Introduction
A depreciation of the exchange rate occurs when a country's currency loses value relative to other currencies, making exports cheaper and imports more expensive. This can influence a country's standard of living (SOL) in both positive and negative ways. A weaker currency can boost net exports (X minus M), raising aggregate demand (AD), economic growth and employment, which in turn improves both material and non-material aspects of living standards. A weaker currency can also lead to imported inflation, however, which reduces purchasing power and may lower living standards, especially in economies heavily dependent on imports. The effectiveness of depreciation in improving the standard of living depends on factors such as the Marshall-Lerner condition, the country's dependence on trade and its resource endowments.
How a depreciation can improve the standard of living
A weaker exchange rate makes exports cheaper for foreign buyers and imports more expensive for domestic consumers. This raises demand for exports and lowers demand for imports, improving net exports (X minus M). A rise in net exports increases aggregate demand from AD0 to AD1, which raises real national income via the multiplier effect from Y0 to Y1.
As the economy expands, businesses increase production, leading to higher economic growth and higher incomes. With greater disposable income, individuals have an increased ability to purchase goods and services, improving material standard of living. As demand for exports rises, firms need to increase production and hire more workers, lowering the unemployment rate and raising household incomes and purchasing power.
Employed individuals enjoy higher living standards than the unemployed, as they have more financial stability. A lower unemployment rate also raises non-material standard of living, since lower joblessness reduces social unrest and crime rates, leading to a more stable and cohesive society.
The extent to which a depreciation improves net exports depends on the Marshall-Lerner condition, which states that for a depreciation to improve the balance of trade, the sum of the price elasticities of demand for exports and imports must be greater than one. If demand for exports and imports is price-inelastic, a weaker exchange rate may not significantly raise export demand or reduce import demand, limiting the effectiveness of depreciation in boosting aggregate demand and economic growth.
How a depreciation may worsen the standard of living
A depreciation makes imported goods more expensive, raising the cost of raw materials, fuel and essential goods. If a country is heavily dependent on imports, for food, energy and industrial inputs, this raises overall production costs. The rise in production costs results in cost-push inflation, causing firms to raise prices, which reduces consumers' real purchasing power. As inflation erodes wages, individuals struggle to afford goods and services, lowering material standard of living.
For economies that lack natural resources, such as Singapore, import dependence is high, making them more vulnerable to inflationary pressures from depreciation. A significant rise in import prices can outweigh the benefits of increased exports, potentially leading to a net decline in living standards.
Conclusion
The effectiveness of exchange rate depreciation in improving the standard of living depends on several factors. If the country has a high dependence on trade, depreciation can have a stronger impact on net exports, boosting growth and employment. The Marshall-Lerner condition must be satisfied for depreciation to improve net exports and effectively raise aggregate demand. For countries that lack natural resources and rely heavily on imported necessities, the negative impact of higher import prices may outweigh the benefits of higher exports, leading to a decline in real purchasing power and material wellbeing. If a country is already at full employment, an increase in aggregate demand may instead cause demand-pull inflation, further eroding real incomes. While depreciation can boost growth and employment, it is therefore not always guaranteed to improve the standard of living, especially for import-dependent economies facing inflationary pressures.