Economic 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. e.g. If 1 = 1 An appreciation of Pound could mean the pound rises to 1 = 1.2 An appreciation could occur due to higher interest rates, lower inflation or improved competitiveness

Effects of an Appreciation in the Exchange Rate

1. The foreign price of UK exports will become more expensive, therefore less UK exports will be demanded. 2. Imports are cheaper, therefore UK consumers are likely to buy more imports. 3. With lower export demand and more spending on imports, there will be a fall in domestic Aggregate Demand, causing lower economic growth. 4. There will be lower inflation because: Import prices are cheaper Lower Aggregate Demand (AD) leads to lower demand pull inflation. With export prices more expensive, UK manufacturers have more incentives to cut costs to try and stay competitive.

Impact of Appreciation on AD/AS

Appreciation contributes to falling AD, leading to lower inflation and lower economic growth.

Impact on the Current Account Balance of Payments

Generally an appreciation is likely to worsen the current account. It will cause a bigger current account deficit. This is because demand for exports falls, but demand for imports rises. However, the impact on the current account does depend on the elasticity of demand for exports and imports. If demand is price elastic, then an appreciation will cause a big fall in spending on imports and the current account will definitely worsen. However, if demand is very inelastic, then there will be a smaller percentage fall in demand, the total value of exports may increase (higher price, small fall in demand). The Marshall-Lerner Condition The Marshall Lerner Condition shows the conditions under which a change in the exchange rate of a country's currency leads to an improvement or worsening of a country's balance of payments. The condition states that, provided that the sum of the price elasticity of demand coefficients for exports and imports is greater than one then a fall in the exchange rate will reduce a deficit and a rise will reduce a surplus.

Evaluation of an Appreciation
If goods have a high value added (e.g. high tech goods), and little competition, then demand may be inelastic and not so affected by an appreciation. However, if goods are price sensitive (e.g. clothing, food) then the impact will be bigger. The impact of an appreciation depends on the situation of the economy. If the economy is in a recession, then an appreciation will cause a significant fall in aggregate demand, and will probably contribute to higher unemployment. However, if the economy is in a boom, then an appreciation will help reduce inflationary pressures and limit the growth rate. It also depends why the exchange rate is increasing in value. If there is an appreciation because the economy is becoming more competitive, then the appreciation will not be causing a loss of competitiveness. But, if there is an appreciation because of speculation or weakness in other countries, then the appreciation could cause a loss of competitiveness. (see: problems of strong currency)

NOTE 1
Fixed Exchange Rates There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.

A floating exchange rate system is where the forces of market demand and supply determine the daily value of one currency against another The value of the pound depends in how strong is demand for the currency relative to supply If overseas investors want to buy into sterling to take advantage of higher interest rates on offer in UK bank accounts, they will swap their own currencies for pounds. This causes an increase in the demand for sterling in the foreign exchange markets, and in the absence of other offsetting factors, this will cause an appreciation. Currencies tend to go up in value either when a country is running a large trade surplus which brings in extra demand for a currency from sales of exports or when overseas investors regard the currency as a good one to buy. This might be because attractive interest rates are on offer by putting money into savings accounts in that currency. Or because there are high expected returns from other types of investment notably property, stocks and shares and so on.

NOTE 2
FREE FLOATING Value of the currency is determined solely by market demand for and supply of the currency in the foreign exchange market. Trade flows and capital flows are the main factors affecting the exchange rate In the long run it is the macro economic performance of the economy (including trends in competitiveness) that drives the value of the currency No pre-determined official target for the exchange rate is set by the Government. The government and/or monetary authorities can set interest rates for domestic economic purposes rather than to achieve a given exchange rate target It is rare for pure free floating exchange rates to exist - most governments at one time or another seek to "manage" the value of their currency through changes in interest rates and other controls UK sterling has floated on the foreign exchange markets since the UK suspended membership of the ERM in September 1992

