Impact of Exchange Rate Appreciations and Depreciations with Eval

Question 1

What happens when a currency appreciates?

Answer 1

Appreciation = SPICED:

Stronger Pound Imports Cheaper, Exports Dearer

Imports ↓ cost → improved living standards

Exports less competitive → current account deficit risk

Domestic demand ↓ → lower inflation, but higher unemployment in exporting sectors

Question 2

What happens when a currency depreciates?

Answer 2

Depreciation = WIDEC:

Weaker Pound Imports Dearer, Exports Cheaper

Boosts export demand → improves current account

Cost-push inflation from more expensive imports

AD ↑ → higher growth, possibly more inflationary pressure

Question 3

How can we evaluate the effects of appreciation and depreciation?

Answer 3

Elasticity of exports/imports (Marshall-Lerner Condition):

If demand is inelastic, depreciation may not improve trade balance.

Time lags:

Takes time for consumers and firms to react to price changes from exchange rate movements.

State of the economy:

If economy is at full capacity, depreciation may cause inflation, not growth.

If there’s a recession, depreciation can help boost demand and employment.

Relative inflation:

If inflation rises faster than in trading partners, the gain from depreciation is eroded.

Global competitiveness:

Non-price factors (quality, branding) also matter in exports.

Question 4

What is a floating exchange rate?

Answer 4

It’s an exchange rate determined by market forces (supply and demand) without government or central bank intervention.

Question 5

How can a floating exchange rate correct a current account deficit?

Answer 5

If a country imports more than it exports, demand for foreign currency rises → depreciation

WIDEC: Weaker currency makes imports dearer, exports cheaper

Exports ↑, imports ↓ → improves trade balance

This is the automatic adjustment mechanism

Question 6

What does WIDEC stand for, and what are the effects?

Answer 6

Weaker Imports Dearer, Exports Cheaper

Helps reduce CA deficit

Increases AD from export growth → higher real GDP

But also increases imported inflation → higher CPI

Question 7

What are the side effects of depreciation (WIDEC)?

Answer 7

📈 Higher inflation (cost-push via expensive imports)

✅ Lower unemployment (boost to export industries)

❗ Possible wage-price spiral if inflation feeds into expectations

🕒 Time lag before trade balance improves