How Do Exchange Rates Affect Prices and Output?
Depreciation means each domestic unit buys less foreign currency. Suppose a machine costs USD 1,000. At USD 0.50 per domestic unit, its domestic price is 1,000 ÷ 0.50 = 2,000. After a fall to USD 0.40 per domestic unit it costs 2,500, assuming the dollar price is unchanged.
Builds on: Why Does a Currency Rise or Fall in Value?
What you will learn
- Depreciation makes unchanged foreign prices dearer domestically and domestic products cheaper abroad.
- Explain conditional effects on growth, employment and purchasing power
Essential definitions
- Appreciation
- An increase in a currency’s value under a floating system.
- Depreciation
- A decrease in a currency’s value under a floating system.
- Exchange-rate pass-through
- The extent to which a currency change affects import or domestic prices.
- Aggregate demand (AD)
- Total planned spending on domestic output: consumption, investment, government spending and net exports.
- Short-run aggregate supply (SRAS)
- The output firms are willing to supply at each price level with some input costs fixed.
- Net exports
- Export revenue minus import expenditure.
- Current account
- The account recording goods, services, primary income and current transfers; section 4.6 develops it fully.
Convert the price before analysing the economy
Depreciation means each domestic unit buys less foreign currency. Suppose a machine costs USD 1,000. At USD 0.50 per domestic unit, its domestic price is 1,000 ÷ 0.50 = 2,000. After a fall to USD 0.40 per domestic unit it costs 2,500, assuming the dollar price is unchanged.
The currency's dollar value fell 20%, but this import price rose 25% because the calculation uses its reciprocal. Domestic exporters keeping local prices unchanged become cheaper to foreign buyers. Whether sales volumes change depends on demand, contracts, substitute goods and available supply.
Read demand and cost effects separately
Both AD–AS diagrams use real output horizontally and the price level vertically. AD slopes down; SRAS slopes up. E1 is their original intersection. The first diagram shifts AD right when stronger exports and reduced import purchases raise spending on domestic output. E2 shows higher output and prices on unchanged SRAS, with a larger output response when capacity is spare.
The second shifts SRAS left because imported fuel and components cost more per unit. E2 then has higher prices and lower output on unchanged AD. Each isolates one channel from the same starting position. Together they put upward pressure on prices but have opposing output effects. Appreciation can reverse these channels, lowering input costs while weakening export competitiveness.
Consider living standards and timing
Import buyers can lose purchasing power; exporters may gain sales and jobs. Borrowers owing foreign currency need more domestic income to service the same debt after depreciation. Firms heavily reliant on imported inputs may benefit less than exporters using domestic resources.
Do not promise an immediate external improvement. The current account includes income and transfers as well as trade, and contracted quantities may respond slowly. Judge import dependence, spare capacity, pricing and adjustment time before concluding who gains. Later HL lessons explain the trade-balance elasticity and timing conditions.
Convert a foreign price
- A machine costs USD 1,000. Initially one domestic unit buys USD 0.50, so its domestic price is 1,000 ÷ 0.50 = 2,000.
- After depreciation, one domestic unit buys USD 0.40: price is 1,000 ÷ 0.40 = 2,500.
- The domestic price rises 25%, assuming the dollar price is unchanged.
The reciprocal quote matters: a 20% fall in the currency’s dollar value raises this import price by 25%.
Depreciation: the net-export demand channel
If trade quantities respond, net exports rise and AD shifts right. With upward SRAS, output and prices rise; appreciation can reverse this channel.
How to read this diagram
- Label price level vertically and real GDP horizontally.
- Draw AD1 and SRAS; shift AD right to AD2.
- Mark E1 and E2 and explain how export and import quantities change.
From E1 to E2, AD rises while SRAS stays fixed: real output increases from 60 to 70 and the price level from 80 to 90. These are illustrative indices, not currency amounts.
On a small screen, scroll the graph horizontally to read all labels.
Assumptions and limits: Isolates the demand effect. Costs and capacity are held fixed; imported costs can produce an additional supply effect.
Depreciation: the imported-cost channel
Dearer imported inputs raise costs, moving SRAS left. Prices rise and output falls with AD fixed. Consider this alongside the net-export channel.
How to read this diagram
- Put real output horizontally and the price level vertically. Draw AD and SRAS1 meeting at E1.
- Shift SRAS upward/left to SRAS2.
- Mark E2 at AD–SRAS2. Project both equilibria: a higher price level and lower real output.
From E1 to E2, SRAS shifts upward/left while AD stays fixed: real output falls from 60 to 50 and the price level rises from 80 to 90. These are illustrative indices, not currency amounts.
On a small screen, scroll the graph horizontally to read all labels.
Assumptions and limits: Isolates the cost effect; unchanged demand and productive capacity. The combined output effect need not have a single sign.
Apply and evaluate
- Spare capacity and price responsiveness determine the scale of the demand effect.
- Imported-input exposure can offset gains in export competitiveness.
Common misconceptions
- A currency change need not shift only AD.
- A percentage change in a quote and its reciprocal are not equal in magnitude.
Knowledge check
Why is the output effect of depreciation ambiguous?
What to remember
Depreciation makes unchanged foreign prices dearer domestically and domestic products cheaper abroad. Spending may rise while imported costs also rise, leaving the overall output effect uncertain.
Completion records your reflection, not a test score.
Lessons in this section
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