AD/AS analysis of exchange rate changes examines how a change in a country’s exchange rate — either appreciation or depreciation — affects the equilibrium national income, real output, price level, and employment through shifts in the Aggregate Demand (AD) and/or Aggregate Supply (AS) curves.
Exchange rate depreciation — effects on AD/AS:
When a currency depreciates, domestic goods become cheaper for foreigners and imported goods become more expensive domestically. This affects the economy in the following ways:
Effect on Aggregate Demand (AD):
- Exports become cheaper → foreign buyers purchase more → export volumes increase → X component of AD rises
- Imports become more expensive → domestic consumers switch to domestic goods → M component of AD falls
- Net effect: (X − M) improves → AD shifts rightward (increase in AD)
- In the short run, the AD shift leads to higher equilibrium national income, higher real output, and a higher price level
Effect on Aggregate Supply (AS):
- Imported raw materials and capital goods become more expensive → production costs rise → AS shifts leftward (decrease in AS)
- This pushes the price level upward (cost-push inflationary pressure) and reduces equilibrium output
Combined effect:
- The rightward shift of AD and leftward shift of AS both raise the price level — the inflationary effect of depreciation is significant
- The net effect on real output and employment depends on which shift dominates
- A depreciation can improve the current account only if the Marshall-Lerner condition holds (elasticities of demand for exports and imports sum to more than 1)
Exchange rate appreciation — effects on AD/AS:
When a currency appreciates:
- Exports become more expensive → export volumes fall → X component of AD decreases
- Imports become cheaper → domestic consumers prefer imports → M component of AD increases
- (X − M) worsens → AD shifts leftward → lower equilibrium national income, lower real output, and a lower price level
- Cheaper imported inputs may reduce costs → AS may shift rightward
- Net effect: downward pressure on output and employment, but lower inflation
Summary table:
| Exchange rate change | AD effect | AS effect | Real output | Price level |
|---|---|---|---|---|
| Depreciation | AD shifts right | AS shifts left (cost-push) | Ambiguous | Rises |
| Appreciation | AD shifts left | AS may shift right | Falls | Falls |