Exchange rates (3)
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1.
Explain the potential benefits and drawbacks of a government choosing to revalue its currency under a fixed exchange rate regime. Consider the impact on economic growth, inflation, and the balance of payments.
Potential Benefits of Revaluation:
- Improved Balance of Payments: A revaluation can boost exports (making them more competitive) and reduce imports (making them more expensive). This can lead to a more favourable balance of payments (trade surplus).
- Reduced Inflation: A stronger currency can reduce the cost of imported goods, which can help to lower inflation. This is particularly relevant for countries that rely heavily on imports of essential goods.
- Increased Foreign Investment: A revaluation can signal economic stability and attract foreign investment, as investors may perceive the country as a safer and more profitable place to invest.
Potential Drawbacks of Revaluation:
- Reduced Economic Growth: Increased export prices can make UK exports less competitive, potentially leading to a decline in export volumes and slower economic growth.
- Increased Unemployment: If export-led industries suffer from reduced competitiveness, they may be forced to cut jobs, leading to higher unemployment.
- Potential for Trade Deficit: If the decline in export volumes is greater than the reduction in import volumes, the country could experience a trade deficit.
The decision to revalue is a complex one, involving a trade-off between potential benefits and drawbacks. The optimal policy depends on the specific economic circumstances of the country.
2.
Using a table, compare and contrast the effects of a revaluation and a devaluation on a country's trade balance, inflation, and economic growth.
[Insert a table here]
| Feature | Revaluation | Devaluation |
| Trade Balance | Generally improves (increased exports, decreased imports) | Generally improves (increased exports, decreased imports) |
| Inflation | Tendency to reduce inflation (cheaper imports) | Tendency to increase inflation (more expensive imports) |
| Economic Growth | Potential for slower growth (reduced export competitiveness) | Potential for faster growth (increased export competitiveness) |
Note: These are general tendencies and the actual effects can be influenced by other factors, such as the elasticity of demand for exports and imports, and the overall state of the global economy.
3.
Explain how changes in interest rates can affect exchange rates, considering both the short-run and long-run effects. How does this relate to the concept of purchasing power parity (PPP)?
Interest Rate Changes and Exchange Rates:
Short-run effects: An increase in interest rates in a country typically attracts foreign capital seeking higher returns. This increased demand for the country's currency leads to appreciation (the currency becomes more valuable). Conversely, a decrease in interest rates can lead to currency depreciation as investors move their capital elsewhere.
Long-run effects: In the long run, interest rate changes are more closely linked to PPP. If a country has higher interest rates, it tends to experience higher inflation. PPP suggests that exchange rates adjust to equalize the price of identical goods and services across countries. Higher inflation in a country with higher interest rates will lead to a depreciation of its currency to maintain PPP.
Relationship to Purchasing Power Parity (PPP):
PPP is a theory that states that exchange rates should adjust to equalize the purchasing power of currencies. The interest rate effect on exchange rates is often seen as a short-run deviation from PPP. If interest rates differ, PPP suggests that exchange rates should adjust to offset the difference in expected inflation. Therefore, changes in interest rates can influence exchange rates in the short run, but PPP provides a framework for understanding the long-run equilibrium exchange rate.