Exchange Rate Policy and Systems

Measuring the exchange rate Exchange rates are expressed in various ways:
o Spot Exchange Rate - the spot rate is the exchange rate for a currency at current market prices. This is determined by the FOREX market on a minute-by-minute basis on the basis of the flow of supply and demand. Forward Exchange Rate - a forward rate involves the delivery of currency at a specified time in the future at an agreed rate. Companies wanting to reduce risks from exchange rate volatility can buy their currency forward on the market. Bi-lateral Exchange Rate - the rate at which one currency can be traded against another. Examples include: $/DM, Sterling/US Dollar, $/YEN or Sterling/Euro

o o

Effective Exchange Rate Index (EER) - a weighted index of sterling's value against a basket of currencies the weights are based on the importance of trade between the UK and each country. Real Exchange Rate - this is the ratio of domestic price indices between two countries. A rise in the real exchange rate implies a worsening of competitiveness for a country.

Exchange rate systems A country can decide the type of exchange rate system that they want to follow. System Main Characteristics Recent UK History

Free Floating The value of the pound is determined purely by demand Rare for pure free floating to exist and supply of the currency Exchange Sterling has floated since the UK suspended Rate Trade flows and capital flows affect the exchange rate membership of the ERM in September 1992 under a floating system The Bank of England has not intervened to No target for the exchange rate influence the pounds value since it became independent No intervention in the market by the central bank Managed Floating Exchange Rate Value of the pound determined by market demand for Governments normally engage in managed and supply of the currency floating if not part of a fixed exchange rate system. Some currency market intervention might be considered as part of demand management (e.g. a desire for a Managed floating was a policy pursued in the UK from 1973-1990 slightly lower currency to boost export demand)

Semi-Fixed Exchange Rates

The UK operated a semi-fixed system from October 1990 - September 1992 when a The currency can move between permitted bands of member of the ERM fluctuation on a day-to-day basis Sterling eventually forced out of the ERM by a Interest rates are set at a level necessary to keep the wave of speculative selling exchange rate within target range or direct intervention in the FOREX market Re-valuations are seen as a last resort

Exchange rate is given a specific target

Fully-Fixed Exchange Rates

The exchange rate is pegged No fluctuations from the central rate System achieves exchange rate stability but perhaps at the expense of domestic stability A country can automatically improve its competitiveness by reducing its costs below that of other countries knowing that the exchange rate will remain stable

The Bretton Woods System which lasted from 1944-1972 was a fixed rate system where currencies were tied to the US dollar

United Kingdom Effective Exchange Rate Index

Trade-weighted index value for sterling in the foreign exchange market, daily value

110

110

105

105

100

100

95
Index

95

90

90

85

85

80

80

75

75

70 Jan Apr Jul 07 Oct Jan Apr Jul 08 Oct Jan Apr Jul 09 Oct Jan Apr 10 Jul

70

Source: Reuters EcoWin

The sterling effective exchange rate index is shown in the chart above. After a period of relative stability in 2004-06 sterling first appreciated by around 5-7% in 2006-07 and then started to depreciate rapidly from the summer of 2007 onwards. From peak to trough at the start of 2009 the exchange rate index fell by 30%, one of the biggest depreciations in the UKs recent economic history. The pound fell sharply against most but not all currencies; the depreciation was most noticeable against the US dollar and versus the Euro. Sterling has rebounded in the foreign exchange markets in the first half of 2009. The Case for Floating Exchange Rates The main arguments for adopting a floating exchange rate system are as follows: 1. Reduced need for currency reserves: There is no exchange rate target so there is little requirement for the central bank to hold big reserves of gold and foreign currency to use in official intervention in the markets 2. Useful instrument of economic adjustment: For example depreciation can provide a boost to exports and therefore stimulate growth during a recession and when there is a risk of deflation.

