Impact of Exchange Rate Changes Using AD/AS

Introduction

Key Concepts

Understanding Exchange Rates

Exchange rates represent the value of one country's currency in terms of another's. They are pivotal in international trade, investment, and economic policy. Exchange rates can be categorized into two main types: fixed and floating. A fixed exchange rate is pegged to another major currency or a basket of currencies, whereas a floating exchange rate is determined by market forces without direct government or central bank intervention.

Aggregate Demand (AD) and Aggregate Supply (AS) Framework

The AD/AS model is a fundamental tool in macroeconomics used to analyze the total demand and total supply in an economy. Aggregate Demand comprises consumption (C), investment (I), government spending (G), and net exports (NX), expressed as:

$$ AD = C + I + G + (X - M) $$

where \( X \) is exports and \( M \) is imports. Aggregate Supply represents the total output producers in an economy are willing and able to supply at a given overall price level. The intersection of AD and AS determines the equilibrium price level and real GDP.

Impact of Exchange Rate on Net Exports

Exchange rates directly affect net exports (NX) by influencing the cost of a country's goods and services abroad (exports) and the cost of foreign goods and services domestically (imports). An appreciation of the domestic currency makes exports more expensive and imports cheaper, potentially reducing NX. Conversely, a depreciation makes exports cheaper and imports more expensive, potentially increasing NX.

Exchange Rate and Aggregate Demand

Changes in exchange rates impact Aggregate Demand primarily through the net exports component. For instance, if the domestic currency depreciates, exports become more competitive internationally, boosting \( X \) and thus AD shifts to the right. Similarly, imports become more expensive, reducing \( M \) and further increasing AD. The opposite occurs with currency appreciation.

Exchange Rate and Aggregate Supply

Exchange rates also influence Aggregate Supply, especially in the short run. A depreciating currency increases the cost of imported inputs for producers, potentially raising production costs. This can cause the AS curve to shift leftward, leading to higher price levels and reduced real GDP, a phenomenon known as cost-push inflation. Conversely, an appreciating currency can lower production costs, shifting AS to the right.

Interest Rates and Exchange Rates

Interest rate differentials between countries affect exchange rates through capital flows. Higher domestic interest rates attract foreign capital, increasing demand for the domestic currency and causing appreciation. Appreciation can dampen AD by reducing net exports, while depreciation can stimulate AD by enhancing net exports.

Expectations and Exchange Rate Movements

Market expectations about future exchange rates can influence current economic decisions. If businesses anticipate a future depreciation, they may increase exports and reduce imports now, shifting AD to the right. Conversely, expectations of appreciation may lead to higher imports and lower exports, shifting AD to the left.

Government Intervention and Exchange Rate Policies

Governments and central banks may intervene in foreign exchange markets to stabilize or influence their currency's value. Such interventions can alter exchange rate dynamics, subsequently impacting AD and AS. For example, selling foreign reserves to depreciate the currency can boost exports and AD, while purchasing foreign currency can appreciate the domestic currency, potentially reducing AD.

Exchange Rate Pass-Through

Exchange rate pass-through refers to the extent to which changes in exchange rates affect domestic prices. High pass-through means that exchange rate changes significantly influence import and export prices, thereby impacting AD and AS. Low pass-through implies a muted effect on prices and, consequently, on AD and AS.

Real Exchange Rate vs. Nominal Exchange Rate

The nominal exchange rate is the rate at which one currency exchanges for another, while the real exchange rate adjusts the nominal rate for differences in price levels between countries. The real exchange rate provides a more accurate measure of a currency's competitiveness. Changes in the real exchange rate have direct implications for net exports and the AD curve.

Case Studies on Exchange Rate Fluctuations

Historical instances of significant exchange rate movements offer insights into their economic impacts. For example, the Plaza Accord of 1985 led to the appreciation of the US dollar, adversely affecting US exports and shifting AD leftward. Conversely, the depreciation of the British pound following the Brexit referendum initially boosted exports but also led to increased import costs, impacting AS.

Mathematical Representation of Exchange Rate Impact

The relationship between exchange rates and aggregate demand can be quantified using elasticity coefficients. Net exports' sensitivity to exchange rate changes is often represented as: $$ \Delta NX = E \times \Delta e $$ where \( \Delta NX \) is the change in net exports, \( E \) is the net export elasticity with respect to the exchange rate, and \( \Delta e \) is the change in the exchange rate.

Fiscal and Monetary Policy Interactions with Exchange Rates

Fiscal and monetary policies can influence exchange rates and, by extension, AD and AS. Expansionary fiscal policy can increase AD, potentially leading to currency appreciation through higher interest rates. Conversely, expansionary monetary policy can depreciate the currency by lowering interest rates, stimulating AD through increased net exports.

