6.4 Exchange rates

The exchange rate tells how much of one currency is needed to buy a unit of another. Always state the quotation convention before interpreting appreciation or depreciation.

If £1 buys more dollars than before, sterling has appreciated against the dollar under that quotation. The market price reflects demand and supply for currencies, arising from trade, investment, interest expectations and confidence.

If £1 rises from $1.25 to$1.30, sterling has appreciated against the dollar; UK imports priced in dollars become cheaper in pounds, other things equal.

“A stronger exchange rate” is meaningless without naming the currency and quote direction, and a market rate is not the same as purchasing-power parity.

Under a floating exchange-rate system, the currency price is mainly determined by market demand and supply rather than a fixed official parity.

Higher demand for exports, domestic assets or the currency’s interest-bearing deposits tends to appreciate it; greater demand for imports or foreign assets tends to depreciate it. Expectations can move the rate before the underlying trade changes.

If overseas investors expect higher returns in a country, demand for its currency may rise and the currency appreciates, potentially making exports less competitive later.

Floating does not mean “random” or “without central-bank influence”; intervention and interest decisions can still affect demand and supply.

A currency appreciates when its market value rises against another currency; it depreciates when its market value falls. The meaning depends on the quotation used.

Appreciation can make imports cheaper in domestic currency and exports more expensive to foreign buyers. Depreciation tends to do the reverse, but the final trade effect depends on elasticities, contracts and the time taken to change quantities.

If £1 moves from $1.20 to$1.30, sterling appreciates against the dollar. If it falls to $1.10, sterling depreciates; a US-dollar input then costs more pounds, other things equal.

Do not call a currency “stronger” without naming the comparison, and do not infer a guaranteed trade-balance improvement from depreciation alone.

A depreciation raises the domestic-currency price of imports and lowers the foreign-currency price of exports, subject to the quotation convention. An appreciation generally reverses these effects.

The short-run trade balance may worsen if contracts and quantities are slow to respond—the J-curve pattern. Later, export and import elasticities determine whether the value of trade improves. Imported input costs can also create cost-push inflation.

After a depreciation, an airline buying fuel in dollars faces higher domestic costs even if its passenger prices are unchanged. Exporters may gain competitiveness, but the net trade effect depends on demand responses.

Currency depreciation is not a free competitiveness gain: imported inflation and foreign-currency debt can offset benefits.

A depreciation may increase net exports and shift aggregate demand right; an appreciation may reduce net exports and shift AD left. The effect is conditional, not automatic.

Pass-through to prices, import content of exports, elasticities, spare capacity and retaliation affect the result. A depreciation can raise SRAS costs through imported inputs, so output and prices may move in opposing directions.

If export demand is elastic and imported inputs are a small share of production, depreciation can raise net exports and output. If imports are essential and inelastic, the cost shock may dominate initially.

An exchange-rate movement is not itself an AD curve shift unless you identify the spending or net-export channel it changes.