Question

In the following problem, assume that the UK currency is the pound sterling (PST) and the currency in the rest of the Europe is the euro (EUR).

a. Suppose that the PST appreciates relative to the EUR. Provide an explanation.

(i) In the UK:

‐ How would the export demand change? Why?

‐ How would the import demand change? Why?

‐ How would net exports change? Why?

(ii) In the rest of Europe:

‐ How would export demand change? Why?

‐ How would import demand change? Why?

‐ How would net exports change? Why?

Suppose that the central bank in the UK (The Bank of England) decides to raise interest rates because it is worried about high inflation. As a result, interest rates in the UK become higher than interest rates in the REST OF EUROPE. This acts as an incentive for EUROPEAN investors to increase the amount of funds they invest in British (UK) interest bearing assets. In order to increase their purchases of those UK assets, which are priced in PST, EUROPEAN investors have to convert EUR into PST. This conversion, in turn, increases the demand for PST. Based on the above information, please explain what will happen to the EUR--‐‑PST exchange rate. In other words, will the increased demand for PST, make PST gain value (appreciate) or lose value (depreciate) against the EUR? Why?

Answer 1

(I) 1. In UK, due to appreciation of PST, the demand for the UK in the rest of the world will decrease, as now the UK exports will become relatively costlier than before.

2. The import demand will increase, as for the UK citizens purchasing foreign goods will comparatively cost less than before, leading to positive change in import demand.

3. Since the demand for UK exports will decline and the imports will increase, Net exports will decline, as Net Export = Exports - Imports.

(2) 1. The export demand in the rest of Europe will increase, as due to currency depreciation in relation to PST, the exports from the rest of the Europe to UK will become cheaper, leading to increase in demand for the exports of the goods from rest of the Europe. However the change in export demand to the rest of the world is uncertain.

2. The import demand in the rest of the Europe from UK will decline as the imports from UK will become costlier due to appreciation of UK PST in relation to EURO.

3. The Net exports in relation to the trade with UK will change positively. This will happen because, for the rest of the Europe the exports to the UK will increase and the imports from the UK will decline.

(3) When the central bank of England decides to increase the interest rates, it will attract foreign investments to flow from rest of the world to UK. Due to the increased flow of investments from rest of the world, and from Europe, the demand for UK PST will increase. This increase in demand for UK PST will result in higher value for PST as compared to EURO, resulting in appreciation of UK PST in comparison to euro.So suppose earlier for every 1Euro, we could get 100 PST, now due to appreciation in PST, this exchange rate will change. So now for every 1 Euro we can get maybe 80 PST. This shows that earlier with 1 euro we could get more UK PST, but with PST's appreciation, 1 Euro is able to fetch lower PST.