The exchange rate of one currency versus the other is influenced by numerous fundamental and technical factors, which includes relative supply and demand of the two currencies, economic performance etc. A currency depreciation has both price and volume effects on the trade balance (Export and Imports)
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.
In the short run, currency depreciation is driven by changes in the demand and supply for a currency in the foreign exchange market. The demand and supply of currency depends on a country’s imports and exports. International financial transactions, speculation on the foreign exchange market, and under “Dirty float”, government intervention in the foreign exchange market and through their policies and economic pronouncements.
When the Rand depreciates, it affects all international transactions of South Africa because they affect international relative prices. In international trade, currency depreciation makes a country’s exports more attractive for the residents of other countries.
Imports are likely to fall when the rand depreciates .The net effects in short run is for the depreciation to worsen the trade balance. This will improve as a result of long term adjustment in demand. When the volume effect is greater than the price elasticity of demand for imports and exports, where the price elasticity of demand refers to how sensitive the demand for imports and exports are changing in the price of imports and exports.
In the long run, currency depreciation is determined by the inflation rate and economic growth of the country. In general terms, a weaker currency will stimulate exports and make imports more expensive, thereby decreasing a nation’s trade deficit (or increasing surplus) over time. A devalued currency can result in “imported” inflation for countries that are substantial importers, where imported products will cost more than they should and reversing the situation will mean reversing the inflation first.
If the country’s residents find that imported goods are very expensive and then they will prefer to switch to buying goods produced domestically, this lowering the volume of imports. Such changes in trade pattern occurs in response to the long term run changes in the exchange rate, and they develop slowly over time because international trade contracts are written well in advance.
When a currency appreciates or strengthens in relation to other currencies, imports get cheaper. This means your Rand will buy more of another foreign currency so that you can purchase foreign goods.
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 a country’s 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.
Is an appreciation good or bad?
- An appreciation can help improve living standards – it enables consumers to buy cheaper imports.
- If the appreciation is a result of improved competitiveness, then the appreciation is sustainable, and it shouldn’t cause lower growth.
- An appreciation could be a problem, if the currency appreciates rapidly during a difficult economic circumstances.
Thanks to MM for the notes.