3. Partial automatic correction for a trade deficit: Floating exchange rates can help when the balance of payments is in disequilibrium i.e. a large current account deficit puts downward pressure on the exchange rate, which should help exports and make imports relatively more expensive. Much depends on the price elasticity of demand and supply of exports and the price elasticity of demand for imports see the later section on the Marshall-Lerner condition and the J-curve effect. 4. Less opportunity for currency speculation: The absence of an exchange rate target might reduce the risk of currency speculation. Speculators tend to attack currencies where a government is trying to maintain an exchange rate out of line with economic fundamentals. 5. Freedom (autonomy) for domestic monetary policy: The absence of an exchange rate target allows policy interest rates to be set to meet domestic objectives such as controlling inflation or stabilising the economic cycle. Countries locked into a single currency system such as the Euro do not have the same freedom to manage interest rates to meet their main macroeconomic aims. The Case for Fixed Exchange Rates The main arguments for adopting a fixed exchange rate system are as follows: 1. Trade and Investment: Currency stability can promote trade and investment because of less currency risk. Overseas investors will be more confident that the returns from their investments will not be destroyed by violent fluctuations in the value of a currency. 2. Some flexibility permitted: Some adjustment to the fixed currency parity is possible if the economic case becomes unstoppable (i.e. the occasional devaluation or revaluation of the currency if agreement can be reached with other countries). Some countries are tempted to engage in competitive devaluations. 3. Reductions in the costs of currency hedging: Businesses have to spend less on currency hedging if they know that the currency will hold its value in the foreign exchange markets. 4. Disciplines on domestic producers: A stable currency acts as a discipline on producers to keep their costs and prices down and may encourage attempts to raise productivity and focus on research and innovation. In the long run, with a fixed exchange rate, one countrys inflation must fall into line with another (and thus put substantial competitive pressures on prices and real wages) 5. Reinforcing gains in comparative advantage: If one country has a fixed exchange rate with another, then differences in relative unit labour costs will be reflected in changes in the rate of growth of exports and imports. Consider the example of China and the United States. For several years China pegged the Yuan against the dollar. Until July 2005 the exchange rate was fully fixed; since then the Chinese have allowed only a gradual depreciation of the dollar against the Yuan. Most estimates indicate that the Chinese currency is persistently undervalued against the dollar. This makes Chinese products cheaper than they would otherwise be and has led to a surge in import penetration from China into the US. This has led to numerous calls from US manufacturers for the Chinese to be persuaded to switch to a floating exchange rate or to adjust their currency by appreciating against the dollar. Competitive devaluations Competitive devaluations occur when a country deliberately intervenes in foreign exchange markets to drive down the value of their currency to provide a competitive boost to demand and jobs in their

export industries. They may also try to do this when faced with the threats of a deflationary recession. Another reason is to entice extra foreign investment into a currency. For nations with persistent trade deficits and rising unemployment a competitive devaluation of the exchange rate can become an attractive option - but there are risks. One is that devaluing an exchange rate to avoid deflation or inject extra demand into export industries can be seen by other countries as a form of trade protectionism that invites some form of retaliatory action. Cutting the exchange rate makes it harder for other countries to export their goods and services hitting their circular flow. One of the reasons often cited as to why the 1930s Great Depression lasted so long was that countries acted independently to protect their own interest by undermining their currencies. Ultimately a competitive devaluation provides only a temporary boost to competitiveness. And a policy of holding down an exchange rate can be costly. For many years the International Monetary Fund (IMF) has tried to help countries coordinate their trade and foreign exchange policies in order to prevent repeated devaluations. The 1976 revision of Article IV of the IMF charter was written to avoid "manipulating exchange rates...to gain an unfair competitive advantage over other members."
Switzerland intervenes to drive their currency lower
Euro - Swiss Franc Exchange Rate
Euros per Swiss Frnace, ECB Reference Rate, Daily Fixing
1.70 1.65 Attempted devaluation 1.60 1.55 1.60 1.55 1.50 1.45 1.40 1.35 1.30 1.25 Apr Jul 07 Oct Jan Apr Jul 08 Oct Jan Apr Jul 09 Oct Jan Apr Jul 10 Source: Reuters EcoWin 1.70 1.65

