Currency Appreciation and Depreciation

CFA Level 1 - Global Economic Analysis

Current and Financial Account Surpluses and Deficits
Current account deficits (or surpluses) and financial deficits (or surpluses) do not directly affect an economy. In fact, these deficits (surpluses) are actually the result of what is occurring in an economy, instead of being the cause. Trade deficits often occur when a nation's economy is growing faster than the economies of its trading partners. Rapid domestic growth increases the demand for imports, while slow or no growth with foreign economies can cause a decline in demand for the country's exports.

Trade balances are also affected by capital flows. If a nation's economy offers investment opportunities that are relatively better than other nations, then capital will flow into the country. With flexible exchange rates, this capital inflow will tend to increase the value of the nation's currency.

Economic statistics support the hypothesis that trade deficits are associated with investment opportunities and economic growth. Between 1973 and 1982, which was a time of stagnant economic growth for the U.S., trade deficits and net foreign investment were fairly small. As the U.S. economy grew rapidly after the 1982 recession, net foreign investment greatly increased. During the recession of the early 1990s, capital inflow greatly decreased and the current account was actually slightly positive during one of those years. The time between 1993 and 2000 was one of substantial economic growth; net capital inflows greatly increased, which caused the U.S. dollar to appreciate and the current account ran large deficits.

Budget deficits and trade deficits tend to be linked
An increase in the U.S. government budget deficit will cause an increase in the real interest rate, which causes additional foreign capital to flow into the country. The inflow of foreign currencies will cause the value of the U.S. dollar to increase in relation to other currencies. The increase in value of the U.S. dollar will make U.S. exports relatively less attractive to foreigners and imports into the U.S. will be relatively less expensive; therefore, net exports will go down. The increase in the budget deficit leads to an increase in the trade deficit.
Causes of a Nation's Currency Appreciation or Depreciation
Factors that can cause a nation's currency to appreciate or depreciate include:

·Income Changes - Suppose that the income of a major trading partner with the U.S., such as Great Britain, greatly increases. Greater domestic income is associated with an increased consumption of imported goods. As British consumers purchase more U.S. goods, the quantity of U.S. dollars demanded will exceed the quantity supplied and the U.S. dollar will appreciate. 

·Inflation Rate Differences - Inflation (deflation) is associated with currency depreciation (appreciation). Suppose the price level increases by 40% in the U.S., while the price levels of its trading partners remain relatively stable. U.S. goods will seem very expensive to foreigners, while U.S. citizens will increase their purchase of relatively cheap foreign goods. The U.S. dollar will depreciate as a result. If the U.S. inflation rate is lower than that of its trading partners, the U.S. dollar is expected to appreciate. Note that exchange rate adjustments permit nations with relatively high inflation rates to maintain trade relations with countries that have low inflation rates.

·Monetary Policy - Countries with expansionary (easy) monetary policies will be increasing the supply of their currencies, which will cause the currency to depreciate. Those countries with restrictive (hard) monetary policies will be decreasing the supply of their currency and the currency should appreciate. Note that exchange rates involve the currencies of two countries. If a nation's central bank is pursuing an expansionary monetary policy while its trading partners are pursuing monetary policies that are even more expansionary, the currency of that nation is expected to appreciate relative to the currencies of its trading partners.

·Relative Product Prices - If a country's goods are relatively cheap, foreigners will want to buy those goods. In order to buy those goods, they will need to buy the nation's currency. Countries with the lowest price levels will tend to have the strongest currencies (those currencies will be appreciating).

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