Examining the Implications for an Economy of a Rising Exchange Rate

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1. Examine the implications for an economy of a rising exchange rate FT 23 8 11 p16 Exchange rate kills Australian steel exports FT 7 9 11 p4 Bold move seen as high risk (Swiss max exchange rate)) FT 9 9 11 p32 Hong Kong faces dilemma over its peg to the dollar Financial Update 11/12 see Brazil, Australia, Switzerland and Japan


Whilst popular opinion centres on the assumption that rising exchange rate has mostly positive effects on the economy, the impacts are both diverse and extensive. In the short run, a major implication is the improvement in the terms of trade as exports become more expensive and imports become relatively cheaper. This rise in the terms of trade leads a larger amount of imports to be purchased with a given amount of exports; an increase in the purchasing power of domestic production As a result of relative price fluctuations, there is likely to be an increase in domestic spending on imports, and decreased demand for exports in foreign countries.

In order to explore rising exchange rate effects on economy we need to understand essential macroeconomics like Aggregate Supply (AS) and Aggregate Demand (AD).

Economics- S. Nordhaus- 16th ed. – 1998 – McGraw-hill- US - p388

The central concepts for understanding the determination of national output and the price level are aggregate supply (AS) and aggregate demand (AD). Aggregate demand consists of the total spending in an economy by household, businesses, governments and foreigners. It represent the total output that would be willingly bought at each price level, given the monetary and fiscal policies and other factors affecting demand. Aggregate supply describes how much output businesses willingly produce and sell giving prices, costs, and market conditions. AS and AD curves have the same shapes as the familiar supply and demand curves analysed in microeconomics. The downwar4d slopping AD curve shows the amount that consumers, firms, and other purchasers would buy at each level of prices, with other factors held constant. The `AS curve depicts the amount that businesses would willingly produce and sell at each price level, other things held constant. The overall macroeconomic equilibrium, determining both aggregate price and output, comes where the AS and AD curves intersect. At the equilibrium price level, purchasers willingly buy what businesses willingly sell. Equilibrium output can depart from full employement and potential output.

Rising exchange rate can only be seen in floating exchange rate regime rather than fixed exchange rate regime.

We can summerize the effects of rising exchange rates on four topics:

1st effect is on BoP:

Economics – A. Griffiths & S. Wall – 2005 – Pearson – 2005 – London – p407-9

Balance of payments

The balance of payment situation for a country will both influence the exchange rate for its currency and in turn be influenced by that exchange rate.

As well as a high level of employment (low unemployment) and low inflation, government policy will seek to contain within reasonable limits any deficit on the balance of payments and may even seek a surplus.

The overall accounts are constructed so that they must balance ( accounting identity), with this balance achieved by either drawing on reserves (if deficit) or adding to reserves (if surplus). The ‘balancing item’ represents these values, which are required to maintain the accounting identity.

Economics – D. Begg – 9th edition – 2008 – McGraw-Hill Education – Berkshire – p552-5

Internal and external balance

Next we discuss the relation between the state of the economy – boom or recession – and the current account on the balance of payments.

Figure 28.3 shows the different combinations of boom and recessions and current account surpluses and deficits. Think about demand and supply for domestic output. Equation (3) reminds us of the basic equation for goods market equilibrium:...
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