Currency appreciation is when the value of a currency increases in relation to other currencies. This appreciation can be caused by a variety of factors, such as economic growth or central bank policy. When a currency appreciates, it takes more of another currency to buy the same amount. For example, if the US dollar appreciates against the euro, it would take more euros to buy the same amount of US dollars. This can have several benefits for a country, such as reducing inflation.
This is in direct opposition to the concept of currency depreciation, which is when the value of a currency decreases in relation to other currencies. This can occur due to several causes including inflation, certain monetary policies, and economic recessions. When a currency depreciates, it takes less of another currency to buy the same amount. For example, if the US dollar depreciated against the Japanese yen, it would take less yen to buy the same amount of US dollars. Depreciation can result in a variety of effects including higher inflation and the falling of real wages.
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One of the main effects of variations in exchange rates is the impact it can have on international trade. When exchange rates change, the prices of goods and services in different countries also change. This can impact the demand for these goods and services, as well as the prices that consumers are willing to pay. For example, if the US dollar appreciates against the euro, this means that US goods and services would become more expensive for European consumers. As a result, demand for these goods and services would decrease, and US exports would fall. The following sections will explore the effects of strong and weak exchange rates on international trade.
Strong Exchange Rate Effects
A strong exchange rate is when the value of a currency is high relative to other currencies. This makes a country's exports more expensive and its imports less expensive. As a result, demand for the country's exports will typically decrease and demand for its imports will typically increase. This can lead to a decrease in the country's trade surplus (or an increase in its trade deficit).
While a strong exchange rate can have some negative effects on a country's trade (in terms of exports), it also has some advantages. For example, it can help to reduce inflation by making imported goods cheaper. It can also encourage foreign investment as the country's assets will appear more valuable to investors. A final advantage worth noting is that it can allow citizens traveling outside of the country to get more value for their money as their currency will go further when exchanged for foreign currencies.
Weak Exchange Rate Effects
As opposed to a strong exchange rate, a weak exchange rate is when the value of a currency is low relative to other currencies. This makes a country's exports less expensive and its imports more expensive. As a result, demand for the country's exports will typically increase while demand for its imports will decrease. This can also lead to an increase in the country's trade surplus (or a decrease in its trade deficit).
Like a strong exchange rate, a weak exchange rate also has some advantages and disadvantages. On the one hand, it can help make exports more competitive in the global market and increase demand for them. This can be beneficial for domestic businesses as it can help to increase their sales and profits. On the other hand, it can lead to imported inflation as the prices of imported goods will increase. It can also make foreign travel more expensive as citizens will get less value for their money when exchanging it for foreign currency.
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It can be useful to explore a few exchange rate examples in order to illustrate how different changes in the rate can have different types of impacts.
Example 1: Depreciation Against the US Dollar
If the Japanese yen depreciates against the US dollar, it would take more yen to buy the same amount of US dollars. For example, if the exchange rate was ¥100 = $1 and then it changed to ¥150 = $1, this would mean that the yen had depreciated by 50%. As a result, it would now take ¥150 to buy $1, which is 50% more than it did previously.
This depreciation could have a large number of possible effects. One probable effect is that Japanese exports to the global market would become cheaper and more competitive. This could lead to an increase in demand for these exports and a corresponding increase in sales for Japanese businesses. Conversely, imports of raw materials, energy, and other products would become more expensive for Japanese businesses, which may cause economic hardship for some. In addition, US imports into Japan would become more expensive, which would likely lead to a decrease in demand for these products. Japanese consumers may either switch to cheaper alternatives or simply reduce their overall level of consumption.
Example 2: Differences between Exchange Rates
A traveler is considering taking a two-month long trip over the summer and is trying to decide where to go. After doing some research, she narrows it down to two options: Japan or Spain. She has $10,000 saved up for the trip and wants to know how far her money will go in each country.
To find out, she looks at the current exchange rates for each country. She sees that the exchange rate is higher (more in favor of the dollar) in Japan than it is in Spain. In other words, her $10,000 would go significantly further in Japan than it would in Spain. She decides to go to Japan for her trip.
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A currency is the kind of money that is used in a specific country or group of countries. The term exchange rate refers to the relative rate at which one country's currency can be exchanged for another country's currency. Many exchange rates experience a continuous state of flux in which the value of one currency rises or falls relative to another. Appreciation is when a country's currency becomes more expensive relative to another currency, while depreciation is when it becomes less expensive. There are many factors that can shift exchange rates including both global and inner-country economic conditions, political stability, inflation, supply and demand, and central bank policies.
International trade is one of the main areas in which the impacts of exchange rate fluctuations are seen. When a country's currency appreciates resulting in a strong domestic currency, it can make exports more expensive abroad and imports cheaper at home. Conversely, when a currency depreciates, exports become cheaper for foreign buyers and imports more expensive for those inside the country. Changes in currency relative values can also affect things such as inflation, international travel, and central bank policy decisions.
