Impact of a Currency Appreciation | A-Level Economics Model Paragraph (AQA, Edexcel, OCR)

Exchange rates are the price of a currency in terms of another. If the value of the pound increases, it means that exports become more expensive and imports become cheaper. This means that exports are likely to increase and imports are likely to decrease, and as a result aggregate demand in the UK will decrease. Aggregate demand is the total planned spending in the economy, and AD = C + I + G + (X-M) - so if (X-M) decreases, then that would cause a left shift in AD.

The diagram shows that the outcome is a decrease in output from y1 to y2. This suggests there would be a fall in real GDP (negative economic growth) and also an increase in unemployment - since the demand for labour is derived from the demand for goods and services - which is now lower due to a fall in demand for UK exports and also a fall in consumer spending (as some people are buying less goods and services domestically and instead spending money on imports). An increase in unemployment is bad because it means that more people have low or no disposable income and this can lead to an increase in inequality and a fall in living standards.

However, the J-curve illustrates that when a currency depreciates, the balance of payments usually worsens before improving. The opposite would be true with a curreny appreciation, causing the balance of payments to improve in the short-run before worsening later. This is because demand for imports and exports are usually inelastic in the short run as it is difficult to find substitutes domestically.

In the short-run, a currency appreciation would make exports more expensive but if we have high quality, unique exports, they would continue to be sold until other countries produce or find substitutes. Similarly, we would not increase our volume of imports suddenly just because they are cheaper. For example, businesses would have a certain level of raw materials which they need to import based on current demand.

Another impact of a strong currency and cheaper imports is that UK firms will face lower costs of production when importing raw materials. This means that we will be able to produce a higher volume of goods and services at each price level, so the SRAS curve will shift to the right.

This is really beneficial for the UK economy (especially since we depend on many imports - particularly for raw materials and manufactured goods). Real GDP would increase from y1 to y2 and price level would fall from p1 to p2. Real GDP increases because firms face lower costs of production so are able to produce more goods and services with the same amount of resources, and price levels fall because firms are able to pass these lower costs onto consumers.

However, it is important to consider that this is just one impact of a stronger currency which happens in the short run. If consumers or firms do adjust and start importing more goods and services, then there would be a combination of different impacts on the UK economy (such as AD shifting left due to higher imports).

Plan

1. currency appreciates
2. imports become cheaper and exports become more expensive
3. (X-M) becomes lower - bigger current account deficit
4. AD will shift to the left
5. draw the diagram
6. output falls
   1. real gdp falls
   2. unemployment rises - more people are importing so there is less demand for DOMESTIC goods and services - less demand for labour
7. price level falls
   1. the marshall lerner condition states that if ped for exports and ped for imports is less than 1 then a currency appreciation will improve the balance of payments on the current account
   2. even though the pound is stronger
   3. we still import and export the same amount
   4. but our exports are more expensive and our imports are cheaper
   5. so we spend more
   6. J-curve

1. currency appreciates
2. imports become cheaper and we do not import a higher quantity of goods and services
3. firms costs of production fall
   1. oil prices
   2. raw material prices
   3. manufactured goods
4. SRAS will shift to the right
5. firms can produce more g and s with the same amount of resources
6. sras right shift diagram
7. price level falls from p1 to p2 and output increases from y1 to y2
8. firms can pass lower prices onto consumers
9. employ more workers/ invest more
10. output increases
11. economic growth
    1. deflation can happen
    2. repeat ml condition - depends on elasticity
    3. conclude that both effects can happen and this mainly depends on elasticity