THE EFFECT OF EURO/DOLLAR EXCHANGE RATE DEPRECIATION ON EXPORTS

THE EFFECT OF EURO/DOLLAR EXCHANGE RATE DEPRECIATION ON EXPORTS

The year 2022 has been characterized by a considerable increase in costs, which has greatly impacted the core of the Italian manufacturing sector consisting mainly of SMEs: with an inflation rate of 8.8% recorded in 2022 and similar forecasts for 2023 as well, there will be higher operating costs, as well as an increase in interest rates and related debt burden.

However, the above has generated positive consequences for Italian exports: in 2022 Italian exports increased by about 10.3%, with positive growth forecasts, +5%, also for 2023 (SACE's Export 2022 report).

For this reason, it seems appropriate to elaborate here on the consequences generated on exports by the dynamics related to inflation and the exchange rate, in order to understand the underlying mechanisms.

EXCHANGE RATE DEFINITION

Inflation is not only a domestic phenomenon: the high degree of openness to foreign countries in today's globalized world and the existence of a multiplicity of exchanges means that the rate of price change is also influenced by foreign price trends; therefore, it becomes essential to monitor the exchange rate between two currencies as well.

The currency exchange rate, or nominal exchange rate, is the price of one currency expressed in the terms of another currency: if the exchange rate of the Euro against the Dollar increases this means that more Dollars are needed for one Euro, or one Euro to buy more Dollars; consequently an increase in the exchange rate reflects an appreciation of the Euro against the Dollar, symmetrically a decrease in the exchange rate reflects a depreciation of the Euro against the Dollar.

The importance of changes in the nominal exchange rate lies precisely in the change they imply in the convenience of buying and selling in different countries: for example, if the E/D rate=1.25(so $1.25 to get € 1), for a good sold for € 1,000 in the U.S. it will take $1,250; if the exchange rate decreases by 10%, it will take $1,125 for the same good, so it would become more convenient to buy than in the previous period.

Demand and supply of money reflect trade in goods and services: for this reason, it is also possible to express the exchange rate in real terms, that is, as the amount of goods and services imported and traded in relation to one unit of good/service exported.

INFLATION AND EXCHANGE RATE

It follows that the change in the real exchange rate is related to the change in the nominal exchange rate and the inflation rate, because in the long run, changes in exchange rates are inverse to changes in prices, i.e. inflation, between two periods. In fact, the exchange rate is determined by 3 main factors:

change in the money supply. If the money supply increases, the domestic price level, inflation, increases to recreate the new balance between supply and demand, causing a depreciation of the domestic currency;
change in interest rates. If the domestic interest rate increases, it reduces demand and consequently reduces supply, so it increases the price level, inflation, generating a depreciation of the domestic currency;
change in the level of production. An increase in the level of production increases the demand for money, consequently the money supply must increase, so the price level is reduced, deflation, causing an appreciation of the domestic currency.

PRACTICAL CONSEQUENCES

Consequently, the exchange rate influences a firm's economic activity to the extent that it changes the cost of inputs or the price of exported goods: in fact, in international trade relations, the exchange rate is an adjustment mechanism that synthesizes the inflation rate gap and the interest rate gap, since the price of the Dollar in terms of the Euro is unique, but the goods and activities being traded are instead heterogeneous, as are their prices.

In detail, if the real Euro/Dollar exchange rate:

increases, this is equivalent to an increase in the price of the basket of European goods relative to the basket of U.S. goods. European goods become more expensive than U.S. goods, and this is reflected in a real appreciation, in this case of the Euro against the Dollar; this implies a worse trade balance, as exports from the EU to the U.S. are disadvantaged. In fact, on the import side, an increase in the real exchange rate implies by definition a decrease in the unit value of foreign goods in terms of domestic goods;
decreases, this is equivalent to a decrease in the price of the basket of European goods relative to the basket of U.S. goods, it is therefore a real depreciation, in this case of the euro against the dollar; in parallel with the above, a decrease in the real exchange rate improves the current account balance, favoring exports.

EMPIRICAL EVIDENCE

In light of what has been said so far, goods turn out to be more or less competitive depending on inflation: if the domestic interest rate rises, demand is reduced and consequently supply is reduced, so the price level, i.e. inflation, rises, generating a depreciation of the domestic currency and an increase in the competitiveness of European goods, thus generating a greater propensity to export. Evidence of this, with respect also to the Italian export data given in the foreword of this paper, are the following graphs that consider:

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