Effects of exchange rate changes
The government may influence the exchange rate in order to influence the economy. The government may influence the exchange rate directly by buying or selling the domestic currency from the currency reserves in the foreign exchange market. Alternatively the government can affect the exchange rate indirectly, by affecting the level of aggregate demand, employment, inflation and the balance of payments.
The government can, for example, increase the value of the exchange rate (by raising short-term interest rates) in order to decrease the prices of imports and reduce the import price-led inflation within the economy. However, this may cause export volumes to fall, especially if they are price sensitive (elastic) as well as leading to a fall in employment.
The government may also decrease the exchange rate to achieve some of its macroeconomic goals, such as improving the balance of payments (imports less competitive and exports more competitive) or increasing employment. However, higher import prices could cause import price led inflation.
Changes in exports
As we have seen, a depreciation of a currency will reduce the overseas price of exports, which should lead to an increase in demand for exports. The higher the price elasticity of demand for exports, the bigger the increase in demand for exports will be.
Changes in imports
A depreciation of a currency will increase the price of imports. This will lead to a decrease in the demand for imports, with the scale of the decrease depending on the price elasticity of demand for imports. If demand is very inelastic, then imports will change very little. If, on the other hand, demand is very elastic, then imports will change considerably.