Having followed the crisis in the Eurozone fairly closely for the past couple years, I think it has become an incredible learning experience for me, as there are many lessons that can be learned with regard to managing a nations economy, austerity measures and bailouts. The other thing I’ve noticed, however, is that many people lack a fundamental understanding of how an exchange rate affects a nation (or bloc of nations’) economy. Many people often assume that the appreciation of the dollar is a good thing for Americans, and I’ve heard several people even welcome the collapse of the Eurozone because “that makes it cheaper to travel there right?”. While on the outside, this may appear to be the case, the effects of an exchange rate fluctuation are far deeper than what we often realize. To better understand how this works, I think it’s best to start out with a hypothetical example:
Let’s say we have two countries, Country A and Country B. Now let’s assume that Country A has vast natural coal deposits and iron ore, while Country B has rich deposits of precious metals, the kinds often used to make things like phones and computers. For the sake of keeping things simple, we’ll assume that Country A has a developed, high-tech manufacturing economy and needs the precious metals mined by Country B in order to produce it’s high-tech products, which are generally exported. Likewise, Country B has a large manufacturing economy and needs the coal and iron of Country A to produce steel, one of it’s chief exports.
Now let’s assume that, one day, the exchange rate of Country A appreciates by 10% compared to the value of the currency of Country B. Once this happens, a few different things take place:
- Exports of Country A decline – While goods and services within Country A remain the same price, exports are now 10% more expensive for customers in Country B. In this case, a company could also reduce their prices to stay competitive, but that reduce their profit margin, forcing them to make cuts elsewhere.
- Slower real GDP growth – As the exchange rate of Country A appreciates relative to the currency of Country B, it causes a slower rate of growth of the real GDP in Country A. Because a reduction in exports also means a reduction in demand and output, business may seek to control costs by laying off employees.
- Outsourcing to Country A slows – Because goods and services are now 10% more expensive in Country A for the rest of the world, companies may do one of two things: reduce compensation to their employees in country A, or reduce the number of employees in country A, in favor of outsourcing them to another country. As a result, unemployment rises further.
- Raw materials become cheaper – Since their currency has appreciated by 10%, it means that raw materials from Country B are now 10% less expensive to import, leading to greater profit margins for manufacturers in Country A.
- Imports from Country B become cheaper – A consumer in Country A can now buy 10% more than they could yesterday since their currency has appreciated relative to Country B. In turn, this may lead to increased imports from Country B, pushing the trade deficit towards the negative.