[2.2.3b] Appreciation & depreciation

Appreciation and Depreciation

Appreciation occurs when a currency rises in value relative to another — one unit of the domestic currency buys more units of the foreign currency than before. Depreciation is the opposite — one unit buys fewer units of the foreign currency than before.

These movements are not simply academic — they have profound real-world effects on import prices, export competitiveness, inflation, growth and employment. Understanding which direction each effect runs is the core skill of this benchmark.

A Worked Example

Worked Example

Starting position: £1 =

.20. A UK exporter sells a car for £20,000; a US buyer pays ,000. A US oil barrel costs ; UK importer pays £66.67.

Scenario A — Appreciation to £1 =

.50:

UK car still costs £20,000. US buyer now pays ,000 — exports more expensive for foreigners.
US oil barrel still . UK importer now pays £53.33 — imports cheaper for domestic buyers.

Scenario B — Depreciation to £1 =

.90:

UK car still costs £20,000. US buyer now pays ,000 — exports cheaper for foreigners.
US oil barrel still . UK importer now pays £88.89 — imports more expensive for domestic buyers.

Impact of Appreciation

Impact Area	Effect of Appreciation
Import prices	Fall — each unit of domestic currency buys more foreign currency, so imported goods cost less. Consumers benefit from cheaper imports
Export prices	Rise in foreign currency terms — domestic goods become more expensive for foreign buyers, reducing export competitiveness and volumes
Current account	Likely to worsen — export volumes fall (exports more expensive) and import volumes rise (imports cheaper). Trade deficit widens
Inflation	Falls — cheaper imports reduce input costs for domestic firms and lower the price of consumer goods. This is the "anti-inflationary" effect of a strong currency
Economic growth	May slow — weaker net exports (exports fall, imports rise) reduce aggregate demand. Domestic export industries face lower revenues
Employment	May fall in export sectors — reduced competitiveness leads to lower output and potential job losses in manufacturing and export-oriented services

Impact of Depreciation

Impact Area	Effect of Depreciation
Import prices	Rise — each unit of domestic currency buys fewer units of foreign currency, so imported goods cost more in domestic terms. Imported inflation results
Export prices	Fall in foreign currency terms — domestic goods become cheaper for foreign buyers, improving competitiveness and potentially increasing export volumes
Current account	Should improve over time — exports more competitive (volumes rise) and imports more expensive (volumes fall). However, the J-curve effect means the deficit may initially worsen before improving
Inflation	Rises — more expensive imports raise input costs for firms (cost-push inflation) and raise the price of consumer goods. Workers may demand higher wages to compensate, risking a wage-price spiral
Economic growth	May improve — stronger net exports boost aggregate demand and GDP. Export industries expand output, generating multiplier effects on domestic income
Employment	May rise in export sectors — increased competitiveness expands output and job opportunities in manufacturing and export services. Import-competing industries also benefit

The J-Curve Effect

When a currency depreciates, the current account does not immediately improve. In the short run, the trade deficit may actually worsen before it improves — this pattern is called the J-curve effect:

Import prices rise immediately (more expensive in domestic terms) but volumes do not fall straight away — consumers and firms have existing contracts and habits that take time to change.
Export prices fall immediately but volumes do not rise straight away — foreign buyers need time to discover the new prices and place orders.
So in the short run, the import bill rises (paying more for the same volume) whilst export revenues are unchanged → deficit worsens.
Over time, as buyers respond to new prices, export volumes rise and import volumes fall → the current account improves.

Key Takeaways

Appreciation: imports cheaper, exports more expensive → lower inflation, weaker growth, worsening current account.
Depreciation: imports more expensive, exports cheaper → higher inflation, stronger growth potential, improving current account (eventually).
The J-curve effect means depreciation worsens the current account in the short run before improving it.
Exchange rate changes involve trade-offs — no movement is universally beneficial. Depreciation helps exporters but harms import-dependent firms and raises inflation; appreciation does the reverse.

c) The impact of appreciation and depreciation of the exchange rate on: • import prices • export prices • current account • inflation • economic growth • employment.