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Currency Appreciation & Depreciation: Effects of Exchange Rate Changes

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  • 0:04 Currency Terms
  • 1:38 Strong Exchange Rate Effects
  • 4:08 Weak Exchange Rate Effects
  • 5:23 Lesson Summary
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Lesson Transcript
Instructor: Aaron Hill

Aaron has worked in the financial industry for 14 years and has Accounting & Economics degree and masters in Business Administration. He is an accredited wealth manager.

Find out how changes in the exchange rate can affect the economy and your own individual situation. Discover how these currency changes can increase and decrease your purchasing power and standard of living.

Currency Terms

Although the effects can take time, changes in the exchange rate can have a big impact on the economy and your own standard of living and purchasing power! There is often debate over whether a country should have a high or low exchange rate. These discussions often revolve around the current economic and political goals at the time. Let's explore the effects of changes in the exchange rate and see how economic variables, such as inflation, the trade balance, GDP and exports & imports, are affected.

To review quickly, an exchange rate is the rate at which one country's currency can be traded for another country's currency. For example, in the United States, the dollar's strength is often judged in relation to other currencies, such as the Japanese yen, the Swiss franc, and the euro. When a currency appreciates, it means it increased in value relative to another currency; depreciates means it weakened or fell in value relative to another currency.

When a dollar buys more than its equivalent in another currency, it's often labeled strong. When it buys less than its equivalent, it's weak. For example the exchange rate as of August 2014 for the American dollar vs. the Mexican peso is 13 to 1; a strong exchange rate! As of that same date, the American dollar vs. the euro is 0.75 to 1; a weaker exchange rate.

Strong Exchange Rate Effects

Do you like your money to go further when you make a purchase? How about the ability to have more choices when you go shopping? When a currency appreciates or strengthens (a higher exchange rate), there are many effects on you and the economy. Some good, some not so good. Let's discuss a few of those now.

  • Imports cheaper: When a currency appreciates or strengthens in relation to other currencies, imports get cheaper. This means your dollar will buy more of another foreign currency so that you can purchase foreign goods. For example, if you were traveling and shopping in Europe and the exchange rate of the dollar vs. euro went from (0.75 to 1) to (0.95 to 1) your dollars would now buy more euros. So, if a can of soda cost two euros, it would have originally cost you $2.66 ($2/0.75 exchange rate). Now it costs you essentially $2.11 ($2/0.95 exchange rate). This is also great news for American companies who import a lot of components and raw materials to manufacture goods. Lower costs often lead to higher profit margins.
  • Lower inflation: When the exchange rate for a currency strengthens, it makes imports cheaper. This means you and I spend less money on foreign goods. This in turn puts pressure on American firms to keep their prices low, so they can remain competitive. All of this leads to lower prices and ultimately more money in your pocket and a higher standard of living.
  • Balance of trade deficit: One of the biggest disadvantages of higher exchange rates or a strong dollar may be that it leads to trade deficits. Because strong currencies lead to cheaper imports, a country tends to import more than they export. This causes a trade deficit, which can exert a contractionary effect on the economy. What does that mean? It simply means that because our currency is strong, our own goods we look to export appear expensive to other countries; so they buy fewer American goods. This lowers demand for American goods and as a result lowers GDP. Over time, this can make it more difficult for American firms to compete and can also damage profit potential.

Weak Exchange Rate Effects

A lower or weak exchange rate can have the opposite effect as a strong exchange rate or currency. Let's discuss those now.

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