Currency Impact on the Economy

A currency’s level has a direct impact on the following aspects of the economy:

Merchandise Trade

This refers to a nation’s international trade or its exports and imports. In general terms, a weaker currency will stimulate exports and make imports more expensive, thereby decreasing a nation’s trade deficit (or increasing surplus) over time.

For example, assume you are a US exporter who sold a million widgets at $10 each to a buyer in Europe two years ago when the exchange rate was €1=$1.25. The cost to your European buyer was, therefore, €8 per widget. Your buyer is now negotiating a better price for a large order, and because the dollar has declined to 1.35 per euro, you can afford to give the buyer a price break while still clearing at least $10 per widget.

Even if your new price is €7.50, which amounts to a 6.25% discount from the previous price, your price in dollars would be $10.13 at the current exchange rate. The depreciation in your domestic currency is the primary reason why your export business has remained competitive in international markets.

Conversely, a significantly stronger currency can reduce export competitiveness and make imports cheaper, which can cause the trade deficit to widen further, eventually weakening the currency in a self-adjusting mechanism. But before this happens, industry sectors that are highly export-oriented can be decimated by an unduly strong currency.

Economic Growth

The basic formula for an economy’s GDP is:

\begin{aligned} &GDP= C + I + G + (X-M)\\ &\textbf{where:}\\ &C = \text{consumption or consumer spending, the biggest}\\ &\text{component of an economy}\\ &I = \text{capital investment by businesses and households}\\ &G = \text{government spending}\\ &(X-M) = \text{exports - imports, or net exports}\\ \end{aligned}​GDP=C+I+G+(X−M)where:C=consumption or consumer spending, the biggestcomponent of an economyI=capital investment by businesses and householdsG=government spending(X−M)=exports - imports, or net exports​

From this equation, it is clear that the higher the value of net exports, the higher a nation’s GDP. As discussed earlier, net exports have an inverse correlation with the strength of the domestic currency. 

Foreign capital tends to flow into countries that have strong governments, dynamic economies, and stable currencies. A nation needs to have a relatively stable currency to attract investment capital from foreign investors. Otherwise, the prospect of exchange losses inflicted by currency depreciation may deter overseas investors.

Capital flows can be classified into two main types – foreign direct investment (FDI), in which foreign investors take stakes in existing companies or build new facilities overseas; and foreign portfolio investment, where foreign investors buy, sell, and trade overseas securities. FDI is a critical source of funding for growing economies, such as China and India.

Governments greatly prefer FDI to foreign portfolio investments since the latter are often akin to “hot money” that can leave the country when the going gets tough. This phenomenon referred to as “capital flight," can be sparked by any negative event, including an expected or anticipated devaluation of the currency.

Inflation

A devalued currency can result in “imported” inflation for countries that are substantial importers. A sudden decline of 20% in the domestic currency may result in imported products costing 25% more since a 20% decline means a 25% increase to get back to the original price point.

Interest Rates

As mentioned earlier, the exchange rate level is a key consideration for most central banks when setting monetary policy. For example, former Bank of Canada Governor Mark Carney said in a September 2012 speech that the bank takes the exchange rate of the Canadian dollar into account in setting monetary policy. Carney said that the persistent strength of the Canadian dollar was one of the reasons why his country's monetary policy had been “exceptionally accommodative” for so long.

A strong domestic currency exerts a drag on the economy, achieving the same end result as tighter monetary policy (i.e., higher interest rates). In addition, further tightening of monetary policy at a time when the domestic currency is already unduly strong may exacerbate the problem by attracting more hot money from foreign investors, who are seeking higher yielding investments (which would further push up the domestic currency).