Advanced Concepts

Theoretical Frameworks: Mundell-Fleming Model

The Mundell-Fleming model extends the AD/AS framework to an open economy, incorporating exchange rate dynamics. It analyzes the interaction between the goods market, the money market, and the foreign exchange market under different exchange rate regimes. The model demonstrates how fiscal and monetary policies affect output and exchange rates, highlighting the trade-offs in policy decisions within the context of exchange rate flexibility.

Exchange Rate Regimes and Economic Stability

Different exchange rate regimes—fixed, floating, and managed float—have distinct implications for economic stability. Fixed regimes provide exchange rate stability, which can enhance trade and investment predictability but limit monetary policy autonomy. Floating regimes offer flexibility in addressing external shocks but can lead to exchange rate volatility, affecting AD and AS. Managed float regimes attempt to balance stability and flexibility through selective interventions.

Purchasing Power Parity (PPP) and Long-Run Exchange Rates

Purchasing Power Parity posits that exchange rates adjust to equalize the price levels of identical goods and services across countries. In the long run, PPP suggests that exchange rates move towards levels that balance the relative price levels, influencing long-term AD and AS by affecting net exports and import costs. Deviations from PPP can indicate misalignments that impact economic decision-making and policy.

Exchange Rate Pass-Through and Inflation Dynamics

The degree of exchange rate pass-through affects how exchange rate movements influence domestic inflation. High pass-through can lead to imported inflation or deflation, affecting the AS curve. Central banks may respond to such inflationary pressures through monetary policy adjustments, impacting the overall AD/AS equilibrium. Understanding pass-through is crucial for predicting inflation dynamics in response to exchange rate changes.

Balassa-Samuelson Effect

The Balassa-Samuelson effect explains how productivity differentials between the tradable and non-tradable sectors can affect exchange rates and real exchange rate appreciation. Higher productivity growth in the tradable sector leads to higher wages, increasing the price of non-tradable goods and causing the real exchange rate to appreciate. This appreciation can reduce net exports and shift AD leftward, impacting economic growth.

Exchange Rate Expectations and Speculative Attacks

Expectations of future exchange rate movements can lead to speculative attacks, where investors rapidly buy or sell currencies based on anticipated changes. Such attacks can destabilize fixed exchange rate regimes, leading to abrupt shifts in exchange rates. The resulting volatility impacts AD through sudden changes in net exports and can disrupt AS by altering production costs.

Time Lags in Exchange Rate Adjustments

Exchange rate adjustments do not occur instantaneously. Time lags in response to policy changes or economic shocks can result in temporary disequilibrium in the AD/AS framework. These lags affect how quickly the economy can stabilize after exchange rate fluctuations, influencing short-term economic performance and the effectiveness of policy interventions.

Currency Reserves and Exchange Rate Management

Countries maintain foreign currency reserves to manage exchange rate policies and respond to market pressures. The level and composition of reserves can influence a country's ability to stabilize its currency, affecting exchange rate volatility and, consequently, AD and AS. Adequate reserves provide a buffer against speculative attacks and external shocks, enhancing economic resilience.

Real Interest Rate Differential and Exchange Rate Dynamics

The real interest rate differential between countries influences capital flows and exchange rate movements. A higher real interest rate attracts foreign investment, increasing demand for the domestic currency and causing appreciation. This appreciation affects AD by reducing net exports and can influence AS through changes in production costs and investment.

Exchange Rate and Business Cycle Synchronization

Exchange rate movements can lead to synchronization or divergence of business cycles between trading partners. Synchronized cycles may enhance the stability of net exports and AD, while divergent cycles can lead to increased volatility in trade balances and economic performance. Understanding this relationship is key to anticipating the broader economic impacts of exchange rate changes.

Exchange Rate Misalignment and Output Gaps

Exchange rate misalignment occurs when the actual exchange rate deviates from its equilibrium value, affecting competitiveness and economic performance. Overvalued currencies can create negative output gaps by reducing net exports, while undervalued currencies can lead to positive output gaps by enhancing net exports. These gaps influence AD and AS, impacting overall economic output and employment.

Financial Market Integration and Exchange Rate Transmission

The degree of financial market integration between countries affects how exchange rate changes transmit across economies. Highly integrated markets facilitate quicker capital flows and exchange rate adjustments, impacting AD and AS more rapidly. Lower integration can lead to delayed transmission effects, influencing the timing and magnitude of economic responses to exchange rate changes.

Comparison Table

Summary and Key Takeaways