A look at the economic impact of a fall in the exchange rate (termed depreciation or devaluation)
A fall in the exchange rate is known as a depreciation in the exchange rate (or devaluation in a fixed exchange rate system). It means the currency is worth less compared to other countries.
When there is a depreciation, and the exchange rate goes down
Exportswill be cheaper
Imports will become more expensive
For example, a depreciation of the dollar makes US exports more competitive but raises the cost of importing goods into the US.
Therefore there will be an increase in exports and decrease in the quantity of imports.
Domestic firms will benefit from increased sales. This may lead to job creation and lower unemployment, especially in export industries.
The increase in (X-M will) help increase Aggregate Demand (AD) and therefore lead to higher economic growth
A depreciation increases the cost of imports so there will be an increase in cost-push inflation.
A depreciation increases domestic demand, so there could be some demand-pull inflation
A depreciation makes exports more competitive – without any effort. In the long-term, this may reduce incentives for firms to cut costs, and could lead to declining productivity and rising prices.
The effect of a depreciation in the exchange rate depends on the state of the economy. If the economy is growing quickly and close to full capacity, then a fall in the exchange rate is likely to increase inflationary pressures. In a recession, the fall in the exchange rate may only cause some temporary cost-push inflation.
Impact of fall in exchange rate on current account balance of payments
A depreciation will tend to improve the current account balance of payments.
This is because exports increase relative to imports.
However, this assumes that demand for exports and imports are relatively elastic.
The Marshall-Lerner condition states that a depreciation improves current account deficit if PED x + PED m >1
In the short-term, demand for exports may be inelastic so there is no improvement in the current account. However, over a longer period of time, demand becomes more elastic and so there is an improvement in the current account. (see J Curve effect)
Summary of a fall in the exchange rate
Tends to increase the rate of economic growth and reduce unemployment.
Tends to benefit exporters, but makes imports more expensive.
Benefits the domestic tourist industry. It is more expensive to travel abroad and foreigners will find the UK more attractive.
Consumers likely to see higher prices – at least for imported goods.
Tends to cause inflation. This is because:
imports more expensive
higher domestic demand
firms have less incentive to cut costs
Tends to improve the current account deficit
Winners and losers from a fall in the exchange rate
Evaluation
The impact of a fall in the exchange rate depends on a few factors:
State of the economy. If the economy is in a recession, a depreciation may help boost growth with little effect on inflation. But, if inflation is already high, a fall in the exchange rate will make inflation worse.
Other components of AD. If the exchange rate falls, this increases export demand. However, if there is a fall in consumer confidence, there may be no overall increase in AD.
Time lag and elasticity of demand. In the short term, demand for exports tends to be inelastic (therefore only a small increase in demand). Over time, demand becomes more elastic. Therefore there is a bigger increase in demand for exports.
Depends on the cause of the fall in the exchange rate. For example, countries experiencing a balance of payments crisis (e.g. Russia 2007/17) will see an outflow of capital as investors become nervous over the speed of the currency devaluation.
Examples of fall in the exchange rate
US Dollar depreciation 2001-2008
The steady fall in the Dollar 2001-08 was generally a period of positive economic growth. Inflation remained low during this period because – apart from import prices rising – inflationary pressures were generally low.
UK devaluation in 1992
In 1990-92, the UK was in a fixed exchange rate mechanism. This led to higher interest rates and a recession. In 1992, there was a sharp fall in the value of Sterling when the UK left the Exchange Rate Mechanism (ERM) The devaluation (and lower interest rates) helped the UK recover from a deep recession, and it led to a period of economic growth. 1992 Exchange Rate Mechanism
UK Depreciation 2007-09
Sterling fell by approx 30% between 2007 and 2009 – this was due to the UK economy being hit hard by global credit crunch and damage to the financial sector. Often a fall in exchange rate boosts domestic demand. But, the UK economy still went into recession because of the credit crunch, fall in bank lending and global recession.
Despite the recession, the UK experience a spike in inflation (5%)
UK Leaving gold standard in 1931
In 1931, the UK economy was in a serious recession – with unemployment rising towards 20%. In 1931, the UK left the Gold Standard, causing the Pound to fall in value. This fall in the exchange rate enabled the economy to recover quicker than many other countries stuck in the great depression.
A lower-valued currency makes a country's imports more expensive and its exports less expensive in foreign markets. A higher exchange rate can be expected to worsen a country's balance of trade, while a lower exchange rate can be expected to improve it.
When exchange rates change, the prices of imported goods will change in value, including domestic products that rely on imported parts and raw materials. Exchange rates also impact investment performance, interest rates, and inflation—and can even extend to influence the job market and real estate sector.
An exchange rate is the price of one currency in terms of another – in other words, the purchasing power of one currency against another. Exchange rates are traded in the global currency market.
Currency depreciation, if orderly and gradual, improves a nation's export competitiveness and may improve its trade deficit over time. But an abrupt and sizable currency depreciation may scare foreign investors who fear the currency may fall further, leading them to pull portfolio investments out of the country.
