Employme It rises due to increase in
nt aggregate demand
Inflation Demand pull rises, cost push
falls
Inverse J-Curve CAN
+
*
Hence exchange rate appreciation is good in short run but bad in long run.
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Long Run
Elastic
As exchange rate rises the price of
exports increases by less but the
demand decreases by a lot due to
demand being elastic in long run
which leads to decrease in export
revenue. Similarly, price of imports
fall by less but the increase in
demand for imports increases by a
lot hence causing increase in
import expenditure. Hence
together with decrease in export
revenue and increase in import
expenditure the current account
deficit worsens.
It decreases as current account
deficit worsens.
It falls due to decrease in aggregate
demand.
Demand pull falls, cost push
remains low
>
time
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 vahesfenports interns of imports
Terms of Trade +

𝐸𝑥𝑝𝑜𝑟𝑡 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥

𝑇𝑒𝑟𝑚𝑠 𝑜𝑓 𝑇𝑟𝑎𝑑𝑒 = × 100
𝐼𝑚𝑝𝑜𝑟𝑡 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥
Favorable ToT(Px>Pm)
Favorable Terms of Trade is greater than 100 (Px > )Pm IfToT > 100 →
TOT
Unfavorable Terms of Trade is less than 100 ( P×< )
Pm n
n < 100 →
Unfavorable( p×< Pm)
Balanced ( Ripon)
Balanced Terms of Trade is equal to 100 ( P×=Pm ) u a = too →

Favorable (Improvements) movements in terms of trades is when terms of trade rises which is
when increase in export price index is greater than import price index or the decrease in export
price index less than import price index.

Unfavorable (Worsening) movements in terms of trade is when terms of trades falls which is
when increase in export price index is less than import price index or the decrease in export
price index greater than import price index.

Factors Affecting Terms of Trade / Causes ofdsintot

Demand Side
-Change in demand of exports and demand of
imports
Rise in Terms of Trade
Terms of Trade can be increased due to 2
reasons. Firstly, It is when demand rises which
causes increases in price of exports which
leads to an increase in Terms of Trade.
Secondly it is when demand of import falls
which then leads to decreases in import prices
which then leads to an increase in Terms of
Trade.
Fall in Terms of Trade
It is when demand of exports falls and demand
of imports to increase. Due to decrease in
demand of exports the price of exports falls
and with increased demand of imports prices
of imports rise causing terms of trade to
worsen.
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Non-Demand Side
1) Supply Side
As Supply of export rises the price of
exports fall causing terms of trade to
worsen.
As supply of imports increase the price
of imports fall, causing increase terms
of trade.
2) Inflation
If there is inflation in the local country
price of local goods would rise causing
increase in price of exports and
increased terms of trade.
If there is inflation in foreign country
prices of import rise causing terms of
trade to worsen.
3) Exchange Rate
If there is exchange rate appreciation
price of exports will increase and price
of imports will decrease causing
increase in terms of trade.
On the other hand due to exchange
rate depreciation price of exports will
fall and price of imports will rise
causing terms of trade to worsen.
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 4) Tariffs
If there is more imposition of taxes
price of imports would rise causing
terms of trade to worsen.

Consequences of Increase in Terms of Trade

General Advantages General Disadvantages

1) Fall in imported and cost push inflation
as price of imports would fall.
2) There is also increase in consumer
choice as consumers can get variety of
products through imports.
1) Demand of exports fall which causes a
current account deficit.
2) Domestic industry suffers as demand
for imports increase.

Is it beneficial? Depends

Causes of Increase in Terms of Trade

If terms of trade is caused by demand side factors it is good for the economy as export revenue
rises and import expenditure falls (as price of X rises due to increase in demand for X, while
price of M falls due to a fall in demand for M) which lead to betterment of current account
which then leads to increase in aggregate demand and increase in GDP.
If Increase in terms of trade is caused by non-demand side factors it depends on the price
elasticity of demand.

