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EFFECTS OF AN EXCHANGE RATE DEPRECIATION-1

A depreciation of the pound sees the market value of the pound fall against other
currencies. The economic effects of a lower pound take time to happen economists say that there are time lags between a change in the exchange rate
and changes in, for example, inflation and the balance of payments.
The last major depreciation in the value of sterling came in the early-mid 1990s
following sterling's departure from the exchange rate mechanism. The pound was
devalued by nearly 15% against a range of currencies in September 1992 and
continued to drift lower in value for the next three years.
This revision note suggests some of the main economic effects of a lower value
for the pound
INFLATION
A fall in the exchange rate makes imported goods and services more expensive
in the UK. Producers may then pass on higher costs of imported components
and raw materials onto consumers. This causes extra "cost-push" inflation.
Wages may rise in response to this triggering off the possibility of a wage-price
spiral.
The extent to which a depreciation of the pound causes inflation depends in part
on how dependent producers are for their imported components and also their
willingness to "price to the market" and pass on costs to consumers.
In a recession demand for many goods is elastic and a lower pound may have
little effect on retail price inflation.

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EXPORTS AND THE BALANCE OF PAYMENTS


Exporters should benefit from a lower pound (even allowing for the inevitable
time lags). A depreciation makes UK goods cheaper priced in a foreign currency.
Demand for exports will grow faster if the demand for UK goods overseas is
elastic
IMPORTS
The demand for imports should fall as imports become more expensive.
However, some imports are essential for production or cannot be made in the UK
and have an inelastic demand - we end up spending more on these when the
exchange rate falls in value. This can cause the balance of payments to worsen
in the short run (a process known as the J curve effect)
WAGE DEMANDS
Partly due to higher inflation and falling real incomes, wages may rise. This
depends on what stage of the economic cycle the economy is in. When
unemployment is high, workers may have little confidence that their wage
demands will be met.
ECONOMIC GROWTH (GDP)
Higher exports (an injection into the circular flow) and falling imports leads to
rising GDP levels.
A lower exchange rate accompanied by lower interest rates will stimulate
consumer spending and general economic recovery. This was the case for the
UK between 1993-95 after the pound left the exchange rate mechanism.

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EFFECTS OF AN EXCHANGE RATE DEPRECIATION -2


In theory, the exchange rate will have an impact on the current account.
If there is a depreciation in the exchange rate. Then that particular country will
experience a fall in the foreign price of its exports. It will appear more competitive
and therefore there will be a rise in the quantity of exports.
Assuming demand for exports is relatively elastic then a depreciation will lead to
an increase in the value of exports and therefore improve the current account
deficit.
Similarly a depreciation of the exchange rate, will also lead to an increase in the
cost of buying imports. This will lead to a fall in demand for imports and also help
to reduce the current account deficit.
Therefore, in theory, a depreciation in the exchange rate should improve the
current account and an appreciation should worsen the current account.
However, in practise this might not happen for a variety of reasons.
1. Elasticity of Demand. The impact of a depreciation depends on the elasticity
of demand. The Marshall Lerner condition states that a depreciation in the
exchange rate will only improve current account if combined PEDx and PEDm
is greater than 1.
e.g. if demand for UK exports is very inelastic. They a depreciation will lead to
only a very small increase in demand.

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2. Profit Margins. A depreciation means exports can be cheaper. However, a


UK firm may decided to keep the same foreign price and just make a bigger profit
margin. This often occurs in the short term. Firms dont adjust prices to
consumers but have exchange rate movements absorbed in their own margins.
This is one reason why a movement in the exchange rate often takes time to
effect the current account.
The J Curve effect states how a depreciation can worsen current account in short
term because demand is inelastic, but, over time, demand becomes more elastic
and

therefore

the

current

account

improves.

See also: Terms of Trade Using example of UK, a depreciation in the Pound
did not effect the terms of trade as much as might be expected.
3. Global Demand.
During 2008-09, the depreciation in the Pound Sterling didnt effect the UK
current account deficit. One reason was the sluggish global growth. There was
little foreign demand for UK exports despite the fall in price.

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Effects of a Falling Dollar-3


Explain what is fall in Dollar her. Connect it to the body.
1. Boost in US manufacturing sector.
A lower dollar increases the price competitiveness of US exports. Cheaper exports will lead to
an increase in demand. If demand is price elastic then there will be an increase in the value of
exports.
- However a devaluation is often just a temporary increase in competitivenes. Devaluation
often causes inflationary pressures which reduce the temporary gain in competitiveness
2. Increase in US import prices.
US consumers will face increased prices of European /imported goods, so the growth in
demand for imports will slow.
However to some extent EU manufacturers can prevent price increases by reducing profit
margins and cutting costs and becoming more efficient, however there is a limit to this. With a
33% increase in the Euro this is becoming more difficult.
3. Improvement in US current account.
Assuming the Marshall Lerner condition is satisfied i.e PEDx +PEDm >1 then a devaluation will
improve the current account and reduce the deficit. However to eliminate a deficit of 6% of
GDP will require a massive devaluation
4. Temporary improvement in US Economic growth and employment
With rising export demand this will help increase output and therefore there will be a
reduction in unemployment which is politically
Inflation in the US is still very low (although now starting to creep up)this is why the federal
bank are not concerned about a falling $ and rising AD.
5. Lower Growth and lower inflation in the EU.
The Euro has borne the brunt of the rising dollar and this will lead to the opposite effect of
falling Exports to the US .
Inflation will be lower in the EU, this is because
1. Imported goods will be cheaper (Many raw commodities are priced in dollars)
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2. AD will be lower or increase at a slower rate.


