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What might cause an appreciation of a floating exchange rate? Discuss whether an appreciation of a country's exchange rate will always be beneficial to that country.

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Introduction

a) what might cause an appreciation of a floating exchange rate? b) Discuss whether an appreciation of a country's exchange rate will always be beneficial to that country. (15) A free, fluctuating or floating exchange rate means the existence of a free or competitive foreign exchange market where the price of one currency in terms of another is determined by the forces of supply and demand operating without any official interference. A rise in the price of a currency in terms of another currency is called an appreciation. The following figure shows the equilibrium price of pounds in terms of U.S dollars. Short and long-term movements in the exchange rate, like any price, are caused by changes in market demand and supply conditions. The appreciation of a country's currency will occur due to either an increase in demand or fall in supply of that currency. The demand for sterling (pounds) in the FOREX markets comes from many sources UK goods and services are exported overseas - . if there is an increase in exports this will create an inflow of currency into to the UK which needs to be turned into sterling this will increase demand for the sterling . When US consumers but British Whisky they supply dollars and this is eventually translated into a demand for pounds. This will cause an outward shift in the demand curve for sterling, thus causing the currency to appreciate. Foreign long term investment flows into the UK economy will again increase the demand for the sterling for example, Pakistani investment ...read more.

Middle

The price of imported goods might have risen. A government concretionary fiscal policy might cause a country's currency to appreciate. A fall in government spending or a rise in taxation (causing disposable incomes to fall) will lead to a fall in imports. Both factors will cause a fall in supply of the currency and cause it to appreciate. Speculators who think that the sterling might rise will hold on to the currency and will refrain from selling to buy some other currency that they might have bought before. This will curtail supply and will cause the sterling to appreciate. Any or a combination of a few of the above situations will lead to an appreciation of a country's currency. When the demand for sterling is high relative to supply, sterling goes up in value (an appreciation). The reverse is true when the market supply of pounds exceeds the demand. (Depreciation). Changes in the exchange rate can have a powerful effect on the economy - but these effects take time to show through. There are time lags between a rise and a fall in the exchange rate, and changes in variables such as inflation, GDP and exports & imports. Much depends on the scale/size of any change in the exchange rate. Different factors affect the exchange rate in different intensities. Different factors will determine whether the change in the currency is short term or long term e.g. factors such as long term investment coming in the country will cause a long tem change while high interest rates will cause a short term change. ...read more.

Conclusion

A fall in the relative price of imports will lead to a rise in import penetration into the domestic economy. This will squeeze domestic output and employment. Some firms may respond to high exchange rate by seeking productivity improvements and this may lead to cutbacks in employment in some industries. High exchange rate may dissuade some foreign firms from investing in the UK. Multiplier effects will arise from a fall in aggregate demand. A trade deficit results in a net outflow of money. According to the kenesian model, this will cause a backward multiplier process. This will lead to a fall in national income and a fall in employment. A fall in employment will obviously cause a serious fall in living standards. Exchange rate and inflation: An appreciation of the exchange rate helps to control cost and price inflation in the economy. A fall in import prices means that it is cheaper to import raw materials, components, finished manufactured products leading to an outward shift in Short Run Aggregate Supply shown in diagram - this has a direct impact on the Retail Price Index Tougher for domestic companies to compete with cheaper imports - lower profit margins as businesses have to adjust (less pricing power in their markets) Slower growth of exports (leading to a slowdown in aggregate demand - possibly the emergence of a negative output gap where actual GDP < potential GDP) A bigger trade deficit represents a net outflow of demand from the circular flow of income and spending - leading to less demand-pull inflation ...read more.

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