Exchange rate determination, the effects of changes in the exchange rate, the use of exchange rate policy and the Marshall-Lerner condition.

What this dot point is asking

WJEC wants you to explain how a floating exchange rate is determined, the effects of an appreciation or depreciation, the use of exchange rate policy, and the role of the Marshall-Lerner condition and J-curve.

The answer

Exchange rate determination

Demand for a currency comes from foreigners wanting to buy the country's exports, to invest in it (foreign direct and portfolio investment), or to hold it as a reserve or speculative asset; supply comes from residents wanting foreign currency for the opposite reasons. The rate rises (appreciates) when demand for the currency rises (stronger exports, higher domestic interest rates attracting capital, greater confidence) and falls (depreciates) when supply rises or demand falls. Because financial flows dwarf trade flows, interest rates, speculation and confidence often move the rate more than trade does in the short run.

Effects of appreciation and depreciation

A depreciation can be remembered by the acronym idea that it helps exporters and hurts importers: SPICED (Strong Pound, Imports Cheap, Exports Dear) reversed. The boost to net exports raises AD, output and employment, but dearer imported food, fuel and components raise the price level and firms' costs. An appreciation eases inflation and benefits import-dependent firms and consumers but harms exporters' competitiveness. Exchange rate policy can be used deliberately: a central bank can influence the rate through interest rates or, in a managed system, through buying and selling currency, though a freely floating rate is left to the market.

The Marshall-Lerner condition and the J-curve

A depreciation improves the current account only if the combined price elasticity of demand for exports and imports exceeds one in absolute value (the Marshall-Lerner condition). If demand is elastic enough, the rise in export volumes and fall in import volumes outweigh the worse price paid per import, so the trade balance improves. The J-curve describes the path over time: in the short run elasticities are low (contracts are fixed, buyers slow to switch), so the current account may worsen first as dearer imports cost more before volumes adjust; as elasticities rise over time the condition is met and the balance improves, tracing a "J". This is why a depreciation may not help the trade balance immediately even if it does eventually.

Examples in context

Example 1. Sterling's fall after the EU referendum. The pound depreciated sharply in 2016 after the EU referendum. As predicted, this raised the cost of imported goods and fed into higher consumer price inflation, while making UK exports and tourism more competitive. The episode is a clear illustration of the twin effects of depreciation: improved competitiveness for exporters set against cost-push inflation from dearer imports.

Example 2. The J-curve and a slow trade response. After a large depreciation, trade balances often worsen before they improve, because import and export volumes take time to respond while prices change immediately. Studies of various currency falls show this J-curve pattern, with the current account dipping for several quarters before recovering. It explains why governments and markets do not expect an instant improvement in the trade balance from a weaker currency, even when the Marshall-Lerner condition ultimately holds.

Try this

Q1. Explain what happens to exports and imports when a currency depreciates. [2 marks]

• Cue. Exports become cheaper to foreign buyers and imports become more expensive to domestic buyers, so export demand tends to rise and import demand to fall.

Q2. State the Marshall-Lerner condition. [2 marks]

• Cue. A depreciation improves the current account only if the sum of the price elasticities of demand for exports and imports is greater than one in absolute terms.