Tag Archives | exchange rates

Real effective exchange rate

The real effective exchange rate measures the value of a currency against a basket of other currencies; it takes into account changes in relative prices and shows what can actually be bought.

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Nominal exchange rate

The nominal exchange rate measures the current value of a currency against another. For example, in Sept 2014

£1 – $1.61 or $1 = £0.62

Effective exchange rate

The effective exchange rate measures a currency against a basked of other currencies. This is usually trade-weighted. When looking at the effective Sterling exchange rate we will compare the value of Sterling against our main trading partners – The Euro, the Dollar, the Yen e.t.c and give a weighting depending on how much we trade with that country, e.g. Eurozone 60%. A weighting will be given to different trading countries depending on how significant they are.

The effective exchange rate is good for looking at the overall performance of a currency. For example, the Pound may appreciate against the Dollar – but this  may be due to just temporary weakness in the Dollar. However, if the overall effective exchange rate increases, it suggests the Pound is becoming stronger.

Real exchange rate

The real exchange rate measures the value of currencies, taking into account changes in the price level. The real exchange rate shows what you can actually buy. It is the value consumers will actually pay for a good.

RER = E.R *(price level in country A/Price level in country B)

Increase in real exchange rate

  • If a countries real exchange rate is rising it means its goods are becoming more expensive relative to its competitors.
  • An increase in the real exchange rate means people in a country can get more foreign goods for an equivalent amount of domestic goods.
  • Therefore an increase in the real exchange rate will tend to increase net imports. Foreigners will buy our less expensive exports. It now becomes more attractive to buy imports. This can cause a widening of the current account deficit and lower domestic AD. It will also help reduce inflation.
  • Similarly a fall in the real exchange rate should increase net exports as domestic goods are more competitive.

(Readers Question: Does an increase in Real Effective Exchange Rate increase or decreases international competitiveness for the country? An increase in the real effective exchange rate will decrease international competitiveness. It means the country has relatively more expensive exports, leading to a fall in net Ex)

Inflation and the exchange rate

If the UK experienced inflation of 10% and US had inflation of 0%. We would expect the nominal value of the Pound to fall 10%. In this case, the real exchange rate would stay the same. The Pound has fallen 10%, but British goods are 10% cheaper. The amount of goods you can buy stays the same.

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The effects of an appreciation

An appreciation means an increase in the value of a currency. It means a currency is worth more in terms of foreign currency.

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A example of an appreciation in the value of the Pound 2009 – 2012

  • Jan 2009  If £1 = €1.1
  • June 2012 £1 = €1.27
  • In this case we can say there was a 15% appreciation in the value of the Pound against the Euro – between Jan 2009 and June 2012

 

Effects of an appreciation on the UK economy

  1. Exports more expensive. The foreign price of UK Exports will increase Europeans will find British exports more expensive. Therefore with a higher price, we would expect to see a fall in the quantity of UK exports.
  1. Imports are cheaper. UK consumers will find that £1 now buys a greater quantity of European goods. Therefore, with cheaper imports we would expect to see an increase in the quantity of imports.
  1. Lower (X-M) With lower export demand and greater spending on imports, we would expect fall in domestic Aggregate Demand (AD), causing lower economic growth.
  1. Lower inflation. An appreciation tends to cause lower inflation because:
    • import prices are cheaper. The cost of imported goods and raw materials will fall after an appreciation, e.g. imported oil will decrease, leading to cheaper petrol prices.
    • Lower AD leads to lower demand pull inflation.
    • With export prices more expensive, manufacturers have greater incentives to cut costs to try and remain competitive.

Impact of appreciation on AD/AS

http://www.economicshelp.org/images/macro/fall-AD.jpg

Assuming demand is relatively elastic, an appreciation contributes to lower AD (or a slower growth of AD), leading to lower inflation and lower economic growth.