MANAGED FLOATING EXCHANGE RATES Value of the pound determined by market demand for and supply of the currency with no predetermined target for the exchange rate is set by the Government Governments normally engage in managed floating if not part of a fixed exchange rate system. Policy pursued from 1973-90 and since the ERM suspension from 1993-1998

SEMI-FIXED EXCHANGE RATES Exchange rate is given a specific target Currency can move between permitted bands of fluctuation Exchange rate is dominant target of economic policy-making (interest rates are set to meet the target) Bank of England may have to intervene to maintain the value of the currency within the set targets Re-valuations possible but seen as last resort October 1990 - September 1992 during period of ERM membership

FULLY-FIXED EXCHANGE RATES Commitment to a single fixed exchange rate No permitted fluctuations from the central rate Achieves exchange rate stability but perhaps at the expense of domestic economic stability Bretton-Woods System 1944-1972 where currencies were tied to the US dollar Gold Standard in the inter-war years - currencies linked with gold Countries joining EMU in 1999 have fixed their exchange rates until the year 2002 Advantages of floating exchange rates Fluctuations in the exchange rate can provide an automatic adjustment for countries with a large balance of payments deficit. If an economy has a large deficit, there is a net outflow of currency from the country. This puts downward pressure on the exchange rate and if a depreciation occurs, the relative price of exports in overseas markets falls (making exports more competitive) whilst the relative price of imports in the home markets goes up (making imports appear more expensive). This should help reduce the overall deficit in the balance of trade provided that the price elasticity of demand for exports and the price elasticity of demand for imports is sufficiently high. A second key advantage of floating exchange rates is that it gives the government / monetary authorities flexibility in determining interest rates. This is because interest rates do not have to be set to keep the value of the exchange rate within pre-determined bands. For example when the UK came out of the Exchange Rate Mechanism in September 1992, this allowed a sharp cut in interest rates which helped to drag the economy out of a prolonged recession. Advantages of Fixed Exchange Rates (disadvantages of floating rates) Fixed rates provide greater certainty for exporters and importers and under normally circumstances there is less speculative activity - although this depends on whether the dealers in the foreign exchange markets regard a given fixed exchange rate as appropriate and credible. Sterling came under intensive speculative attack in the autumn of 1992 because the markets perceived it to be overvalued and ripe for a devaluation. Fixed exchange rates can exert a strong discipline on domestic firms and employees to keep their costs under control in order to remain competitive in international markets. This helps

the government maintain low inflation - which in the long run should bring interest rates down and stimulate increased trade and investment.

How does a change in the exchange rate influence the economy?

Changes in the exchange rate can have powerful effects on the macro-economy affecting variables such as the demand for exports and imports; real GDP growth, inflation, business profits and jobs

As with most variables in economics, there are time lags involved. The impact of movements in currencies on the economy depends in part on: The scale of any change in the exchange rate i.e. a 5%, 10% or even larger movement Whether the change in the currency is short-term or long-term i.e. is the change in the exchange rate temporary or likely to persist for some time? How businesses and consumers respond to exchange rate fluctuations price elasticity of demand is important here i.e. will there be a large change in demand for exports and imports?

The size of any multiplier and accelerator effects When the currency movement takes place i.e. at which point of an economic cycle

How can changes in the exchange rate affect the rate of inflation? The exchange rate affects the rate of inflation in a number of direct and indirect ways:

Changes in the prices of imports this has a direct effect on the consumer price index. For example, an appreciation of the exchange rate usually reduces the sterling price of imported consumer goods and durables, raw materials and capital goods.

Commodity prices and the CAP: Many commodities are priced in US dollars so a change in the sterling-dollar exchange rate has a direct impact on the UK price of commodities such as foodstuffs. A stronger dollar makes it more expensive for Britain to import these items.

Changes in the growth of UK exports: A higher exchange rate makes it harder to sell overseas because of a rise in relative UK prices. If exports slowdown (price elasticity of demand is important in determining the scale of any change in demand), then exporters may choose to cut their prices, reduce output and cut-back employment levels.

