In this 22/25 essay, I explore the benefits and costs of a governments decision to artificially lower or raise exchange rates. The graph mentioned is a standard Keynesian long run market equilibrium one.
The exchange rate can be defined as the price of one currency in terms of another and it can be ‘easily’
manipulated by a country’s central bank for a whole host of reasons.
If a central bank successfully manages to artificially lower its country’s exchange rate, it can more easily
attract foreign investment and international trade to said country. For example, if UK goods are being
sold for £10 and the same goods are being sold in the US for $10 it is up to investors to decide which
country’s goods to buy based on a host of non-pecuniary factors. By lowering the Uk’s exchange rate,
the central bank gives investors a pecuniary incentive to buy their goods. Using the same example as
before, if £2 is now worth $1 then the UK goods are now much cheaper than those of the US and it
makes much more sense for investors to buy UK goods. This increased price competitiveness will
hopefully lead to an increase in overseas exports as well as investment which will both work to increase
the UK’s aggregate demand and thereby, its real GDP. As can be seen on fig.1, an increase in the Uk’s AD
will increase the Uk’s real GDP from Y1 to Y2 and also increase the UK’s price level from Pl1 to PL2. This
outward shift of AD can be seen to have caused an increase in the UK’s AS, but it must be noted that this
graph is specific to the short run and is dependent on the UK economy being relatively stable outside of
its exchange rate. Through artificially lowering the exchange rate a central bank is able to increase GDP,
which of course benefits the economy, as well as promote a cyclical rise in employment since more
factors of production will be in use due to the expansion in AS. Of course, the increased international
competitiveness that lowering a country’s exchange rate brings may actually lead to structural
unemployment and thus negate any rises in cyclical employment. With a higher number of foreign
investors investing in Uk firms, it can be assumed that said firms will be making a much larger revenue
than before. This excess revenue when combined with worldwide advances in communication
technology and the business’ possible objective of maximising their own utility, may mean that they
begin offshoring their work and using foreign workers who not only do not contribute to the Uk’s
employment rate but also rarely repatriate their earnings back into the UK.
Regardless, the allure of offshoring is wholly dependent on the individual objectives of UK firms as well
as on whether the initial costs of begin an offshoring program, e.g., buying new offices and interviewing
new workers, will outweigh the benefits of sticking to their current tried and tested system. Similarly,
there is no guarantee that firms will actually utilise the increased competitiveness that a lower exchange
rate will give them. If they keep their prices the same rather than lowering them then it is likely that
they will miss out on the possibility of increased revenue and arguably earn around the same revenue as
before. This stagnant revenue is not conducive to the aforementioned increased GDP, investment, or
employment but rather a UK that is essentially the same as before but with much more expensive
imports. In the worst-case scenario, the Uk’s resultant lack of imports may actually lead to increased
political tensions with its trading partners and thus national economic uncertainty may lead to an
increase in people saving their money rather than positively contributing it to the UK economy.
In addition to this, by making imports more expensive, a central bank may be inadvertently causing cost
push inflation. If for example, the majority of Uk firms source their raw materials from outside of the Uk
then the artificially low exchange rate may mean that they have little choice but to use more expensive
UK materials instead or even continue to buy the same foreign materials as before but for a higher price.
In real terms, regardless of the firm’s decision they will be spending more on production costs than
before and many firms may choose to offset their rising costs by increasing the prices of their goods and
negatively affecting the consumer. This is represented on fig.2 by the increase in overall AS from AS1 to
AS2 and the resultant decrease in real GDP and increase in the price level.
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