Economics 101: Understanding the Effects of Exchange Rates

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:

1. 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.
2. 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.
3. 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.
4. 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.
5. 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.

As you can see, a fluctuation in the exchange rate of Country A has both positive and negative effects on it’s economy.  The key is to keep the exchange rate at a certain balance to ensure that it doesn’t go to the extremes.  On the one hand, if a country’s currency appreciates too high (as we see in more developed countries like Switzerland), exports fall with drastic consequences to employment.  This is one of the reasons why Switzerland recently decided to set a minimum exchange rate of 1 Swiss Franc to 1.20 Euros, in order to keep the currency from appreciating too high.  On the other hand, other countries like China may attempt to keep their currency artificially low in order to attract business looking to outsource labor, and increase their exports to other countries.

This is why economics is so complicated.  A slight appreciation or depreciation of a country’s currency isn’t necessarily bad or good, it all depends on the country’s situation.  If you look at a country like Germany, for example, you’ll see that they rely heavily on manufacturing and exports in order to maintain their economic strength.  Since many of the major importers of German goods lie within the Eurozone (France, Netherlands, Italy, Austria), it makes sense why Germany would choose to join a currency union that, ideally, would provide a level of security, ensuring that the cost of exporting goods to each country would remain the same, even with small fluctuations in the exchange rate of the Euro.  If Germany were to, say, go back to the D-Mark and let their currency float freely, it would quickly appreciate as it did shortly before the adoption of the Euro, leading to decreased exports, increased unemployment and catastrophic consequences for the German economy.

This is why the idea of a currency union, or even pegging a currency to another, makes economical sense. The problem with currency unions is that they are at risk of becoming overextended.  As we are seeing with countries like Greece, Ireland, Portal, Spain and Italy, overextending a currency union to many countries, without closely examining their economic structure, can lead to a decline of the union as a whole.

So what is the solution then? With the Euro declining even further against major world currencies every day, what can be done to protect the Eurozone?  The short answer: no one really knows.  Because of the interconnected-ness of the global economy, it’s extremely difficult to say exactly what would happen should Greece leave the Eurozone.  One thing is for sure though, whatever happens over these next few weeks, months, and years, it will prove to be a lesson for all currency unions in the future.

*Side note – I know I’m missing a few things in my list, and I know it’s been dumbed-down a bit, but I’ll continue to add to it as things come to mind.*