Exchange rates

An exchange rate is the price of one currency in terms of another. Under a floating system, it is determined in the foreign-exchange market by the demand for and supply of the currency, just like any price.

On a forex diagram, the exchange rate is on the vertical axis and the quantity of the currency on the horizontal axis. Demand for the currency comes from foreigners who need it to buy the country's exports and to invest in the country; supply comes from residents selling the currency to buy imports and to invest abroad. The equilibrium exchange rate is where demand equals supply.

A depreciation (a fall in the currency's value) occurs when the demand for the currency falls or its supply rises. Causes include:

• A fall in demand for the country's exports (foreigners need less of the currency).
• A rise in demand for imports (residents supply more of the currency to buy them).
• A fall in domestic interest rates, which makes the country less attractive to foreign savers, causing capital outflows (currency demand falls / supply rises).
• Falling confidence in the economy or speculation that the currency will fall.

On the diagram, any of these shifts the demand curve left or the supply curve right, lowering the equilibrium exchange rate. The depreciation then makes the country's exports cheaper and imports dearer (WPIDEC), affecting trade and inflation.

The interest-rate cut reduced the return on Country R's currency, causing capital outflows and a fall in demand for the currency — hence the 15% depreciation.

The depreciation makes Country R's exports cheaper abroad and imports dearer at home (WPIDEC). This tends to raise net exports (X − M), shifting AD to the right, which can increase real output and employment — helpful if the economy has spare capacity. The improved competitiveness can also help the current account.

However, there are costs. Dearer imports raise the price of imported goods and imported raw materials, increasing firms' costs and causing cost-push inflation, which also squeezes consumers' real incomes. If Country R is heavily dependent on imported energy or components, this inflation effect could be significant.

So the depreciation is a mixed blessing: it boosts competitiveness, output and the current account, but risks higher inflation. The net effect depends on the price elasticity of exports and imports and on how import-dependent the economy is.

A fall in the exchange rate (depreciation) makes exports cheaper and imports dearer. Whether this is 'good' for the economy involves weighing competing effects.

The case that a depreciation is good. Cheaper exports become more competitive abroad and dearer imports encourage import substitution, so net exports (X − M) tend to rise. This shifts AD to the right, raising real output and employment — valuable in a recession with spare capacity. The rise in net exports can also improve the current account, helping a country with a trade deficit. Domestic firms competing with imports may also gain market share.

The case against. A depreciation has significant costs. Dearer imports raise the price of imported finished goods and, crucially, imported raw materials and components, raising firms' costs and causing cost-push inflation; this erodes consumers' real incomes. For an economy heavily dependent on imported energy or inputs, the inflation effect can be severe. The benefit to the current account also depends on elasticities: if demand for exports and imports is price-inelastic, the depreciation may worsen the current account (at least initially — the J-curve effect at A Level). A depreciation can also reflect weakness or lost confidence in the economy.

Judgement. A fall in the exchange rate is not automatically good. It is most beneficial when demand for exports and imports is price-elastic, the economy has spare capacity (so output can rise without excessive inflation), and the economy is not heavily import-dependent — then it boosts competitiveness, output and the current account with limited inflation. But where demand is inelastic or the economy relies heavily on imports, the inflation cost can outweigh the competitiveness gain. The most defensible conclusion is that a depreciation is a mixed blessing whose net benefit depends on elasticities, spare capacity and import dependence, rather than being good in all circumstances.

A strong (appreciating) currency makes exports dearer and imports cheaper. The view that this is always harmful overstates the case.

The case that a strong currency is harmful. An appreciation makes exports less competitive and imports cheaper, so net exports (X − M) tend to fall, shifting AD left and lowering output and employment — damaging for export-led economies. It can worsen the current account and hurt domestic producers competing with cheaper imports. For a country relying on exports, these are real costs.

The case that a strong currency can be beneficial. A strong currency makes imports cheaper, which lowers inflation (less imported cost-push pressure) and reduces the cost of imported raw materials and capital goods for firms — potentially improving competitiveness in the long run. It raises consumers' real purchasing power over imported goods, improving living standards, and lowers the cost of imported essentials (e.g. energy, food, medicines). An appreciation can also reflect strength and confidence in the economy (e.g. strong export demand or inward investment), which is positive.

Judgement. A strong currency is not always harmful. Its effects involve a trade-off: it harms export competitiveness, output and the current account, but benefits the economy through lower inflation, cheaper imported inputs and higher real incomes. Which dominates depends on the economy's structure — an export-dependent economy is harmed more, whereas an economy that imports a lot of inputs/essentials or is fighting inflation may benefit. The most defensible conclusion is that a strong currency brings both costs and benefits, so it is harmful in some circumstances (export-led economies) but beneficial in others (import-dependent or inflation-prone economies) — 'always harmful' is too strong.