This, in turn, will increase demand for non-tradable goods and services produced in Australia. In order to meet the increased demand for their products, Australian firms will have to hire more workers, which will increase employment and lower the unemployment rate in Australia.
In principle, a depreciation of the exchange rate will increase inflation in two ways. First, the prices of imported goods and services will increase, contributing to inflation. Second, the expansion of aggregate demand and increase in employment will cause an increase in wages and other costs that are inputs to production and may be passed on to prices more generally, which will also contribute to higher inflation. Should these factors contribute to excessive inflation, the Reserve Bank may need to tighten monetary policy in order to achieve its inflation target.
In practice, there is typically a lag between an exchange rate movement and its effect on economic activity and inflation. In the discussion above we have assumed exchange rate changes are immediately reflected in the prices of imported goods and services. But firms selling imported items often price them in Australian dollars, so it is up to the firm selling the item to decide when to pass on the higher cost from the depreciation to those buying the product. Exchange rates are volatile, and firms may be reluctant to change their prices until they are sure that an exchange rate movement will not reverse.
Even after prices adjust, it may take time for households and firms to adjust their spending patterns. The extent and timing of the responses will also depend on how easy it is for households and firms to substitute between goods and services produced in Australia and goods and services produced overseas.
Most estimates suggest that it takes between one and three years for exchange rate movements to have their maximum effect on economic activity and inflation. When considering the implications of exchange rate movements for economic activity what matters is the change in the volume, or quantity, of exports and imports.
In determining the consequences of exchange rate movements for the balance of payments, however, it is the value — that is the prices as well as the quantity — of exports and imports that matters.
Once again, we use the example of a depreciation of an Australian dollar to describe these effects. The direct effect of an exchange rate depreciation is to increase the price of imports relative to exports, which will tend to decrease the value of net exports exports less imports and widen the current account deficit. However, the indirect effects of an exchange rate depreciation increase the volume of exports and reduce the volume of imports.
This will tend to increase net exports and diminish the current account deficit. These two effects differ in their timing. The direct effect of an exchange rate depreciation occurs immediately, while the indirect effects on export and import volumes typically occur with a lag. Because of this, in the short run, an exchange rate depreciation is likely to reduce the value of net exports. As a result, the firm may choose to reduce its exports, or it may raise its selling price, which will also tend to reduce its exports.
Conversely, for a foreign firm selling in the U. Each dollar earned through export sales, when traded back into the home currency of the exporting firm, will now buy more of the home currency than expected before the dollar had strengthened. As a result, the stronger dollar means that the importing firm will earn higher profits than expected. The firm will seek to expand its sales in the U. In this way, a stronger U. The tourist receives more foreign currency for each U.
Imagine a U. Clearly, was the year for U. For foreign visitors to the United States, the opposite pattern holds true. A relatively stronger U. A stronger dollar injures the prospects of a U.
If in the meantime the U. However, a stronger U. That foreign investor converts from the home currency to U. If, in the meantime, the dollar grows stronger, then when the time comes to convert from U. The preceding paragraphs all focus on the case where the U. The corresponding happy or unhappy economic reactions are illustrated in the first column of Figure 2. The following feature centers the analysis on the opposite: a weaker dollar. Scenario 1: What will happen to the price of a Ford pickup truck in the U.
First, we note that the demand for U. The dollar affects the price faced by foreigners who may purchase U. Next, consider that, if the dollar weakens, the pound rises in value. A weaker dollar means the foreign currency buys more dollars, which means that U. From this, we conclude that a weaker U. For a foreign exporter, the outcome is just the opposite. By contrast, a currency represents the economy of a country, and a currency rate is quoted by pairing two countries together and calculating an exchange rate of one currency relative to the other.
Consequently, the underlying economic factors of the representative countries have an effect on that rate.
An economy experiencing growth results in a currency appreciating, and the exchange rate adjusts accordingly. The country with the weakening economy may experience currency depreciation, which also has an effect on the exchange rate. When a nation's currency appreciates, it can have a number of different effects on the economy. Here are just a couple:.
Currency rates are thus subject to the ebb and flow, or appreciation and depreciation, that correspond with the economic and business cycles of the underlying economies and are driven by market forces. China's ascension onto the world stage as a major economic power has corresponded with price swings in the exchange rate for the yuan, its currency.
Beginning in , the currency rose steadily against the dollar until , when it plateaued at a value of 1 dollar equaling 8. The dollar remained relatively strong during this period. It meant cheaper manufacturing costs and labor for American companies, who migrated to the country in droves. It also meant that American goods were competitive on the world stage as well as the United States due to their cheap labor and manufacturing costs. Portfolio Management. Your Privacy Rights.
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