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A depreciation of the pound sees the market value of the pound fall against other currencies.
The economic effects of a lower pound take time to happen - economists say that there are time
lags between a change in the exchange rate and changes in, for example, inflation and the
balance of payments.

The last major depreciation in the value of sterling came in the early-mid 1990s following
sterling's departure from the exchange rate mechanism. The pound was devalued by nearly 15%
against a range of currencies in September 1992 and continued to drift lower in value for the next
three years.

This revision note suggests some of the main economic effects of a lower value for the pound

INFLATION

A fall in the exchange rate makes imported goods and services more expensive in the UK.
Producers may then pass on higher costs of imported components and raw materials onto
consumers. This causes extra "cost-push" inflation. Wages may rise in response to this triggering
off the possibility of a wage-price spiral.

The extent to which a depreciation of the pound causes inflation depends in part on how
dependent producers are for their imported components and also their willingness to "price to the
market" and pass on costs to consumers.

In a recession demand for many goods is elastic and a lower pound may have little effect on
retail price inflation.
?
ORTS AND TH? BALANC? OF
AYM?NTS

Exporters should benefit from a lower pound (even allowing for the inevitable time lags). A
depreciation makes UK goods cheaper priced in a foreign currency.

Demand for exports will grow faster if the demand for UK goods overseas is elastic

IM
ORTS

The demand for imports should fall as imports become more expensive. However, some imports
are essential for production or cannot be made in the UK and have an inelastic demand - we end
up spending more on these when the exchange rate falls in value. This can cause the balance of
payments to worsen in the short run (a process known as the J curve effect)

WAG? D?MANDS

Partly due to higher inflation and falling real incomes, wages may rise. This depends on what
stage of the economic cycle the economy is in. When unemployment is high, workers may have
little confidence that their wage demands will be met.

?CONOMIC GROWTH (GD


Higher exports (an injection into the circular flow) and falling imports leads to rising GDP
levels.

A lower exchange rate accompanied by lower interest rates will stimulate consumer spending
and general economic recovery. This was the case for the UK between 1993-95 after the pound
left the exchange rate mechanism.

 

  

p

1.The £ is stronger therefore, exports are more expensive to buy. More foreign currency is
needed to get the same amount of British goods

2. Imports will be cheaper.

3. Therefore, we will get a rise in the quantity of imports and a fall in quantity of exports.

4. Assuming demand is relatively elastic this will cause a fall in the value of exports and rise in
value of imports.
5. AD = C + I + G + X - M. Therefore, a fall in exports and rise in imports will reduce AD, or
lower the growth of AD.

6. A fall in AD will cause a lower rate of economic growth and a lower rate of inflation.

7. A fall in exports and rise in imports will lead to a worsening of the current account, e.g. deficit
will get bigger

 
p

As depreciation makes imports more expensive and exports cheaper (both in terms of the buyer's
currency), it should increase exports and decrease exports.

However, there may be a period of adjustment while the volumes of imports and exports adjust
to the new prices. It takes time for importers and exporters to find new products, deals already
agreed will have to be fulfilled, manufacturers of substitutes may take time to adjust their
production, etc.

The result is that a depreciation initially causes a sharp worsening of the balance of trade (value
of exports less the value of imports), which then gradually recovers to a higher level than
previously.

Similarly, an appreciation in the value of a currency would, if this argument is correct, cause an
inverted J-curve.

p

 

 

Changes in the amount of future cash flows, for contracts entered in foreign currency but not
settled.p A business contract may extend over a period of months. Foreign exchange rates can
fluctuate instantaneously. Once a cross-currency contract has been agreed upon, for a specific
quantity of goods and a specific amount of money, subsequent fluctuations in exchange rates can
change the value of that contract.

?ample:-
Dayton, a U.S.-based manufacturer of gas turbine equipment, has just concluded negotiations for
the sale of a turbine generator to a British firm for the sum of £1,000,000. The sale is concluded
in March but payment will be made three months later, in June.

Assumptions

^ p Spot exchange rate: $1.7640/£.

Dayton can:
^ p p÷emain unhedged
Ñ p Hedge in the forward market

Dnhedged
osition:-

Suppose Dayton decides to accept the transaction risk.

