The Effect of the Increase and Decrease of Inheritance Tax in the UK Economy - Essay Example

Exchange rate is the value of two currencies relative to each other, like exchanging the US dollar for a certain number of British pounds. This may be floating which means it changes from day to day or it may be pegged to another which means that it may have a certain amount of its currency held in another currency. The former is volatile while the latter is more stable since their setting is by the government fiat. [Aguirre, A., Ferreira, A. & Notini, H., 2003] The exchange rates have been experiencing fluctuations in different regions of the world and this has had major impacts in these regions which have involved the private sector as well as the government and in some cases the government has had to play the role of the private sector so as to stabilise the rate. In this context the exchange rate rise has been on the fore front and this has had adverse effect and implications on the economic activities as well as the social aspect of the people in these regions. The rise if the foreign exchange affects the foreign direct investment [FDI]. This is an international flow of capital that provides the multinational organisations and companies with control over foreign affiliates. The foreign exchange can influence both the total FDI and the allocation of this investment across different countries. The increase reduces the countries production costs and the wages relative to those of the foreign country. This means that the value of its currency depreciates relative to that of the other country. This means that the overall rate of return to foreigners is increased and this contemplates the overseas investment projects in a country. The increase in the foreign exchange may be sometimes anticipated and this will leads to higher costs of financing of the projects due to interest rate parity conditions. In these cases, multinationals prefer to fund their overseas projects from the local kit as financing from the local become relatively expensive. This covers their monitoring costs and even the capital that keeps on increasing. The volatility of the exchange rates affects the production flexibility and also the risk aversion. There arises a problem where the producer produces the goods without the knowledge of the exchange rates as they affect the rate of production and the actual level of employment. Where there was risk aversion, the investors demand that they be paid compensation for the risks they incurred as the higher exchange rate raises the variability of and lowers the certainty. In this case therefore, the high rates of exchange tend to raise the values of the investment projects and due to the high costs; the profits are reduced. [Goldberg and Kolstad, 1995] The Australian bank decided to leave the rate of cash unchanged, while the central bank highlighted on its ability to lower the benchmark of the nation’s interest rate so as to ease the inflation pressures. Fig 1: Graphical illustration of Australian Interest rates from January 2004 through January 2010 This rising exchange rate leads to the tightening of the monetary policy. This in effect raises the interest rates to higher levels which are visibly seen to rise faster in the short run than in the long run. The result of this is that the foreign investors hold foreign assets because of the increased rate of return on the domestic assets with the tightened monetary policy and they expect that the domestic value will fall in future. There arises foreign debt due to the high appreciation of the real exchange rate. These may make the local currency to reach parity against the foreign currency like it was for the euro against the dollar between Australia and US. [Aron, J., Elbadawi, I.A. & Kahn, B., 1997] Identify the possible causes of this appreciation and analyse the extensive implications on the Australian economy which was saved by the collapsing economy of the Australian government and economy. The appreciation of the real exchange rate brings diverse effects which are extensive the short term aspect of it is that the exports become relatively expensive while the imports become relatively cheaper, thereby bringing about an improvement in the terms of trade. This in effect allows a larger amount of imports to be purchased for a smaller amount of exports bringing about favorable terms of trade. The result of this is that there will be reduced demand for exports in other countries and the domestic spending will increase [Arize, C.A. Osang, T. & Slottje, J.D., 2000]. The result of the high export prices will be the closure of the export firms and the deployment of the labor that was working there. The native country will henceforth not be able to compete in the foreign market. In the long run, there will be a structural change within the economy since the economies exports will become more expensive and therefore the industries will become less competitive as compared to those of the other country. The greatest impact to this is the mining, tourism, manufacturing and farming industries. The result will be that those who cannot compete with the increased exchange rate will have to contract. The labor and the capital that was previously utilised by the inefficient industries will be utilized in expanding other sectors like the mining industry which may remain competitive in the long run. In the effect of this, there will be increased economic growth when this labor is sent to the better performing industries. The result of this will be a balance with the previous standard only that this time, fewer industries will be involved and will thereby lead to higher and better living standards for this workers as they will earn better wages for their labour. Inadvertently, there will be rise in the employment rate in these sectors which are still performing. This is likely to exceed the previous rate of unemployment that was expected to rise. But the result will be different in that the unemployment will have structurally increased. In the short term, there is valuation effect from appreciation that results to falling