Evaluating the impact of exchange rate changes on output, employment, prices and agents

Overview

Effect of a depreciation on real output, effect of a depreciation on employment and effect of a depreciation on households as consumers.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Analyse the effect of a depreciation on real output.

   Model answer

   Cheaper exports and dearer imports raise net exports, so aggregate demand shifts right and firms respond by increasing production, with the initial gains concentrated in manufacturing, tourism and other tradable sectors and then spreading through their supply chains. Working against this, the higher cost of imported raw materials, energy and components raises firms’ costs and shifts short-run aggregate supply left, which reduces output. The net effect is positive where there is spare capacity, where buyers respond strongly to the price change and where import content is low, and can be negative in an economy that depends heavily on imported inputs.

2. 2

   Analyse the effect of a depreciation on employment, identifying which sectors gain and which lose.

   Model answer

   Exporting industries and those competing with imports gain orders, so they increase hours, recruit and reduce redundancies, and employment rises in manufacturing, agriculture, tourism and the transport and logistics that serve them. Losers are firms that rely on imported inputs and sell mainly at home, since their costs rise without any offsetting gain in sales, and retailers of imported goods, who face weaker demand as prices rise. Because real incomes are squeezed by higher import prices, employment in consumer services can fall even as export employment rises, so the aggregate effect depends on the balance between the two.

3. 3

   By what routes does a depreciation raise the domestic price level?

   Model answer

   First, imported finished goods such as clothing, electronics and cars cost more in domestic currency, and these enter the consumer price index directly. Second, imported raw materials, components, energy and food cost more, so domestic firms’ unit costs rise and they pass the increase into their own prices, which is imported cost-push inflation and shifts short-run aggregate supply left. Third, the improvement in net exports raises aggregate demand, which adds demand-pull pressure as the economy approaches capacity, and if workers respond to the higher cost of living with larger pay claims, the initial rise can become embedded.

4. 4

   Analyse the effect of a depreciation on households as consumers.

   Model answer

   Households face higher prices for imported goods and for domestic goods made with imported inputs, and because food and energy have a large import content and inelastic demand, the squeeze falls hardest on essentials. Real disposable income therefore falls unless money wages rise to match, which reduces the volume of goods and services households can buy and hits lower-income households hardest, since essentials take up a larger share of their budget. Set against this, households whose employment depends on exporting industries may gain more secure work and more hours.

5. 5

   Analyse the effect of a depreciation on a firm that imports components and sells its finished goods at home.

   Model answer

   The firm gains nothing from the export channel, because it does not sell abroad, but it pays more in domestic currency for every imported component, so its unit costs rise immediately. It must either absorb the increase, which compresses its profit margin and may make investment unaffordable, or pass it on in higher prices, which risks losing sales to competitors with lower import content. Its position improves only to the extent that dearer imported finished goods make its rivals abroad less competitive in the domestic market.

6. 6

   Analyse the effect of a depreciation on an exporting firm.

   Model answer

   The firm can either leave its domestic price unchanged, in which case its goods become cheaper in foreign currency and it should win extra volume, or raise its domestic price, in which case it keeps the foreign-currency price unchanged and takes the benefit as a wider margin. In practice most firms do some of each, so both volumes and margins improve, and profitability and the case for investing in extra capacity strengthen. The gain is reduced to the extent that the firm's own inputs are imported, since those have become dearer, and it may be temporary if the currency movement reverses.

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