3.1.5 Exchange rate changes


    A change in exchange rates has many different effects in an economy and specifically on:

    • The balance of payments (current account)
    • Economic growth (of firms)
    • Employment levels
    • The rate of inflation
    • FDI flows


    Balance of payments – an accounting record of all monetary transactions between a country                                and the rest of the world (difference between all money in and out)


    There are three components to the balance of payments, the current account, capital account and financial account. The current account is measured mainly through the trade of visible goods and invisible services which are deemed debits or credits, these make up the balance of trade. The financial account is a record of all transactions for financial investment: FDI flows, portfolio flows (shares and property sales) and ‘hot money’ flows both in and out. The capital account is the transfer of funds associated with buying fixed assets such as land as well as the sale/transfer of patents, copyrights, franchises and other transferable contracts and goodwill. For the UK, a negative current account is balanced out by a positive financial account.

    Current account (BOP) Causes exports to become cheaper, increasing demand for them, imports also become relatively expensive. UK current account deficit improves due to more money inflows (exports) than outflows (imports) Causes imports to become cheaper, increasing demand for them, exports also become relatively expensive. UK current account deficit worsens due to more money outflows (imports) than inflows (exports)
    Economic growth Due to rising FDI and export-led growth, there are more injections into the circular flow of income, creating more jobs and money remains within the economy As exports fall due to a stronger currency, there will be a negative effect on AD as more money leaves the economy and AD will fall as money is leaving the economy
    Inflation In imports become more expensive, there will be cost-plus inflation due to increased costs of raw materials As imported goods are cheaper, consumers will have more spending power so there may be dis/deflation
    Unemployment If exports become cheaper, the greater level of demand will cause more output. This will require more workers and more jobs are created, decreasing unemployment As domestic firms suffer from competition, they may cut output and need less workers. This will lead to increased unemployment
    FDI It becomes cheaper to invest in the UK so FDI is likely to increase It becomes more expensive to invest in the UK and FDI is deterred as the UK is a less desirable investment opportunity
    Domestic firms Domestic firms become more competitive as foreign imports become relatively expensive Domestic firms will have to compete against the cheaper foreign imports and may not survive/will struggle
    Importing/Exporting firms UK exporters will become more competitive in foreign markets as they are cheaper, however, this depends on the PED of the product.

    Firms importing into the UK may export less as they will have lower profit margins or raise prices and suffer a fall in demand: imports fall.

    Firms importing into the UK will thrive as they have lower costs and can compete better. If PED is elastic, then they will see an increase in TR.

    Exporting firms will suffer as they become less competitive in comparison and will demand fall as they become more expensive


    The introduction of the Eurozone and the single currency was an attempt to remove the uncertainty of floating exchange rates which are destabilising. This created a stable environment for EU businesses and remove the need for expensive foreign currency transactions, allowing for more trade and growth. However, as the UK suffers from  constant trade deficit, they would struggle without the fluctuating pound to make exports more desirable and reduce these deficits; under a single currency their deficit may just keep growing.


    When the Eurozone became more integrated it became easier to borrow from banks in other economies which mainly benefited weaker countries. The main borrowers are Ireland, Spain, Portugal and Greece. The Southern Mediterranean countries found it difficult as the euro was often influenced by Northern economies, so it is often higher than suitable for these countries, but this is remedied by their borrowing which allows them to be competitive.


    In the 2008 financial crisis, the southern economies were dependent on borrowing  and wanted to continue to do so. However, the northern economies wanted them to undertake contractionary policies as they were unwilling to lend due to their recession as their banks seized up. This caused growth to decline and caused increased deficits which increased pressure to pursue austerity.


    The policies that the northern Eurozone and IMF wanted them to pursue were contractionary i.e. cutting Gov. spending and increasing taxation. This would not only make the government unpopular but also mean that the economy slumps with no stimulation and causes deficits to increase and become more difficult to reduce.


    The problem with the Eurozone’s effectively fixed exchange rate is that member countries that cannot compete internationally at this rate must accept slower growth as they cannot increase competitiveness through depreciation. Instead they must try different business strategies and structural reforms e.g. funding innovation, to gain competitive advantage through price or new features. This issue could be solved through political agreement but as each economy has their own government this is not possible as fiscal policy is determined individually by each country.


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