Exchange Rate Appreciation (Edexcel IGCSE Economics)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
Appreciation (Revaluation)
Appreciation occurs in a floating exchange rate system
If there is excess demand for the currency on the FOREX, the price rises (the currency is worth more/is more expensive to buy)
An appreciating exchange rates is also known as strengthening exchange rate, or revaluation
Different currencies can be bought and sold, just like any other product
The forces of demand and supply determine the rate at which one currency exchanges for another
If there is excess demand for the currency on the FOREX market, then price rises (the currency appreciates)
If the supply of the currency decreases, this can also result in an appreciation
Diagram analysis
The initial exchange rate equilibrium for Euro/US$ is found at P1Q1
When Europeans visit the USA, they demand US$
The increased demand for the US$ shifts the demand curve to the right
This results in the value of the $ appreciating from P1 → P2
A new market equilibrium forms at P2Q2
Impact of Appreciation on the Current Account
The relationship between the current account on the balance of payments and the exchange rate is dynamic
Changes in the exchange rate will change the price of imports and exports
Impact of Appreciation on Exports, Imports (Current Account)
Impact | Explanation |
|---|---|
Exports |
|
Imports |
|
Current account |
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Worked Example
The USA imports most of its olive oil from Spain, Italy and Portugal in Europe, and is the largest olive oil importer in the world.
Which one of the following best describes the effect of an appreciation of the US dollar against the European Euro?
A. There will be an increase in US imports of European olive oil and the US current account will improve
B. There will be a decrease in employment in European olive fruit pickers and the US current account will worsen
C. There will be an increase in employment in European olive fruit pickers and US imports of European olive oil will decline
D. There will be an increase in US imports of European olive oil and the US current account will worsen
D is the correct answer
The appreciation of the dollar will reduce the relative price of European olive oil, increasing imports and therefore worsening the US current account balance
A is incorrect, as the increased imports of olive oil will increase the flow of US Dollars out of the US, thereby worsening the current account
B is incorrect, as there is likely to be an increase in the employment in European olive fruit pickers
C is incorrect, as the price of European olive oil will become cheaper, therefore imports will increase, not decline
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