4.5.2 Causes & Consequences of Exchange Rate Fluctuations

• Numerous factors influence floating exchange rates, resulting in an appreciation or depreciation of a currency

Factors influencing floating exchange rates

1. Relative interest rates: influence the flow of hot money between countries. If the UK increases its interest rate, then demand for £'s by foreign investors increases and the £ appreciates. If the UK decreases its interest rate, then the supply of £'s increases as investors sell their £'s in favour of other currencies and the £ depreciates
   
   
2. Relative inflation rates: as inflation in the UK rises relative to other countries, its exports become more expensive so there is less demand for UK products by foreigners, which means there is less demand for £s and so the £ depreciates
   
   
3. Net  foreign direct investment (FDI): FDI into the UK creates a demand for the £ which leads to the £ appreciating. FDI by UK firms abroad creates a supply of £'s which leads to the £ depreciating
   
   
4. The current account: EU exports have to be paid for in €'s. EU imports have to be paid for in local currencies, which requires €'s to be supplied to the forex market. Due to this, an increasing net exports will result in an appreciation of the € and falling net exports will result in a depreciation of the €
    
5. Changes in tastes/preferences: As global demand for quinoa increased as it became fashionable, Bolivia's exports of quinoa increased dramatically which put upward pressure on their currency. Foreigners demanded the Boliviano in order to pay for the quinoa
   
   
6. Speculation: the vast majority of currency trades are speculative. Speculation occurs when traders buy a currency in the expectation that it will be worth more in the short to medium term, at which point they will sell it to realise a profit
   
   
7. Net Portfolio Investment: Portfolio investment into the UK creates a demand for the £ which leads to the £ appreciating. Portfolio investment by UK firms abroad creates a supply of £'s which leads to the £ depreciating
    
8. [popover id="RbhwpSYhQds6BEol" label="Remittances"]: Some countries receive high levels of remittances which help to keep the demand for their currency strong e.g. the Philippines
   
   
9. Relative growth rates: Countries with stronger economic growth rates will attract higher levels of FDI resulting in an appreciation of their currency
    
10. Central Bank intervention: Any form of monetary policy is likely to influence exchange rates e.g. higher interest rates will increase the hot money flows. Direct intervention using foreign reserves will also influence the exchange rate

• Changes to exchange rates may have far-reaching impacts on an economy
   

 1. Likely impact on the macro economy of a currency depreciation

A depreciation means that imports are more expensive and exports are cheaper. Net exports should rise leading to an increase in AD from AD1 → AD2

 

2. Likely impact on the macro economy of a currency appreciation

 

An appreciation means that imports are cheaper and exports are more expensive. Net exports should fall leading to a decrease in AD from AD1 → AD2
 

Impact of an Appreciation or Depreciation on the Economic Indicators

Economic Indicator	Explanation
The Current Account	From a UK perspective, the depreciation of the £ causes exports to be cheaper for foreigners to buy and imports to the UK are more expensive The extent to which a currency depreciation improves the current account balance depends on the price elasticity of demand for exports and imports This follows the revenue rule which states that in order to increase revenue, firms should lower prices for products that are price elastic in demand If the price elasticity of demand for UK exports is elastic, then depreciation of the currency will result in a larger than proportional increase in demand for UK exports, which will rapidly improve any current account deficit
Economic growth	Net exports are a component of aggregate demand A depreciation that results in an increase in net exports will lead to economic growth
Inflation	Cost-push inflation can be caused by a depreciating currency as the price of imported raw materials increases with a weaker currency Net exports are a component of aggregate demand A depreciation that results in an increase in net exports will lead to an increase in aggregate demand This may lead to an increase in demand-pull inflation   An appreciation of the currency will have the opposite effect
Unemployment	If depreciation leads to an increase in exports, unemployment is likely to fall as more workers are required to produce the additional products demanded An appreciation of the currency will have the opposite effect
Living standards	The impact of depreciation on living standards can be muted  As imports are more expensive, households face higher prices and less choice, which detracts from living standards Rising exports can decrease unemployment and increase wages/income which means an improved standard of living for some households   The impact of an appreciation of living standards will be the opposite