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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