Impact of a Currency Depreciation | 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 falls, it means that exports become more cheaper and imports become more expensive. This means that exports are likely to increase and imports are likely to decrease, and as a result aggregate demand in the UK will increase. Aggregate demand is the total planned spending in the economy, and AD = C + I + G + (X-M) - so if (X-M) increases, then that would cause a right shift in AD.

The diagram shows that there is an increase in output from y1 to y2. This means that there would be an increase in real gdp (economic growth) and a decrease in unemployment. This is because demand for labour is derived from the demand for goods and services (which is greater due to the higher demand for our exports). Also, if imports become more expensive, then people start buying more goods and services domestically, and this increases consumption, leading to new jobs being created.

However, price level increases from p1 to p2. This suggests there would be higher inflation, which is when average price level increases. If this is large increase, it would cause a cost of living crisis because people's disposable incomes would fall due to the higher prices yet constant wages.

Furthermore, exports and imports are likely to be inelastic in the short run at least. The Marshall-Lerner condition states that if the demand for imports and exports is inelastic (PED < 1), then a currency depreciation will cause the balance of payments to worsen. The J-curve below shows that over time, exports and imports become more elastic, and the economy adjusts to the change in the value of the currency, but there could a currency depreciation could be damaging in the short run.

paragraph 2 - short-run impact of weaker currency

In the short run, consumers and firms cannot adjust to a weaker currency, because they rely on importing certain goods and services - and they may not be able to find them domestically. For example, firms have to import raw materials from abroad which cannot be found in the UK. As a result, firms' costs of production increases, which causes short-run aggregate supply to shift to the left.

The diagram shows that there would an increase in price level from p1 to p2, which means there is cost-push inflation. This has a negative impact on firms who struggle due to higher costs and that leads to them raising prices for customers. Consumers struggle to keep up with higher prices as wages would likely not increase at the same rate, and this would lead to greater cost of living, causing a fall in disposable incomes and a drop in living standards. There would also be an increase in unemployment and a fall in real GDP because output decreases.

However, as the J-curve showed, this is only likely to be the impact in the short-run. Over time, exports and imports become more elastic so consumers and firms are able to respond to expensive imports and switch to buying domestically. If there are strong supply side factors in place, this will help speed this process up - as it means the UK have the skills and investment to learn how to produce goods and services that we were previously importing.