3. Manufacturers have increased incentives to cut costs. therefore a devaluation will help
reduce EU inflation. This could cause a recession but evidence suggest EU growth is more
resilient and the ECB have said a cut in interest rates is not necessary at the moment.
6. Pressure to revalue Chinese Yuan and Other currencies.
China and other Asian countries such as Thailand have a fixed exchange rate against the dollar.
Thus at the moment they are benefiting from a competitive exchange rate increasing exports
and creating more jobs.
However arguably the Chinese economy would benefit from a moderate appreciation. This is
because growth is very fast and it is approaching full capacity and therefore could cause an
increase in inflationary pressures. An increase in the value of the currency would help reduce
this.

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Follow these steps when writing a cause and effect essay


1. Distinguish between cause and effect. To determine causes, ask, "Why did this
happen?" To identify effects, ask, "What happened because of this?"
2. Develop your thesis statement. State clearly whether you are discussing causes,
effects, or both. Introduce your main idea, using the terms "cause" and/or "effect."
3. Find and organize supporting details. Back up your thesis with relevant and sufficient
details that are organized. You can organize details in the following ways:
Chronological. Details are arranged in the order in which the events occurred.
Order of importance. Details are arranged from least to most important or vice
versa.
Categorical. Details are arranged by dividing the topic into parts or categories.
Use appropriate transitions. To blend details smoothly in cause and effect essays, use
the transitional words and phrases listed below.
For causes
because, due to, on cause is, another is, since, for, first, second
For Effects
consequently, as a result, thus, resulted in, one result is, another is, therefore

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Macro Economic Essays


http://www.economicshelp.org/macroeconomics/macroessays/
These are a collection of essays. Although some may no longer up to date (e.g. exchange rate
changes). They still express basic economic principles
Exchange Rate Essays
1. Effects of a falling Dollar
2. Why Dollar keeps falling
3. Discuss Policies to Stop the Dollar Falling
4. Does Devaluation Cause Inflation?
5. Benefits and Costs of Falling Dollar
6. Reasons for Falling Dollar
7. The Dollar as the Worlds Reserve Currency
Economic Growth Essays
1. Evaluate Benefits of Economic Growth
2. Essays on Recessions
3. Causes of Recessions
4. Problems of Recovering from a Recession
5. What can Increase Long Run Economic Growth?
6. Discuss Effect of a fall in the Savings Ratio
Inflation Essays
1. Discuss the Difficulties of Controlling Inflation
2. Should the Aim of the Government be to Attain Low Inflation?
3. Explain What Can Cause a Sustained Increase in the Rate of Inflation
4. Reasons for Low inflation in the UK
5. Inflation Explained
6. Difficulties of Inflation targeting
7. Hyperinflation
Unemployment Essays
1. Explain what is meant by Natural Rate of Unemployment?
2. Should the Main Macro Economic Aim of the Government be Full Employment?
3. The True Level of Unemployment in the UK
4. What explains low inflation and low unemployment in the UK?

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Demand Side Policies


1. Discuss effect of Expansionary demand side policies on Balance of Payments and
Environment
2. Effects of a Falling Stock Market
3. How do Mortgage Defaults affect and Economy?
4. Discuss effect of Increased Government spending on eduction
5. Phillips Curve Trade off between inflation and Unemployment
Development Economics
1. Why Growth may not benefit developing countries
2. Does Aid Increase Economic Welfare?
3. Problems of Free Trade for Developing Economies
Fiscal Policy
1. Will US Economy benefit from Tax Cuts?
2. Can Fiscal Policy solve Unemployment?
Trade
1. Explain Reasons for UK Current Account Deficit
2. Benefits of Globalization for Developing and Developed Countries
Monetary Policy
1. Discuss Effects of an Increase in Interest Rates
2. How MPC set Interest Rates
3. Benefits of High Interest Rates (and recessions)
4. Who Sets interest rates - Markets or Bank of England?
Economic History
1. Economics of the 1920s
2. What Caused Wall Street Crash of 1929
3. UK economy under Mrs Thatcher
4. Lawson Boom of the 1980s
5. UK recession of 1991
General Economic Essays
1. The Dismal Science
2. Difference Between Economists and Non Economists
3. War and Recessions
4. The Economics of Fear
5. The Economic of Happiness
6. Can UK and US avoid Recession?
7. 3 Of the Worst Economic Policies
8. Overvalued Housing Markets

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US Economy
1. What Went Wrong with US Economy?
2. Problem with Bailing out financial sector
UK Economy
1. Problems of Personal Debt
2. Problem of Inflation
3. UK Outlook
4. National Debt in UK
Recessions
1. How To Survive a Recession
2. Can A recession be a good thing?
Chinese Economy
1. Problems of Chinese Economic Growth
2. Should We worry About A Strong China
3. Chinese Growth and Costs of Growth
4. Chinese Interest Rates and Economic Growth

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