Devaluation and Depreciation

A devaluation or depreciation should work in the opposite direction, improving the trade balance thanks to soaring exports and falling imports.

If, however, imports have an elasticity to price less than 1, their values in local currency will grow instead of falling.

"International comparisons of current values converted to a common currency are "distorted" by wide exchange rate fluctuations."

Hosting different industries, regions usually exhibit a differenciated degree of international openness: exchange rate fluctuations will have a uneven impact on them. Similarly, the number of job places and the working conditions may be influenced by the degree of international competition and exchange rates levels.

Exchange rate influences also the external purchasing power of residents abroad, for example in term of purchasing real estate and other assets (e.g. firm equity as a foreign direct investment), so by different channels, also the balance of payments.

Exchange rate devaluation or depreciation give rise to inflationary pressures: imported good become more expensive both to the direct consumer and to domestic producer using them for further processing.

Symmetrically, the central bank may use a fixed exchange rate as a nominal anchor for the economy to keep inflation under control, compelling domestic producer to face tougher competition as soon as they decide to increase prices or accept to pay higher wages.

The Balance of Payments

Can highlight pressures for devaluation or revaluation, reflected in large and systematic trend of foreing currency reserves at the central bank. In particular, large inflows, due for instance to a rise in the world price of main exports tend to revaluate the exchange rate. Conversely, a collapse in the trust of government to manage the economic conditions might provoke a flight of capital, the exhaustion of foreign currency reserves and force a devaluation / depreciation.

Levels and Fluctuations

Impact on other variables

Levels and fluctuations in the exchange rate exert a powerful impact on exports, imports and the trade balance. A high and rising exchange rate tends to depress exports, to boost import and to deteriorate the trade balance, as far as these variables respond to price stimuli. Consumers find foreign goods cheaper so the consumption composition will change. Similarly, firms will reduce their costs by purchasing intermediate goods abroad.

In extreme cases, local firms producing for the domestic market might go bankrupt. If the reason of appreciation was a soaring world price of main exports (e.g. energy carriers, like oil for many oil producing countries), the composition of the industrial texture would be starkly simplified and concentrated to those exports, in the opposite direction of the diversification of the economy that is often the stated goal of public strategies in countries depending on too few productions (high export concentration).

Exchange Rates Behaviour

Business cycle behaviour

Too many elements are at work for the exchange rate possessing a clearly-defined business cycle behaviour. To the extent that the exchange rate is determined by the trade balance, the exchange rate is counter-cyclical as the latter. At peaks, the trade deficit would depress the exchange rate, forcing it to depreciate.

If it is rather the interest rate that turns out to the main driver of the exchange rate, a possible pro-cyclicity of the interest rate would imply a pro-cyclical exchange rate.

In this scenario, recovery and boom are accompanied by rising interest rates and exchange rates. At peaks, we would see very strong currency. Together with domestic demand pressures, this would be the source of a high trade deficit.

If autonomous dynamics in the forex market are the main determinants of the exchange rate, then intense micro-fluctuations and long term tides would ride the exchange rate, possibly with central bank significant interventions.