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PAR 1 – Effect of increase in interest rates
The exchange rate rises – the inflow of foreign funds raises demand for the domestic currency and so pushes up the exchange rate. This has the benefit of lowering import prices and thereby bearing down on domestic inflation. However, it makes exports more expensive and possibly harder to sell. The long-term effect on the balance of payments could be beneficial or harmful depending on the elasticity of the demand and supply for traded goods.
PAR 2 – Effect of increased inflation above 5%
Weakens country’s competitive position – if inflation in a country exceeds that in a competitor country, then it makes exports less attractive (assuming unchanged exchange rates) and imports more competitive. This could mean fewer sales of that country’s goods at home and abroad and thus a bigger trade deficit. For example the decline of Britain’s manufacturing industry can be partly attributed to the growth of cheap imports when they were experiencing high inflation in the period 1978-1983.
Question:
In both paragraphs the import prices reduce. I am trying to differentiate between the two paragraphs. Why doesn’t the reduced import prices in par 2 also bear down on inflation.
Para 1 is fine, Para 2 is wrong:
Different inflation rates will inevitably cause different exchange rates (purchasing power parity). If the Uk inflation rate was higher than the US rate, the £ would weaken relative to the $ and goods imported from the US would be more expensive, potentially fuelling inflation.
UK manufacturing in areas such as cars declined because it wasn’t competitive in design and quality, nor was it competitive on cost because many developing economies had (and often still have) lower labour costs.
So would you say that in your answer, the competitive position of UK would weaken? and how?
I would say no it would strengthen because local goods would be sell more as they will be cheaper than imports and exports would be more competitive. Is that correct?
Year 1 Goods cost £1000 to make in UK. Exchange rate currently 1£ = $1.5.
Price of goods in USA $1,500.
Uk inflation 10%; Us inflation 3%
Exchamge rate after,1 year = 1.5 x 1.03/1.10 = 1.4045
Year 2 To make the goods would cost £1,000 x 1.1 = £1,100
Price in US would be 1,100 x 1.4045 = $1,545
Of course 1545 is 1500 x 1.03,,but all competing goods made in the USA would have inflated by 3% too.
So, in theory no,differemce in competetive position
@kengarrett said:
Of course 1545 is 1500 x 1.03,,but all competing goods made in the USA would have inflated by 3% too.
So, in theory no,differemce in competetive position
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Is the fact that the price has risen by 3% a negative aspect? The inflation rate is lower than that in the UK – 10%. And also the dollar has strengthened – a positive side
I’m sorry I’m a bit confused. What are the two sides to the competitive position of the UK – the positive and the negative sides. Please can you elaborate.
As demonstrated in my example above, as far as I can see, inflation makes no difference to a country’s competetive position, provided exchange rates move in line with purchasing power parity theory.
See here:
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