EUR/CHF

1.50 1.45 1.40 1.35 1.30 1.25 Jan

The Swiss Central Bank has opted to intervene directly in the currency exchanges. This is the first time a leading central bank has intervened in the foreign exchange markets since Japan sought to weaken the yen in 2004. And it is the first official intervention in the markets by the Swiss since 1995 although they have tried verbal intervention in the past in an attempt to talk the currency down. At times of global economic uncertainty investors look for assets and currencies that hold their value and offer a safe haven - gold and the Swiss Franc fit neatly into this category and the result has been strong demand for Francs driving it higher against the Euro. For the Swiss National Bank an appreciating currency represents an inappropriate tightening of monetary conditions during an economic slowdown and they have decided to enter the market and use Swiss Francs to buy other foreign currencies. This will lead to an outward shift in the market supply of Swiss Francs and an outward shift in the demand for Euros. The Swiss franc had risen some 6 percent against the euro since December and some 10 percent against a range of currencies in trade-weighted terms since the credit crisis broke in 2007. Official policy interest rates are already at zero and the Swiss economy (which is heavily export dependent) is facing the worst recession for 30 years and a serious risk of price deflation. Source: Tutor2u economics blog, March 2009 The Swiss franc has continued to appreciate in value against the Euro since this blog was written

Currencies in Europe: The European Exchange Rate Mechanism II

Pegging to the Euro - Estonia and Latvia
Local exchange rates to the Euro, daily value
15.95 15.85
EUR/EEK
Estonian currency

15.95 15.85 15.75 15.65 15.55 15.45

Latvian currency

15.75 15.65 15.55 15.45 0.700

0.700 0.650 0.600 0.550 0.500

EUR/LVL

0.650 0.600 0.550 0.500 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Source: Reuters EcoWin

Fix or float? Decisions about which exchange rate system to choose are important for most of the countries inside the European Union. The UKs brief membership of ERM from 1990 to 1992 was the closest the country came to embracing Economic and Monetary Union (EMU). In the years that followed the UK pounds ERM exit, it has floated freely against the euro and Britain. In reality the chances of the UK joining the Euro Zone in the short term are remote. However, following the launch of the euro in January 1999 ERM II was created for EU member states that had not yet joined the euro. ERM II is designed to ensure exchange rate stability between the euro and prospective members of the single currency. Each ERM currency is given a central exchange rate against the euro with a maximum fluctuation band of +/-15%. Once a currency has been in ERM for two years without any devaluation outside the permitted band, it meets one of the key convergence criteria for entering the Euro Zone. If a countrys currency is close to falling outside the permitted bands the European Central Bank (ECB) and the central bank of the country affected will intervene by buying and selling currency to try to stabilise the exchange rate. Interventions of this kind are only for short term exchange rate problems not in circumstances where for example the currency is clearly overvalued (similar to the UK in 1992). When ERM II came into being in 1999 there were only two members, Denmark (which like the UK has an opt out from the euro) and Greece. However, the latter joined the euro in 2001. Denmarks fluctuation bands for its currency the Krone are only +/- 2.25% for a central rate against the euro and hence its monetary policy is tied strongly to the ECB. In recent years several countries have been in the ERM, Slovenia, Malta, Cyprus and Slovakia, but they have now all joined the euro and are no longer in the ERM. Along with Denmark there are only three other countries currencies in the ERM II; Estonia, Lithuania and Latvia. Indeed Estonia has pegged her exchange rate to the Euro since the Euro was launched in 1999. Latvia locked into the ERMII at the start of 2005. Countries hoping to join the ERM in the next couple of years are Hungary (2010), Bulgaria (2010) and Romania (2011). But the current recession and credit crunch has hit many eastern European economies hard and some of these provisional dates may be a little over ambitious. An anomaly is the position of Sweden which has decided to stay out of ERM even though it is technically committed to euro membership by the terms of its membership in 1995. If the euro continues to expand its membership most EU countries will pass through ERM membership at some stage as the opt out afforded to the UK and Denmark is not available to new members. Adapted from EconoMax, author Robert Nutter

What determines the value of a currency? In floating exchange rate systems, the market value of a currency is determined by the demand for and supply of a currency. Most currency dealing is purely speculative but trade and investment decisions also have a role to play. Some of the key factors that can affect a currency are as follows: 1. Trade balances countries that have strong trade and current account surpluses tend (ceteris paribus) to see their currencies strengthen as money flows in from exports of goods and services and investment income. 2. Foreign direct investment an economy that attracts high net inflows of capital investment from overseas will see an increase in currency demand 3. Portfolio investment much currency trading is used to finance cross-border portfolio investment, for example investors putting funds into stocks and shares, government bonds and property. Strong inflows of portfolio investment from overseas can cause a currency to appreciate 4. Interest rate differentials - if UK interest rates are higher than rates on offer in other countries then ceteris paribus we expect to see an inflow of currency into UK banks and other financial institutions. The higher the interest rate differential, the greater is the incentive for funds to flow across international boundaries and into the economy with the higher interest rates. Countries offering high interest rates can expect to see hot money flowing across the currency markets and causing an appreciation of the exchange rate.

