AS Economics Notes

• • An exchange rate is the price at which one currency can be exchanged for another currency. 

  • It is a key element in international trade and finance, determining how much of one currency can be traded for another.

A floating exchange rate is determined by the forces of supply and demand in the foreign exchange market. Here’s how it works:

• • • Demand for a currency can be influenced by factors such as international trade (exports and imports), investment flows, and speculation.

    • Supply of a currency is influenced by factors like the country's economic policies, trade balances, and capital flows.

Depreciation: 

• This occurs when the value of a currency falls relative to other currencies. 

• For example, if the exchange rate moves from 1 USD = 0.75 EUR to 1 USD = 0.70 EUR, the USD has depreciated against the EUR. 

• Depreciation makes a country's exports cheaper and imports more expensive.

Appreciation: 

• This happens when the value of a currency rises relative to other currencies. 

• For instance, if the exchange rate moves from 1 USD = 0.75 EUR to 1 USD = 0.80 EUR, the USD has appreciated against the EUR. 

• Appreciation makes exports more expensive and imports cheaper.

Several factors can lead to changes in a floating exchange rate, including:

• Economic Indicators: Changes in interest rates, inflation rates, and economic growth impact currency value. Higher interest rates often attract foreign investment, increasing demand for the currency and causing appreciation.

• Trade Balance: A trade surplus (exports > imports) tends to increase demand for a currency, leading to appreciation. Conversely, a trade deficit (imports > exports) can lead to depreciation.

• Capital Flows: Investment flows, both direct and portfolio, can affect exchange rates. Inflows of foreign capital increase demand for a currency, causing appreciation, while outflows can lead to depreciation.

• Speculation: If traders believe a currency will strengthen in the future, they may buy it now, increasing its value. Conversely, if they believe it will weaken, they may sell it off, leading to depreciation.

• Political Stability and Economic Performance: Countries with stable political environments and strong economic performance often have stronger currencies due to increased investor confidence.

Aggregate Demand (AD) and Aggregate Supply (AS) analysis can help us understand the impact of exchange rate changes on the domestic economy. Here’s how exchange rate changes affect equilibrium national income, real output, price level, and employment:

Impact on Aggregate Demand (AD): 

• Depreciation: A weaker domestic currency makes exports cheaper and imports more expensive. This typically boosts export demand (increase in AD) and can also reduce import demand. As a result, AD shifts to the right.

• Appreciation: A stronger domestic currency makes exports more expensive and imports cheaper. This usually decreases export demand and increases import demand, causing AD to shift to the left.

Impact on Aggregate Supply (AS):

• Short-Run AS: 

  1. Exchange rate changes can affect the cost of imported raw materials and intermediate goods.

  2. Depreciation increases the cost of imports, raising production costs for firms that rely on imported inputs, which can shift the Short-Run Aggregate Supply (SRAS) curve to the left.

  3. Appreciation lowers the cost of imports, potentially reducing production costs and shifting the SRAS curve to the right.

• Long-Run AS: 

  1. Over the long term, the impact of exchange rates on aggregate supply is less direct. However, significant changes in exchange rates can influence investment decisions and long-term productive capacity.

Impact on Equilibrium National Income and Real Output:

• Depreciation: With increased AD, the equilibrium national income and real output typically rise, leading to potential short-term economic growth. However, higher production costs (from more expensive imports) may limit this growth and lead to higher inflation.

• Appreciation: A decrease in AD can lead to lower equilibrium national income and real output. Lower production costs from cheaper imports might help offset some of this impact, but the overall effect is usually a slowdown in economic growth.

Impact on Price Level and Employment:

• Depreciation: Higher AD might lead to higher prices (inflation) as firms face higher input costs and increased demand. Employment may rise in the short term due to increased production.

• Appreciation: Lower AD might reduce the price level (disinflation or deflation) and potentially lead to higher unemployment as firms cut back on production due to decreased demand.