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A currency (from Middle English: curraunt, “in circulation”, from Latin: currens, -entis) in the most specific use of the word refers to money in any form when in actual use or circulation as a medium of exchange, especially circulating banknotes and coins. A more general definition is that a currency is a system of money (monetary units) in common use, especially in a nation. Under this definition, US dollars, British pounds, Australian dollars, and European euros are examples of currency. These various currencies are recognized stores of value and are traded between nations in foreign exchange markets, which determine the relative values of the different currencies. Currencies in this sense are defined by governments, and each type has limited boundaries of acceptance.
Other definitions of the term “currency” are discussed in their respective synonymous articles banknote, coin, and money. The latter definition, pertaining to the currency systems of nations, is the topic of this article. Currencies can be classified into two monetary systems: fiat money and commodity money, depending on what guarantees the value (the economy at large vs. the government’s physical metal reserves). Some currencies are legal tender in certain political jurisdictions, which means they cannot be refused as payment for debt. Others are simply traded for their economic value. Digital currency has arisen with the popularity of computers and the Internet.
Currency fluctuations are a natural outcome of the floating exchange rate system that is the norm for most major economies. The exchange rate of one currency versus the other is influenced by numerous fundamental and technical factors. These include relative supply and demand of the two currencies, economic performance, outlook for inflation, interest rate differentials, capital flows, technical support and resistance levels, and so on. As these factors are generally in a state of perpetual flux, currency values fluctuate from one moment to the next. But although a currency’s level is largely supposed to be determined by the underlying economy, the tables are often turned, as huge movements in a currency can dictate the economy’s fortunes. In this situation, a currency becomes the tail that wags the dog, in a manner of speaking.
Currency Effects are Far-Reaching
While the impact of a currency’s gyrations on an economy is far-reaching, most people do not pay particularly close attention to exchange rates because most of their business and transactions are conducted in their domestic currency. For the typical consumer, exchange rates only come into focus for occasional activities or transactions such as foreign travel, import payments or overseas remittances.
A common fallacy that most people harbor is that a strong domestic currency is a good thing, because it makes it cheaper to travel to Europe, for example, or to pay for an imported product. In reality, though, an unduly strong currency can exert a significant drag on the underlying economy over the long term, as entire industries are rendered uncompetitive and thousands of jobs are lost. And while consumers may disdain a weaker domestic currency because it makes cross-border shopping and overseas travel more expensive, a weak currency can actually result in more economic benefits.
The value of the domestic currency in the foreign exchange market is an important instrument in a central bank’s toolkit, as well as a key consideration when it sets monetary policy. Directly or indirectly, therefore, currency levels affect a number of key economic variables. They may play a role in the interest rate you pay on your mortgage, the returns on your investment portfolio, the price of groceries in your local supermarket, and even your job prospects.
Currency Impact on the Economy
A currency’s level has a direct impact on the following aspects of the economy:
Merchandise trade: This refers to a nation’s international trade, or its exports and imports. In general terms, a weaker currency will stimulate exports and make imports more expensive, thereby decreasing a nation’s trade deficit (or increasing surplus) over time.
A simple example will illustrate this concept. Assume you are a U.S. exporter who sold a million widgets at $10 each to a buyer in Europe two years ago, when the exchange rate was EUR 1=1.25 USD. The cost to your European buyer was therefore EUR 8 per widget. Your buyer is now negotiating a better price for a large order, and because the dollar has declined to 1.35 per euro, you can afford to give the buyer a price break while still clearing at least $10 per widget. Even if your new price is EUR 7.50, which amounts to a 6.25% discount from the previous price, your price in USD would be $10.13 at the current exchange rate. The depreciation in your domestic currency is the primary reason why your export business has remained competitive in international markets.
Conversely, a significantly stronger currency can reduce export competitiveness and make imports cheaper, which can cause the trade deficit to widen further, eventually weakening the currency in a self-adjusting mechanism. But before this happens, industry sectors that are highly export-oriented can be decimated by an unduly strong currency.
Economic growth: The basic formula for an economy’s GDP is C + I + G + (X – M) where:
C = Consumption or consumer spending, the biggest component of an economy
I = Capital investment by businesses and households
G = Government spending
(X – M) = Exports minus imports, or net exports.