Impact of an appreciation on the current account

Assuming demand is relatively elastic, we would expect an appreciation to worsen the current account position. Exports are more expensive, so we get a fall in eXports. Imports are cheaper and so we see an increase in iMports. This will cause a bigger deficit on the current account.

However, the impact on the current account is not certain:

  1. An appreciation will tend to reduce inflation. This can make UK goods more competitive, leading to stronger exports in the long term, therefore, this could help improve the current account.
  2. The impact on the current account depends on the elasticity of demand. If demand for imports and exports is inelastic, they the current account could even improve. Exports are more expensive, but if demand is inelastic, there will only be a small fall in demand. The value of exports will increase. If demand  for exports is price elastic, there will be a proportionately greater fall in export demand, and there will be a fall in the value of exports. Continue Reading →
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What happens to value of currency during recession?

Readers Question: What will happen to the value of a currency during times of deep recession and high inflation?

There is no hard and fast rule about what will happen to the value of a currency during a deep recession. For example, when the great recession started in 2008, the UK experienced a significant depreciation.

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The Pound Sterling fell nearly 20% from 2007 (before the start of the great recession) to July 2009

But the Euro and Dollar were less affected by the great recession.

U.S._Dollar_IndexThe US dollar index (which shows the value of the US dollar against a trade weighted basket of other currencies, e.g. Euro and Yen) has fluctuated but overall has remained at similar value to the start of the recession.

Note in early 1980, the US went into recession, but during this period the value of the Dollar rose.

It was a similar experience in the UK, in the 1980s, In 1980,  there was a rapid appreciation in Sterling (which was one factor contributing to the recession of 1980/81.)

Economic Theory behind the value of a currency in recession

Suppose one country, e.g. the UK, enters a deeper recession than all its other competitors. How might we expect the currency to behave?

Recession and interest rates. If the UK enters a recession, then we would expect UK interest rates to fall compared to other countries. This would make the UK less attractive for investors to save money. Hot money flows are likely to leave the UK and move to countries with higher interest rates. If people move money out of the UK, they will sell Pounds and buy other currencies, causing a fall in the value of Sterling. Therefore, in theory, we might expect a recession to cause a fall in the value of the currency.

Evaluation

1. In a recession, inflation is likely to fall. Lower inflation will help the country become more competitive and this may increase demand for the currency causing it to rise.

2. Many factors affect the value of currency. For example, if the UK had a large current account deficit, then we might expect this trade deficit to put downward pressure on the currency. The fall in the value of Sterling in 2008 was partly related to the UK’s trade deficit and lack of competitiveness. However, if a country like Germany entered recession, they may be less downward pressure on their currency (the Euro) because Germany have a large current account surplus. Continue Reading →

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Does a devaluation really help the economy?

Recently, we looked at whether a strong currency would help the economy – Is a strong currency a good thing?

The other side of the equation is – to what extent will a devaluation will help an economy? Commentators frequently write that devaluation (1) should help ‘rebalance’ the economy and help create an export led recovery. But, since 2008, we’ve seen a 25-30% devaluation in Sterling and we are left with only very weak recovery, cost push inflation and a surprisingly large current account deficit. It seems the depreciation in the pound has done very little to help the UK economy. (This all makes a very good A – Level question – discuss the macroeconomic effects of a depreciation in the exchange rate? – because there’s plenty of scope for evaluation.

In theory, a devaluation will cause the following to happen:

  • The price of UK exports will be lower in foreign currencies. This will increase the competitiveness of UK exports and should cause an increase in demand for UK exports.
  • The price of imported goods into the UK will increase. This will reduce our spending on imports and instead we will be more likely to buy domestic goods.
  • The increase in (X-M) should cause an increase in AD, economic growth and cause a reduction in unemployment.
  • The increased competitiveness should cause an improvement in the current account.

What has happened in the UK since late 2007?

The pound has fallen considerably against the Euro.

