Understanding Exchange Rate

Readers Question: I want to understand what happens when the exchange rate depreciates and appreciates please can you make me a brief summary based on exchange rates.

Since early this summer the £ sterling has depreciated against the dollar. £1 used to equal $2. Now £1 is only equal $1.75

What does this Depreciation in the value of the £ mean?

• Buying goods from America becomes more expensive. If a meal cost $10 it used to require £5 for a British tourist. But, now after the depreciation the $10 meal will cost effectively £5.70
• The depreciation in the £ may discourage British tourists to travel to the US.
• It makes US imports into the UK more expensive so it may reduce imports
• UK Exports will become relatively more competitive. It is cheaper for Americans to buy UK goods, so quantity of exports may increase.
• Summary: Depreciation in exchange rate makes exports more competitive and imports more expensive
• A depreciation helps UK exporters and improves UK growth prospects
• The amount demand changes depends on the elasticity of demand
  

Effects of Appreciation

The affects of an appreciation in Sterling will be the opposite. A higher value of sterling makes American imports cheaper for British consumers, but, UK exports become more expensive.

An appreciation in the exchange rate will reduce aggregate demand (assuming demand is relatively elastic) Because exports will fall and imports increase

An appreciation is likely to worsen the current account (assuming Marshall Lerner condition and demand is relatively elastic)

An Appreciation is likely to reduce inflation because:

• Import prices are cheaper
• Fall in Aggregate Demand
• Firms have more incentives to cut costs.

See also: Factors influencing exchange rates

Questions on Exchange Rates