- Changes to exchange rates may have far-reaching impacts on an economy
The impact of changes to exchange rates on an economy
Economic Indicator |
Explanation |
The Current Account
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- Depreciation of the £ causes exports to be cheaper for foreigners to buy & imports to the UK are more expensive
- The extent to which this improves the current account balance depends on the Marshall-Lerner condition
- This follows the revenue rule which states that in order to increase revenue, firms should lower prices for products that are price elastic in demand
- If the combined elasticity of exports/imports is less than 1 (inelastic), a depreciation (fall in price) will actually worsen the current account balance
- It is also important to recognise that there is a time lag between the depreciation of the £ and any subsequent improvement in the current account balance
- This is explained by the J-Curve effect
- It takes time for firms & consumers to respond to changes in price
- Once it becomes evident that price changes will last for a longer period of time, firms & consumers switch
- E.g. a firm in the USA has been importing electric scooters from the UK. If the Euro depreciates, the price of scooters in France becomes relatively cheaper. In the short-term, the USA firm will not switch immediately to purchasing scooters from France as the exchange rate may soon bounce back. They also have a good relationship with their UK suppliers. In the long term they are likely to switch
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Economic growth
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- Net exports are a component of aggregate demand (AD)
- A depreciation that results in an increase in net exports will lead to economic growth
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Inflation
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- Cost push inflation is likely to occur as the price of imported raw materials increases with currency depreciation
- Net exports are a component of aggregate demand (AD)
- A depreciation that results in an increase in net exports will lead to an increase in aggregate demand
- This may lead to an increase in demand pull inflation
- An appreciation of the currency will have the opposite effect
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Unemployment
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- If depreciation leads to an increase in exports, unemployment is likely to fall as more workers are required to produce the additional products demanded
- An appreciation of the currency will have the opposite effect
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Living standards
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- The impact of a depreciation on living standards can be muted
- As imports are more expensive, households face higher prices & less choice, which detracts from living standards
- Rising exports can decrease unemployment & increase wages/income which means an improved standard of living for some households
- The impact of an appreciation on living standards will be the opposite
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Foreign direct investment (FDI)
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- Depreciation of a currency makes it cheaper for foreign firms to invest in the country and can increase the FDI
- The money they have available to invest is worth more when the currency has depreciated
- An appreciation has the opposite effect
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