Why worry about having a low domestic exchange rate?

There has been a lot in the news recently about the weak exchange rates of countries such as Brazil and India, mainly as a result of the impeding action being taken by the Federal Reserve (US Central Bank) to taper its Quantitative Easing scheme (that is to say, they will be reducing the amount of money they pump into the economy). The reason for this, is that US investors who were using QE dollars to speculate in the Indian and Brazilian economy’s, are now removing some of that money in order to place it in other US bonds which are expected to increase in yield. There are also some fundamental issues in certain countries, but this article will just explore the effects of a low exchange rate.

A strong currency will result in large amounts of imports, whilst a weak currency will help boost exports (ceteris paribus). The reason for this is that a strong currency purchases for more foreign goods, but similarity makes domestic products more expensive for foreigners. Conversely, a weak exchange rate means more currency is needed to purchase foreign goods, whilst foreigners can afford to purchase more domestic goods.Therefore a lot of commentators have been saying that for economies with large current account deficits (where imports exceed exports) or economies which are in trouble and need to boost AD, a low exchange rate will help. The reasoning behind this, is that exports is a component of aggregate demand (AD=C+I+G+(X-M)) and therefore a boost in exports (providing imports don’t largely increase, but which may be likely to fall if the exchange rate is weak) and hence to the overall economy: this should lead to more jobs and tax revenues for the government. Both Brazil and India have current account deficits; so surely a weak exchange rate is beneficial for their economy?

Firstly, we have already said that a weak currency makes foreign goods more expensive, this includes foreign produced (or goods/commodities which are denominated in a foreign currency) goods or commodities which may be used in the production process of goods at home. This is particularly important for economies which manufacture products requiring commodities in the production process. Let us take Britain as our supposed manufacturing base. Because Britain is a developed country it generally only produces expensive or at least intensive products – it doesn’t try to compete on price because it can’t, instead, it focuses on quality and doing things other nations can’t. This means that they won’t be simply extracting minerals from the ground and then selling them. Instead they will be sourcing materials from all around the world in order to manufacture another good. Say for example a high quality car. A large supply chain is required, and materials from all over the world are sourced because Britain can’t produce all the supply products as well as the commodities. Although a low exchange rate will make British cars cheaper for foreigners – and so we would expect them to purchase more as they may be for competitive against international competitors – imports are more expensive for British companies. This means that all the materials required to produce a car to export rise in price for the British producers due to the low exchange rate, the result, a higher price which erodes at the competitive advantage Britain has in a weak currency. Therefore a fall in the currency may not have the benefit of rising exports as is promised. However, is problem might not be as acute for countries which produce goods that require few materials in their manufacturing process. For example, a country which simply extracts minerals from the ground to sell abroad may well benefit from a weak currency because they should be able to sell more goods, assuming that supply is elastic.

Following on from the point about having a low exchange rate should boost exports – this is only the case if demand is price elastic. If demand is price inelastic for exports then it is likely to have little effect accept cause domestic inflation. In the UK, most of our exports are price inelastic in demand because we produce a lot of expensive high quality products such as aeronautics and chemicals which aren’t very price sensitive.

The second issue, following on from the first, which arises from a weak exchange rate is that because imports are more expensive it can result in inflation and diminish standards of living for a country’s citizens. If a country doesn’t domestically manufacture many goods, say it is a service based economy, then they import most of their manufactured goods from abroad. A weak currency makes these goods more expensive which will cause inflation and may also mean that people have to purchase fewer goods, thus reducing their standard of living.
Furthermore, for developing countries a weak exchange rate means it has to use more of its scarce currency in order to purchase capital goods which are needed in order to grow economically and produce goods to sell abroad and/or to improve living standards at home.

A long exchange rate, as well as making exports cheaper, also make domestic assets cheaper for foreigners, this may result in a wave if hostile takeovers of domestic companies, and large purchases of debt and other assets such as houses. The hostile takeovers of domestic companies can result in job losses in the domestic economy and the purchase of houses for speculation and as second homes may cause high prices keeping new buyers out of the housing market. Large purchases of assets is likely to increase their price which although may allow domestic people to profit initially, can cause exuberant confidence resulting in bubbles.

On the other hand, a weak exchange rate makes it cheaper for foreigners to travel to country which could produce a boost in tourism to benefit the economy. Additionally, as previously mentioned with caveats, exports are also likely to increase as goods are cheaper for foreigners to purchase.

This blog post just goes to show that in economics there are many considerations to take into account and it is very rare for a policy to have a single result, as I hope I have shown, there are many things, positive and negative, which can arise from having a low exchange rate, and it may not be as simple as commentators suggest. Therefore the costs and benefits of a weak currency need to be seriously debated for each individual case before there are calls for manufactured devaluation, but unfortunately devaluation isn’t always a choice.

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