16.3 Macroeconomic effects of exchange rates

A central bank    will be concerned about the exchange rate for multiple reasons: (1) Movements in the exchange rate will affect the quantity of aggregate demand in an economy; (2) frequent substantial fluctuations in the exchange rate can disrupt international trade and cause problems in a nation’s banking system–this may contribute to an unsustainable balance of trade and large inflows of international financial capital, which can set the economy up for a deep recession if international investors decide to move their money to another country. Let’s discuss these scenarios in turn.

Exchange rates, aggregate demand, and aggregate supply

Foreign trade in goods and services typically involves incurring the costs of production in one currency while receiving revenues from sales in another currency. As a result, movements in exchange rates can have a powerful effect on incentives to export and import, and thus on aggregate demand in the economy as a whole.

For example, in 1999, when the euro first became a currency, its value measured in U.S. currency was $1.06/euro. By the end of 2013, the euro had risen (and the U.S. dollar had correspondingly weakened) to $1.37/euro. Consider the situation of a French firm that each year incurs €10 million in costs, and sells its products in the United States for $10 million. In 1999, when this firm converted $10 million back to euros at the exchange rate of $1.06/euro (that is, $10 million × [€1/$1.06]), it received €9.4 million, and suffered a loss. In 2013, when this same firm converted $10 million back to euros at the exchange rate of $1.37/euro (that is, $10 million × [€1 euro/$1.37]), it received approximately €7.3 million and an even larger loss. This example shows how a stronger euro discourages exports by the French firm, because it makes the costs of production in the domestic currency higher relative to the sales revenues earned in another country. From the point of view of the U.S. economy, the example also shows how a weaker U.S. dollar encourages exports    .

Since an increase in exports results in more dollars flowing into the economy, and an increase in imports means more dollars are flowing out, it is easy to conclude that exports are “good” for the economy and imports are “bad,” but this overlooks the role of exchange rates. If an American consumer buys a Japanese car for $20,000 instead of an American car for $30,000, it may be tempting to argue that the American economy has lost out. However, the Japanese company will have to convert those dollars to yen to pay its workers and operate its factories. Whoever buys those dollars will have to use them to purchase American goods and services, so the money comes right back into the American economy. At the same time, the consumer saves money by buying a less expensive import, and can use the extra money for other purposes.