Readers Question: When exchange rate goes down, what positive thing can happen?
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, the exports of a country will be cheaper and imports will become more expensive, e.g. a depreciation of the dollar makes US exports more competitive.
- Therefore there will be an increase in exports and decrease in quantity of imports. Therefore, domestic firms will benefit from increased sales. This may lead to job creation and lower unemployment, especially in exporting 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 inflation.
- The current depreciation in the US dollar is helping US exports. The boost in the US export sector is particularly beneficial because the US economy is currently facing a recession from lower consumer spending.
- A depreciation will also help 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 elastic. (Marshall-Lerner condition states that a depreciation improves current account deficit if PED x + PED m >1)
Summary of Depreciation in Exchange Rate
- Tends to increase rate of economic growth and reduce unemployment
- Tends to cause inflation. This is because:
- imports more expensive
- higher domestic demand
- firms have less incentive to cut costs
The impact of a fall in the exchange rate depends on a few factors:
- State of 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 exchange rate will make inflation worse.
- Other components of AD. If the exchange rate falls, this increase export demand. However, if there is a fall in consumer confidence, there may be no overall fall in AD.
- Time lag. In the short term, demand for exports tends to be inelastic (therefore only small increase in demand). Over time, demand becomes more elastic, therefore there is a bigger increase in demand for exports.
Video on Effect of Depreciation in Value of Pound