From this equation, it is clear that the higher the value of net exports, the higher a nation’s GDP. As discussed earlier, net exports have an inverse correlation with the strength of the domestic currency.
Capital flows: Foreign capital will tend to flow into countries that have strong governments, dynamic economies and stable currencies. A nation needs to have a relatively stable currency to attract investment capital from foreign investors. Otherwise, the prospect of exchange losses inflicted by currency depreciation may deter overseas investors.
Capital flows can be classified into two main types – foreign direct investment (FDI), in which foreign investors take stakes in existing companies or build new facilities overseas; and foreign portfolio investment, where foreign investors invest in overseas securities. FDI is a critical source of funding for growing economies such as China and India, whose growth would be constrained if capital was unavailable.
Governments greatly prefer FDI to foreign portfolio investments, since the latter are often akin to “hot money” that can leave the country when the going gets tough. This phenomenon, referred to as “capital flight”, can be sparked by any negative event, including an expected or anticipated devaluation of the currency.
Inflation: A devalued currency can result in “imported” inflation for countries that are substantial importers. A sudden decline of 20% in the domestic currency may result in imported products costing 25% more since a 20% decline means a 25% increase to get back to the original starting point.
Effect of a devaluation of the currency
1. Exports cheaper. A devaluation of the exchange rate will make exports more competitive and appear cheaper to foreigners. This will increase demand for exports. Also, after a devaluation, UK assets become more attractive; for example a devaluation in the Pound can make UK property appear cheaper to foreigners.
2. Imports more expensive. A devaluation means imports, such as petrol, food and raw materials will become more expensive. This will reduce demand for imports. It may also encourage British tourists to take a holiday in UK, rather than US – which now appears more expensive.
3. Increased aggregate demand (AD). A devaluation could cause higher economic growth. Part of AD is (X-M) therefore higher exports and lower imports should increase AD (assuming demand is relatively elastic). In normal circumstances, higher AD is likely to cause higher real GDP and inflation.
4. Inflation is likely to occur following a devaluation because:
- Imports are more expensive – causing cost push inflation.
- AD is increasing causing demand pull inflation
- With exports becoming cheaper manufacturers may have less incentive to cut costs and become more efficient. Therefore over time, costs may increase.
5. Improvement in the current account. With exports more competitive and imports more expensive, we should see higher exports and lower imports, which will reduce the current account deficit. In 2016, the UK had a near record current account deficit, so a devaluation is necessary to reduce the size of the deficit.
6. Wages. A devaluation in the Pound makes less attractive for foreign workers. For example, with fall in the value of the Pound, migrant workers from Eastern Europe may prefer to work in Germany than the UK. In the UK food manufacturing industry, more than 30% of workers are from the EU. UK firms may have to push up wages to keep foreign labor. Similarly, it becomes more attractive for British workers to get a job in the US, because a dollar wage will go further. (FT – migrants become more picky about UK jobs)
Evaluation of a devaluation
The effect of a devaluation depends on:
1. Elasticity of demand for exports and imports. If demand is price inelastic, the a fall in the price of exports will lead to only a small rise in quantity. Therefore, the value of exports may actually fall. An improvement in the current account on the balance of payments depends upon the Marshall Lerner condition and the elasticity of demand for exports and imports
- If PEDx + PEDm > 1 then a devaluation will improve the current account
- The impact of a devaluation may take time to have effect. In the short term, demand may be inelastic, but over time demand may become more price elastic and have a bigger effect.
2. State of the global economy. If the global economy is in recession, then a devaluation may be insufficient to boost export demand. If growth is strong, then there will be a greater increase in demand. However, in a boom, a devaluation is likely to exacerbate inflation.
3. Inflation. The effect on inflation will depend on other factors such as:
- Spare capacity in the economy. E.g. in a recession, a devaluation is unlikely to cause inflation.
- Do firms pass increased import costs onto consumers? Firms may reduce their profit margins, at least in the short run.
- Import prices are not the only determinant of inflation. Other factors affecting inflation such as wage increases may be important.
