4.5.3 Consequences of Changes to the Exchange Rate Notes

1. We have already discussed that changes in the exchange rate can influence a country’s imports.
2. But what is the reason behind this?
3. When the currency of an exporting country appreciates, goods become more expensive for foreign buyers, reducing demand for exports and causing net exports (X–M) to decrease.
4. When the currency depreciates, goods become cheaper for foreign buyers, increasing demand for exports and leading to a rise in net exports (X–M).
5. Currency appreciation or depreciation also impacts:
   1. Inflation rate: appreciation lowers import prices, reducing inflation; depreciation raises import prices, increasing inflation.
   2. Economic growth: appreciation dampens growth by reducing exports; depreciation stimulates growth through higher exports.
   3. Unemployment: appreciation may raise unemployment in export industries; depreciation can lower unemployment by boosting demand.
   4. Current account balance: appreciation worsens the balance as exports fall; depreciation improves it as exports rise.
   5. Living standards: appreciation raises purchasing power for imports; depreciation reduces it due to higher import costs.

Inflation Rates

Demand-Pull Inflation

Since (X–M) is a determinant of aggregate demand (AD):

1. An increase in (X–M), caused by currency depreciation, leads to an increase in AD.
2. This rise in AD pushes up the price level, resulting in demand-pull inflation.
3. A decrease in (X–M), caused by currency appreciation, leads to a decrease in AD.
4. This fall in AD lowers the price level, reducing demand-pull inflation.

Cost-Push Inflation

If a firm uses imported inputs in production:

1. An increase in import prices due to currency depreciation raises the cost of production, reducing short-run aggregate supply (SRAS).
2. As a result, SRAS shifts left, the price level rises, and cost-push inflation occurs.
3. A decrease in import prices due to currency appreciation lowers the cost of production, increasing SRAS.
4. As a result, SRAS shifts right, the price level falls, and cost-push inflationary pressures are reduced.

Economic Growth

1. The effects of exchange rate changes influence economic growth through their impact on aggregate demand (AD).
   1. An increase in (X–M) from currency depreciation raises AD, leading to higher total output and thus economic growth.
   2. A decrease in (X–M) from currency appreciation lowers AD, reducing total output and slowing economic growth.
2. However, if currency depreciation also causes an increase in input costs, short-run aggregate supply (SRAS) will fall.
3. If the decrease in SRAS outweighs the increase in (X–M), the economy may experience negative growth.

Unemployment

1. The depreciation of a currency increases (X–M) and therefore raises aggregate demand (AD).
   1. This expansion in AD stimulates economic growth and creates more job opportunities, reducing cyclical unemployment.
   2. At the same time, however, depreciation also generates cost-push inflation.
   3. If the impact of cost-push inflation outweighs the positive effect of rising AD, the economy may contract, leading to job losses.
2. Conversely, a currency appreciation reduces (X–M) and lowers AD.
   1. This contraction in AD slows the economy and increases cyclical unemployment.

Current Account Balance

1. Currency depreciation makes a country’s exports cheaper and more competitive in international markets, boosting export volumes.
   1. At the same time, it raises the price of imports, reducing import demand. Together, these effects can improve the current account balance.
2. Currency appreciation, on the other hand, makes exports more expensive and imports cheaper, which can worsen the current account balance.

Living Standards

1. If the prices of imported goods rise due to currency depreciation, consumers who rely on those goods face higher costs, leading to a decline in their living standards.
2. Additionally, if the currency of country X appreciates while the currency of country Y depreciates, visitors from Y to X will find goods and services in X more expensive.
   1. As a result, these visitors will be worse off.