SPOT & FORWARD Exchange Rates Spot exchange rates are the rates that are applicable for purchase and sale of foreign exchange on spot delivery basis or immediate delivery basis. Although, the term spot denotes immediate happening and closing of transaction, practically it takes two business days for a spot exchange transaction to get settled. So, we can say that the Spot rate is the rate of exchange of the day on which the transaction has occurred and of the days the execution of the transaction is taking place. Forward exchange rates, in contrast, are the rates that are applicable for the delivery of foreign exchange at a certain specified future date. For example, a foreign exchange contract may specify that the payment has to be settled after 3 months, or it may be a 90-day maturity contract. When a contract is agreed upon, the dealer of the foreign exchange settles the payment due after the 90-day period at the agreed forward exchange rate. This settlement will be at the initially agreed rate, called forward exchange rate, and will not be affected by the spot exchange rates prevailing at the time of settlement at maturity. This is a way by which uncertainty and risk could be avoided in dealing with foreign exchange transactions. Forward rates may be greater than the current spot rate or less than the current spot rate. The forward exchange rate of a currency will be slightly different from the spot exchange rate at the present date due to uncertainties and future expectations.

Factors which influence the exchange rate

Exchange rates are determined by supply and demand. For example, if there was greater demand for American goods then there would tend to be an appreciation (increase in value) of the dollar. If markets were worried about the future of the US economy, they would tend to sell dollars, leading to a fall in the value of the dollar. Note: Appreciation = increase in value of exchange rate Depreciation / devaluation = decrease in value of exchange rate.

Main Factors that Influence Exchange Rates

1. Inflation If inflation in the UK is relatively lower than elsewhere, then UK exports will become more competitive and there will be an increase in demand for Pound Sterling to buy UK goods. Also foreign goods will be less competitive and so UK citizens will buy less imports. Therefore countries with lower inflation rates tend to see an appreciation in the value of their currency. 2. Interest Rates If UK interest rates rise relative to elsewhere, it will become more attractive to deposit money in the UK. You will get a better rate of return from saving in UK banks, Therefore demand for Sterling will rise. Higher interest rates cause an appreciation. This is known as hot money flows and is an important short run factor in determining the value of a currency. 3. Speculation If speculators believe the sterling will rise in the future, they will demand more now to be able to make a profit. This increase in demand will cause the value to rise. Therefore movements in the exchange rate do not always reflect economic fundamentals, but are often driven by the sentiments of the financial markets. For example, if markets see news which makes an interest rate increase more likely, the value of the pound will probably rise in anticipation. 4. Change in Competitiveness If British goods become more attractive and competitive this will also cause the value of the Exchange Rate to rise. This is important for determining the long run value of the Pound. This is similar factor to low inflation. 5. Relative strength of other currencies. In 2010 and 2011, the value of the Japanese Yen and Swiss Franc rose because markets were worried about all the other major economies - US and EU. Therefore, despite low interest rates and low growth in Japan, the Yen kept appreciating.

6. Balance of Payments A deficit on the current account means that the value of imports (of goods and services) is greater than the value of exports. If this is financed by a surplus on the financial / capital account then this is OK. But a country who struggles to attract enough capital inflows to finance a current account deficit, will see a depreciation in the currency. (For example current account deficit in US of 7% of GDP was one reason for depreciation of dollar in 2006-07) 7. Government Debt. Under some circumstances, the value of government debt can influence the exchange rate. If markets fear a government may default on its debt, then investors will sell their bonds causing a fall in the value of the exchange rate. For example, Iceland debt problems in 2008, caused a rapid fall in the value of the Icelandic currency. For example, if markets feared the US would default on its debt, foreign investors would sell their holdings of US bonds. This would cause a fall in the value of the dollar. See: US dollar and debt 8. Government Intervention Some governments attempt to influence the value of their currency. For example, China has sought to keep its currency undervalued to make Chinese exports more competitive. They can do this by buying US dollar assets which increases the value of the US dollar to Chinese Yuan. see also: Chinese Currency | Swiss Franc pegged against Euro

