Exchange rate policy
Exchange rate policy The exchange rate of an economy affects aggregate demand through its effect on export and import prices, and policy makers may exploit this connection.
Deliberately altering exchange rates to influence the macro-economic environment may be regarded as a type of monetary policy. Changes in exchanges rates initially work there way into an economy via their effect on prices.
For example, if £1 exchanges for $1.50 on the foreign exchange market, a UK product selling for £10 in the UK will sell for $15 in New York. If the exchange rate now appreciates, so that £1 buys $1.60, the UK product in New York will now sell for $16. Assuming that demand in New York is price inelastic, this is good news for UK exporters because revenue in USDs will rise. However, if demand is elastic in New York, the effect of the appreciation of the Pound would be damaging to UK exporters.
If the UK also imports goods from the USA, the rise in the exchange rate would mean that a $10 US product is now cheaper in London, falling from £6.67p to £6.25p. Importers do relatively well from the appreciation of the pound, in that the cost of imported raw materials or finished goods falls.
Therefore, whenever the exchange rate changes there will be a double effect, on both import and export prices. Changes in import and export prices will lead to changes in import and export volumes, causing changes in import spending and export revenue.
Exchange rates can be manipulated so that they deviate from their natural equilibrium rate. To stimulate exports, rates would be held down, and to reduce inflationary pressure rates would be kept up. While the Bank of England does not specifically target the exchange rate, the Monetary Policy Committee (MPC) will take exchange rates into account. Clearly, the MPC would prefer a relatively high rate, as this reduces the price of imports and works against inflationary pressure. However, the MPC must keep an eye on export competitiveness, and, if
Deliberately altering exchange rates to influence the macro-economic environment may be regarded as a type of monetary policy. Changes in exchanges rates initially work there way into an economy via their effect on prices.
For example, if £1 exchanges for $1.50 on the foreign exchange market, a UK product selling for £10 in the UK will sell for $15 in New York. If the exchange rate now appreciates, so that £1 buys $1.60, the UK product in New York will now sell for $16. Assuming that demand in New York is price inelastic, this is good news for UK exporters because revenue in USDs will rise. However, if demand is elastic in New York, the effect of the appreciation of the Pound would be damaging to UK exporters.
If the UK also imports goods from the USA, the rise in the exchange rate would mean that a $10 US product is now cheaper in London, falling from £6.67p to £6.25p. Importers do relatively well from the appreciation of the pound, in that the cost of imported raw materials or finished goods falls.
Therefore, whenever the exchange rate changes there will be a double effect, on both import and export prices. Changes in import and export prices will lead to changes in import and export volumes, causing changes in import spending and export revenue.
Exchange rates can be manipulated so that they deviate from their natural equilibrium rate. To stimulate exports, rates would be held down, and to reduce inflationary pressure rates would be kept up. While the Bank of England does not specifically target the exchange rate, the Monetary Policy Committee (MPC) will take exchange rates into account. Clearly, the MPC would prefer a relatively high rate, as this reduces the price of imports and works against inflationary pressure. However, the MPC must keep an eye on export competitiveness, and, if