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Exchange Rates » Appreciation and Depreciation

What you'll learn this session

Study time: 30 minutes

Edexcel spec: 2.2.3 (c), (d)

What appreciation, revaluation, depreciation and devaluation mean
How a change in the exchange rate changes export and import prices
How demand for exports and imports, and the current account, then change

This topic is examined on Paper 2: Macroeconomics and the Global Economy.

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When an exchange rate goes up or down

An exchange rate is not fixed in stone. It can rise or fall. Which word you use depends on how the change happens, so there are two pairs of words to learn.

Key terms:

Appreciation: a rise in the value of a currency against another currency, when the exchange rate is set by the market.
Depreciation: a fall in the value of a currency against another currency, when the exchange rate is set by the market.
Revaluation: a rise in the value of a currency that the government or central bank decides on, in a fixed exchange rate system.
Devaluation: a fall in the value of a currency that the government or central bank decides on, in a fixed exchange rate system.
Floating exchange rate: a rate set by the demand for and supply of the currency.
Fixed exchange rate: a rate that the government or central bank sets and then works to keep.

Here is a simple way to remember it. Appreciation and depreciation happen in the market (floating). Revaluation and devaluation are chosen by the government (fixed). The effects on trade are the same either way.

A currency that appreciates is sometimes called a stronger currency. One that depreciates is a weaker currency. Remember that a rise in one currency is a fall in the other. If the pound rises against the dollar, the dollar falls against the pound.

Appreciation: what happens?

When your currency appreciates, holidays abroad get cheaper because each pound buys more foreign currency

Let us use the pound and the dollar. The pound appreciates from £1 = $1.25 to £1 = $1.50. Each pound now buys more dollars. That sounds good, but look at what it does to prices.

Worked example: appreciation

Exports. A UK firm sells a machine for £30,000. Its price for an American buyer is:

Before: £30,000 × 1.25 = $37,500

After: £30,000 × 1.50 = $45,000

The UK price in pounds has not changed, but the price in dollars has gone up by $7,500.

Imports. A UK shop buys a US jacket that costs $60. Its price in pounds is:

Before: $60 ÷ 1.25 = £48

After: $60 ÷ 1.50 = £40

The jacket is now £8 cheaper for UK buyers.

📦 Exports

Export prices rise for foreign buyers. UK goods look more expensive abroad, so the demand for exports falls.

🛍 Imports

Import prices fall for UK buyers. Foreign goods look cheaper, so the demand for imports rises.

So the UK is likely to sell fewer exports and buy more imports. Export earnings are likely to fall and spending on imports is likely to rise. The current account moves towards deficit: a surplus gets smaller or a deficit gets bigger. (You met the current account in the lesson called The Current Account.)

Depreciation: what happens?

A depreciation makes exports cheaper abroad, helping firms like this whisky distillery sell more overseas

Now the pound depreciates from £1 = $1.50 back to £1 = $1.25. The effects go the other way.

Worked example: depreciation

Exports. The £30,000 machine now costs an American buyer:

£30,000 × 1.25 = $37,500, down from $45,000.

Imports. The $60 jacket now costs a UK buyer:

$60 ÷ 1.25 = £48, up from £40.

📦 Exports

Export prices fall for foreign buyers, so the demand for exports rises.

🛍 Imports

Import prices rise for UK buyers, so the demand for imports falls.

The UK is likely to sell more exports and buy fewer imports. The current account is likely to move towards surplus: a deficit gets smaller or a surplus gets bigger.

Putting it in a table

Effect on...	Appreciation or revaluation	Depreciation or devaluation
Export prices (in foreign currency)	Rise	Fall
Import prices (in home currency)	Fall	Rise
Demand for exports	Falls	Rises
Demand for imports	Rises	Falls
Current account	Moves towards deficit	Moves towards surplus

Showing it on a diagram

For a floating rate you can show appreciation with the currency diagram. Draw the exchange rate (the price of £1 in dollars) on the vertical axis and the quantity of pounds on the horizontal axis. Draw a downward-sloping demand curve D and an upward-sloping supply curve S, meeting at the first equilibrium. Label the exchange rate ER1. To show appreciation, shift D to the right to D1. The new equilibrium gives a higher exchange rate, ER2. For depreciation, shift D to the left, or shift S to the right, and show the exchange rate falling.

Common mistakes

Mixing up the words. Appreciation and depreciation are market moves. Revaluation and devaluation are government decisions.
Saying a stronger currency is always good. It makes imports cheaper but it makes exports dearer, so it can hurt firms that sell abroad.
Getting the price direction wrong. After an appreciation, export prices rise in foreign currency, and import prices fall in home currency. Say whose currency you mean.
Saying the price in pounds of an export changes. It stays the same. Only the price in the buyer's currency changes.

Do the demand changes always happen?

The size of the change depends on how responsive buyers are to price changes. If demand for exports is price inelastic, a fall in export prices may not bring many extra sales. You met this idea in the lessons on price elasticity of demand.

Exam-style question

Country Tirvana has a floating exchange rate. Its currency is the tiv. The exchange rate falls from 1 tiv = 2.00 Sorian dollars to 1 tiv = 1.60 Sorian dollars.

(a) Define depreciation. [2 marks]

(b) A Tirvana firm sells a tractor for 10,000 tivs. Calculate the new price of the tractor in Sorian dollars. [2 marks]

Model answer

(a) A fall in the value of a currency against another currency (1) when the exchange rate is set by the market (1).

(b) 10,000 × 1.60 (1) = 16,000 Sorian dollars (1). The old price was 20,000 Sorian dollars.

(c) The fall in the tiv makes Tirvana's exports cheaper in Sorian dollars (1), so the demand for exports is likely to rise (1). Imports from Soria become more expensive in tivs (1), so the demand for imports is likely to fall (1). Export earnings are likely to rise and import spending to fall, so the current account is likely to move towards surplus.

Exam tip

For a "may affect" question, follow the chain: exchange rate, then prices, then demand, then the current account. Each link earns a mark.

Recap

Appreciation and depreciation are market-driven changes in a currency's value. Revaluation and devaluation are government decisions in a fixed system.
Appreciation or revaluation: export prices rise, import prices fall, export demand falls, import demand rises, current account moves towards deficit.
Depreciation or devaluation: export prices fall, import prices rise, export demand rises, import demand falls, current account moves towards surplus.
To work out a new price, multiply or divide by the new exchange rate.

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