Exchange rates affect aggregate demand through their effects on exports and imports. Specifically, it affects the relative prices of imported or exported goods and, ultimately, their competitiveness and demand. For example, appreciation makes the price of exported goods more expensive for foreigners, lowering their demand. Instead, it makes imported goods cheaper for domestic buyers. As a result, exports decline, and imports increase, lowering aggregate demand.
As defined by economists, aggregate demand comprises household consumption, business investment, government spending, and net exports. The last is the difference between exports and imports.
- Aggregate demand = Household consumption + Business investment + Government spending + Net exports
- Aggregate demand = Household consumption + Business investment + Government spending + (Exports – Imports)
As in the formula, changes in net exports have a direct impact on aggregate demand. For example, if net exports are positive (exports exceed imports, also known as a trade surplus), it adds aggregate demand. Conversely, negative net exports (imports exceed exports, called a trade deficit) reduce aggregate demand.
Why do exchange rates affect exports and imports?
International trade involves goods and services and currencies as a means of payment. For example, when importing, we have to pay for it in dollars by exchanging the domestic currency. On the other hand, when we export, we get dollars as payment and translate them into the domestic currency to buy goods and services in the economy.
Thus, when the domestic currency is valued higher or lower against the dollar, it ultimately affects the relative prices of exported and imported products. And we call the price of the domestic currency against the dollar the exchange rate.
If the domestic currency becomes weaker against the dollar, exported goods become cheaper to overseas buyers when converted to dollars. Conversely, domestic buyers pay more for imported goods because they have to exchange more domestic currency to earn 1 dollar.
The opposite effect applies when the domestic currency becomes stronger against the dollar. Exported goods become more expensive for overseas buyers. In contrast, imported goods become cheaper for domestic buyers.
How the exchange rate affects exports and imports
Let’s take a simplified case. Assume the euro’s exchange rate against the US dollar is EUR1.5/USD. A European company exports its product to the United States market and sells it for EUR6 per unit. Then, the company imports raw materials from the United States for USD 3 per unit.
Say the exchange rate changes to EUR2/USD. Europeans say the euro is depreciating because they have to spend 2 euros to get 1 US dollar, more than before (1.5 euros). So, in this case, the euro exchange rate is weaker.
On the other hand, for Americans, the US dollar appreciates. That’s because by exchanging 1 dollar, they get 2 euros, more than before (1.5 euros). So Americans will say the dollar is stronger against the euro.
Now, assume the raw material prices do not change. The company’s imported raw materials are becoming more expensive due to depreciation. Previously, they only took 4.5 euros (USD3 per unit x EUR1.5/USD) and converted it to 3 US dollars to buy one unit. But, as the euro depreciated, they had to spend 6 euros [USD3 x EUR2/USD].
On the other hand, for Americans, the change in the exchange rate makes European products cheaper. For example, to get 1 unit, they only spend 3 dollars [EUR6 per unit / (EUR2/USD)] to convert it to 6 euros and buy the product. That’s less than before, when the exchange rate equaled EUR1.5/USD, where they had to exchange 4 dollars [EUR6 per unit / (EUR1.5/USD)] for the product.
On the other hand, if the exchange rate changes to EUR1/USD, then the raw materials become cheaper for the European company because they only need 3 euros (USD3 per unit x EUR1=/USD) to buy 1 unit. But, in contrast, the product becomes more expensive for Americans because it costs 6 US dollars [EUR6 per unit / (EUR1/USD)] to buy 1 unit.
The above example’s important point is how exchange rate changes affect the relative prices of goods exported and imported, even if producers do not change their selling prices in their home currency. Thus, since exchange rate fluctuations affect prices, they ultimately affect their competitiveness and demand.
The above case is a simplified example. Actual calculations may be more complex.
How do exchange rates affect aggregate demand and the economy?
Before continuing, in this subheading, assume you are European, and the United States is your trading partner. In addition, assume your country’s trade balance is balanced, where exports equal imports.
- If the euro appreciates, you earn more US dollars for every 1 euro you exchange.
- If the euro depreciates, you earn fewer US dollars than before for every 1 euro you exchange.
How do these appreciations and depreciations affect the trade balance, net exports, and aggregate demand?
When the euro depreciates against the US dollar, it becomes less valuable when you convert it to US dollars. So, you have to use more euros to get one US dollar.
Because the euro is weaker against the US dollar; as a result, American products become more expensive for you. You have to spend more euros to buy the product. Consequently, you and other domestic buyers may reduce demand, lowering imported products. You and others may be looking for a cheaper alternative.
On the other hand, depreciation makes exported goods cheaper for buyers in America. This is because they have to pay less to get the same amount. As a result, exported goods become more competitive in the US market, encouraging exports to increase.
Since imports tend to decline and exports tend to rise, the trade balance becomes a surplus (positive net exports). Consequently, it increases aggregate demand and stimulates higher domestic economic growth as domestic producers seek to increase output to export more.
However, depreciation may also contribute to imported inflation. Without substitution in the domestic market, depreciation will result in domestic producers paying more when buying raw materials from the Us. As prices rise, production costs also rise. Finally, they increase the selling price to maintain profit.
Appreciation reduces exports but increases imports. Exported goods have become more expensive for buyers in the United States. On the other hand, imported goods are cheaper for you and other domestic buyers. Finally, it increases the demand for imports but decreases the demand for exports.
As exports fall while imports increase, the trade balance leads to a deficit (negative net exports). As in the formula above, a deficit reduces aggregate demand. This situation could weaken domestic economic growth as export-oriented producers reduce their output.
Although export-oriented manufacturers maintain selling prices, their products are becoming more expensive for Americans due to appreciation. As a result, their competitiveness in the United States market fell. Americans then reduced their demand and looked for cheaper alternatives. This situation leads to a decline in exports.
On the other hand, American products are becoming cheaper for domestic buyers due to appreciation. As a result, they become more attractive to domestic buyers, encouraging them to increase demand. Some may switch from domestic products to American products. As a result, this situation leads to an increase in imports.
What to read next
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- Demand Shock: Definition and a Brief Explanation
- How Exchange Rates Affect Aggregate Demand and the Economy
- How Fiscal Policy Affects Aggregate Demand and the Economy
- How Household Wealth Affects Aggregate Demand and the Economy
- How Monetary Policy Works Affects Aggregate Demand and the Economy