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International Trade: The Falling Dollar or Rising Pound? - Activity

US Dollars

Image: The falling dollar may mean a rise in tourism to the US but the effect might be mitigated by the increased security measures being introduced by US authorities.
Source: Jake Levin, stock xchng

Since 2003, the value of the UK currency (£ sterling) has risen quite sharply against the United States dollar (US$). For those involved with international trade, this can have a significant impact on their activities and indeed their profitability. If, for example, a UK company conducts a large amount of its business in the US, its profit levels will be hit fairly badly after it converts its dollar revenues back into pounds.

This happened with the publishing and exams based company Pearson. Pearson owns the Financial Times, Penguin publishers and Dorling Kindersley as well as having bought into the Edexcel examination board. Pearson generates some 60% of its revenues from publishing, a high proportion of which is carried out in the US.

For companies trading in many countries, the issue of exchange rates is always a major issue in considering its planning and its performance. Small movements in exchange rates can have significant effects on costs and potential revenues and this can be complicated by the contradictory effects of exchange rate movements in different countries. For example, a depreciation of the pound against the euro may well benefit a business if it sells products to the eurozone; a fall in the exchange rate with China, however, may be damaging if it buys its raw materials or semi-finished and finished goods from that country to then sell in Europe. The overall effect will depend on the proportion of its costs and revenues linked to each country it trades with. If trading with a dozen countries, it is easy to see how complex the picture can become!

The chart below shows the exchange rate between the UK pound, the dollar and the euro. Under the chart there is a range of questions guiding you in developing your thinking and understanding about various aspects of international trade, the balance of payments and exchange rates.

The exchange rate between the UK pound and the dollar

The exchange rate between the UK pound and the dollar 2004-07

Source of data: Bank of England (http://213.225.136.206/mfsd/iadb/Index.asp?first=yes&SectionRequired=I&HideNums=-1&ExtraInfo=true&Travel=NIx)

  1. Describe the trends in the movement of the £ against the $ and the € since January 2003.
  2. Using your knowledge of economics, explain TWO factors that may have caused the trends you have identified.
  3. Explain the impact on both importers and exporters of the trends in the sterling exchange rate.
  4. Given the trends identified, what would you predict would be happening to the UK current account of the balance of payments?
  5. Examine the impact of these trends on a business if it sells 45% of its output in the United States, 35% in Europe and the remainder in the domestic market. Assume its annual turnover is £5 million.
  6. Examine the impact of these trends on a business with a turnover of £10 million buying 60% of its raw materials from the US and selling 30% to the EU and the remainder in the domestic market.
  7. Distinguish between the volume of trade and the value of payments and receipts involved in trade.
  8. Explain what you would expect to happen to the balance of payments given the following:
    1. The value of sterling appreciates against all other currencies.
    2. The value of sterling depreciates against all other currencies.
  9. Assume the balance of payments on current account is in deficit to the value of £15 billion per year. Consider the impact of changes in the exchange rate on the volume of trade and the value of payments and receipts and hence on the balance of payments given the following information:
    1. The exchange rate depreciates against all other currencies, causing import prices to rise by 15% and export prices to fall by 12%.
    2. The price elasticity of demand for imports is -0.35 and the price elasticity of demand for exports is -1.25.
  10. Now consider the impact given the following figures for elasticity:
    1. The price elasticity of demand for imports is -0.8 and the price elasticity of demand for exports are -0.75.
  11. The fall in the value of the dollar is causing concerns in the US that inflation may begin to accelerate. Explain why there might be this concern.
  12. Assume the balance of payments on current account is in deficit to the value of £9 billion per year. Consider the impact of changes in the exchange rate on the volume of trade and the value of payments and receipts and hence on the balance of payments given the following information:
    1. The exchange rate appreciates against all other currencies, causing import prices to fall by 6% and export prices to rise by 7.5%.
    2. The price elasticity of demand for imports is -0.4 and the price elasticity of demand for exports is -2.6.
  13. Now consider the impact given the following figures for elasticity:
    1. The price elasticity of demand for imports is -0.75 and the price elasticity of demand for exports are -0.85.
  14. Use the information in questions 9a and 12a to comment on the impact on the terms of trade for the UK.
  15. Look at the following article: 'How Far Will the Dollar Fall?' by Richard W. Rahn. (http://www.cato.org/dailys/01-02-04.html)
    1. Explain how the fall in the dollar might help to reduce the US trade deficit.
    2. Assess Dr Rahn's argument that taxation and regulation are the principle causes of the potential for the limits to growth in the world economy.