Dollar-Sterling and Interest Rate Differentials

US dollars per 1, daily closing exchange rate; US and UK official policy interest rates (%) 2.2 2.0 2.2 2.0 1.8 1.6 1.4 1.2 7 6 UK Interest Rates 5 4 3 US Interest Rates 2 1 0 01 02 03 04 05 06 07 08 09 10 2 1 0

GBP/USD

1.8 1.6 1.4 1.2 7 6 5

Percent

4 3

Source: International Monetary Fund

There are inevitable risks in shifting funds across international markets. What might happen to the currency if you leave $200,000 worth of cash in a UK bank account? What happens to the value of your investment if sterling depreciates against the US dollar? What are the risks in exchanging a similar value of US dollars and putting it into the UK stock market or into government bonds? Investors often consider the risk-adjusted relative rate of return from different financial investments.

The Carry Trade The carry trade refers to a strategy where investors borrow low-yielding currencies and lend highyielding currencies. For example hundreds of billions of $s have been staked on borrowing in Japanese Yen (where official interest rates have been very low for several years) and lending / investing in countries offering a more attractive interest rate or rate of return - such as New Zealand, Iceland or economies in Eastern Europe. The big risk in carry trading is that foreign exchange rates are volatile and move sharply in a direction that wipes out gains made through carry trade speculation to the effect that the investor would have to pay back more expensive currency with less valuable currency. There is also some evidence that some of the explosion in carry-trade activity funded money flowing in sub prime lending in the USA. Dangers from the Carry Trade (Bob Nutter) In recent years many speculators have made a financial success of what is known in the money markets as the carry trade. The carry trade involves speculators borrowing money in one country where interest rates are low and investing that money in another country where either the interest rate is high or asset values are rising. When the speculator repays the low interest loan the profit is what is left over; making it seem a certain way to make money without really trying. Origins in Japan The carry trade first became part of global currency dealings in recent years when Japan had very low or zero interest rates in the 1990s. Japan was in a period of negligible economic growth and deflation and low interest rates were part of a package of monetary and fiscal policies to get the economy moving again. At this time it was thus very cheap to borrow in Japan and interest rates elsewhere were relatively higher.
Japan's Zero Interest Rate Policy
Per cent

1.00 0.75
Percent
Official Policy Interest Rates (%)

1.00 0.75 0.50 0.25 0.00 -0.25 -0.50 104.0 Consumer Price Index 103.0 102.0 101.0 100.0 99.0 99 00 01 02 03 04 05 06 07 08 09 10

0.50 0.25 0.00 -0.25 -0.50 104.0 103.0 102.0 101.0 100.0 99.0

Index

Source: Reuters EcoWin

For example if a speculator borrowed the equivalent of $100,000 in yen at 1% interest and then converted the yen into Australian dollars where interest rates were say 5% a profit of $4,000 could be made in a year. Many carry trade transactions involved much more of an outlay than that and so there is the potential for a lot of easy money for speculators. Unfortunately there is a significant risk in the carry trade. The risk for speculators comes with the movements of exchange rates. If, in the above example, the yen had depreciated during the carry period this would have led to increased profit. However, an appreciation would mean that a lot of the profit made in Australian dollars would be lost in the exchange transaction as more dollars would then be needed to buy yen. It is the

unpredictability and volatility of exchange rates that makes the carry trade dangerous for speculators and potentially destabilising for the global financial markets. Part of the problem relates to what is called uncovered interest parity theory which basically says that economies with low exchange rates and low interest rates are likely to see an appreciation of their currency in the near future. Similarly high exchange rate and high interest rate economies are likely to see a fall in their currencies. In this latter case the high current interest rates are to compensate currency dealers for the expected fall in the currency. Thus according to this theory borrowing in a low interest rate currency and investing in a high interest rate currency could cause problems in the future if exchange rates have moved in the way suggested. Related to this issue is the time when speculators in carry transactions unwind their investments and take the profits. Those that are first to the door generally make good returns, but, as the volume of transactions increase back into the currency where the money was borrowed, it is possible that the volume of monetary movements will pull the exchange rates in unfavourable directions for the speculators. The currency being sold will depreciate and the buying currency will appreciate thus progressively reducing the potential gains. Risks of unstable finance markets
How might low US interest rates affect Hong Kong property prices?
US policy rates (top pane) , Hong Kong property price index (bottom pane)

