A summary for understanding exchange rates. Factors that affect exchange rates and the impact of exchange rates on the economy.

Terminology

• Depreciation/devaluation – fall in value of exchange rate – exchange rate becomes weaker (see also: definition of devaluation and depreciation)
• Appreciation – increase in the value of exchange rate – exchange rate becomes stronger.

Example of Pound Sterling depreciating against the Dollar

• £1 used to equal $2.
• Now £1 is only equal to $1.75

Video on Exchange rates

What is the effect of a depreciation in the value of the Pound?

• Buying goods from America becomes more expensive.
• If a meal cost $10, it used to require £5 (10/2) for a British tourist.
• But, now after the depreciation, the $10 meal will cost £5.71 (10/1.75)
• The depreciation in the pound may discourage British tourists to travel to the US.
• It makes US imports into the UK more expensive, so it may reduce UK imports
• UK exports will become relatively more competitive. It is cheaper for Americans to buy UK goods, so the quantity of exports should increase.
• UK inflation will increase. Imported goods are more expensive (cost push inflation). Also, British goods are more attractive causing a rise in demand (demand pull inflation)

Summary of depreciation

• A depreciation in exchange rate makes exports more competitive and imports more expensive
• A depreciation helps UK exporters and improves UK growth prospects, but causes higher prices and inflation.

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The output gap is a measure of the difference between actual output (Y) and potential output (Yf).

Output gap = Y- Yf

A Negative Output Gap occurs when actual output is less than potential output gap. In a recession, a fall in Real GDP causes a negative output gap. However, it can become difficult to know what potential output should actually be. Therefore, there can be different opinions about how the size of the output gap.

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