The Economics of Foreign Exchange: Appreciation and Depreciation of Currencies

Appreciation and Depreciation of Currencies As was just pointed out, exchange rates change frequently under the current system of international exchange. Currency appreciation occurs when there is an increase in the number of units of one nation's currency that must be given up to purchase each unit of another nation's currency. For example, the dollar appreciates relative to the German mark if the equilibrium price (the exchange rate) of a dollar increases in terms of the mark. If the equilibrium price of a dollar goes up from 2 marks to 3 marks, the dollar has appreciated relative to the mark. Similarly, currency depreciation occurs when there is a decrease in the number of units of one nation's currency that must be given up to purchase each unit of another nation's currency. The data in Box 4 shows that the dollar depreciated against the mark between 1986 and 1988 when its exchange rate fell from 2.196 marks per dollar in July 1986 to only 1.639 marks per dollar in January 1988. When the dollar appreciates in terms of the mark, it follows that the mark depreciates in terms of the dollar. It takes more marks to purchase a dollar, and fewer dollars are needed to purchase a mark. Similarly, if the dollar depreciates in terms of the mark, the mark appreciates in terms of the dollar. Between July 1986 and January 1988 the mark appreciated from 0.4554 to 0.6101 mark per dollar. Note that when the U.S. dollar appreciates, other things being unchanged, goods and services produced in the United States become more expensive in terms of foreign currencies. This decreases the foreign demand for U.S. goods and services and tends to decrease U.S. net exports and real GNP. Similarly, because foreign currencies depreciate when the U.S. dollar appreciates, foreign goods become cheaper in terms of U.S. currency, inducing U.S. citizens to spend more dollars on foreign goods and services. This also decreases aggregate demand for U.S. goods. Currency appreciation or depreciation in a free market results from shifts in either the demand for or supply of the currency. To forecast changes in foreign exchange rates thus requires an understanding of the forces underlying the demand for dollars and assets denominated in dollars held by foreigners. It also requires an understanding of the forces influencing the supply of dollars offered in exchange for foreign currencies. The Principle of Purchasing Power Parity The principle of purchasing power parity of one nation's money for another's states that the exchange rate between any two currencies tends to adjust to reflect changes in the price levels in the two nations. The logic behind purchasing power parity is that similar goods produced in different countries should sell for the same price when exchange rates and transaction costs are taken into consideration. Using this logic, a rise in the U.S. price level tends to cause the dollar to depreciate in terms of foreign currency. Similarly, a decline in the U.S. price level tends to result in an appreciation of the dollar in terms of foreign currency. If the principle held precisely, then whenever the U.S. price level rose 10 percent relative to, say, the German price level, the price of the dollar in terms of the mark would fall by exactly 10 percent. The principle of purchasing power parity holds only if foreign exchange markets are free. As you'll soon see, central banks and other governing authorities often intervene in foreign exchange markets. For example, the Fed may buy dollars on the international market, thereby increasing demand and preventing the price of the dollar from falling in terms of foreign currencies. Similarly, governments often control exchange rates to keep the prices of imports low to their citizens. Even when foreign exchange markets are free, there is often a lag between changes in the price levels and changes in foreign exchange rates between two nations. Nominal and Real Exchange Rates The nominal exchange rate of a currency is the price of a unit of that currency in terms of a unit of foreign currency. The real exchange rate of a currency is the sacrifice of their own goods and services that buyers must make when they use their currency to purchase a unit of the currency of another nation. For example, the real exchange rate of a dollar to an Italian is the sacrifice of Italian goods and services that person makes when Italian lire are used to buy one dollar. An increase in the real exchange rate of the dollar occurs when the price of the dollar in terms of lire increases after adjustment for differences in the rates of inflation in both the United States and Italy. When the real exchange rate of the dollar increases, foreigners give up more purchasing power for each dollar's worth of U.S. goods they buy. On the other hand, when the real exchange rate of the dollar increases, U.S. buyers will sacrifice fewer goods and services for any given purchase of foreign goods denominated in foreign currency. For example, the purchase of 400,000 lire worth of Italian goods involves less of a sacrifice for U.S. buyers when the real exchange rate of the dollar rises in terms of lire. Remember: When the exchange rate of the dollar appreciates in terms of the lira, the exchange rate of the lira in terms of dollars must fall. Changes in real exchange rates therefore affect the attractiveness of U.S. exports in foreign markets and also affect U.S. demand for imports by changing the prices of imports and exports after adjustment for inflation.