I don't understand strong and weak currencies

Quoted from Forex.com.bd-Editorial External answer — Economics Stack Exchange Author: 1muflon1 Source score (net votes, not local likes): 2 Original post: https://economics.stackexchange.com/a/61169 License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/ Adaptation: HTML converted to plain text; contact email addresses removed. You are confused about different kinds of exchange rates. When people talk about weaker or stronger currency they talk about real exchange rates. You are talking about nominal exchange rate. That’s a tremendously important key distinction. Your thought experiment is actually a very good way of seeing why economists care primarily about the real exchange rate. Suppose the exchange rate is $$ 1\text{ euro} = 5\text{ dollars}. $$ An ice cream costs €1 in country A and $5 in country B. A person with €1 can therefore buy one ice cream in either country. Now suppose, as in your example, that every nominal quantity in country B is multiplied by 10. The exchange rate becomes $$ 1\text{ euro} = 50\text{ dollars}, $$ but the price of an ice cream in B also rises from \$5 to \$50. Nothing economically meaningful has changed. The dollar is worth one tenth as many euros, but each dollar also buys one tenth as much domestically. Economists capture this distinction using the real exchange rate. If (E) is the number of dollars per euro, ( $P_A$ ) is the price level in country A, and ( $P_B$ ) is the price level in country B, then we can define the real exchange rate as $$ q = \frac{E P_A}{P_B}. $$ Initially, $$ q = \frac{5 \times 1}{5} = 1. $$ After your hypothetical change, $$ q = \frac{50 \times 1}{50} = 1. $$ So although the nominal exchange rate changed dramatically, the real exchange rate did not change at all. In your example, multiplying all dollar prices and dollar quantities by 10 is essentially just a change in units. It is similar to deciding to measure a distance in centimetres instead of metres. The numbers change, but the underlying economic situation does not. When does a weaker currency actually matter? Now consider a different situation. Suppose the exchange rate changes from $$ 1\text{ euro} = 5\text{ dollars} $$ to $$ 1\text{ euro} = 10\text{ dollars}, $$ but prices in country B do not immediately double. The ice cream in country B still costs $5. Someone from country A can now exchange €1 for $10 and buy two ice creams in country B. Conversely, someone in country B now needs more dollars than before to buy European products. This is a real depreciation of the dollar, at least initially. Goods produced in country B have become cheaper relative to goods produced in country A. This has important economic consequences. Exports from B become relatively cheaper for foreigners, potentially increasing demand for B’s exports. Imports into B become relatively more expensive, encouraging consumers and firms in B to substitute towards domestically produced goods. For these reasons, a depreciation can increase demand for domestic production and employment. However, there is no free lunch. Residents of B have simultaneously become poorer in terms of what their income can purchase abroad. Imported food, energy, electronics, holidays abroad, and imported intermediate inputs all become more expensive. A weaker currency therefore improves the competitiveness of domestic producers partly by reducing domestic purchasing power relative to the rest of the world. A stronger currency produces approximately the opposite effects. Imports become cheaper and residents can purchase more foreign goods, but domestic exporters become less competitive because their products become more expensive from the perspective of foreigners. Why does your thought experiment not happen instantaneously in reality? If all prices and wages adjusted instantaneously and proportionally to exchange rate movements, then many nominal exchange rate changes would indeed have little real effect. In reality, prices and wages are often sticky. They may be fixed in contracts, wage agreements, catalogues, menus, or business plans and therefore do not adjust instantaneously. Moreover, international prices are frequently denominated in particular currencies. Suppose, for example, that the dollar depreciates by 20%. American wages do not immediately rise by 20%, American firms do not immediately increase every price by 20%, and foreign firms selling into the United States may not immediately increase their dollar prices by the full 20%. Consequently, a nominal exchange rate movement can change relative prices, particularly in the short run. Over longer horizons, domestic prices Will eventually adjust. If a weaker dollar eventually causes US prices to rise substantially, part of the original improvement in competitiveness disappears. There is also an important economic concept behind your intuition: purchasing power parity (PPP). In its simplest form, PPP suggests that exchange rates should eventually reflect differences in countries’ price levels: $$ E \approx \frac{P_B}{P_A}. $$ If prices in country B permanently become ten times higher while nothing else changes, we would expect approximately ten times as many dollars to be required to purchase one euro. This is essentially the situation you constructed. Is a strong currency good or bad? Neither a strong nor a weak currency is inherently desirable. It depends on why the exchange rate changed and whose welfare we are considering. A stronger currency benefits consumers and firms purchasing foreign goods because imports become cheaper. It also increases residents’ purchasing power abroad. However, it can hurt exporters and domestic firms competing with imports. A weaker currency can help exporters and import-competing industries because domestic production becomes relatively cheaper. However, it makes imports more expensive and reduces households’ international purchasing power. It can also contribute to inflation, particularly in economies heavily dependent on imported energy, food, or intermediate inputs. Therefore, economists would generally be cautious about statements such as “a strong currency is good” or “a weak currency is good.” The nominal exchange rate itself tells us relatively little. To sum up, in your example you are confusing real vs nominal exchange rate movements. If the exchange rate and every relevant price move proportionally, nothing real has changed. Exchange rate movements matter when they change the relative prices of domestic and foreign goods, assets, wages, or debts. This occurs because prices do not all adjust simultaneously and because many contracts and financial obligations are denominated in particular currencies.

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