In this video we will conclude our study of exchange rates.
This lesson will focus on the effects of changing exchange rates on the domestic and external
economy, using AD, Marshall-Lerner and J-curve analysis.
This information is important in that it will allow you to deeply analyse and evaluate the
impact changes exchange rates can have.
It’s very important that you grasp these concepts to really push for those higher evaluation
marks, so keep focused.
First, let’s see what happens when the currency strengthens.
As it appreciates, export revenue falls because our exports are now more expensive to foreign
buyers.
They need to exchange more of their currency to buy the same amount of ours as before.
It is likely they will substitute away to other countries’ exports that may be cheaper.
Our import expenditure will rise because our currency is stronger and that makes foreign
goods and services more affordable.
In the summer of 2016 the dollar was very strong against the pound leading me to conclude
that there was probably a rise in American tourism to the UK as well as an increased
amount of British imports being purchased by American buyers.
Aggregate demand will fall as one of its components, net exports, decreases in value.
If AD falls, real GDP will most likely fall.
However, this still depends upon where the economy was operating in relation to potential
output.
With a fall in real GDP will come a rise in unemployment as firms need to decrease production
to respond to falling demand from abroad.
The price level could fall or stay the same, once again depending on the actual output
of the economy.
If it happens when there is significant excess capacity within the economy, the price level
may change very little.
However, if the economy is operating closer towards the potential output, a decrease in
the price level is more likely.
I’ve demonstrated the impact of a currency appreciation above.
The shift in AD to AD1 represents what could happen if the currency were to strengthen.
It is important to remember that the change in the price level and output is linked to
where I plotted my initial aggregate demand curve against LRAS.
The impact of the change will depend upon the magnitude of the appreciation, the elasticity
of exports and imports and will also depend upon where the economy was operating with
regards to full employment, prior to the appreciation.
Now let’s see what happens when the currency weakens.
As the currency weakens, foreign buyers need to use less of their money to buy ours, so
exports become cheaper to them, resulting in increased export volume.
As it now takes more domestic currency to buy foreign currency, consumers are more likely
to opt for domestic goods and services more than imported goods and services.
Aggregate demand will then increase as the value of net exports rises.
This could increase real GDP or keep it the same, depending on where the economy is currently
operating with regards to potential output.
If real GDP rises, unemployment falls because firms need to increase production to meet
rising demand from abroad.
This requires them to employ more workers.
The price level could increase or stay the same, once again depending on the level of
actual output of the economy.
I’ve just explained to you why the value of net exports rises, resulting in this rightward
shift of the aggregate demand curve.
It’s important tor remember that the impact of a depreciation/devaluation of a currency
depends on the magnitude of the change, the elasticity of exports and imports and also
where the economy was operating with regards to potential output before the currency changed
in value.
I’ll elaborate on the elasticity component next.
The Marshall Lerner condition addresses the importance of long-term elasticities when
considering the impact a change in the value of a currency will have on the value of net
exports.
The condition states that a depreciation or devaluation of a currency will only move a
country towards a more favourable trade balance IF the sum of the long-term export and import
elasticities is greater than 1.
The same condition holds in order for an appreciation or revaluation to move a country towards a
trade deficit in the long run.
The J-curve demonstrates the impact of a devaluation or depreciation on an economy’s trade balance
over a period of time, assuming that the Marshall-Lerner condition holds.
The decrease in the value of the currency immediately causes imports to become more
expensive and exports become cheaper.
The assumption is that behaviour does not change immediately but is more likely to over
time.
So, immediately, a decrease in the value of the currency will cause the trade balance
to worsen.
As time passes, exports will start to rise as foreign buyers find our goods more price
competitive.
Domestic consumers will switch away from the now expensive imports and import expenditure
should fall.
The underlying theory behind the J-curve is that it takes time for a fall in the value
of the currency to take effect.
Foreign buyers need time to respond as do domestic consumers.
Their behaviour is what is behind the shape of this curve.
Here’s a look at what would happen with a J-curve in an economy with a trade surplus
looking to move towards a deficit.
Once again, the time it takes for foreign buyers and domestic consumers to respond to
changes underlies the shape of the curve.
This question is from Winter 2010, paper 1, question 28.
In a country the Marshall-Lerner condition for an improvement in the trade balance is
satisfied in the long run, but quantities of imports and exports are slow to respond
to price changes.
The government devalues its currency to reduce its trade deficit.
Which curve indicates the probable behaviour of the trade balance?
There’s a lot of information in this question: (1) the country seeks an improvement in its
trade balance (2) the government devalues its currency (3) it is seeking to reduce its
deficit (4) quantities of exports and imports are slow to respond.
It’s clear we are looking at a J-curve.
Since we already know what it looks like, we’ve got our work cut out for us.
We should start off this problem in a trade deficit position, which means having a negative
trade balance.
That leaves us with only B and C. However, B shows that the long run impact of a devaluation
will lead to a trade surplus whereas C shows an initial trade deficit with immediate movement
towards a surplus, indicating imports and exports are immediately responsive to changes
in price.
Therefore, our correct answer is B.
That’s an extensive analysis and evaluation of changing exchange rates and the effects
they can have.
I hope this video has helped you clarify your understanding and come to grips with this
somewhat difficult topic.
As always, if you have any questions or comments, please leave them below or email me at enhancetuition@gmail.com.
You can also tweet me @enhancetuition.
That’s us done for now and I will see you in the next one!