7 6 5
Percent

7 6 5 4 3 2 1 0
Hong Kong Property Price Index (monthly)

4 3 2 1 0

150 140 130 120 110 100 90 80 70 60 50

150 140 130 120 110 100 90 80 70 60 50 04 05 06 07 08 09 10

Source: OECD

Index

00

01

02

03

There is now renewed concern that the carry trade is going to destabilise the financial markets more than the yen carry trade did in the 1990s. Some blame the yen carry trade for the Asian Crisis in1997. The fear is that a dollar carry trade could have devastating results unless it is checked. With Ben Bernanke at the Federal Reserve saying recently that US interest rates are going to stay exceptionally low for an extended period it is now possible to borrow very cheaply in dollars and invest in some high yielding assets especially in the Far East, e.g. the Hong Kong property market where house prices rose 28% over the last year. The fact that the Hong Kong dollar is pegged to the US dollar reduces the risk of such carry activity. The real worry is that the dollar will continue to fall partly because of low interest rates and also the dollars carry trade causing the selling of dollars. In addition the US government may be happy to see a dollar depreciation as it will help revive the US economy. However, a falling dollar can cause global inflation as many commodities are priced in dollars. In addition the dollar carry trade could cause asset price bubbles all over the world and this could further destabilise the financial markets. Zhao Qingming, a Beijing-based analyst at China Construction Bank Corp., said recently that low borrowing costs in the U.S. have spurred a carry trade with some currencies, notably the Australian dollar after recent rate increases by that nations central bank. The carry trades will further drive down the dollars value and fuel commodity prices, Zhao said. The dollars depreciation has also caused excessive liquidity in the global market.

Will the dollar carry trade cause a global asset bubble that will inevitably burst with dire consequences? Time will tell. Source: EconoMax, Robert Nutter

Reserve currencies A reserve currency is sometimes called an anchor currency and is a currency that national governments and other institutions are happy to hold as a key part of their foreign exchange reserves. It also acts as a global pricing currency for many commodities such as gold, oil, wheat and copper. For decades the reserve currency of choice has been the US dollar partly because the USA is the worlds biggest economy. For the Americans one of the benefits of this is that the USA can borrow from the rest of the world at a slightly lower interest rate because there has been a lengthy queue of foreign investors willing to purchase $ denominated assets such as US Treasury bonds. China for example has amassed a mountain of foreign exchange reserves arising from their super-charged trade surpluses. The bulk of their $2 trillion worth of foreign exchange reserves are in dollars and a large percentage of US government debt is owned by the Chinese the fortunes of the two economies are now closely entwined. China is spooked by the scale of the fiscal stimulus being introduced by the Obama administration and the likely size of the quantitative easing that the US Federal Reserve will undertake to drag the US economy out recession. If the worlds supply of US dollars increases at too fast a rate the US dollar will lose value and Chinas huge investments in the US economy will suffer too. In recent years there has been a shift in holdings of foreign exchange there are now more Euros in circulation than dollars, and the euros role as an international reserve currency is growing. By the first half of 2008 the euro accounted for 27 per cent of official foreign reserves, up from 18 per cent soon after its launch. The dollars share fell from 71.2 per cent to 62.5 per cent during the same period. The two requirements for a currency to have reserve status is credibility of a government that it will not default on its debt or attempt to debase its currency by printing too much of it. China, India, Russia and Brazil are four emerging economies with growing global power but they are not yet ready to assume the mantle of an economy large enough for their domestic currency to have reserve qualities. Is it time for a Tobin Tax?