A currency crisis is brought on by a sharp decline in the value of a country's currency. This decline in value, in turn, negatively affects an economy by creating instabilities in exchange rates, meaning one unit of a certain currency no longer buys as much as it used to in another currency.
In general, inflation tends to devalue a currency since inflation can be equated with a decrease in a money's buying power. As a result, countries experiencing high inflation tend to also see their currencies weaken relative to other currencies.
By raising the domestic currency price of foreign exchange devaluation increases the price of traded goods relative to non- trade ones. This causes a reallocation of resources resulting in increased production in import competing sectors.
When an exchange rate changes, the value of one currency will go up while the value of the other currency will go down. When the value of a currency increases, it is said to have appreciated. On the other hand, when the value of a currency decreases, it is said to have depreciated.
In general, a weaker currency makes imports more expensive, while stimulating exports by making them cheaper for overseas customers to buy. A weak or strong currency can contribute to a nation's trade deficit or trade surplus over time.
That is, the exchange rate is the price of a country's currency in terms of another currency. For example, if the exchange rate between the U.S. dollar (USD) and the Japanese yen (JPY) is 120 yen per dollar, one U.S. dollar can be exchanged for 120 yen in foreign currency markets.
In general, when a currency loses value, people's purchasing power declines as well because products — especially imported ones — cost more money. And when that causes a general rise in prices, it's called inflation.
No one knows for sure whether the dollar decline will continue, but if it does there would be a number of implications for your portfolio. A weak dollar would benefit foreign stock market companies and funds held by U.S. investors.
Depreciation of your local currency makes the cost of importing goods more expensive, which could lead to a decreased volume of imports. Domestic companies should benefit from this as a result of increased sales, profits and jobs.
Exchange rates, which give the price of a country's currency relative to foreign currencies, fluctuate based on global market dynamics. These fluctuations can affect domestic inflation rates.
The economics of supply and demand dictate that when demand is high, prices rise and the currency appreciates in value. In contrast, if a country imports more than it exports, there is relatively less demand for its currency, so prices should decline. In the case of currency, it depreciates or loses value.
Three effects of the rise of the real exchange rate (or of its appreciation) on the economic growth are positive (work effort, capital/labour ratio, education level), while the five (exports, foreign direct investments, employment, relative importance of industrial production and of state- owned enterprises) are ...
A fall in the exchange rate should reduce the terms of trade. This is because a decline in the exchange rate will make exports cheaper. An appreciation in the exchange rate should improve the terms of trade because exports will rise in price and imports become cheaper.
An exchange is a marketplace where securities, commodities, derivatives and other financial instruments are traded. The core function of an exchange is to ensure fair and orderly trading and the efficient dissemination of price information for any securities trading on that exchange.
Exchange rates float freely against one another, which means they are in constant fluctuation. Currency valuations are determined by the flows of currency in and out of a country. A high demand for a particular currency usually means that the value of that currency will increase.
Lower interest rates usually decrease the demand for a currency. The reason investors look to buy currencies with higher interest rates is it creates an additional rate of return on their currency exchange.
A fixed or pegged rate is determined by the government through its central bank. The rate is set against another major world currency (such as the U.S. dollar, euro, or yen). To maintain its exchange rate, the government will buy and sell its own currency against the currency to which it is pegged.
How often do exchange rates change? With bankers and traders buying and selling currencies 24/7 in the foreign exchange market, exchange rates are always changing—not just once per day, but multiple times. Because of this, the value of a currency never stands still.
Inflation, interest rates, and forex rates are correlated. Each of these factors can affect the other two. Low inflation and high-interest rates can attract foreign funds to a country, strengthening its exchange rate.
If a currency appreciates it is more valuable; if a currency depreciates it is less valuable. When an exchange rate changes, the value of one currency will go up while the value of the other currency will go down.
We mustn't confuse it with depreciation, even though both mean one currency loses value against another. On the one hand, devaluation happens when a government makes monetary policy to reduce a currency's value; on the other hand, depreciation happens as a result of supply and demand in a free foreign exchange market.
A weaker dollar, however, can be good for exporters, making their products relatively less expensive for buyers abroad. Investors can also try to profit from a falling dollar by owning foreign-currency ETFs or investing in U.S. exporting companies.
A strong dollar is good for some and relatively bad for others. With the dollar strengthening over the past year, American consumers have benefited from cheaper imports and less expensive foreign travel. At the same time, American companies that export or rely on global markets for the bulk of sales have been hurt.
This improves the current account balance. On the contrary, depreciation of a currency makes imports more expensive to the country leading to a reduction in the demand for imports. This reduces the deficit. In practice, however, this may not happen for various reasons.
Does Inflation Depreciate Currency? In general, inflation tends to devalue a currency since inflation can be equated with a decrease in a money's buying power. As a result, countries experiencing high inflation tend to also see their currencies weaken relative to other currencies.
Introduction: My name is Annamae Dooley, I am a witty, quaint, lovely, clever, rich, sparkling, powerful person who loves writing and wants to share my knowledge and understanding with you.
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