Discuss Whether a Rise in the Exchange Rate Will Always Lead to a Fall in Inflation. Essay

299 WordsMar 2, 20152 Pages
Inflation is a sustained increase in the cost of living or the general price level leading to a fall in the purchasing power of money. A rise in a country’s exchange rate generally results in an increase in imports and a decrease in exports. This is because the UK has the ability to purchase more goods for a ‘cheaper’ price, however foreign countries can buy less because it will cost them more. A rise in the exchange rate of the pound causes an increase in export prices which makes foreign counties to import from another country. A reduction in exports could result in a negative net balance as they may import more goods from abroad as It will essentially cost us less. This may result in aggregate demand to fall from AD1 to AD2 because of the decrease in exports. This could result in the real gap falling from YFE to Y1 as output has decreased so the price level will fall from P1 to P2. However, this depends on whether demand reacts to price changes. If the UK provides a particular good, that no other country does, to a foreign country, the country may have no choice but to import from the UK. However this could lead to more domestic (UK) firms moving abroad in order to increase investment which may reduce aggregate supply. This is because the economy’s production capacity has fallen. This would result in a increase in cost-push inflation. In conclusion, because of a change in exchange rates, imports may increase and exports may decrease. This depends on other components of AD as to whether inflation falls. If exports fall and imports increase but government spending and consumption also increased, they could potentially cause an increase in AD and cause demand pull

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