Exchange rates and AD/AS

Depreciation and AD/AS

1. A depreciation lowers the foreign-currency price of exports and raises the domestic-currency price of imports.
2. Cheaper exports and dearer imports tend to raise net exports (X − M), a key component of aggregate demand.
3. Higher net exports shift aggregate demand (AD) to the right.
4. Dearer imported raw materials, energy and components raise firms' costs, which can also shift short-run aggregate supply (SRAS) to the left (shift of SRAS is not shown below).

Impact on the economy

1. The rightward AD shift raises the economy's equilibrium national income and real output.
2. As firms expand production they hire more workers, so employment rises and unemployment falls.
3. The price level rises, both from stronger demand (demand-pull) and from dearer imported inputs (cost-push).
4. On the diagram the average price level sits on the vertical axis and real output on the horizontal axis, with AD shifting right to a new macroeconomic equilibrium.

Appreciation in reverse

1. An appreciation raises the foreign price of exports and lowers the domestic price of imports.
2. Net exports tend to fall, so AD shifts to the left.
3. Equilibrium national income, real output and employment fall as demand weakens.
4. Cheaper imports ease cost pressures, so inflationary pressure is reduced.

What determines the size

1. The price elasticities of demand for exports and imports determine whether the trade balance actually improves.
   1. If demand is unresponsive the rise in net exports may be small, so the outcome depends on responsiveness.
2. The amount of spare capacity, or the output gap, shapes how much real output can rise.
   1. With plenty of spare capacity output rises easily (the Keynesian range of AS), but near full capacity extra demand mainly raises the price level (the classical range).
3. The economy's dependence on imported inputs determines how strong the cost-push inflation is.

Does a depreciation always improve the economy?

1. A depreciation can improve the economy when demand for exports and imports is price elastic: cheaper exports and dearer imports then raise net exports strongly, shifting AD right and lifting real output and employment, especially where spare capacity lets firms expand.
2. But the gain is not automatic. If demand for exports and imports is price inelastic, the value of net exports may barely rise, or even fall at first, because dearer imports are still bought in much the same quantity; and even a favourable move often shows up only slowly, as buyers take time to switch suppliers.
3. A depreciation also raises the cost of imported energy, raw materials and components, feeding imported inflation; near full capacity the extra demand mainly pushes up the price level rather than output, so growth is limited while inflation worsens and real incomes are squeezed.
4. On balance, a depreciation is most likely to help when demand for exports and imports is elastic, spare capacity exists and reliance on imported inputs is low, and most likely to harm the economy when demand is inelastic and inflation is already high. Whether it improves the economy therefore depends on elasticities, the output gap and import dependence.