2.2.3 - Appreciation, depreciation and trade

Floating and fixed-rate changes

An appreciation is an increase in a currency's value under a floating exchange-rate system; a depreciation is a decrease. A revaluation is an official increase in the value set for a currency in a fixed or managed fixed-rate system; a devaluation is an official decrease in that set value.

Use the quote US dollars per £1 throughout. A rise from 1.20 to 1.50 US dollars per £1 is a pound appreciation: each pound buys more dollars. A fall from 1.50 to 1.20 is a pound depreciation. If the authorities officially make those changes to a fixed rate, the terms are revaluation and devaluation respectively. Similar price consequences can follow, but the source of the change differs.

The percentage-change base is the original rate:

From 1.20 to 1.50 the change is 25%. From 1.50 to 1.20 it is −20%, a 20% fall. Reversing the same two rates does not produce equal percentage changes because the base changes. An exchange rate is a price, not a percentage rate; subtracting 1.20 from 1.50 gives 0.30 US dollars per pound, not 0.30 percentage points.

Currency changes and trade prices

Changing the exchange rate changes prices expressed in the other currency even when the supplier keeps its own price unchanged.

Assume an exporter keeps a British machine's price at £100 and an overseas supplier keeps an imported component's price at 120 US dollars. Ignore fees, tariffs and changes in supplier prices. These are illustrative figures.

The pound's appreciation makes this export dearer in dollars and this import cheaper in pounds. Reversing the change makes the export cheaper in dollars and the import dearer in pounds. Remember whose price changes: a British exporter need not raise its pound price for its foreign-currency price to rise.

An appreciation can lower import costs for a British firm, helping production costs, but can make its finished exports less competitive abroad. A depreciation can improve export price competitiveness while raising the cost of imported materials. Firms selling abroad but relying heavily on imported inputs therefore face competing effects.

These effects assume prices are passed through. Suppliers may adjust their prices or profit margins, and contracts may temporarily fix the buyer's price. Currency changes also depend on which trading partners' currencies move; a bilateral pound–dollar change does not describe every exchange rate.

Currency changes and demand for trade

Buyers' responses connect the exchange-rate price effect to the quantities imported and exported.