Context: The Japanese yen experienced a sharp decline in value in 2022, which analysts attribute to global economic instability and rising commodity prices worldwide.
Introduction
A currency depreciation refers to a fall in the value of a country's currency relative to others under a floating exchange rate system, meaning each unit of domestic currency buys fewer units of foreign currency, making exports cheaper and imports more expensive. The overall impact must be assessed in terms of key macroeconomic indicators, including the rate of inflation, unemployment, real economic growth and the balance of trade. While depreciation can improve export competitiveness and stimulate aggregate demand, boosting growth and employment, it may also raise import prices, contributing to cost-push inflation and worsening the terms of trade. The final outcome depends on factors such as the price elasticity of demand for exports and imports, the economy's reliance on imported inputs and the broader global context.
The case for depreciation: growth and the trade balance
A major benefit of depreciation lies in improved export competitiveness. As the domestic currency weakens, the foreign-currency price of exports falls, making them more attractive overseas. Assuming exports are price elastic, this raises export volume and net exports, a component of aggregate demand (AD). An increase in AD shifts the curve rightward, raising real national income and employment and helping the economy grow. The increase in demand for exports encourages firms to expand output and hire more labour, lowering unemployment, and through the multiplier effect increased incomes trigger secondary rounds of spending, further boosting national income. In the external sector, if depreciation raises export revenue and lowers imports, it can improve the balance of trade and reduce current account deficits, particularly beneficial for economies with persistent external imbalances.
The case against depreciation: imported and cost-push inflation
Despite its potential to stimulate growth, depreciation presents significant downsides, particularly imported inflation. When the domestic currency weakens, foreign goods become more expensive in local currency terms. For consumers this means higher prices for imported items like food, electronics and fuel, while for firms reliant on imported intermediate goods or raw materials, production costs increase. This shifts the Short-Run Aggregate Supply (SRAS) curve leftward, pushing up the general price level. This cost-push inflation erodes real incomes and may worsen the material standard of living, with the burden especially severe in economies that import essentials such as oil, food or medicine. Moreover, if rising input costs feed into the prices of exports, the initial gain in export competitiveness may be eroded over time, and exporters facing higher production costs may see thinner profit margins and a reduced ability to scale up, undermining the very advantage depreciation was supposed to provide.
Key factors determining the overall impact
The Marshall-Lerner condition
A depreciation will only improve the balance of trade if the sum of the price elasticities of demand for exports and imports is greater than one. If demand is inelastic, the quantity response to the price change is small, so the value of imports may remain high and export volumes may not rise sufficiently, worsening the trade balance in the short term.
Import dependency
The structure of the economy matters. In import-reliant economies like Singapore, where a large proportion of goods, including necessities and production inputs, are imported, the cost-push inflationary effects of depreciation can be severe. By contrast, economies that are more self-sufficient or have a large manufacturing base may benefit more, as they can substitute imports with domestic production and expand exports without being overly affected by higher input costs.
State of the economy
The impact also depends on initial conditions. If the economy is in recession with spare capacity, depreciation can stimulate demand and reduce unemployment without triggering significant inflation. However, if the economy is already close to full employment, the increase in export demand could worsen inflationary pressure.
Evaluative conclusion
In theory, currency depreciation can be a powerful tool to stimulate growth, improve export competitiveness and narrow trade deficits, with benefits most evident when the economy has price-elastic trade flows, spare capacity and low import dependency. However, in practice depreciation often comes with costs, including imported inflation, rising production costs and pressure on real incomes, especially in economies reliant on imported goods and energy. The net impact therefore depends on the structure of the economy, the responsiveness of trade flows and how effectively the government manages inflationary risks. For Japan, where the yen fell sharply in 2022 amid rising global commodity prices, the inflationary impact may have neutralised much of the benefit from increased export competitiveness.