Evaluate the overall impact of a currency depreciation on an economy’s performance.
The Japanese yen experienced a sharp decline in value in 2022. Analysts suggest this was driven by global economic instability and increasing prices of commodities worldwide.
b. Evaluate the overall impact of a currency depreciation on an economy’s performance. [15]
Introduction
A currency depreciation refers to a fall in the value of a country’s currency relative to others under a floating exchange rate system. This means that each unit of domestic currency now buys fewer units of foreign currency, making exports cheaper and imports more expensive. The overall impact of such a depreciation must be assessed in terms of its effects on an economy’s performance — commonly measured by key macroeconomic indicators such as the rate of inflation, unemployment levels, real economic growth, and the balance of trade. While depreciation can improve export competitiveness and stimulate aggregate demand, thereby boosting growth and employment, it may also raise import prices, contributing to cost-push inflation and worsening the terms of trade. The final outcome depends on factors such as the price elasticity of demand for exports and imports, the economy’s reliance on imported inputs, and the broader global economic context.
Pros & Cons of Currency Depreciation
A major benefit of depreciation lies in improved export competitiveness. As the domestic currency weakens, the foreign currency price of exports falls, making them more attractive to overseas consumers. Assuming exports are price elastic, this leads to an increase in export volume and hence an increase in net exports (X – M), which is a component of aggregate demand (AD).
An increase in AD causes a rightward shift from AD₀ to AD₁ on the AD-AS diagram.
This leads to a rise in real national income from Y₀ to Y₁ and an increase in employment, helping the economy grow.
The increase in demand for exports also encourages firms to expand output and hire more labour, contributing to lower unemployment. Moreover, through the multiplier effect, increased incomes among workers and suppliers trigger secondary rounds of spending, further boosting national income.
In the external sector, a depreciation—if it results in higher export revenues and lower imports—can improve the balance of trade, reducing current account deficits. This is particularly beneficial for economies with persistent external imbalances.
Despite its potential to stimulate growth, depreciation also presents significant downsides, particularly in terms of imported inflation.
When the domestic currency weakens, foreign goods become more expensive in local currency terms. For consumers, this means higher prices for imported items like food, electronics, and fuel. For firms, especially those that rely on imported intermediate goods or raw materials, production costs increase. This leads to a leftward shift of the short-run aggregate supply (SRAS) curve from AS₀ to AS₁, pushing up the general price level from P₀ to P₁.
This form of cost-push inflation erodes real incomes and may worsen the material standard of living for households. The burden is particularly severe in economies that import essential goods, such as oil, food, or medicine.
Moreover, if rising input costs begin to feed into the prices of exports, the initial gain in export competitiveness may be eroded over time. Exporters may also face higher production costs, which dampen profit margins and limit their ability to scale up output. This undermines the very advantage that depreciation was supposed to provide.
Key Factors Determining the Overall Impact
The actual outcome of depreciation depends heavily on several factors:
The Marshall-Lerner Condition
This economic principle states that a depreciation will only lead to an improvement in the balance of trade if the sum of the price elasticities of demand for exports and imports is greater than one. If demand is inelastic, the quantity response to the price change will be small. In such cases, the value of imports may remain high due to inelastic import demand, and export volumes may not rise sufficiently, leading to a worsening trade balance in the short term.
Import Dependency
The structure of the economy matters. In import-reliant economies like Singapore, where a large proportion of goods—including necessities and production inputs—are imported, the cost-push inflationary effects of depreciation can be severe. Rising costs of food and energy reduce real incomes, while higher input costs make it harder for domestic producers to remain competitive even after the currency weakens.
In contrast, economies that are more self-sufficient or have a large manufacturing base may benefit more from a weaker currency, as they can substitute imports with domestic production and expand exports without being overly affected by higher input costs.
State of the Economy
The impact also depends on the initial conditions of the economy. If the economy is in a recession with spare capacity, depreciation can help stimulate demand and reduce unemployment without triggering significant inflation. However, if the economy is already close to full employment, the increase in demand from exports could worsen inflationary pressures.
Conclusion
In theory, currency depreciation can be a powerful tool to stimulate economic growth, improve export competitiveness, and narrow trade deficits. These benefits are most evident when the economy has price elastic trade flows, spare capacity, and low import dependency. However, in practice, depreciation often comes with costs, including imported inflation, rising production costs, and pressure on real incomes—especially in economies that rely heavily on imported goods and energy. The net impact of depreciation therefore depends on the structure of the economy, the responsiveness of trade flows, and how effectively the government manages inflationary risks. For countries like Japan, where the currency fell sharply in 2022 amid rising global commodity prices, the inflationary impact of depreciation may have neutralised much of the benefit from increased export competitiveness.
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