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Unlock This CourseWhen a currency appreciates it rises in value against another currency. When it depreciates it falls in value. Both ideas come from the lesson on how exchange rates are determined. This lesson asks: so what? The answer is that a change in the exchange rate changes the prices people pay for traded goods, and so changes how much they buy.
Key terms:
Our made-up country is Tilvara. Its currency is the tilv. We start at a rate of 1 tilv = $0.50.
Pellin Ceramics, a firm in Tilvara, sells a tea set to a buyer in the USA. The price is 200 tilvs and Pellin keeps that price the same. The US buyer must pay in dollars, so the dollar price depends on the exchange rate:
Appreciation makes exports more expensive for foreign buyers. Depreciation makes exports cheaper for foreign buyers. The home price in tilvs has not changed at all.
Kellan Hardware, a shop in Tilvara, imports power drills from the USA. Each drill costs $240 in dollars. Divide the dollar price by the rate to find the price in tilvs:
Appreciation makes imports cheaper for home buyers. Depreciation makes imports more expensive for home buyers.
A quick check helps. After an appreciation each tilv buys more dollars, so each dollar costs fewer tilvs. The drill must get cheaper in tilvs.
A change in price changes the quantity demanded. How big the change is depends on price elasticity of demand (PED). Remember from earlier lessons: if demand is elastic, quantity changes by a bigger percentage than price. If demand is inelastic, it changes by a smaller percentage.
With elastic demand the response is large. With inelastic demand it is small. If the tea sets had a PED of −0.5 instead of −2, the same 20% price rise would cut sales by only 10%.
Pellin sells 1,000 tea sets a month at $100. Demand for them abroad is elastic, with a PED of −2. Kellan sells 120 drills a month at 480 tilvs. Demand for drills is inelastic, with a PED of −0.6.
Appreciation: the dollar price rises from $100 to $120, which is +20%. Quantity falls by 20% × 2 = 40%. Sales fall from 1,000 to 600 sets.
Depreciation: the dollar price falls from $100 to $80, which is −20%. Quantity rises by 40%. Sales rise from 1,000 to 1,400 sets.
Appreciation: the price falls from 480 to 400 tilvs, about −17%. Quantity rises by about 17% × 0.6 = 10%. Sales rise from 120 to 132 drills.
Depreciation: the price rises from 480 to 600 tilvs, which is +25%. Quantity falls by 25% × 0.6 = 15%. Sales fall from 120 to 102 drills.
| Exchange rate | Tea set price (US$) | Tea sets sold | Drill price (tilvs) | Drills sold |
|---|---|---|---|---|
| 1 tilv = $0.50 | $100 | 1,000 | 480 | 120 |
| 1 tilv = $0.60 (appreciation) | $120 | 600 | 400 | 132 |
| 1 tilv = $0.40 (depreciation) | $80 | 1,400 | 600 | 102 |
Notice the pattern. The exporter gains from a depreciation and loses from an appreciation. The importer's customers gain from an appreciation and lose from a depreciation. Demand for the drills moves only a little because it is inelastic. Demand for the tea sets moves a lot because it is elastic.
These changes spread through the economy. Here are the main ones.
After an appreciation, exporters like Pellin sell fewer goods and may cut output or jobs. After a depreciation they sell more and may hire more workers. Firms that use imported materials pay less after an appreciation, so their costs fall. After a depreciation their costs rise and they may raise their own prices.
After an appreciation, imported goods and holidays abroad get cheaper, so households can buy more. After a depreciation, imports and holidays abroad cost more. Buyers may switch to home-made goods, which can help home producers.
Jorvane's currency is the jorv. Jorvane Tea exports tea to the USA at 50 jorvs a box. The exchange rate rises from 1 jorv = $0.20 to 1 jorv = $0.25. Before the change, the firm sold 8,000 boxes a month. All figures are made up.
(a) Calculate the price of a box in dollars before and after the change. [2 marks]
(b) Explain why the number of boxes sold in the USA is likely to fall. [3 marks]
(c) Analyse how the change could affect a Jorvane shop that imports coffee machines priced in dollars. [4 marks]
(a) Before: 50 × $0.20 = $10 (1). After: 50 × $0.25 = $12.50 (1).
(b) The jorv has appreciated (1). So the tea costs more in dollars for US buyers (1). A higher price means a smaller quantity demanded, so fewer boxes are sold (1).
(c) The jorv is worth more dollars (1). So each machine costs fewer jorvs for the shop (1). The shop can cut its price or make more profit (1). A lower price means home customers buy more machines, especially if demand is elastic (1).
In (c), use real numbers if you can: show how the jorv price of a machine falls, then say what the shop does next.