The impact of changes in exchange rates (Balance of Payments, Exchange rates and International Competitiveness)

An exchange rate is the price of one currency in terms of another. When that price falls, the currency has depreciated (under a floating system) or been devalued (a deliberate cut under a fixed or managed system). When it rises, the currency has appreciated (floating) or been revalued (fixed). The economic effects are the same whether the move is market-driven or policy-driven — only the label differs.

The whole subtopic turns on one mechanical idea: a change in the exchange rate changes the relative prices of traded goods. Two mnemonics lock this in.

WPIDEC — a depreciation (Weaker Pound).

• Imports Dearer: foreign goods now cost more in domestic currency.
• Exports Cheaper: domestic goods now cost less to foreign buyers.

SPICED — an appreciation (Stronger Pound).

• Imports Cheaper: foreign goods cost less at home.
• Exports Dearer: domestic goods cost more abroad.

Move	Mnemonic	Exports become…	Imports become…	Likely effect on (X − M)
Depreciation / devaluation (weaker)	WPIDEC	cheaper	dearer	tends to rise
Appreciation / revaluation (stronger)	SPICED	dearer	cheaper	tends to fall

A quick numerical anchor. Suppose the exchange rate is £1 = $2 and a British car sells for £20,000, i.e. $40,000 abroad. If the pound depreciates to £1 = $1.50, the same car now costs foreigners only $30,000 — cheaper, so exports become more competitive. Meanwhile an American good priced at $60 that used to cost £30 now costs £40 — dearer, so imports fall.

A* link. Keep 'depreciation' (floating, market-driven) and 'devaluation' (fixed/managed, policy-driven) distinct in the vocabulary, but treat their trade effects as identical. The examiner rewards the precise term and the correct WPIDEC/SPICED direction — the two most common lost marks in this subtopic are reversing the direction and muddling the four terms.

Because net exports (X − M) are a component of aggregate demand, a change in the exchange rate feeds through the whole macroeconomy. Take a depreciation and trace the chain.

1. Current account. Cheaper exports and dearer imports tend to raise net exports (X − M), improving the trade balance — the largest part of the current account. (Crucially, this only holds if the Marshall–Lerner condition is met — see the next section.)

2. Aggregate demand, growth and employment. Higher net exports raise spending on domestic output at every price level, so AD shifts right (AD → AD₁). Against an upward-sloping SRAS, real output rises (faster growth) and firms hire more, so unemployment falls — especially in exporting and import-competing industries. The multiplier amplifies the initial injection.

3. Inflation. Here is the trade-off. A depreciation raises the domestic price of imports — imported raw materials, components, fuel and finished goods all cost more — creating imported cost-push inflation that shifts SRAS left. On top of that, the demand-pull pressure from higher AD adds to inflation if the economy is near capacity. So a depreciation can boost growth but at the cost of higher inflation.

An appreciation runs the chain in reverse: net exports fall, AD shifts left (weaker growth, higher unemployment), but imported inflation eases and cheaper imported inputs can lower firms' costs.

Effect	Depreciation (WPIDEC)	Appreciation (SPICED)
Net exports (X − M)	tends to rise	tends to fall
Current account	tends to improve (if M–L holds)	tends to worsen
AD / growth	AD right → faster growth	AD left → slower growth
Employment	tends to rise	tends to fall
Inflation	rises (imported cost-push + demand-pull)	eases (cheaper imports)

In the diagram, a depreciation raises net exports and shifts AD right from AD to AD₁: equilibrium moves from E to E₁, so the price level rises to P₁ and real output rises to Y₁. The output gain is the growth-and-jobs benefit; the higher price level (worsened further by imported cost-push) is the inflation cost.

WPIDEC tells us a depreciation makes exports cheaper and imports dearer — but whether spending on net exports actually improves depends on how much quantity responds to those price changes. That is a question of price elasticity of demand (PED).

The Marshall–Lerner condition states that a depreciation (or devaluation) will improve the current account only if the sum of the price elasticities of demand for exports and imports is greater than one:

$PED_X + PED_M > 1$

(Here the elasticities are taken as absolute values.) The intuition:

• Exports. A depreciation cuts the foreign-currency price of exports. If foreign demand for exports is elastic, quantity rises more than proportionately, so export revenue rises.
• Imports. A depreciation raises the domestic price of imports. If domestic demand for imports is elastic, quantity falls sharply, so spending on imports falls.

