Question

During the presentation of 2018 budget speech, the Minister of Finance proposed to grant accelerated depreciation for capital expenditures by qualifying investments in priority sectors. Using Macroeconomic theory analyze the effects of such a policy measure on domestic investment, interest rate, exchange rate and trade balance

Answer 1

The 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.

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)

• 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.

• 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.

1. Differentials in Inflation

Typically, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the 20th century, the countries with low inflation included Japan, Germany, and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency about the currencies of their trading partners. This is also usually accompanied by higher interest rates.

2. Differentials in Interest Rates

Interest rates, inflation, and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates – that is, lower interest rates tend to decrease exchange rates.

3. Current Account Deficits

The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest, and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

4. Public Debt

Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.

In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate.

5. Terms of Trade

A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows' greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners.

6. Strong Economic Performance

Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.