Exchange Rate Depreciation (Edexcel IGCSE Economics)
Depreciation and Devaluation
Spec point —
2.2.3d
Depreciation (Devaluation)
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Depreciation occurs in a floating exchange rate system
- If there is excess supply for the currency on FOREX, the price falls (the currency is worth less/is cheaper to buy)
- Depreciation may also be referred to as devaluation
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If there is excess supply for the currency on FOREX, then price of that currency will fall (the currency depreciates)
- An increase in supply of the currency can cause a depreciation
- A decrease in demand for the currency can cause a depreciation
The market for Euros in Dollars shows an increase in supply of Euros
Diagram analysis
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The initial exchange rate equilibrium for Euro/US$ is found at P1Q1
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When Europeans visit the USA, they demand US$ and supply Euros
- The increased supply of the Euro shifts the supply curve to the right
- This results in the value of the Euro depreciating from P1 → P2
- A new market equilibrium forms at P2Q2
Impact of Depreciation on the Current Account
Spec point —
2.2.3d
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The relationship between the current account on the balance of payments and the exchange rate is dynamic
- A depreciation means that imports become more expensive and exports become cheaper
Impact of Depreciation on Exports, Imports (Current Account)
| Impact | Explanation |
|---|---|
| Exports | - When a country's currency depreciates, its exports become relatively cheaper for foreign buyers, potentially leading to an increase in export volumes |
| Imports | - A weaker exchange rate makes imports more expensive and exports cheaper - Imports become relatively more expensive for domestic consumers, which may result in a **decrease in import volumes ** |
| Current account | - Domestic consumers may switch demand from foreign goods to domestic goods and as imports falls, the balance on the current account improves - The** increase in export volumes** also leads to an improvement on the current account |
Worked Example On Forex, foreign currency dealers believe that the Thai Bhat is likely to depreciate by 4% against the Japanese Yen over the coming year.
Which diagram depicts this expectation of events on Forex?
A. The market for Japanese Yen, showing a shift left of supply of Yen
B. The market for Japanese Yen, showing a shift right of supply of Yen
C. The market for Thai Baht, showing a shift right of supply of Thai Baht
D. The market for Thai Baht, showing a shift left of supply of Thai Baht
Final answer: C is the correct answer
As dealers sell Thai Baht in order to purchase Japanese Yen, the supply of Thai Baht will shift right
A is incorrect, as there is no shift in supply for Japanese Yen, but there is a shift in demand for the Yen
B is incorrect, as there is no shift in supply for Japanese Ye, but demand for Yen shifts right
D is incorrect, as a shift left in supply would be caused by fewer dealers supplying Thai Baht, but the opposite is true
Exam Hint Working with exchange rates can be confusing. Always work from the point of view of one individual currency and its effects, when thinking about appreciating or depreciating exchange rates. Consider what happens to the price of exports and the price of imports from one country's point of view as a starting point, which will aid understanding about the effects on current accounts and employment in export-related industries.
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