6.4 Exchange Rates

The exchange rate is the price of one currency in terms of another currency

Example:

  • 1 USD = 0.80 GBP
  • Exchange rates determine:
    • Price of exports
    • Cost of imports
      → directly affect a country’s competitiveness and current account

Determination of a Floating Exchange Rate

  • A floating exchange rate is determined by demand and supply of the currency in the foreign exchange market

Demand for a Currency Comes From:

  • Exports (foreigners buying domestic goods)
  • Foreign investment into the country

Supply of a Currency Comes From:

  • Imports (domestic residents buying foreign goods)
  • Domestic investment abroad
  • If demand > supply
    → currency appreciates
  • If supply > demand
    → currency depreciates

Appreciation vs Depreciation

Appreciation

  • Increase in value of a currency
  • Exports become more expensive
    → export demand falls
  • Imports become cheaper
    → import demand rises

→ likely worsening of current account

Depreciation

  • Decrease in value of a currency
  • Exports become cheaper
    → export demand rises
  • Imports become more expensive
    → import demand falls

→ likely improvement in current account

Causes of Changes in Exchange Rates

1. Changes in Demand

  • Increase in exports or foreign investment
    → higher demand for currency
    → appreciation

2. Changes in Supply

  • Increase in imports or capital outflows
    → higher supply of currency
    → depreciation

3. Interest Rates

  • Higher interest rates
    → attract foreign investors
    → increase demand for currency
    → appreciation

4. Inflation

  • Higher inflation
    → exports less competitive
    → demand for currency falls
    → depreciation

5. Economic Growth

  • Strong growth
    → higher imports
    → increased supply of currency
    → depreciation

6. Speculation

  • If investors expect appreciation
    → demand rises now
    → currency appreciates

AD/AS Analysis of Exchange Rate Changes

A. Depreciation of Currency

Impact on AD

  • Exports increase (X ↑)
  • Imports decrease (M ↓)
    → net exports (X – M) increase
    → AD shifts right

Impact on Real Output

  • Higher demand
    → firms increase production
    → real GDP rises

Impact on Employment

  • Increased output
    → more labour needed
    → unemployment falls

Impact on Price Level

  • Higher AD → demand-pull inflation
  • More expensive imports → cost-push inflation

→ price level rises

B. Appreciation of Currency

Impact on AD

  • Exports decrease
  • Imports increase
    → net exports fall
    → AD shifts left

Impact on Real Output

  • Lower demand
    → production falls
    → real GDP decreases

Impact on Employment

  • Reduced output
    → firms cut jobs
    → unemployment rises

Impact on Price Level

  • Lower AD → reduces inflation
  • Cheaper imports → lower costs

→ price level falls (or inflation decreases)

Evaluation

Elasticity Matters

  • If demand for exports/imports is elastic
    → exchange rate changes have large effects
  • If inelastic
    → impact is limited

Time Lag (J-Curve Effect)

  • After depreciation
    → current account may worsen initially
    → improves later as demand adjusts

Inflation Trade-Off

  • Depreciation boosts growth
    BUT
    → increases inflation

External Dependence

  • Economies dependent on imports
    → depreciation can be harmful (higher costs)

Final Summary

  • Exchange rate = price of one currency in another
  • Floating rates determined by demand and supply
  • Appreciation:
    • ↓ exports, ↑ imports → AD falls
  • Depreciation:
    • ↑ exports, ↓ imports → AD rises
  • Effects:
    • Output, employment, inflation all affected
  • Key evaluation:
    • Depends on elasticity, time lags, and economic structure