Exchange Rate Depreciation (Edexcel IGCSE Economics)

Revision Note

Author

Steve Vorster

Expertise

Economics & Business Subject Lead

Depreciation (Devaluation)

Depreciation occurs in a floating exchange rate system
- If there is excess supply for the currency on FOREX, the price falls (the currency is worth less/is cheaper to buy)
- Depreciation may also be referred to as devaluation

If there is excess supply for the currency on FOREX, then price of that currency will fall (the currency depreciates)
- An increase in supply of the currency can cause a depreciation
- A decrease in demand for the currency can cause a depreciation

Supplying the Euro to buy US$ causes the Euro to depreciate — **The market for Euros in Dollars shows an increase in supply of Euros**

Diagram analysis

The initial exchange rate equilibrium for Euro/US$ is found at P₁Q₁
When Europeans visit the USA, they demand US$ and supply Euros
- The increased supply of the Euro shifts the supply curve to the right
- This results in the value of the Euro depreciating from P₁ → P₂
- Anew market equilibrium forms at P₂Q₂

Impact of Depreciation on the Current Account

The relationship between the current account on the balance of payments and the exchange rate is dynamic
- A depreciation means that imports become more expensive and exports become cheaper

Impact of Depreciation on Exports, Imports (Current Account)

Impact	Explanation
Exports	When a country's currency depreciates, its exports become relatively cheaper for foreign buyers, potentially leading to an increase in export volumes
Imports	A weaker exchange rate makes imports more expensive and exports cheaper Imports become relatively more expensive for domestic consumers, which may result in a decrease in import volumes
Current account	Domestic consumers may switch demand from foreign goods to domestic goods and as imports falls, the balance on the current account improves The increase in export volumes also leads to an improvement on the current account

Worked Example

On Forex, foreign currency dealers believe that the Thai Bhat is likely to depreciate by 4% against the Japanese Yen over the coming year.

Which diagram depicts this expectation of events on Forex?

A. The market for Japanese Yen, showing a shift left of supply of Yen

B. The market for Japanese Yen, showing a shift right of supply of Yen

C. The market for Thai Baht, showing a shift right of supply of Thai Baht

D. The market for Thai Baht, showing a shift left of supply of Thai Baht

C is the correct answer

As dealers sell Thai Baht in order to purchase Japanese Yen, the supply of Thai Baht will shift right

A is incorrect, as there is no shift in supply for Japanese Yen, but there is a shift in demand for the Yen

B is incorrect, as there is no shift in supply for Japanese Ye, but demand for Yen shifts right

D is incorrect, as a shift left in supply would be caused by fewer dealers supplying Thai Baht, but the opposite is true

Exam Tip

Working with exchange rates can be confusing. Always work from the point of view of one individual currency and its effects, when thinking about appreciating or depreciating exchange rates. Consider what happens to the price of exports and the price of imports from one country's point of view as a starting point, which will aid understanding about the effects on current accounts and employment in export-related industries.

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