Transcript exchange arets

Exchange Rate
Determination
The Exchange Rate
• The rate at which one currency can
be converted into another
currency.
The Exchange Rate
o Bi-lateral Exchange Rate - the rate at which one currency can
be traded against another. Examples include:
o Sterling/US Dollar, $/YEN or Sterling/Euro
o Effective Exchange Rate Index (EER) - a weighted index of
sterling's value against a basket of international currencies the
weights used are determined by the proportion of trade between
the UK and each country
o Real Exchange Rate - this measure is the ratio of domestic
price indices between two countries. A rise in the real exchange
rate implies a worsening of international competitiveness for a
country.
Equilibrium Exchange Rates
•
Currency is bought and sold on foreign exchange
markets.
•
Three main reasons why currency is bought and sold:
a.
b.
c.
To finance trade in goods and services.
Inward Investment
Speculation
Equilibrium Exchange Rates
• The equilibrium exchange rate is where demand for a
currency equals supply.
• The demand curve for a currency is downward sloping
• A fall in the price of pounds should lead to an increase
in quantity demanded of pounds. Why?
• Why is the supply curve upward sloping?
Equilibrium Exchange Rates
•
What will happen if:
a.
b.
c.
d.
British exports to the USA increase?
If imports from the USA increase?
Rate of Interest in the UK increases?
There is an inflow of funds for long – term
investment.
Speculators believe the value of the pound will fall
against the dollar.
e.
Purchasing Power Parity Theory
If PPP exists, a given amount of a currency in one country,
converted into another currency, will buy the same
bundle of goods.
E.g. If £1 = $2, and consumers only buy jeans, PPP will
exist if a £20 pair of jeans cost $40 in the US. PPP won’t
exist if the jeans cost $30.
If two goods exist, clothing and food, PPP will exist if an
identical bundle of food and clothes costs £100 when it
costs $200 in the US.
Purchasing Power Parity Theory
• PPP Theory states that exchange rates in the long run change
in line with different inflation rates between countries.
• Assume UK has BOP equilibrium, but 5% inflation. Assume no
inflation in rest of world. At the end of one year, UK exports
will be 5% dearer than at the beginning. Imports will be 5%
cheaper. At end of 2nd year, gap will be even wider.
• Starting from a PPP of £1 = $2, the change in relative inflation
rates will affect volume of imports and exports. BOP will
move into deficit.
• A fall in demand for £ and a rise in supply of £ will lead to a
fall in value of £.
• SO, PPP theory states that in long run exchange rates will
change in line with inflation. If annual UK inflation is 4%
higher than US inflation, £ will fall in value at a rate of 4%
against $
Joint Supply
• Where an increase/decrease in
supply of one good leads to an
increase/decrease in supply of
another
• Beef/hides; Lamb/wool;
oil/fuels;milk/dairy products;
cocoa/husks etc
Joint Supply
Price
S Petrol
S Oil
Price
S1
15
Surplus
6
10
D1 5
D
100
150
Quantity bought and sold
D
80
95
120
Quantity bought and sold
Composite Demand
• Where goods have more than one use –
an increase in the demand for one leads
to a fall in supply of the other.
• Milk – used for cheese, yoghurts,
cream, butter etc
• If more milk is used for cheese, ceteris
paribus there is less available for
butter
Composite Demand
S1
Price
S Milk
Price
20
9
10
6
S Cheese
Shortage
D1
D
100
130
Quantity bought and sold
D
20
50
80
Quantity bought and sold
Derived Demand
• Where the demand for one good is
dependent on the demand for
another related good
• Construction industry – demand for new
office construction – demand for office
space
• Demand for construction workers –
demand for construction work
• Factor markets – derived demand
Derived Demand
Price
(000s)
S Houses
Wage Rate
(£ per hour)
S Plasterers
20
200
12
180
Shortage
D1
D1
D
100
130
Quantity bought and sold
D
80 90
120
Quantity hired
Consumer Surplus
• The difference between the price that a
consumer is prepared to pay and the
actual price paid
• Related to the value we place on items
• Linked to the degree of utility
• Useful concept in analysing welfare gains and
losses as a result of resource allocation
• Emphasis on the MARKET demand – of those
in the market there are some who are willing
to pay higher prices than the market price
Consumer Surplus
Price (£)
Market Price = £5
20 consumers willing to pay £5
15 Consumers WILLING to pay £9
These 15 consumers get 15 x £4
of consumer surplus
9
Total utility = value represented by
blue and gold area
5
Blue area is amount paid to
acquire good;
Gold area = total consumer surplus
D = Marginal Utility
15
20
Quantity Demanded
Producer Surplus
• Difference between the market
price received by the seller and
the price they would have been
prepared to supply at.
• Price received – linked to factor
cost + element of normal profit
• Producer surplus = abnormal profit
Price (£)
Producer Surplus
S
Market price = £10
At £10, suppliers willing to offer
60 for sale
10
Total Revenue = blue area
£10 x 60 = £600
Some suppliers would have offered
35 for sale at £6:
Producer surplus = 35 x £4 = £140
6
Gold area = Producer surplus
35
60
Quantity Supplied