IB Economics - Effects of Exchange Rate Changes

This study note for IB economics covers The Effects of Exchange Rate Changes

Exchange rates play a crucial role in the global economy, influencing a country's trade dynamics, inflation, employment, and overall economic growth. Understanding the effects of changes in exchange rates is essential for evaluating the economic health and policy decisions of a country.

Exchange rates determine how much one currency is worth in terms of another. When the value of a currency changes, it is referred to as either an appreciation (increase in value relative to another currency) or a depreciation (decrease in value relative to another currency). These changes can have significant implications for an economy.

Economic Consequences of Exchange Rate Changes

1. Impact on Inflation Rate

• Imported Inflation:
  • Depreciation increases the cost of imported goods and services, leading to higher domestic prices, especially for countries heavily reliant on imports. For example, the UK experienced imported inflation when the British Pound depreciated sharply after the Brexit vote in 2016.
  • Appreciation makes imports cheaper, potentially lowering the inflation rate, as seen in Japan when the yen appreciated in the early 2010s, reducing the cost of imported oil and other raw materials.
• Cost-Push Inflation:
  • A weaker currency raises production costs for businesses reliant on imported inputs, leading to cost-push inflation.
• Exchange Rate Pass-Through:
  • The degree to which exchange rate changes affect domestic prices depends on the pass-through effect, which varies by country and industry.

2. Effects on Employment

• Export Competitiveness:
  • Depreciation improves export competitiveness by making goods and services cheaper for foreign buyers, potentially boosting production and employment in export-oriented industries. For example, after the 2008 financial crisis, the US dollar depreciation helped American exporters.
  • Appreciation can harm export sectors by making products more expensive abroad, potentially leading to job losses.
• Import-Competing Industries:
  • A stronger currency can harm domestic industries that compete with imports, leading to potential job losses, as seen in the EU automotive sector when the Euro was strong in the early 2000s.
• Tourism and Services:
  • A depreciated currency can boost tourism by making the destination cheaper for foreign tourists, thereby creating jobs in hospitality and related services.

3. Impact on Economic Growth

• Net Exports Contribution to GDP:
  • A weaker currency tends to increase net exports (exports minus imports), contributing positively to GDP growth. For instance, China's economic growth has often been supported by a deliberately undervalued yuan to boost exports.
• Investment Flows:
  • Exchange rate stability can attract foreign direct investment (FDI). However, a volatile or depreciating currency might deter investment due to the uncertainty of returns when converted back to the investor’s home currency.
• Consumer Spending:
  • An appreciating currency can enhance consumer spending power by reducing the cost of imported goods, contributing positively to GDP.

4. Effects on the Current Account Balance

• Improvement with Depreciation:
  • A depreciated currency can improve the current account balance by making exports more competitive and reducing import demand due to higher prices of foreign goods.
• Deterioration with Appreciation:
  • An appreciated currency can worsen the current account balance by making exports less competitive and encouraging imports.
• Elasticity of Demand:
  • The impact on the current account balance also depends on the price elasticity of demand for exports and imports. If demand is elastic, currency depreciation will more significantly improve the trade balance.

Real-World Examples and Recent Data

• Brexit and the British Pound:Post-Brexit referendum, the British Pound depreciated sharply against major currencies. This led to a rise in import prices, driving inflation above the Bank of England's target and squeezing household incomes.
• US Dollar and Trade Wars (2018-2020):During the US-China trade war, the Chinese Yuan was allowed to depreciate, partially offsetting the impact of US tariffs on Chinese exports and contributing to ongoing trade imbalances.
• Japanese Yen and Deflation:Japan's currency appreciation in the 2010s put downward pressure on inflation, contributing to deflationary pressures and prompting the Bank of Japan to implement aggressive monetary easing to weaken the yen.
• Turkish Lira Crisis (2021):A significant depreciation of the Turkish Lira led to runaway inflation, surging import costs, and a loss of consumer purchasing power, severely affecting the Turkish economy's stability.

Glossary of Key Terms

• Appreciation: An increase in the value of a currency relative to another currency.
• Cost-Push Inflation: Inflation caused by an increase in the cost of production inputs, such as labor or raw materials.
• Current Account Balance: A measure of a country's international trade in goods and services, net income from abroad, and net current transfers.
• Depreciation: A decrease in the value of a currency relative to another currency.
• Exchange Rate Pass-Through: The degree to which changes in the exchange rate affect domestic prices.
• Foreign Direct Investment (FDI): Investment made by a firm or individual in one country into business interests located in another country.
• Net Exports: The value of a country's total exports minus its total imports.
• Price Elasticity of Demand: A measure of how much the quantity demanded of a good responds to a change in the price of that good.
• Trade Balance: The difference between a country's exports and imports of goods and services.

Possible IB Economics Essay-Style Questions

1. "Evaluate the impact of a depreciating currency on a country’s balance of payments."
2. "Discuss the effects of exchange rate changes on inflation and economic growth in developing economies."
3. "To what extent does a country’s exchange rate policy impact its employment levels?"
4. "Examine the role of currency appreciation in influencing a country's trade competitiveness."
5. "Analyze the factors that determine the extent of exchange rate pass-through to domestic prices."

Retrieval Questions for A-Level Students

1. What is the difference between currency appreciation and depreciation?
2. How does a depreciated currency affect a country's inflation rate?
3. Explain how exchange rate changes can impact employment in export-oriented industries.
4. What are the possible effects of a stronger currency on a country's current account balance?
5. Why might exchange rate stability be important for attracting foreign direct investment?

This structured guide provides a thorough exploration of the effects of exchange rate changes, offering valuable insights for students preparing for IB and undergraduate economics examinations. Understanding these dynamics is crucial for analyzing real-world economic situations and their broader implications.