Pearson Edexcel International Advanced Level Economics: Exchange rate effects (YEC11) – Revision Notes

These notes condense 4.3.3 item 2, points a to g, of the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11) specification, Issue 2, June 2018. It is IA2 content in Unit 4, Developments in the global economy, so it applies to the full IAL and not the IAS. Fuller explanations are in the study guide, then test yourself with the practice questions. Also useful: the course hub, the checklist and the free diagnostics. All figures are invented. The ark is Country A’s currency and the bel is Country B’s; rates are quoted in bels per ark.

Key terms (2a, 2d, 2e)

Term	Definition
Floating rate	Set by market demand and supply
Fixed rate	Set officially and defended by the central bank
Managed rate	Market-determined but with official intervention
Appreciation	Market-driven rise in a floating currency
Revaluation	Official rise in a fixed or target rate
Depreciation	Market-driven fall
Devaluation	Official fall in a fixed or target rate
Capital flight	Rapid outflow of funds after a loss of confidence
Competitive depreciation	Lowering the rate to win price competitiveness, which others may copy

Market words (appreciation, depreciation) go with floating rates. Official words (revaluation, devaluation) go with fixed or managed rates.

Intervention (2b)

Tool	Effect on the rate	Cost or limit
Foreign currency transactions	Buying the currency with reserves raises it; selling it lowers it	Reserves run out when defending a high rate
Interest rates	A higher rate attracts funds and raises it; a lower rate does the reverse	Higher rates slow growth and tie policy to the rate
QE	Lowers yields and tends to lower the rate	Aimed mainly at spending; the fall is a by-product

To lower the rate the central bank sells its own currency, cuts interest rates or uses QE. QE is not a tool for raising the rate.

Systems at a glance.

	Advantage	Drawback
Fixed	Certainty; discipline on inflation	Reserves needed; interest rates tied; speculative attack
Floating	Automatic adjustment; policy freedom	Volatile; imported inflation after a fall
Managed	Some stability and some flexibility	Needs reserves and judgement; markets may test it

Peg check. Demand for arks is Qd = 100 − 20R and supply Qs = 40 + 20R. Equilibrium: 60 = 40R, so R = 1.50. A peg at 1.80 gives Qd = 64 and Qs = 76. The excess supply is 12 billion arks. Reserves needed: 12 × 1.80 = 21.6 billion bels.

Floating rate factors (2c)

Method in steps:

1. Name the factor and the shift it causes: demand for the currency, supply of it, or both.
2. State the direction: rate up if demand rises or supply falls.
3. Say why: export buyers, investors or speculators.
4. Add a limit or a time frame.

Factor	Effect on currency
Higher interest rates than abroad	Up
Lower inflation than abroad	Up over time
Current account deficit	Down
Stronger economy and prospects	Usually up
Capital flight	Down
Expected rise or fall	Self-fulfilling
Fall in a commodity price (exporter)	Down

PPP quick form. Rate = price level of basket abroad ÷ price level at home. If a basket costs 90 arks and 180 bels, PPP is 2.00 bels per ark. Relative PPP: the currency of the country with higher inflation should depreciate by about the gap. With inflation of 3% in A and 5% in B, the ark should rise by 1.05 ÷ 1.03 − 1 = 1.94%.

Effects of a change (2f)

Area	After a depreciation	Main limit
Current account	Exports cheaper abroad, imports dearer: balance improves if the sum of the two price elasticities of demand is above 1	Short-run elasticities low
Capital and financial accounts	Cheaper domestic assets attract inflows; expected further falls prompt outflows	Expectations
Growth	Net exports rise, AD shifts right, multiplied	Spare capacity needed
Employment	Jobs in exporters and import-competing firms	Labour intensity, lags
Inflation	Imported goods and inputs dearer; demand-pull from higher AD	Pass-through, import share
FDI	Lower foreign-currency cost of entry	Stability and returns matter more

An appreciation has the opposite effects.

Marshall-Lerner and the J-curve. A depreciation improves the current account when PED for exports plus PED for imports is above 1. Below 1, the balance worsens. In the short run elasticities are low (contracts and habits), so the balance worsens first and then improves: a J-shape over time.

J-curve sketch. Vertical axis: current account balance. Horizontal axis: time since the depreciation. The line starts at zero, dips below it, bottoms out, then climbs above zero.

balance
  +              _____
                /
  0 ---\       /
        \_____/
  -
        time after depreciation

Marshall-Lerner mini-example. Short-run elasticities of 0.2 and 0.3 sum to 0.5: worse. Long-run elasticities of 0.9 and 0.6 sum to 1.5: better.