What is National Income? National income measures the monetary value of the flow of output of goods and servicesproduced in an economy over a period of time. Measuring the level and rate of growth of national income (Y) is important for seeing:

The rate of economic growth Changes to average living standards Changes to the distribution of income

Gross Domestic Product Gross domestic product (GDP) is the total value of output in an economy and is used to measure change in economic activity GDP includes the output of foreign owned businesses that are located in a country following foreign direct investment. For example, the output produced at the Nissan car plant on Tyne and Wear and by foreign owned restaurants and banks all contribute to the UKs GDP. There are three ways of calculating GDP - all of which should sum to the same amount: National Output = National Expenditure (Aggregate Demand) = National Income (i) The Expenditure Method - aggregate demand (AD) The full equation for GDP using this approach is GDP = C + I + G + (X-M) where C: Household spending I: Capital Investment spending G: Government spending X: Exports of Goods and Services M: Imports of Goods and Services The Income Method adding factor incomes Here GDP is the sum of the incomes earned through the production of goods and services. This is: Income from people in jobs and in self-employment +

Profits of private sector businesses + Rent income from the ownership of land = Gross Domestic product (by factor incomes) Only those incomes that are come from the production of goods and services are included in the calculation of GDP by the income approach. We exclude:

Transfer payments e.g. the state pension; income support for families on low incomes; the Jobseekers Allowance for the unemployed and welfare assistance such housing benefit.

Private transfers of money from one individual to another Income not registered with the Inland Revenue or Customs and Excise. Every year, billions of pounds worth of activity is not declared to the tax authorities. This is known as the shadow economy or black economy. According to a World Bank report published in October 2010, the average size of the shadow economy (as a percentage of "official" gross domestic product) in Sub-Saharan Africa is 38.4 percent; in Europe and Central Asia (mostly transition countries), it is 36.5 percent, and in high-income OECD countries, it is 13.5 percent.

Published figures for GDP by factor incomes will be inaccurate because much activity is not officially recorded including subsistence farming, barter transactions and the share economy mentioned above. Value Added and Contributions to a Nations GDP There are three main wealth-generating sectors of the economy manufacturing, oil& gas, farming, forestry & fishing and a wide range of service-sector industries. This measure of GDP adds together the value of output produced by each of the productive sectors in the economy using the concept of value added. Value added is the increase in the value of goods or services as a result of the production

process
Value added = value of production - value of intermediate goods Let us say that you buy a ham and mushroom pizza from Dominos at a price of 14.99. This is the final retail price and will count as consumption. The pizza has many ingredients at different stages of the supply chain for example tomato growers, dough, mushroom

farmers and also the value created by Dominos themselves as they put the pizza together and get it to the consumer. Some products have a low value-added, for example those really cheap tee-shirts that you might find in a supermarket for little more than 5. These are low cost, high volume, low priced products. Other goods and services are such that lots of value can be added as we move from sourcing the raw materials through to the final product. Examples include designer jewellery, perfumes, meals in expensive restaurants and sports cars. And also the increasingly lucrative computer games industry. GDP by output the distribution of GDP from different industries The UK is an advanced economy where the majority of GDP comes from the service industries such as banking and finance, tourism, retailing, education and health and a vast range of other businesses services. In 2008 less than half of one per cent of our GDP came from the agricultural sector. Manufacturing accounted for less than 15 per cent of GDP and construction a further 6 per cent. In contrast, the service industries now contribute nearly three quarters of national income. Manufacturing and service industries are not separate! For example the health of a car exporting business will have a direct bearing on demand, output, profits and jobs in many service businesses such as transportation, design, marketing and vehicle retailing. Equally service businesses such as online banking require plenty of physical inputs such as machinery and infrastructure to be successful. The main service sector industries

Hotels and restaurants, and a range of services provided by local government Transport, logistics, storage and communication Business services and finance, motor trade, wholesale trades and retail trade Land transport and air transport, post and telecommunications Real estate activities, computer and related activities, Education, Health and social work Sewage and refuse disposal Recreational, cultural and sporting activities