If the future spot rate is $1.76/£, Dayton will receive X1 000 000X$1
76Xp = $1 760 000 in 3
months. However, if the future spot rate is $1.65/£, then Dayton will receive only $1,650,000,
well below the acceptable rate.
Forward Market Hedge:-

The forward contract is entered at the time the A/÷ is created, i.e. in March. The sale is recorded
at the spot rate, in this case $1.7640/£. If Dayton does not have an offsetting A/P of the same
amount, then the firm is considered uncovered.

Hedging in the forward market here means selling £1,000,000 forward at the 3-month forward
rate of $1.7540/£. In 3 months, Dayton will receive £1,000,000 and exchange them at the rate
$1.7540/£, receiving $1,754,000 with certainty.

This is $6,000 less than the uncertain $1,760,000 expected from the unhedged position.

The forward contract creates a foreign exchange loss of $10,000 (X1 000 000(1
76401
7540)).

ƒp èormally reckoned by the forward premium/ discount over spot rate.

(F1 ± S0)/S0

ƒp True cost of forward hedge cannot be calculated in advance.

ƒp Should be dependent upon the future spot rate.

True cost of forward hedge:

(F1 ± S1)/S0

Money Market Hedge:-

A money market hedge also includes a contract and a source of funds, similar to a forward
contract. In this case, the contract is a loan agreement. The firm borrows in one currency and
exchanges the proceeds for another currency. Hedges can be left ³open´ (i.e. no investment) or
³closed´ (i.e. investment).

To hedge in the money market, Dayton will borrow pounds in London, convert the pounds to
dollars and repay the pound loan with the proceeds from the sale.

To calculate how much to borrow, Dayton needs to discount the PV of the £1,000,000, i.e.

£1 000 000/1
025

= £975 610
p

Thus Dayton must borrow £975,610 today and repay £1,000,000 in 3 months with the proceeds
from the sale.
This hedge creates a pound denominated liability that offsets with a pound denominated asset,
thus creating a balance sheet hedge.

In order to compare the forward hedge with the money market hedge, Dayton must analyze the
use of the loan proceeds.

What can Dayton do with the loan?

It can exchange the £975,610 at the spot rate of $1.7640/£, which gives $1,720,976, and invest it
in a US$-denominated asset. Unlike the funds involved in a forward contract, the loan amount
can be used immediately.

º 
Two parties exchange principle and interest in one currency for principal and interest in another
currency.

In interest rate swap the notional principal is not exchanged but in the currency swap the first
step is generally the exchange of principal.

·


In 1981 the relevant interest rate in the U.S. was at 17 percent, an extremely high rate due to the
anti-inflation tight monetary policy of the Fed under Paul Volcker. In West Germany the
corresponding rate was 12 percent and Switzerland 8 percent. The problem for the World Bank
was that the Swiss government imposed a limit on World Bank could borrow in Switzerland. The
World Bank had borrowed its allowed limit in Switzerland and the same was true of West
Germany.

IBM at that time, 1981, had large amounts of Swiss franc and German deutsche mark debt and
thus had debt payments to pay in Swiss francs and deutsche marks. IBM and the World Bank
worked out an arrangement in which the World Bank borrowed dollars in the U.S. market and
swapped the dollar payment obligation to IBM in exchange for taking over IBM's Swiss franc
and deutsche mark obligations.

Types:-

1) Currency Swap.

2) Interest ÷ate Swap.


Futures Hedge:-

Exporter is expecting 10,000$ , but comes to know that ÷s. is appreicating which would render
him to a loss.

Thus in the physical market he would go long on $ (as it is depreciating wrt ÷s.)

But in the futures market one takes a reverse position than the physical market, it will go short on
$ ( sell $ futures ) and buy them back .

Importer has to pay 10,000$ , but comes to know that ÷s is depreciating which would force him
to pay more .

Thus in the physical market he would go short on $(as it is appreciating wrt ÷s)

But in the futures market one takes a reverse position so he will go long on $(buy $) and sell
them back at a future date.
With An exchange rate appreciation the average cost of domestic financing is reduced in the
banking system