of the value of a country’s currency and the a lower interest debt servicing and the result is an increase in the imports consumption and reduced foreign export demand resulting to the deterioration of the current account where deficits start to form. This has been the case with Australia. Where the mining sector has expanded at the expense of other sectors which have died down and due to its low savings, the high level of external borrowing will worsen the conditions of the deficit in the current account. But if the imported capital is being effectively used, [Stevens, G. (2010)] argues that there will not arise a problem. There results reduced inflationary pressures with the appreciation of a currency through the reduced prices of the imports and this will reduce the inflation in the long run especially through the structural adjustments and increased efficiency. The result of this will be to loosen the monetary policy to reduce the inflation. Like in the graph below the Australian currency has appreciated. Due to the structural adjustments, the mining sector has picked and is substituting the other sectors which were done away with. In this economy, there are trainings that are carried out so as to equip the laborers with the new fields. The employment also increases in the long run but deceases in the short run, so is inflation. Fig 2: Graph illustrating Mining Investment as a share of nominal GDP, from 1969-2009 . The US trade with the Canadians has been seen as an imperative case of the effects that the rising exchange rate will have in an economy. Canada depends on trade for its development and this trade is mostly with the US. The Canadian dollar has appreciated by a great margin and there has been an expectation that this might lead to the Canadian economy. The Canadian government has had a reduction of the profits from the trade with the US by keeping their market share constant and this has led to close down on other industries. This situation is not that that bad to the Canadian businesses, this is because the importers are going to import at lower costs while the exporters are to export at higher prices. Due to the integrated number of exports, the numbers of exports have been mostly from the imports and this has led to an increased profit margin from these. In addition t this, the higher dollar has raised the cost of investment in the countries involved like Canada as most of its machinery and equipments for production are imported. The rising exchange rate negatively affects the tourism industry in that the tourists will to dig deeper in their pockets so that they can afford to pay the high costs of their visit in different destination, here taking the case study of Canada and US. Touring Canada has become relatively expensive and this has led to the tourism sector suffering reduced tourists visit in their country. In addition to this, the tourism sector also suffers from the reduced earnings in the sector as the tourists are few. The funds that are brought by the tourists help in the balancing of the currency. The local versus the foreign and is used in the importation of materials, tools and implements from these regions of their origin. This, therefore, means that there will be a reduced amount in terms of foreign currency that would have been used to purchases these materials. The hotels and the cultures of the people that are displayed and used in the accommodating the tourists will have a reduced significance. The cultureless and the dancers who entertain the tourists are therefore rendered jobless as the tourists are few. The hotels are closed down and the workers are laid off as they can no longer be sustainable for the large population that is involved as workforce. The import oriented services may not suffer the same fate as the export oriented industries. This is because the industries will operate locally and will benefit from the rising exchange rate. Some of these industries are the insurance industries, education and finance which have high investment rates and capital stock. In essence, the materials and equipments they use like the computers and the software which are all manufactured abroad. The effect of this is that they are imported at lower costs and reduce the capital that is required in obtaining them [Chowdhury, A.R., 1993]. Through continuous trading, there has arisen the formation of trading blocs between nations and also contracts some of which are for the supply of certain materials in the regions that the nation requires. The consumers of these products have an upper hand in this as they experience a positive show of it with the lower prices of the imports. The prices of the domestic goods remain constant and therefore the locals will save and direct their savings to other sectors of the economy and would therefore act as an implicit wage hike. There will be an increase in equity prices from the industries which have been left to operate. The dividends also have to increase as the returns are high. The demands will make the company’s tax revenues to increase and there shall be royalties which shall be paid to the governments. However, the resources and the immediate benefits will be focused on the rich states. There will be an increase of the investment goods and some of this will have to be sourced domestically. This will be for the benefit of the locals or the nation that has invested on them. On the contrary, the costs of these firms will increase especially for those that use the outputs form these industries as raw materials for their production. If these products that are produced by these industries that have been left to operate in the nation have a stronger world demand, then there will be upward pressure on the exchange rate making the nations imports relatively cheaper and those outputs that are not from these industries will be less competitive as even their demand will be low whereas their prices will be high. There will be balance of payment deficits that will come about due to the accounts no balancing. If a country like the USA runs a deficit in the current account, then it is because the imports in that country are more that what it exports. The surplus is certainly offset able in its capital account for these two have to balance. Failure to produce enough surpluses to cover these deficits will force the government to transfer currency and the financial reserves to the nations that are experiencing a surplus in their current accounts where much of the deficit is offset from the foreign investment surpluses of the country, in this case the US. Sometimes this leads to borrowing from the well up countries. To pay for goods that a country has imported and to maintain surpluses will require that the country borrows from the other countries. The benefit f this or the hazard depends on the manner in which these are used the prices of imports are affected by the rising exchange rate [Engler P, M. Fidora and C. Thimann, June 2007]. Example, if the price of the dollar appreciates, then the value or the price of goods imported will be relatively cheaper in the country. The decrease in the price of the imported goods will reduce the inflation. The rise in the exchange rates has raised the prices of fuel which has automatic effect on the cost of the operations. The prices of fuel have affected the airlines in different ways which also include triggering economic recessions which has reduced the demand for air travel and the air cargo. The operating expenses of the airlines often constitute around 12% as fuel costs. Any increase in the costs of the fuel costs the jet a lot of money and this is partly solved by the pricing power where there is an allowance to pass these costs on in terms of larger fares which come off the bottom line. The airline industry has been handicapped by these effects because even minor effects have adverse effects on it as even minor recessions results in reduced demand and the prices are very sensitive especially those for leisure as well as those traveling for business purposes. The profitability of airlines has suffered from a direct consequence of a weak economy. The figure below represents a great departure which exceeded what the system could withstand and therefore the exchange rate collapsed, as seen by the reduction of the prices to the line but that is not to stay for long. This occurs when the country tries to fix a currency and there for leads to greater stock of money than its trading partner which is doing well that itself. [Takaendasa, P, 2005] The result is a very fast rise in the prices as compared to those of its counterpart. This makes the investments to be shifted to the other countries due to the high inflation in the country. This is what happened in Mexico as compared to the US as shown in the graph below. Fig 3: A graph showing price level, money supply and exchange rate The consumption composition changes and the consumers find that the foreign goods or services are cheaper and therefore go for them instead. The effect of this is that the country will be producing for exports and the locals are going to be importing for consumption of which will be relatively cheaper. In the same line, there will be intermediate products abroad. The domestic firms may end up closing down and if the reason is a rise in the prices of the main exports, then the composition of the industrial texture will be concentrated and starkly simplified on the exports. This does not diversify the economy which is always the stated goal in the public strategies where countries are depending on very few productions. Reference list: Aguirre, A., Ferreira, A. & Notini, H., 2003. The impact of exchange rate volatility on manufactured exports. Retrieved 11 November 2011 http://www.eg.fjp.mg.gov.br/publicacoes/ Arize, C.A. Osang, T. & Slottje, J.D., 2000. Exchange rate volatility and foreign trade: evidence from thirteen LDC’s. Journal of Business and Economics Statistics, 18(1), pp 10-17. Aron, J., Elbadawi, I.A. & Kahn, B., 1997. Determinants of the real exchange rates in South Africa. Retrieved 11 November 2011 www.csae.ox.ac.uk/resprogs/smmsae/pdfs/smmsae-2002-13.pdf Asseery, A. & Peel, D., 1991. The effects of exchange rate volatility on exports. Economic Letters, 37, pp. 173–177.22 Aziakpono, M., Tsheole, T. & Takaendasa, P., 2005. Real exchange rate and its effect on trade flows: New evidence from South Africa. Retrieved 11 November 2011 http://www.essa.org.za/download/2005Conference/Takaendesa.pdf Bah, I. & Amusa, H.A., 2003. Real exchange rate volatility and foreign trade: Evidence from South Africa’s exports to the United States. The African Finance Journal, 5(2), pp. 1- 20. Choudhry, T., 2005. Exchange rate volatility and the United States exports: Evidence from Canada and Japan. Journal of the Japanese and International Economies, 19, pp. 51- 71. Chowdhury, A.R., 1993. Does exchange rate volatility depress trade flows?: Evidence from error correction models. Review of Economics and Statistics, 75(4), pp.700-706. De Grauwe, P., 1988. Exchange rate variability and the slowdown in growth of international trade. IMF Staff Papers, 35, pp. 63-84. De Grauwe, P. & Bellfroid, B., 1989. Long-run exchange rate variability and international trade. In Arndt, S. & Richardson. J.D. Real Financial Linkage among Open Economies. The MIT Press. London. pp 193-212. De Vita, G. & Abbott, A., 2004. The impact of exchange rate volatility on UK exports to EU countries. Scottish Journal of Political Economy, 51(1), pp. 62-81. Dieppe A. and T. Warmedinger, 2007.Modelling intra- and extra-area trade substitution and exchange rate pass-through in the euro area” Doroodian, K., 1999. Does exchange rate volatility deter international trade in developing countries? Journal of Asian Economics, 10 (3). pp65-474. Engler P, M. Fidora and C. Thimann, June 2007 “External imbalances and the US current account: how supply-side changes affect an exchange rate adjustment”. Goldberg, Linda & Charles Kolstad. (2005) “Foreign Direct Investment, Exchange Rate Variability and Demand Uncertainty.” International Economic Review, vol. 36 no.4, Stevens, G. (2010). ‘Recent Developments’, Address to Western Sydney Business Connection, 9 June, Western Sydney. pp. 855-73. Read More