Markets - Foreign exchange market

Theory 4 - Effects of exchange rate changes - why do they matter?

Exchange rate changes can have a significant effect on the economy. Let's take the example of a depreciation of the exchange rate, and see what impact this has.

If the exchange rate falls, this changes the relative prices of imports and exports. Exports will appear to become relatively cheaper in other currencies, and imports will appear to be more expensive. Because we buy imports, they are included as part of the retail price index, and so if the price of imports goes up, this could be inflationary especially as in the UK we import a lot of raw materials and semi-finished products. There we have the first effect of a depreciation - it could trigger inflationary pressures in the economy.

The effects on aggregate demand may compound this inflationary impact. Since exports are relatively cheaper overseas, this should increase the demand for them. In addition the demand for imports should fall. The combination of the two will have a positive impact on aggregate demand because net exports is one of the components of the AD function (AD= C+I+G+(X-M) How much the demand increases depends on the price elasticity of demand for exports, but the demand should certainly grow. Growth in aggregate demand could also be inflationary if the economy is close to its capacity. On the diagram below you can see the shift in aggregate demand (AD1 to AD2) pulling up the price level (demand-pull inflation).

In the long-run the effect of the depreciation on the balance of payments is far from certain. The impact depends on how much the demand for imports and exports change. That depends on the price elasticity of demand for imports and exports. When the exchange rate falls imports get more expensive and exports cheaper. That should raise the demand for exports and lower the demand for imports. However, for exports we still receive the same amount in sterling. They are cheaper in the local currency, but we still receive the same amount in sterling. Imports, however, cost us more in sterling. So the overall effect on the balance of payments depends on the price elasticity of exports and imports.

Let us look at a simple example to illustrate:
Assume the exchange rate between the £ and the € is £1 = €2. A good, X, in the UK is priced at £5. At this exchange rate 100 of these items are purchased from abroad - export earnings are therefore £500. A product Y in Europe is locally priced at €5, The UK buys 200 of these items at the current exchange rate. This means that we have to give up £2.50 to buy each unit. Total expenditure on imports therefore is £500. At this point the balance of payments is 0.

Let us now assume that the exchange rate depreciates from £1 = €2 to £1 = €1. Europeans buying good X from the UK will now have to give up only €5 to acquire the good rather than the €10 they had to previously. Given that the product appears cheaper we would expect demand for exports to rise.UK buyers of good Y from Europe however now have to give up £5 to acquire the necessary euro to buy the product. It appears to the UK buyer that prices have risen and we would expect demand for imports to fall. The price of exports has fallen by 50% whilst the price of imports appears to have risen by 100%.Now let us look at the impact on the actual demand for imports and exports given two different scenarios.

Scenario 1:
The Price Elasticity of Demand (PED) for exports is -1.4 and the PED for imports is -0.2.
Demand for exports would rise by 1.4 times the fall in price and so would rise by 70 units. In this case, export earnings would now be 170 x £5 = £850.
Demand for imports would fall by 0.2 x the change in price and so would fall by 20% - a decrease of 40 units. Expenditure on imports would now be 160 x £5 = £800.
We would now have a balance of payments surplus of £50!

Scenario 2:
The PED of exports is -0.8 and the PED for imports is -0.5.
Demand for exports would rise by 0.8 x the change in price = 40 units. Total export earnings would be 140 x £5 = £700.
Demand for imports would fall by 0.5 x the change in price (100%) = 50%. Import expenditure would now be 100 x £5 = £500.
In this situation the balance of payments would be in surplus at +£200

The 'Marshall-Lerner' condition says that if the sum of the price elasticities for imports and exports is greater than 1, then the balance of payments will improve. The evidence for the UK suggests that the condition holds in the long-run, but not in the short-run. This will mean that when the exchange rate depreciates, the balance of payments will initially deteriorate, but in the long-run it will improve. This gives what is known as a 'J-curve effect'. This effect is shown below.

The effect occurs because it will take time for the exchange rate changes to be factored in by decision makers - contracts will have been signed for example, which will not immediately reflect any change in the exchange rate.