4. It depends why the currency is being devalued. If it is due to a loss of competitiveness, then a devaluation can help to restore competitiveness and economic growth. If the devaluation is aiming to meet a certain exchange rate target, it may be inappropriate for the economy.
Examples of devaluation
- Leaving the ERM in 1992
- UK devaluation of 1967
- Devaluation of Indian Rupee
- Why is Chinese currency undervalued? – impact of weaker Chinese currency
The Pound fell against major currencies, especially the Dollar due to Brexit. The effects will be:
- Higher prices of imported goods.
- Inflation. However, UK inflation was low to start off with, and the global economy is facing a period of deflationary pressures. So in this scenario the inflationary effects of a devaluation are less damaging than usual.
- Exports should see a rise in demand because of the falling value of Sterling. However, the rise in exports may be muted by weak growth in the Eurozone and global economy. If global growth is low, we may see less growth in exports than we might usually expect. Demand may prove inelastic.
- The Pound is falling, but with decline in consumer confidence and investment, it may not be enough to prevent a technical recession (falling real GDP for two consecutive quarters. See: Will Brexit cause recession?)
Effects of an appreciation
- Exports more expensive. The foreign price of UK Exports will increase Europeans will find British exports more expensive. Therefore with a higher price, we would expect to see a fall in the quantity of UK exports.
- Imports are cheaper. UK consumers will find that £1 now buys a greater quantity of European goods. Therefore, with cheaper imports we would expect to see an increase in the quantity of imports.
- Lower (X-M) With lower export demand and greater spending on imports, we would expect fall in domestic Aggregate Demand (AD), causing lower economic growth.
- Lower inflation. An appreciation tends to cause lower inflation because:
- import prices are cheaper. The cost of imported goods and raw materials will fall after an appreciation, e.g. imported oil will decrease, leading to cheaper petrol prices.
- Lower AD leads to lower demand pull inflation.
- With export prices more expensive, manufacturers have greater incentives to cut costs to try and remain competitive.
Impact of an appreciation on the current account
Assuming demand is relatively elastic, we would expect an appreciation to worsen the current account position. Exports are more expensive, so we get a fall in eXports. Imports are cheaper and so we see an increase in iMports. This will cause a bigger deficit on the current account.
However, the impact on the current account is not certain:
- An appreciation will tend to reduce inflation. This can make UK goods more competitive, leading to stronger exports in the long term, therefore, this could help improve the current account.
- The impact on the current account depends on the elasticity of demand. If demand for imports and exports is inelastic, they the current account could even improve. Exports are more expensive, but if demand is inelastic, there will only be a small fall in demand. The value of exports will increase. If demand for exports is price elastic, there will be a proportionately greater fall in export demand, and there will be a fall in the value of exports.
- Often in the short term, demand is inelastic, but over time people become more price sensitive and demand more elastic. It also depends what goods you export. Some goods with little competition will be inelastic. China’s manufacturing exports are more likely to be price sensitive because there is more competition.
Evaluation of an appreciation
- Elasticity. The impact of an appreciation depends upon the price elasticity of demand for exports and imports. The Marhsall Lerner condition stations that an appreciation will worsen the current account if (PEDx + PEDm >1)
- The impact of an appreciation depends on the situation of the economy. If the economy is in a recession, then an appreciation will cause a significant fall in aggregate demand, and will probably contribute to higher unemployment. However, if the economy is in a boom, then an appreciation will help reduce inflationary pressures and limit the growth rate.
- It also depends on economic growth in other countries. If Europe was experiencing strong growth, they would be more likely to keep buying UK exports, even though they are more expensive. However, in 2012, the EU economy was in a recession, and therefore were sensitive to the increased price of UK exports.
- It also depends why the exchange rate is increasing in value. If there is an appreciation because the economy is becoming more competitive, then the appreciation will not be causing a loss of competitiveness. But, if there is an appreciation because of speculation or weakness in other countries, then the appreciation could cause a bigger loss of competitiveness.
Is an appreciation good or bad?
- An appreciation can help improve living standards – it enables consumers to buy cheaper imports.
- If the appreciation is a result of improved competitiveness, then the appreciation is sustainable, and it shouldn’t cause lower growth.
- An appreciation could be a problem, if the currency appreciates rapidly during a difficult economic circumstances.