Changes in exchange rate affect inflation:
(a) Cost-push inflation: currency depreciation makes imports more expensive => cost of imported FoP increase => leftward shift of the SRAS curve & cost-push inflation.
(b) Demand-pull inflation: currency depreciation makes exports cheaper & imports more expensive => net exports (X − M) increase => rightward shift of the AD curve & demand-pul inflation.
Effects on employment: (i) if the economy is close to potential GDP, the increase in AD (due to higher net exports) may cause a temporary decrease in natural unemployment; (ii) if the economy is in a recessionary gap a rise in AD causes a fall in cyclical unemployment.
Effects on economic growth: in the case of a currency appreciation, economic growth results (due to the above consequences of growing net exports).
Currency appreciation (by directly reducing
net exports) is likely to damp economic growth. However, since a currency appreciation makes imports cheaper, there may result increased imports of FoP that can be used to increase private or government investment spending and therefore impact positively on potential output.
Effects on the current account balance: if a country has an excess of imports over exports to begin with (a trade 'deficit'), there will be downward pressure on the currency, leading to depreciation which will reduce the deficit. If it has an excess of exports over imports to begin with (a trade 'surplus'), its trade surplus become larger. An appreciation, by contrast, will cause net exports to fall, thus having the opposite effects on the current account balance.