If both effects are strong enough that the elasticities sum to more than 1, net exports (X − M) rise and the current account improves. If they sum to less than 1 (demand is jointly inelastic), the higher price of imports can outweigh the modest volume changes, and the current account can actually worsen.

Worked check. Suppose after a depreciation $PED_X = 0.7$ and $PED_M = 0.5$.

$PED_X + PED_M = 0.7 + 0.5 = 1.2 > 1$

Because the sum 1.2 exceeds 1, the Marshall–Lerner condition holds, so the depreciation should improve the current account. Had the sum been, say, $0.4 + 0.3 = 0.7 < 1$, the condition would fail and the current account could worsen.

Golden rule: a depreciation is not automatically good for the current account. Always check the elasticities: improves only if PEDx + PEDm > 1.

The J-curve explains why the current account can get worse before it gets better after a depreciation. The reason is time: price elasticities of demand are low (inelastic) in the short run and rise (become elastic) over time.

Short run — the dip. Immediately after a depreciation:

• Trade contracts and orders are already priced and agreed, so volumes barely change at first.
• Consumers and firms are slow to switch suppliers out of habit, brand loyalty and search costs.
• So exports and imports are inelastic — quantities are 'sticky'. But imports are now dearer, so the import bill rises while export volumes have not yet grown. The result: net exports fall and the current account first worsens (the Marshall–Lerner sum is below 1).

Long run — the recovery. As time passes:

• Foreign buyers respond to cheaper exports and export volumes rise.
• Domestic buyers find alternatives to dearer imports and import volumes fall.
• Demand becomes more elastic, the Marshall–Lerner sum rises above 1, and the current account improves — rising above its starting level.

Plotting the current-account balance against time from the moment of the depreciation (t₀) traces a J shape: it starts on the balance line, dips below into a worsening deficit, reaches a trough, then rises back up and above where it began.

In the diagram, at t₀ the depreciation occurs on the zero (balance) line. In the short run demand is inelastic, so the current account worsens — the curve dips below the line to a trough. As elasticities rise over time, the account improves, and the curve rises back through the zero line and above its starting level: the classic J shape.

Golden rule: the J-curve shows the current account gets worse before it gets better — the improvement is delayed and depends on elasticities rising over time.

Whether a depreciation is good for the economy — and how strong its effects are — is genuinely conditional. Top-band evaluation weighs three levers.

1. Elasticities (does Marshall–Lerner hold?). The whole current-account benefit depends on PEDx + PEDm > 1. If demand for exports and imports is jointly inelastic — as it is in the short run (the J-curve dip) or for economies reliant on price-inelastic commodity imports (oil, food) — a depreciation can worsen the current account and simply import inflation. The more elastic demand, the bigger and faster the improvement.

2. Spare capacity. The AD boost from higher net exports raises real output only if the economy can produce more. With plenty of spare capacity (a negative output gap), the depreciation lifts growth and jobs with little inflation. Near full capacity, the same shift feeds mainly into a higher price level, so the inflation cost dominates and the growth gain is small.

3. Persistence and expectations. Firms only invest in expanding export capacity or re-sourcing imports if they believe the exchange-rate change will last. A depreciation seen as temporary produces little volume response (elasticities stay low), so the J-curve never recovers strongly. A persistent, credible change gives firms time and reason to respond, so elasticities rise and the benefit materialises.

Other evaluation lines.

• The cause of the depreciation matters: a fall driven by weak fundamentals (capital flight, loss of confidence) is different from a deliberate, competitive devaluation.
• Imported inflation can erode the very competitiveness gain — if higher import costs push up domestic prices and wages, the real-terms price advantage fades.
• Retaliation / competitive devaluations by trading partners can cancel the effect and invite protectionism.
• The size of the trade sector: an open economy feels a bigger AD effect than a relatively closed one.

Judgement. A depreciation can improve the current account and boost growth and employment — but only if Marshall–Lerner holds, only after the J-curve delay, and more so when there is spare capacity and the change is expected to persist. Otherwise it risks importing inflation for little lasting gain. The mature verdict is that a depreciation is a conditional, medium-term tool, not an automatic or instant cure.