The Impact of Exchange Rates on the Current Account (Edexcel IGCSE Economics)

Current Account and Exchange Rates

• The exchange rate is the relative price of one currency expressed in terms of another currency

Impact of an appreciation

• Appreciation often leads to a worsening of the current account balance

• A currency appreciation occurs when the value of a currency rises, making a nation's exports relatively more expensive and its imports less expensive

  • E.g The appreciation of the Japanese Yen in the early 2010's made exports (cars and electronics) more expensive for foreign buyers compared to similar products from South Korea and China. This increased its trade deficit

Exports fall

• Foreign buyers look for substitute products which are priced lower

  • Exports fall, and the balance on the current account worsens

Imports rise

• Similarly, currency appreciation makes imports cheaper

  • Domestic consumers may switch demand to foreign goods, and as imports rise, the balance on the current account worsens

Impact of a depreciation

• Depreciation often leads to an improvement in the current account balance

• A currency depreciation occurs when the value of a currency falls, making a nation's exports relatively more attractive and its imports less attractive

  • E.g the depreciation of the British pound following Brexit helped increase exports and reduce its trade deficit

Exports rise

• The number of foreign buyers increases as they are attracted by the relatively cheaper prices

  • Exports rise and the balance on the current account improves

Imports fall

• Similarly, currency depreciation makes imports more expensive

  • Domestic consumers may switch from purchasing foreign goods to purchasing domestic goods, and as imports fall, the balance on the current account improves

Impact of a Current Account Deficit

• The consequences of current account deficits include:

  • Increasing unemployment
    With falling demand for locally produced goods and services, fewer workers will be required and unemployment will rise

  • Slow down in economic growth or a recession
    Exports are a key component of the real GDP of many countries, and a fall in exports may significantly reduce the level of economic growth

  • Lower standards of living
    A fall in economic growth usually leads to a reduction in wages, which leads to a decrease in the standards of living

  • Increased levels of borrowing
    If the deficit is caused by increasing levels of imports, then it is likely that these imports are being paid for through higher levels of borrowing

  • Depreciating exchange rate
    While this may ultimately help to increase exports again, it makes the cost of imported goods and raw materials more expensive and may cause cost push inflation

The J-Curve Effect

• It is also important to recognise that there is a time lag between the depreciation of the currency and any subsequent improvement in the current account balance

• This time lag is explained by the J-Curve effect

  • It takes time for firms and consumers to respond to changes in price

  • Once it becomes evident that price changes will last for a longer period of time, firms and consumers change their patterns

  • E.g A firm in the USA has been importing electric scooters from the UK. If the Euro depreciates, the price of scooters in France becomes relatively cheaper. In the short-term, the USA firm will not switch immediately to purchasing scooters from France as the exchange rate may soon bounce back. They also have a good relationship with their UK suppliers. In the long term, they are likely to switch

Diagram analysis

• In the short run, the sum of PEDs for exports and imports was less than one, which is inelastic, so the deficit widens

• However, in the long run, combined PED of imports and exports is greater than one, and the trade balance begins to improve

• With any currency depreciation/devaluation, the trade balance will initially worsen before it improves