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1. Economic growth. In terms of economic growth, the past five years have been worse than the great depression. The devaluation hasn’t really caused any significant export led growth.

2. Current account deficit. The current account deficit has actually got bigger.

boe-uk-current-account-05-12

In 2008, the current account deficit was less than 2% of GDP. At the end of 2012, this current account is getting close to 5% of GDP. (more at current account balance of payments) This seems to contradict economic theory – you would expect a devaluation to improve the current account not worsen it.

How do we explain failure of devaluation to rebalance the economy?

1. Inelastic demand for exports and imports Evidence suggests that demand for UK exports is relatively inelastic. UK exports have become less price competitive as we’ve moved away from low-cost manufacturers to a variety of services and high-tech manufacturing; these goods tend to have relatively few close substitutes. Therefore, even if the price falls, the increase in demand is relatively low. Similarly, demand for imports is relatively inelastic meaning we continue to pay the higher price. (The Marshall-Lerner condition states a devaluation will worsen the current account if PEDx + PEDm >1)

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Is a strong currency a good thing?

Readers Comment from post: Should the UK join the Eurozone

So now it is 2013. Britain has spent a number of years with it’s interest rate set at just about zero, has entered a triple recession, has lost it’s AAA credit rating and Sterling is only worth €1.15 a drop of over 30% against the Euro.

So for those who still cannot see the wood for the trees and still believe the “anti-euro” propaganda wake up and smell the coffee.

I will put it this way, despite the turmoil the Eurozone has been suffering for the last 5 years, despite it’s inability to drop interest rates to zero to make itself more competitive, despite it’s differing economies and demographics it has risen in value against the UK as a Nation but over 30%. Can you smell the coffee yet?

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A while back, I wrote a post – How to measure success in the Eurozone? The main argument of that post is that you can’t measure economic success just from bond yields. In late 2012, the ECB were very happy to see falling bond yields – there was almost a sense that falling bond yields meant the Euro was now doing well, but falling bond yields alone don’t solve unemployment and the wider Eurozone crisis. Sometimes, we judge economic success from only a very limited standpoint, ignoring much more important factors.

One example, is judging the desirability of an economic policy from the strength of a currency.

When you have a large current account deficit, when your economy is in recession, a depreciation is exactly what the economy needs. Having a strong currency, when economic fundamentals don’t support that level just creates further economic misery.

One obvious example that springs to mind is the effort in 1992 to keep the Pound artificially overvalued within the ERM. To keep the Pound at a set level against the D-Mark, we put up interest rates to 15% and caused a severe recession. The strong pound was completely unsuitable for the UK economy, but we persisted with the policy because of a mistaken belief that keeping a ‘strong’ pound was ‘good’.

Another classic mistake was the decision in 1925 to rejoin the gold standard at a level that was unsuitable for the post-war UK economy. The consequence of this decision was deflation, low growth and a rising debt to GDP ratio. (see: UK economy in 1920s)In this case, the strong pound was damaging to the UK economy.

Strength of the Euro

The strength of the Euro has not necessarily increased living standards for people in the Eurozone. For those on the southern periphery of the Eurozone, the strength of the Eurozone has been an important factor in contributing to a prolonged recession and high unemployment.

eu-current-account-deficits

In 2008-11, Eurozone economies faced exceptionally large current account deficits of close to 10% of GDP (and upto 15% in case of Greece). This reflected a fundamental misalignment of the economy. Within the Euro, Portugal, Spain, Greece were uncompetitive, the Euro was too strong making their exports very uncompetitive. In the Eurozone, exporters couldn’t compete leading to lower demand, lower exports, and higher unemployment.

If the UK had been in the Eurozone, we wouldn’t have been able to devalue by 30%. The Pound could now be 30% overvalued. The consequence of this would have been:

  • An even larger current account deficit.
  • Lower domestic demand. The strong Euro would have increased demand for imports, and reduced demand for UK exports.
  • The recession would have been deeper, putting pressure on the government deficit.