Price Elasticity of Demand of Exports and Imports

As terms of trade rise meaning that price of exports rise, and price of imports fall; In the short
run the price elasticity of demand is inelastic. In short run the price of export increases by a lot
and price of imports falls by a lot but demand for exports fall by less and demand of imports
also increase by less causing betterment of current account and increase in GDP, which is good.

However, on the other hand demand is elastic in the long run. So, the demand of exports
decreases by a lot and demand of imports increase by a lot causing current account deficit
which worsens the GDP and is bad for the country. (inverse J curve effect: see consequences of
appreciation)

Therefore Terms of Trade increase is always good if it is by demand side factors and if not it
depends on the elasticity, meaning it is good in SR but bad in LR.

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Consequences of Decrease in Terms of Trade

General Advantages General Disadvantages

1) Price of exports fall which lead to an
increase in demand of exports which
causes current account to become
better and lead to an increase in GDP.
2) Local Industry gets a competitive edge
as price of imports increase.
1) Cost push and imported inflation rise
as price of imports rise.
2) Consumer choice falls as price of
imports souses
fall.

Causes of Decrease in Terms of Trade

If decrease in terms of trade is caused by demand side factors it is bad for the economy as
export revenue falls and import expenditure rises which lead to worsening of current account
which then leads to decrease in aggregate demand and decrease in GDP.
If Increase in terms of trade is caused by non-demand side factors it depends on the price
elasticity of demand.

Price Elasticity of Demand of Exports and Imports

As terms of trade worsen meaning that price of imports rise, and price of exports fall; In the
short run the price elasticity of demand is inelastic and in the long run it is elastic. In short run
the price of export decreases by a lot and price of imports rise by a lot but demand for exports
increase by less and demand of imports also decrease by less causing worsening of current
account and decrease in GDP, which is bad.

However, on the other hand demand is elastic in the long run. So, the demand of exports
increases by a lot and demand of imports decrease by a lot causing current account betterment
which worsens the GDP and is good for the country. J curve effect (see consequences of
depreciation)

Therefore, Terms of Trade decrease is always bad if it is by demand side factors and if it is
caused by other factors, it is good in the long run.

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 * GnsequaIT(P×4YPmt)
§mYmteYFÉF costpush a- t as Pmt

2) Consumer ChoiceT@cheaperorates.p
3) Quality of ✗
can

Geueraliisadvaulages
qqyYpPpg
FR Ms due to
.

1) D ✗
I → C At →
( may

2) Domestic industry suffer as Dmt as Pmt

Is it beneficial or not
? Depends .

is caused by
Dm v1→ Pxtypmtf it is good
demand side
factors (Dii/ '

unapt
1 1

for an eco as
/
XP Mt → CAT → ADT →GBP9 +
9 intoT is due
Jf to non demand
depends PED
fadg.g
→
-

on

② PED f XD M '
e- .

Fitts
inelastic)
in the S R (PED - is
→ Die /Dri → ✗ RT/Met →CAT → GDPT (
Good
on the L R (PED is elastic) →D✗
Conclusion
-

→
HDMI
cat → GDPt ( Bad)
9inTot is
always Good if caused by demand
it's factors
&
if ,

caused
by other factors good
,
in SR .
 * GnsequenusfTo(P×t / Pmt)

%¥IY¥:→E%%ñ edge
temp

as Pmt DI to
→

② local industry gets

a
competitive
heneralDisadnantages_ T Pmt
① Cost push dsmportedñ
as

I Pmp
Consumer choice
.
as

②
Is it beneficial or not ? Depends
causeftintottftm.TT
isdue to demand
that will be bad for eco as CA
t→ factors
( Dxt /Dmt→
GDPj ¥
PxtfPmt) →
I
9ft intoTis due to other factors
: -
,

m¥÷¥kIF¥É inelastic Pxt /Pmt →RiYDñ→

→ as

✗Rt /MET → CAT → GDPt ( Bad)

In L R.
PED is elastic →
as asP×YPm9→D×T/Dmt →

✗pin Met → CAT → AD PT

/
Conclusion by demand factor
if
,
had caused
t.in Tot is always the LR
others it is
good
in

if caused
by ,
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