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