II.

Exchange Rates - Macroeconomic Effects of

Currency Fluctuations

Changes in the external value of a currency can have important effects on a number of
macroeconomic outcomes and objectives.

Exchange Rate and Inflation:

The exchange rate affects the rate of inflation in a number of direct and indirect ways:

 Changes in the prices of imported goods and services – this has a direct effect on the
consumer price index. For example, an appreciation of the exchange rate usually
reduces the price of imported consumer goods and durables, raw materials and capital
goods.
 Commodity prices: Many commodities are priced in dollars – so a change in the sterling-
dollar exchange rate has a direct impact on the UK price of commodities such as oil and
foodstuffs. A stronger dollar makes it more expensive for Britain to import these items.
 Changes in the growth of exports: A higher exchange rate makes it harder to sell
overseas because of a rise in relative prices. If exports slowdown (price elasticity of
demand is important in determining the scale of any change in demand), then exporters
may choose to cut their prices, reduce output and cut-back employment levels.

Bank of England research for the UK economy suggests that 10% depreciation in the
exchange rate can add up to 3% to the level of consumer prices three years after the
initial change in the exchange rate. But the impact on inflation of a change in the
exchange rate depends on what else is going on in the economy.

The Exchange Rate and Unemployment

 An exchange rate appreciation causes a slower growth of real GDP because of a fall in
net exports (reduced injection) and a rise in the demand for imports (an increased
leakage in the circular flow).
 A reduction in demand and output may cause job losses as businesses seek to control
costs. Some job losses are temporary – reflecting short term changes in export demand
and import penetration. Others are permanent if imports take up a permanently higher
share of the domestic market. Thus a higher exchange rate can have a negative
multiplier effect on the economy.
 Some industries are more exposed than others to currency fluctuations – e.g. sectors
where a high percentage of total output is exported and where demand is highly price
sensitive (price elastic)

What are some of the Macroeconomic Benefits of a Weaker Currency?

 A fall in a currency is an expansionary monetary policy and can be used as a counter-

cyclical measure to stimulate demand, profits, output and jobs when an economy is in
recession or slowdown

 It ought to bring about an improvement in the balance of trade and, through higher export
sales, drive an expansion of output in industries that serve export businesses – this is
known as the ‘supply-chain’ effect.

 Economists at Goldman Sachs have estimated that a 1% fall in the exchange rate has
the same effect on UK output as a 0.2 percentage-point cut in interest rates. On this
basis, the 25% decline in sterling in 2008 was equivalent to a cut in interest rates of
between 4 and 5%. Without the depreciation in sterling at this time, the recession in the
UK would have been much deeper.

In brief, a cheaper currency provides a competitive boost to an economy and can lead to
positive multiplier and accelerator effects within the circular flow of income and
spending.
Depreciation of also has the effect of increasing the value of profits and income for a
country’s businesses with investments overseas. And it is a boost to tourist and farming
industries.

For farmers in Europe, CAP payments are made in Euros, so a lower sterling/Euro
exchange rate increases the sterling value of farm subsidies for farmers in Britain.

Some of the benefits of a weaker currency happen in the near term; but there are also
some potential gains in the medium term. For many years the UK economy has been
criticized for over-consumption and under-investment with the economy being
unbalanced and too dependent on borrowing.

Evaluation – What are the Limits of a Currency Depreciation to solve Economic

Problems?

Not all of the effects of a cheaper currency are positive – here are some downsides and risks:

 A weak currency can make it harder for the government to finance a budget deficit if
overseas investors lose confidence. When investors take their money out, this is known
as capital flight

A weak currency also makes it harder to pay for a trade deficit that is owed to overseas creditors

 Depreciation increases the cost of imports– e.g. rising prices for essential foodstuffs, raw
materials and components and also imported technology. This can cause an inward shift
of SRAS (and has inflationary risks) and might also affect long-run productive potential.
 Weak global demand can dampen the beneficial effects of a lower currency – it is then
harder to export when key markets are in recession and overseas sales are falling
 If the price elasticity of demand for exports and imports is low, a depreciation of the
exchange rate may initially cause a worsening of the balance of trade in goods and
services. This is known as the J-Curve Effect

Exchange rates and balance of payments adjustment - The ‘J-Curve’ effect

 In the short term depreciation may not improve the current account of the Balance of
Payments
 This is due to the low price elasticity of demand for imports and exports in the short term
 Initially the quantity of imports will remain steady because contracts for imported goods
will have been signed. Export demand will be inelastic in response to the exchange rate
change
 Earnings from exports may be insufficient to compensate for higher spending on imports.
 The balance of trade may worsen and this is known as the ‘J-Curve’ effect
 Providing that the elasticity of demand for imports and exports are greater than one, then
the trade balance will improve over time. This is known as the Marshall-Lerner condition.
Reflection:

VI. Purchasing Power

REVIEWED BY ADAM HAYES
Updated Jul 8, 2019

What Is Purchasing Power?