In recent months, in the wake of the global financial crisis, there has been a revival in support for a Tobin tax on foreign currency transactions i.e. when one currency is converted into another. James Tobin, after whom the tax concept is named, first proposed the idea in 1972 after the collapse of the Bretton Woods fixed exchange rate system in 1971. The 1970s, another era of economic instability, saw the bulk of the major currencies move to a floating exchange rate system where spot rates were determined by market forces. Thanks to the progressive relaxation of exchange controls

this led to volatile exchange rate movements as speculators moved hot money around the financial world chasing the best short term return. A speculative attack on a currency can cause an economic crisis as it plunges in value causing policy makers to instigate unnecessary interest rate increases to stem the outflow. The UKs ERM exit in 1992 and the Asia Crisis in 1997 are examples of the power of speculators in foreign exchange markets in a globalised financial world. A Tobin tax would simply impose a tax of less than 1% on currency transactions. The idea would be to reduce the huge speculative flows that can cause a foreign exchange rate to reflect merely short term expectations rather than long term fundamentals. Emerging economies are keen to find ways of controlling boom-bust capital flows, and hope a transaction tax could help dampen the destabilising effect of sharp swings in "hot money" flowing in and out of their countries. Indeed Brazil has already imposed a 2% tax on currency transactions, to try and prevent its currency, the real, from appreciating too rapidly over the coming months. However, even if a Tobin tax gained widespread agreement internationally, a necessary condition for it to work effectively globally, at what rate would it be set at? A rate as low as 0.005% has been suggested which would raise over 35bn annually; while a rate of 0.05% could raise up to 400bn. Is there an optimal rate for a Tobin tax? Some economists have suggested that the tax should be set on a sliding scale, with a high tax rate for those who hold currency for the shortest period of time. This would hopefully have the effect the deterring the short term hot money flows that causes such volatile swings in currencies. Another major hurdle for the Tobin tax to surmount is what should happen to the proceeds of the tax? Many foreign exchange transactions are done in London so would this mean that the UK exchequer would benefit rather disproportionately? Should the tax revenue been pooled by say the IMF and then used to fund development aid to reduce global poverty? Should countries use these tax revenues to reduce their fiscal deficits? Many financiers and fund managers dislike the idea of a Tobin tax as it might negatively affect equity and bond markets and add to business costs. Will the UK, with its reliance on the financial sector, really be as committed to the tax if there could be potential damage to the City of London? In short there is a need for intergovernmental agreement before any real progress can be made. There is certainly a need to set up a global regulatory framework for the banking and financial sector. In addition, with governments in severe debt, a dislike for the financial sector among the public at large as well as a feeling that the banks and financial institutions need to give something back after their rescues by the state maybe the time for a Tobin tax has finally come. Source: EconoMax, Bob Nutter, spring 2010 The scale of global currency transactions Despite the financial crash in recent years, the Bank of International Settlements has confirmed that the UK retained its top spot for leading on global currency transactions. London-based banks handled 37% of the worlds foreign exchange deals in a three year period to April 2010, followed by the United States with 18% and Japan with 6%. Currency transactions grew by 20% in the last three years, with an average daily turnover of $4 trillion. This sum is equivalent to the entire output of the global economy being traded around once a fortnight on currency markets. This implies that if a Tobin Tax was imposed, it would generate quite the revenue for governments! Source: Tutor2u Economics Blog, August 2010, Mo Tanweer

The Exchange Rate and Inflation:

The exchange rate affects the rate of inflation in a number of direct and indirect ways: 1. Changes in the prices of imported goods and services 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. 2. Commodity prices and the CAP: Many commodities are priced in dollars so a change in the sterling-dollar exchange rate has a direct impact on the UK price of commodities such as oil and foodstuffs. A stronger dollar makes it more expensive for Britain to import these items. 3. 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. Bank of England research suggests that a10% depreciation in the exchange rate can add up to 3% to the level of consumer prices three years after the initial change in the exchange rate. But the impact on inflation of a change in the exchange rate depends on what else is going on in the economy.

Inflation and the Exchange Rate for the UK

Exchange rate index (top pane) and inflation (lower pane)
110 105 100
Index
Sterling Exchange Rate Index 110 105 100 95 90 85 80 75 70 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5

95 90 85 80 75 70 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 95

Percent

Consumer Price Inflation

96

97

98

99

00

01

02

03

04

05

06

07

08

09

10

Source: Reuters EcoWin

Sterlings depreciation during 2008 contributed to rising inflation through higher import prices. A year before, the relative strength of sterling helped to partially cushion the blow of the severe rise in oil and food prices many of which are priced in US dollars. The Exchange Rate and Unemployment 1. An exchange rate appreciation tends to cause a slower rate of growth of real GDP because of a fall in net exports (reduced injection) and a rise in the demand for imports (an increased leakage in the circular flow). 2. A reduction in demand and output may cause job losses as businesses seek to control costs. Some job losses are temporary reflecting short term changes in export demand and import penetration. Others are permanent if domestic industries move out of some export markets or

if imports take up a permanently higher share of the UK market. Thus a higher exchange rate can have a negative multiplier effect on the economy. 3. Some industries are more exposed than others to currency fluctuations e.g. sectors where a high percentage of total output is exported and where demand is highly price sensitive (price elastic)

