Effects of Movements in the Exchange Rate
How Do Changes in the Price of a Currency Affect the Prices of Exports and Imports?
In the world, many different countries use many different currencies. For example, China has the Yuan, Japan has the Yen, and the United States has the US Dollar. Where a transaction has occurred that is between two different currencies, a currency exchange rate needs to be determined. Consider a transaction between two different countries - Australia and the United States. Australia produces an export that the United States demands costing $10 AUD, while Australia demands an import from the United States that costs $10 USD. As these currencies are not the same, an exchange rate will need to be determined. With an exchange rate of $1 AUD = $1 USD the export will cost the United States $10 USD while the import will cost Australia $10 AUD.
A Depreciation from $1 AUD = $1 USD to $1 AUD = $0.75 USD
Consider a depreciation of the currency from $1 AUD = $1 USD to $1 AUD = $0.75 USD. This positions Australia's export as more competitive as the United States now pays less for Australia's export, at $7.50 USD. The price of the Australian export has not changed in terms of Australian dollars, it still remains at $10 AUD, yet it is now cheaper for overseas buyers to purchase it due to a depreciation. All things being equal, a lower price means that overseas buyers will demand more. However, imports now cost more. As $1 AUD = $0.75 USD, this being in reverse $1 USD = $1.33 AUD (divide both sides by 0.75). Hence, the cost of the US import now costs $13.33 AUD, which is less competitive as it is more expensive. The price of the import has not changed in terms of US currency and is still valued at $10 USD.
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An Appreciation from $1 AUD = $1 USD to $1 AUD = $1.25 USD
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Consider an appreciation of the currency from $1 AUD = $1 USD to $1 AUD = $1.25 USD. This positions Australia's export as more expensive at $12.50 USD and less internationally competitive as overseas buyers have to pay more. The price of the export has not changed in terms of Australian dollars and still costs $10 AUD. However, imports are now cheaper. As $1 AUD = $1.25 USD, in reverse $1 USD = $0.80 AUD, meaning the price paid by Australia for the import is now $8 AUD and is more competitive with domestic goods and services as it is cheaper. The price of the import has not changed in terms of US Dollars and still costs $10 USD.
Effects of a Depreciation (Winners & Losers)
A depreciation will have an expansionary effect as it will increase net exports and the trade balance as exports become more internationally competitive and imports less competitive.
Exporters: Boosted international competitiveness
Government: Higher aggregate demand and economic growth, leading to higher tax receipts
Importers & Consumers: Imports become more expensive
Domestic businesses that Use Imports: Higher cost of inputs such as oil
Reserve Bank: Import prices rises could increase inflation rates
Effects of an Appreciation (Winners & Losers)
An appreciation will have a contractionary effect as it will decrease net exports and the trade balance as exports become less internationally competitive and imports more competitive.
Importers & Consumers: Imports become cheaper
Domestic Businesses that use Imports: Lower cost of inputs
Reserve Bank: Lower import prices could decrease inflation rates
Exports: Exports become more expensive and hence, less competitive
Government: Lower aggregate demand and economic growth, leading to lower tax receipts