Purchasing power is the value of a currency expressed in terms of the amount of
goods or services that one unit of money can buy. Purchasing power is important
because, all else being equal, inflation decreases the amount of goods or
services you would be able to purchase.

In investment terms, purchasing power is the dollar amount of credit available to

a customer to buy additional securities against the existing marginable
securities in the brokerage account. Purchasing power may also be known as a
currency's buying power.

Understanding Purchasing Power

Inflation reduces the value of a currency's purchasing power, having the effect of
an increase in prices. To measure purchasing power in the traditional economic
sense, you would compare the price of a good or service against a price index
such as the Consumer Price Index (CPI). One way to think about purchasing
power is to imagine if you made the same salary as your grandfather 40 years
ago. Today you would need a much greater salary just to maintain the same
quality of living. By the same token, a homebuyer looking for homes 10 years
ago in the $300,000 to 350,000 price range had more options to consider than
people have now.

Purchasing power affects every aspect of economics, from consumers buying

goods to investors and stock prices to a country’s economic prosperity. When a
currency’s purchasing power decreases due to excessive inflation, serious
negative economic consequences arise, including rising costs of goods and
services contributing to a high cost of living, as well as high interest rates that
affect the global market, and falling credit ratings as a result. All of these factors
can contribute to an economic crisis.

As such, a country’s government institutes policies and regulations to protect a

currency’s purchasing power and keep an economy healthy. One method to
monitor purchasing power is through the Consumer Price Index. The U.S.
Bureau of Labor Statistics (BLS) measures the weighted average of prices of
consumer goods and services, in particular, transportation, food and medical
care. The CPI is calculated by averaging these price changes and is used as a
tool to measure changes in the cost of living, as well as considered a marker for
determining rates of inflation and deflation.

A concept related to purchasing power is purchasing price parity (PPP). PPP is

an economic theory that estimates the amount that needs to be adjusted to the
price of an item, given two countries’ exchange rates, in order for the exchange
to match each currency’s purchasing power. PPP can be used to compare
countries’ income levels and other relevant economic data concerning the cost of
living, or possible rates of inflation and deflation.

KEY TAKEAWAYS

 Purchasing power is the amount of goods or services that a unit of

currency can buy at a given point in time.
 Inflation tends to erode the purchasing power of a currency over time.
 Central banks try to keep prices stable through maintaining the purchasing
power of the currency by setting interest rates and other mechanisms.
Peso purchasing power declines even as economy booms
ABS-CBN News

MANILA – The purchasing power of the peso has declined steadily, as consumer prices rise in
one of Asia’s fastest growing economies, data from the Bangko Sentral ng Pilipinas showed.

As of December 2016, the purchasing power or real value of the peso was at P0.68. It held at
P0.69 from July to November and at P0.70 from January to May.

Inflation, or the rate of increase in consumer prices, accelerated to 2.6 percent in December from
1.3 percent at the start of 2016, BSP data showed.

Jeepney driver Rolly Lozorata said his daily earnings of P300 to P400 was enough for a kilo of
rice, when before, he could buy up to two kilos.

“Sabon na lang po, shampoo hindi na kami nakakabili,” Lozorata told ABS-CBN News as he
waited for passengers at a busy Manila street.

(We make do with soap. We can’t afford shampoo.)

Economic Planning Secretary Ernesto Pernia said there should be “quality jobs” to help the poor
cope with rising prices.

“Quality jobs, meaning full time and also better pay. To get a better paying job, the worker must
be productive,” he told reporters.

Gross domestic product grew 6.6 percent in the last three months of 2016, bringing average
growth for the full year at 6.8 percent, among the fastest in Asia.

President Rodrigo Duterte aims to lift 1.5 million people from poverty in every year of his term
by sustaining annual economic growth of at least 7 percent, according to his economic
managers. – with reports from Michelle Ong, ABS-CBN News

Reflection: