Exchange rate change effects

You need to know how a change in the value of a currency will affect:

Exchange rate change effect on inflation rate

As with everything in economics – IT DEPENDS. Especially on what the country in consideration exports and imports.

Currency appreciation

  • Exports – less competitive internationally because their price seems higher to foreigners. This might lower aggregate demand and decrease inflation (Keynesian model) if the economy was at its potential or the bottleneck. Otherwise, changes in exports arising from changes in exchange rate will not affect inflation much.
  • Imports – they now seem cheaper due to appreciation of the currency. That means every firm which uses imports in their production process as inputs will face lower costs of production. Hence, the price level in the economy should fall (AS shifts down) and inflation decrease as a result of appreciation in the exchange rate. However, when evaluating you could mention that producers might keep the same prices and just increase their profits.

Currency depreciation

  • Exports – become more competitive internationally. Therefore, as demand for exports grows, AD increases and might push the economy to the bottleneck or its potential resulting in increasing inflation rate. Goods/services which have low PEDs (price elasticity of demand) will not be likely to affect the AD by much (e.g. oil).
  • Imports – seem more expensive and therefore, producers might face growing production costs. A lot of industries use oil as an input in their production process. If the country considered is a net oil importer it will be very likely to face increases in inflation rate due to depreciating exchange rate (AS shifts up).

Exchange rate change effect on employment and economic growth

To find the effect of changing exchange rates on employment and economic growth we need to do a similar analysis as we did with the effect on inflation.

Currency appreciation

  • Exports – less competitive, lower demand for them, producers might have to cut production, hence, increasing unemployment and lower economic growth (or even possibly falling GDP). If the country is exporting oil (or other low PED goods/services) the effect will be much smaller.
  • Imports – seem cheaper, so if they are used as inputs, producers face lower production costs and that might encourage to increase the quantities produced. Therefore, increasing employment and economic growth (GDP grows) as AD shifts to the right. However, because imports seem cheaper, people might substitute away from domestic goods to imported ones and that would lead to falling employment and lower GDP.

Currency depreciation

  • Exports – more competitive internationally. As quantity demanded grows, producers hire more workers and increase production -> employment grows and GDP increases. The size of this effect might depend on the price elasticities of exports.
  • Imports – seem more expensive. Possible higher production costs -> lower production quantities -> workers being fired and GDP falls. However, people might substitute from imports which now seem more expensive to domestically produced goods. As AD shifts to the right (because C component increases and M component decreases) producers increase quantities produced, hire workers and GDP grows.

Exchange rate change effect on current account balance

The effect of changes in the exchange rate on the current account balance depends on the same thing: on goods and services that the considered country exports/imports. To be precise – on the PEDs of the country’s exports and imports.