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IB.ECONOMICS
collection of Internal Assessment works for Economics in
International Baccalaureate programme
| exchange rates | |
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Commentary number 3. The situation in USA perfectly pictures how the level of exchange rates work as a both – the image of the condition of the economy and the factor influencing the current account deficit1. Exchange rates indicate how much unit of one currency we can obtain for one unit of another currency (e.g. how much dollars we can obtain for 1 €). As in the case of the products whose price is dictated by the supply and demand, these two are the essential factors influencing the exchange rates. Similarly to goods and services when the demand for currency increases and/or supply decreases the exchange rates fall (the price of Euro falls from $1.5 to $1.3 when the demand for dollars increases) – the appreciation of the currency took place (see Fig. 1). If the demand for the currency decreases and/or its supply increases the exchange rates rise – the depreciation of the currency took place (see Fig. 2). _1.JPG "exchange rates") The demand as well as the supply for the currency often reflects the condition of the economy in the state. If domestic firms produce with great efficiency the goods and services of high quality, they could export a lot hence creating demand for domestic currency (the foreign countries have to pay for the goods bought in the currency of the country in which goods were produced). Additionally if the economy is effective the profitability of investments increases, what attract foreign capital. This again increases the demand for the domestic currency, since investors need it to finance their enterprises. As it was proved above, the strength of economy leads to the appreciation of the currency. On the other hand the weakness is followed by the deprecation, what was proved in the situation which arose in United States. _1.JPG "business cycle") In last years the greatest economy in the world has been constantly weakening (what was the result of different economical and political factors). Concerning the business cycle2 (Fig. 3) the trough should be followed by the recovery3 – now suspected in USA. This predictions were supported by the prognoses of higher employment of labour – the indicator of economic growth. When this prognoses proved to be false, some investors and financial institutions decided to withdraw their capital from United States. More profitable for them was investing in other countries with more effective economies. Thus they tried to exchange dollars for other currencies generating the higher supply of dollar. Worse results of the economy lowered also the demand for it since people were less interested in investing in United States. In this way the current account deficit resulted in the depreciation of dollar. Higher exchange rates being the result of weakening of economy, are the causes for economic growth and recovery. Higher exchange rates make the export more profitable (if for example before depreciation dollar cost 0.8 € and after depreciation costs 0.6 €, the exporter selling goods worth 0.8 mln. € instead of gaining $1 mln. would gain $1.3 mln.) The higher export could effectively push the economy initiating the recovery. This was evident in Poland in 2003, when the low exchange rates encouraged Polish producers to export their goods abroad. The massive export generated the significant injection into circular flow seriously increasing the national income4 and hence the aggregate demand5. As a result after year 2002 – the year of no economic growth (1%), in 2003 the growth of GDP was 3.7 % and 6.9% in the first quarter of 20046. However such good consequences for United Sates indicates the problem for other important economies in the world. For European Union and Japan the depreciation of dollar means the less profitable export to USA and more profitable import (which can threaten domestic producers). Thus to hold back disadvantageous tendency governments of those countries could plan some interventions (such intervention was proposed by the Japanese official). The most common and in fact the easiest tool to influence the exchange rates and hence the balance of payment is the use of currency reserves7. If the Japanese national Bank would buy dollars from its market it would increase the demand for it and lower the exchange rates. However because the national reserves are limited this is only the short-run strategy. In long-run however the United States economy will stabilise and hence any drastic intervention will be unnecessary. 1 Current account deficit – the difference between the spending and income flowing in and out of the country (in the situation in which the flow from the country exceeds the flow to the country) 2 Business cycle – the fluctuation of the national output around the long-term trend. The fluctuation is periodic and consists of two phases: expansion (starting shortly after a trough ending with the peak) and contraction (starting shortly after peak and ending with the trough). 3 Recovery – one of the two periods of expansion (the second one which follows recovery is prosperity) 4 National income – the income achieved from the economic activity on the territory of a given country in the period of one year. 5 Aggregate demand – the total expenditure on goods and services in a country during one year. Aggregate demand consists of consumer spending, investment, government spending and the expenditure on export less expenditure on import. Source for 2003: Source for first quarter 2004: |
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