Capital account chain. Depreciation → assets cheaper to foreigners → inflow. But expected further falls → investors sell now → outflow. The result depends on expectations.

Quick calculation. Net exports rise by 30 million arks. MPW is 0.4, so the multiplier is 2.5 and GDP rises by 75 million, if there is spare capacity.

Inflation quick form. Imports are 15% of the basket and import prices rise 10%. Direct effect: 0.15 × 10 = 1.5%.

Competitive depreciations (2g)

• Chain: A devalues → exports gain → B loses market share → B devalues → gains cancel.
• Consequences: dearer imports, inflation, uncertainty, trade barriers, weaker incentive to raise productivity, volatile markets.
• Evaluation: it can work if retaliation is slow and elasticities are high, but if every country does it, nobody gains relative to the others.
• Gains are temporary and fall mainly on the country that is slow to retaliate.

Method: analysing a change in the rate

1. State what happened and why (official decision or market force).
2. Give the direct effect on export and import prices, with a number if the data allows.
3. Apply elasticities and the time period to the current account.
4. Trace the knock-on effect through aggregate demand, output, jobs and prices.
5. Weigh the effects and say which dominates, and under what conditions.

Percentage reminder. The ark moves from 2.50 to 2.00 bels. A 600-ark good costs 1,500 bels, then 1,200: a fall of 20% for buyers abroad. The ark itself has fallen by (2.00 ÷ 2.50 − 1) = 20%.

Evaluation checklist

• Time period (J-curve) and size of elasticities
• Spare capacity or full employment
• Import share of production and consumption
• Retaliation and global conditions
• Whether quality, not price, drives sales
• Which groups gain: exporters, tourists; lose: importers, consumers abroad

Quick self-test

1. The ark falls from 1.25 to 1.00 bels. State the percentage change in the ark and in the bel (in arks).
2. A basket costs 90 arks and 180 bels. What is the PPP rate?
3. Price elasticities are 0.35 (exports) and 0.45 (imports). Does the Marshall-Lerner condition hold?
4. A 250-ark good sells at 3.00 then 2.40 bels per ark. Find the bel price each time and the percentage change.
5. Inflation is 3% in A and 5% in B. What does relative PPP imply for the ark?
6. A bel saver has 80,000 bels. Deposit rates are 4% in A and 1.5% in B, and the start rate is 2.00. Compare outcomes if the end rate is 1.95.
7. Distinguish devaluation from depreciation.
8. Net exports rise by 30 million and MPW is 0.4. Find the change in GDP.
9. Imports are 15% of the basket, and import prices rise 10%. Find the direct effect on prices.
10. Name two ways a central bank can defend a peg.

Answers

1. Ark: 1.00 ÷ 1.25 − 1 = −20%. Bel in arks: from 0.80 to 1.00 = +25%.
2. 180 ÷ 90 = 2.00 bels per ark.
3. 0.35 + 0.45 = 0.80, below 1. No: the balance worsens.
4. 750 and 600 bels; a fall of 20%.
5. The ark should appreciate by about 1.94%.
6. Deposit in A: 40,000 arks become 41,600, then 41,600 × 1.95 = 81,120 bels. Staying: 81,200. The saver loses 80 bels. Break-even end rate is 81,200 ÷ 41,600 = 1.952.
7. Devaluation is an official cut in a fixed or target rate; depreciation is a market fall in a floating rate.
8. 30 ÷ 0.4 = 75 million.
9. 1.5%.
10. Buy the currency with reserves; raise interest rates.

Where marks are usually lost

• Mixing up devaluation with depreciation, or revaluation with appreciation.
• Claiming a depreciation automatically fixes a deficit, without elasticities or timing.
• Quoting the Marshall-Lerner condition as a single elasticity rather than the sum.
• Saying exports “rise” without saying they are cheaper in foreign currency.
• Reading the direction of a rate quote the wrong way round.
• Treating the percentage fall of one currency as the percentage rise of the other.
• Stating a chain of reasoning in one sentence with no link between steps.
• Ending an evaluation with “it depends” and no reason.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11), Specification, Issue 2, June 2018, first teaching September 2018, published by Pearson Education Limited. Section 4.3.3, item 2, points a to g.