We shall analyze the impact on exports as well as imports.

Transcription

1 Using shifts in supply and demand curves, describe how a change in the exchange rate affected your industry. Label the axes, and state the geographic, product, and time dimensions of the demand and supply curves you are drawing. Product car Industry car manufacturing industry Geography United Kingdom (UK) Time 2007 vs Case Pound depreciated with respect to Euro Car manufacturing industry in UK is an export-driven industry with most of the manufactured cars being exported to Europe. If there is a depreciation in the value of the Pound, it will make UK exports cheaper, and it will make imports into the UK more expensive. Year exchange rate was 1 = Year Pound had fallen in value. Now, 1 = We shall analyze the impact on exports as well as imports. 1) Impact on exports One UK car sells for 5,000 in the UK. In 2007, the European price of this car was 7,500 (5,000 *1.5) In 2009, the European price of this car is 5,500 (5,000 *1.1) The pound depreciation means that European consumers now find UK goods much cheaper. The effective market price in Europe has fallen. This should increase demand for UK goods. Hence, the demand curve shifts rightwards

2 2) Impact on raw materials imports The disadvantage of a depreciation is that UK firms which import raw materials will face an increase in the cost of buying raw materials. If the UK car company imports engines from Germany (Europe) to make the car, it will have to pay more to buy the engines. One engine costs 1000 to import from Germany. In 2007, this costs 666 (1,000/1.5). In 2009, they will have to spend 909 (1,000/1.1) to buy the same German engine. As the profits go down, the willingness of the manufacturers to supply the product goes down. Hence, the supply curve shifts leftwards. Overall effect:

3 Explain what happened to industry price and quantity by making specific references to the demand and supply curves. Demand curve shifts rightwards, while supply curve shifts leftwards. Hence, the overall effect is that equilibrium prices increase. Whether quantity increases of decreases depends on the relative movement of demand and supply curves. If demand curve moves more than the supply curve, then quantity increases. If demand curve moves less than the supply curve, then quantity decreases. Hence quantity may increase or decrease. Question- How can you profit from future shifts in the exchange rate? A UK firm has 2 choices: It can reduce the European price from 7,500 to 5,500; this should lead to an increase in the quantity sold, and increase UK exports. It can keep the price at 7,500 and make a bigger profit margin. It is a good choice for manufacturers to have reduce European price and sell more or keep price same and make a bigger profit margin.

4 How do you predict future changes in the exchange rate? There are generally 4 methods of predicting future changes in the exchange rates: 1. Purchasing Power Parity (PPP) Based on theoretical Law of One Price, which states that identical goods in different countries should have identical prices. For example, a car in UK should be the same price as a car in the Europe after accounting for exchange rate and excluding transaction and shipping costs. There should be no arbitrage opportunity to buy pencils cheap in one country and sell them in another for a profit. Now, the PPP approach says that the exchange rate will change to offset price changes due to inflation. Suppose that prices in the Europe are expected to increase by 4% over the next year while prices in UK are expected to rise by only 2%. The PPP approach would forecast that the Europe euro would have to depreciate by approximately 2% to keep prices between both countries relatively equal. 2. Relative Economic Strength Approach The rationale is that a strong and potentially high growth economic environment is more likely to attract investments from foreign investors. To purchase investments in the desired country, an investor would buy the country's currency, creating increased demand that should cause the currency to appreciate. For example, high interest rates will attract investors looking for the highest yield on their investments, causing demand for the currency to increase, which again would result in an appreciation of the currency. 3. Econometric Models This approach involves understanding factors that you think affect the movement of a currency and creating a model that relates these factors to

5 the exchange rate. These factors usually have some economic theory behind their inclusion in the model. 4. Time Series Model The rationale for using this method is based on the idea that past behavior and price patterns can be used to predict future price behavior and patterns. This method is purely technical in nature and is not based on any economic theory. Example - autoregressive moving average (ARMA) process.