Essay: The Effects of an Appreciation in the Exchange Rate.

1. The £ is stronger therefore, exports are more expensive to buy. More foreign currency is needed to get the same amount of British goods

2. Imports will be cheaper.

3. Therefore, we will get a rise in the quantity of imports and a fall in quantity of exports.

4. Assuming demand is relatively elastic this will cause a fall in the value of exports and rise in value of imports.

5. AD = C + I + G + X - M. Therefore, a fall in exports and rise in imports will reduce AD, or lower the growth of AD.

6. A fall in AD will cause a lower rate of economic growth and a lower rate of inflation.

7. A fall in exports and rise in imports will lead to a worsening of the current account, e.g. deficit will get bigger.

Evaluation of an appreciation

1. Does on State of Economy.

If economy is growing rapidly and is close to full capacity then an appreciation can help to reduce inflationary pressures.

2. The exchange rate is only a small factor affecting AD. For example, the UK has seen an appreciation in the exchange rate, but the MPC has needed to increase interest rates 4 times in the past 8 months to control inflationary pressures.

3. Depends on other factors affecting AD.

E.g. Rising house prices have led to rising consumer confidence and therefore growth in the UK has been strong, despite an appreciation in the £.

4. Depends on Elasticity of demand.

If demand is inelastic, an appreciation in the exchange rate will cause a rise in AD and improvement in the current account. However, it is rare for demand to be inelastic, at least in the long run.

5. An Appreciation can reduce inflation.

Lower AD - less demand pull inflation
Cheaper imports - lower cost push inflation
Increased incentive for exporters to cut costs and become more efficient. Helps reduce cost push inflation.

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Perma Link | By: T Pettinger | Thursday, May 17, 2007
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