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Video Transcript
Currency Terms
Although the effects can take time, changes in the exchange rate can have a big impact on the economy and your own standard of living and purchasing power! There is often debate over whether a country should have a high or low exchange rate. These discussions often revolve around the current economic and political goals at the time. Let's explore the effects of changes in the exchange rate and see how economic variables, such as inflation, the trade balance, GDP and exports & imports, are affected.
To review quickly, an exchange rate is the rate at which one country's currency can be traded for another country's currency. For example, in the United States, the dollar's strength is often judged in relation to other currencies, such as the Japanese yen, the Swiss franc, and the euro. When a currency appreciates, it means it increased in value relative to another currency; depreciates means it weakened or fell in value relative to another currency.
When a dollar buys more than its equivalent in another currency, it's often labeled strong. When it buys less than its equivalent, it's weak. For example the exchange rate as of August 2014 for the American dollar vs. the Mexican peso is 13 to 1; a strong exchange rate! As of that same date, the American dollar vs. the euro is 0.75 to 1; a weaker exchange rate.
Strong Exchange Rate Effects
Do you like your money to go further when you make a purchase? How about the ability to have more choices when you go shopping? When a currency appreciates or strengthens (a higher exchange rate), there are many effects on you and the economy. Some good, some not so good. Let's discuss a few of those now.
- Imports cheaper: When a currency appreciates or strengthens in relation to other currencies, imports get cheaper. This means your dollar will buy more of another foreign currency so that you can purchase foreign goods. For example, if you were traveling and shopping in Europe and the exchange rate of the dollar vs. euro went from (0.75 to 1) to (0.95 to 1) your dollars would now buy more euros. So, if a can of soda cost two euros, it would have originally cost you $2.66 ($2/0.75 exchange rate). Now it costs you essentially $2.11 ($2/0.95 exchange rate). This is also great news for American companies who import a lot of components and raw materials to manufacture goods. Lower costs often lead to higher profit margins.
- Lower inflation: When the exchange rate for a currency strengthens, it makes imports cheaper. This means you and I spend less money on foreign goods. This in turn puts pressure on American firms to keep their prices low, so they can remain competitive. All of this leads to lower prices and ultimately more money in your pocket and a higher standard of living.
- Balance of trade deficit: One of the biggest disadvantages of higher exchange rates or a strong dollar may be that it leads to trade deficits. Because strong currencies lead to cheaper imports, a country tends to import more than they export. This causes a trade deficit, which can exert a contractionary effect on the economy. What does that mean? It simply means that because our currency is strong, our own goods we look to export appear expensive to other countries; so they buy fewer American goods. This lowers demand for American goods and as a result lowers GDP. Over time, this can make it more difficult for American firms to compete and can also damage profit potential.
Weak Exchange Rate Effects
A lower or weak exchange rate can have the opposite effect as a strong exchange rate or currency. Let's discuss those now.
- Imports more expensive: If the dollar or your own currency declines, this erodes the value of your personal finances. You now have to spend more dollars to buy foreign currencies so that you can purchase foreign goods. Traveling outside your home country just got more expensive!
- Increased inflation: Higher import prices by foreign firms also give domestic firms the ability to raise or charge higher prices at home. As a result, inflation can increase which continues to erode the value of your cash holdings.
- Balance of trade surplus: On the other hand, a weak dollar or currency can help exports. Foreign countries now can purchase more dollars with their own currency; so they demand more American goods. As a result, American firms manufacture and sell more products, leading to more profits. This can strengthen the economy and increase job growth over time. All of this can lead to a balance of trade surplus or at least narrow the trade deficit.
Lesson Summary
In summary, the effects of changes in the exchange rate can be both good and bad. Whether they are positive or negative often may depend on your own individual situation and view of the economy.
A strong dollar or increase in the exchange rate (appreciation) is often better for individuals because it makes imports cheaper and lowers inflation. This gives individuals more purchasing power in the world marketplace. This often leads to a better standard of living. Over time though, the strong currency can lead to fewer exports by American firms and a balance of trade deficit. This can weaken an economy and eventually lead to job loss.
A weak currency or lower exchange rate (depreciation) can be better for an economy and for firms that export goods to other countries. This can help during times of slow growth or when an economy is coming out of a recession. The weak dollar means foreign countries and individuals can now purchase more American currency with less of their currency. This encourages exports by American firms and can lead to more profits and higher job growth over time. The disadvantage of a lower exchange rate is that it causes imports to be more expensive and can result in higher inflation.
Learning Outcomes
You will have the ability to do the following after watching this video lesson:
- Define exchange rate
- Explain the advantages and disadvantages of both strong and weak exchange rates
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