AP Syllabus focus: ‘A currency depreciation increases net exports, which raises aggregate demand and can increase output, employment, and the price level.’
A currency’s value affects international purchasing power and trade flows. This page explains how a depreciation changes net exports, shifts aggregate demand, and alters key macroeconomic outcomes in the short run.
Currency Depreciation and Net Exports
What a depreciation does to relative prices
Currency depreciation: a fall in the value of a currency in the foreign exchange market, meaning it buys fewer units of foreign currency.
When the domestic currency depreciates, domestic goods become cheaper to foreigners and foreign goods become more expensive to domestic buyers (in domestic-currency terms). This shifts spending toward domestically produced output.
Net exports rise (typical direction)
Net exports (NX): exports minus imports; the net foreign demand for a country’s goods and services.
A depreciation tends to increase NX because:
This diagram shows the classic J-curve: after a depreciation, net exports () can initially fall before rising above the original level over time. It reinforces that the longer-run direction is usually higher , while reminding you that adjustment can be delayed due to existing contracts and slow quantity responses. Source
Exports rise: foreign buyers face lower prices for domestic goods, increasing quantity demanded.
Imports fall: domestic consumers and firms face higher prices for foreign goods, reducing quantity demanded.
The balance of trade component improves when the change in export and import spending raises .
From Net Exports to Aggregate Demand
Net exports are a component of aggregate demand
Aggregate demand includes spending on domestically produced final goods and services. When NX rises, aggregate demand increases because foreign and domestic buyers shift purchases toward domestic output.
= total planned spending on domestic output (real GDP)
= consumption spending
= investment spending
= government purchases
= net exports,
An increase in NX shifts the AD curve right, holding other components constant.
This figure illustrates a rightward shift of the aggregate demand curve (from to ). A rightward AD shift means that at every price level, planned spending on domestically produced output is higher, which is the AD-side mechanism your notes attribute to rising net exports after a depreciation. Source
The size of the AD shift depends on how strongly exports and imports respond to the change in the exchange rate.
Why this changes real GDP and the price level
With sticky nominal wages and some prices adjusting slowly in the short run, a rightward AD shift typically leads to:
Higher real output (real GDP) as firms expand production to meet higher demand.
Higher employment as firms hire more labor to increase output.
Higher price level as stronger demand bids up prices, especially as the economy approaches capacity.
Macroeconomic Outcomes of Depreciation (Short Run)
Output and employment effects
A depreciation-driven rise in NX increases demand for domestically produced goods across export industries and import-competing industries. Firms respond by:
Increasing production and capacity utilisation
Raising labor demand, reducing cyclical unemployment
Price level effects
As AD rises:
Firms may raise prices due to stronger demand and higher marginal costs at higher output levels.
Imported inputs can become costlier after depreciation, adding upward pressure on some domestic prices (a demand shift can coincide with cost pressures, but the core AP link here is the AD increase via NX).
Key conditions that influence the strength of the effect
The AD and real GDP impact is larger when:
Trade flows are responsive to price changes (more elastic export and import demand).
The economy has slack (unemployed resources), so output can rise more with less immediate inflation pressure.
Domestic firms can scale production to meet higher foreign and domestic demand without severe bottlenecks.
FAQ
Not necessarily. Existing contracts, slow quantity adjustments, and pricing-to-market can delay trade-volume responses even if relative prices change quickly.
Pass-through is how much a currency depreciation raises import prices in domestic currency.
Low pass-through can mute import reduction; high pass-through can strengthen NX but raise inflationary pressure.
If export and import demands are price elastic, quantities respond strongly, so $NX$ rises more and $AD$ shifts further right.
If demands are inelastic, the $NX$ response may be small.
Yes. If the economy is near full capacity, extra demand mostly bids up prices.
Also, higher imported-input costs can raise firms’ costs, reinforcing price increases.
Firms reliant on imported intermediate goods may face higher costs and cut production.
Households may reduce real purchasing power as import prices rise, partly offsetting the demand boost from $NX$.
Practice Questions
(2 marks) Explain how a depreciation of a country’s currency affects its net exports and aggregate demand.
1 mark: Depreciation tends to increase net exports (exports rise and/or imports fall).
1 mark: Higher net exports increase aggregate demand (rightward shift of AD).
(5 marks) A country experiences a depreciation of its currency. Using AD–AS reasoning, analyse the likely short-run effects on real output, employment, and the price level.
1 mark: Depreciation increases net exports (exports up and imports down).
1 mark: Increase in increases (rightward shift).
1 mark: Real output (real GDP) rises in the short run.
1 mark: Employment rises (unemployment falls) as firms expand production.
1 mark: Price level rises due to higher aggregate demand.