Price level

LRAS

Price level

LRAS

SRAS1 SRAS AD1 SRAS2 AD2 AD

Y2

Y1

Real National Output

Y1 Y2

Real National Output

A fall in export demand - lower GDP negative output gap

A fall in the cost of importing raw materials - Increase in GDP reduction in inflation

The 2008 depreciation of sterling In 2008 the pound fell sharply against a range of currencies. Sterlings weakness was put down to several macroeconomic factors: Steep cuts in official policy rates by the Bank of England A dramatic weakening of the real economy with growth forecasts being slashed and a realisation that a recession was inevitable. Currency traders decided that the UK economy was more exposed than most to the downturn in the world economy and the unwinding of the property bubble. Linked with the recession - a downgrading of expected real returns from investment in the UK

The macroeconomic benefits of a weaker currency A fall in the currency represents an expansionary monetary policy and can be used as a countercyclical measure to stimulate demand, profits, output and jobs. It ought to bring about an improvement in the balance of trade and, through higher export sales, drive higher demand and output in industries that serve export businesses the so-called supply-chain effect. Economists at Goldman Sachs have estimated that a 1% fall in the exchange rate has the same effect on UK output as a 0.2 percentage-point cut in interest rates. On this basis, the 25% decline in sterling in 2007-08 was equivalent to an additional cut in interest rates of between 4 and 5 percentage points this at a time of domestic and global economic weakness. Without the depreciation in sterling at this time, the recession in the UK would have been much deeper.

In brief, a cheaper currency provides a competitive boost to an economy and can lead to positive multiplier and accelerator effects within the circular flow of income and spending. In the latter part of 2008 and into 2009 the hope was that a lower currency could help to provide the impetus for an export-led recovery, reducing the size of the negative output gap and limiting the scale of higher unemployment caused by the recession. Depreciation of sterling also has the effect of increasing the value of profits and income for UK businesses with investments overseas. And it is a boost to tourist and farming industries. For farmers, CAP payments are made in Euros, so a lower /Euro exchange rate increases the sterling value of farm subsidies. Some of the benefits of a weaker currency happen in the near term; but there are also some potential gains in the medium term. For many years the UK economy has been criticised for over-consumption and under-investment with the economy being unbalanced and too dependent on borrowing. As this extract from a recent article from FT columnist Martin Wolf explains. The fall in the pound is not the problem; it is the solution. The UK must ultimately save more and the current account must go into surplus. If these are to be achieved, a big real depreciation of the exchange rate must occur. This can be secured either by a long period of falling nominal wages and prices of non-tradable goods and services or by a fall in sterling. Fortunately, the latter has delivered what is needed. Evaluation points the limits of currency depreciation Not all of the effects of a cheaper currency are positive here are some downsides and risks: A weak currency can make it harder for the government to finance a budget deficit if overseas investors lose confidence. When investors take their money out, this is known as capital flight. Depreciation increases the cost of imports e.g. rising prices for essential foodstuffs, raw materials and components and also imported technology. This can cause an inward shift of SRAS (and has inflationary risks) and might also affect long-run productive potential. Weak global demand has dampened the beneficial effects of a lower currency it is harder to export when key markets are in recession and, as the table below shows, some of the economies of the UKs main trading partners have been in deep recession in 2009. If the price elasticity of demand for exports and imports is low, a depreciation of the exchange rate may initially cause a worsening of the balance of trade in goods and services.
REAL GDP COUNTRY UK USA Euro Area China Japan (% CHANGE) -3.6 -2.6 -3.5 6.0 -6.5 INFLATION (% CHANGE) 0.7 -1.0 0.8 4.1 -1.4 INDUSTRIAL PRODUCTION (% CHANGE) -2.8 -2.0 -5.0 9.0 -18.0

Source: International Monetary Fund, May 2009