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Forecast for Pound Sterling in 2013

A look at the future prospects for the Pound in the coming months of 2013.

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Sterling index

The Sterling index measures the value of the Pound Sterling against a basket of trade weighted currencies.

  • In  Dec 2011 the index was 80.4
  • By Oct 2011, the exchange rate index has increased to 83.6

This modest appreciation in the Pound has occurred despite:

  • Double dip recession in UK
  • UK Inflation remaining above target
  • Growing current account deficit
  • Quantitative easing increasing money supply.
  • One of largest budget deficits in OECD

Therefore the appreciation in the Pound is not so much a reflection of the strength of the UK economy – but a reflection of market nervousness about other currencies. In particulary, given the Euro crisis and difficulties of Eurozone economies, the Pound offers a greater semblance of normality and confidence.

However, given the weak state of the UK economy, it is likely that the fortunes of the Pound could deteriorate in 2013 – especially against the dollar and currencies other than the Euro.

In particular, the growing UK current account deficit (now over 5% of GDP) suggests underlying lack of balance between imports and exports.

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The UK has one of the largest current account deficits in the OECD. There are other reasons to explain the current account deficit, but the widening of the deficit to over 5% of GDP, suggests the Pound is becoming more uncompetitive against its main rivals. In a floating exchange rate, this is likely to lead to some depreciation in the future.

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Australian and New Zealand Dollar

Readers Question:

Part A ii)
On 1 July, AUD1 = NZD 1.10. On 1 August, AUD1 = NZD 1.15.

On 1 July, your aunt in New Zealand booked the accommodation your families will stay in when you have a family reunion in Melbourne in August. She expects this to cost NZD 5400 when she pays the bill on August 1. You agreed to cover the costs she might incur if any exchange rate fluctuations took place between these dates. Will you have to help out? How much will you have to pay?

Again the important thing to note is that the Australian Dollar has appreciated in value. In August the Australian dollar now gains more NZD. It has appreciated by 4.5%. Therefore the cost of buying Australian goods will be higher for people paying with NZD.

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Australian Dollar and British Pound

Readers Question:. (i) On 1 March, AUD1 = GBP 0.42. On 1 July, AUD1 = GBP 0.45.
Your company exports native flowers to British florists. You signed a contract on March 1 to sell 10
tonnes of flowers at AUD 385 per tonne, to be delivered on July 1. Explain how the exchange rate
movement between the two dates impacts on the Australian seller.

On 1July the Australian Dollar has appreciated against the British Pound. 1 Australian dollar now gets 0.45 GBP rather than 0.42. This means British companies will have to pay more in Pounds to get the same amount of Australian goods.

For example, in March, the price of buying a tonne of Australian flowers is 385* 0.42 = GBP 161

In July the price of buying the same tonne is 385 * 0.45 = £173

Therefore, the appreciation in the Australian Dollar makes the Australian flowers more expensive for British importers. In this situation Australian exporters may do two things

  1. Keep the same price in Australian Dollars, this may lead to a fall in demand by British importers.
  2. Try and keep the price for British importers. This means they would have to reduce their profit margins and accept a lower amount of Australian Dollars. If they kept the price £161 then with the new exchange rate the Australian exporters would only receive 161 / 0.45 = 364 Aus Dollars.

Forward Exchange Rate Contracts

A forward exchange rate contract is a way of insuring your contracts (such as buying a property) against fluctuations in the exchange rate.

For example, if you agree to buy a house for Euros 20,000 an appreciation in the Euro, could increase the Pound Sterling value by a considerable amount.

The way forward exchange rates work.

On a particular day, there will be a spot price for future contracts between the Euro and Pound. If you buy this contract then you are able to exchange money at a specified day for this particular price.

It means that you can have certainty that you will be able to buy foreign exchange at a certain price. It enables you to have insulation against rapid fluctuations.

This is an example of a bank offering forward exchange contracts

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