The effects of foreign exchange rate on the economy, inflation and trade balance have been studied in the literature on open economy macroeconomics and monetary policy. The views are spliced into two parts.
The first one is on the Mundell-Fleming model, which states the depreciation of foreign exchange rate has ‘expansionary effect’ on the economy via expenditure-switching effects. (Feldman and Dornbusch, 1981). This argument concludes depreciation of foreign exchange rate adjusts the trade imbalances and has a positive effect on aggregate demand as it promotes exports and reduces imports.
The second view is depreciation of foreign exchange rate has ‘contractionary effect’ on the economy across different channels, separated into aggregate demand or aggregate supply. (Diaz-Alejandro, 1963; Cooper, 1972; Krugman and Taylor, 1978; Alogoskoufis, 1985; Van Wijnbergen Sweder, 1986; Barbone Luca et al. 1987; Agénor, 1991; Kandil and Mirzaie, 2002). Channels for aggregate demand consists of financial statements, true balance, trade liberalization, tax, income reallocation and wealth effects; and channels for aggregate supply include imported input cost, wage indexation, cost of working capital and efficiency wage consideration. (Berument et al., 2003; Sencicek Mehmet et al., 2010; Nusair, 2014)
Effects on Trade Balance
Many macroeconomic theorists believe that foreign exchange rate depreciation has a positive effect on trade balance. There are three approaches to how foreign exchange rate affects the trade balance. They comprise of “absorption, monetary and elasticities approaches”. (Yiheyis et al, 2018)
Following the absorption approach, the trade balance is indicated by “real income and absorption” (Alexander, 1952). The trade balance is improved through “expenditure-switching and expenditure-reducing effects”. It decreases “domestic consumption due to real cash balance effects and higher interest rates”. They improve trade balance by working together in the same direction. (Yildirim et al, 2016)
The monetary approach deals with the balance of payment. If the domestic currency depreciates, this increases demand for money and consequently consumers will lessen purchasing of goods and selling of assets to increase liquidity which brings a excess to the balance of payment. (Frenkel et al, 1975; Johnson, 1977). Foreign exchange rate depreciation corrects the trade balance “via a fall in real expenditures resulting from the negative real balance effect of depreciation”. (Yildirim et al, 2016)
As per the elasticities approach, the trade balance may improve from foreign exchange rate depreciation depending “on the price elasticities of demand and supply of imports and exports”. It improves trade balance by driving imports’ relative price up, hence lowering import quantities and causing export quantities to rise up. The Marshall-Lerner (ML) condition is the “phenomenon of the domination of the volume effect over the price effect in the long run”. (Jamilov, 2013) Under this condition, the foreign exchange rate depreciation will promote the trade balance if the sum of these elasticities is greater than one”, where the elasticities are the export and import quantities. When the ML condition is not met, “the trade balance follows a J-curve”: the foreign exchange rate depreciation affects the trade balance in the short-term and helps it in the long-term. (Bahmani-Oskooee et al, 2004; Bahmani-Oskooee et al, 2010; Bahmani-Oskooee et al, 2013)
Effects on inflation
Foreign exchange rate depreciation in theory is expected to engender inflation through various channels from its supply and demand effects. (Dornbusch, 1988; Furstenberg and Dornbusch, 2015; Age?nor and Montiel, 2015) The impact of foreign exchange rate on price is instantly and directly distributed through changes in the domestic-currency price of goods imported. (Furstenberg and Dornbusch, 2015) Nominal devaluation of foreign exchange rate drives up the latter if no remedial measures are taken up. As such, this increases demand and hence the price of imports. (Yiheyis et al, 2018)
The supply-side effect runs from the imported input channel. Foreign exchange rate depreciation is more likely to increase inflation due to rising prices of import goods whereas an appreciation in foreign exchange rate will usually decrease inflation as import prices becomes cheaper. (Yildirim et al, 2016) The relationship between foreign exchange rate and inflation has been studied in different industries like Petrochemical and automobile. (Bernhofen and Xu, 2000; Goldberg, 1995)
The demand-side effect rises from the expenditure-switching channel as foreign exchange rate depreciation causes aggregate demand by increasing net export which increases inflation by increasing input prices and nominal wages.
The indirect way foreign exchange rate affects inflation is by increasing production costs. In pricing model (Taylor, 1990), the cost-push inflation influenced by foreign exchange rate increases the price of imports, labor costs and interest costs related to funding of working capital. The effect of foreign exchange rate depreciation on inflation has seen studied (Campa and Goldberg, 2005) and is found to be macroeconomic in nature, at least for Organisation for Economic Co-operation and Development (OECD) countries.
It has also been found that foreign exchange rate depreciation could influence price formation by changing inflationary expectations.(Mohanty and Klau, 2001; Domaç and Yucel, 2004)
There have been many studies done to the relationship of foreign exchange rate depreciation and the Consumer Price Index, Producer Price Index and Wholesale Price Index, which concludes the aggregate consumer prices “appears to be modest” depending on the ‘inflation regime”, and elasticities of export supply and import demand of the country and its trading partners. (Kreinin,1977; Woo, 1984; Feinberg, 1986, 1989; Papell, 1994; Parsley and Popper, 1998; McCarthy, 2000; Choudhri and Hakura, 2006).
But, depending on exchange rate regime, inflation can actually influence nominal exchange rate depreciation. The three exchange rate regimes are as follows: floating, managed and fixed. For the floating regime, “domestic inflation would lead to nominal exchange rate depreciation to maintain external balance” in absence of central bank involvement in reserve adjustment. For the managed exchange rate regime, the modification arising from internal inflation depends on exchange rate, “which makes the external balance modestly responsive to inflation performance”. And, for the fixed exchange rate approach, the domestic inflation and external balance are dissociated in the short-term. (Yiheyis et al, 2018)
Inflation is also associated to real exchange rate depreciation. (Azam, 2001)
Effects on Interest Rates
Foreign exchange rate depreciation indirectly affects interest rate through its influence on inflation. When inflation rises, the nominal interest rates will increase. As such, foreign exchange rate depreciation causes a higher nominal interest rate. (Yildirim et al, 2016) Many studies have been done which shows statistically significant evidence for the relationship between foreign exchange rate and interest rates. (Edison and Melick, 1999; Nagayasu and MacDonald, 1999; Alam et al, 2001)