Question

Explain the effects of an increase in the value of the domestic currency on a firm’s revenues under each of the following conditions:

a) The firm sells only domestically

b) The firm purchases supplies from other countries

c) The firm sells products domestically and in other countries

d) The firm has manufacturing plants located in other countries

Answer 1

An increase in the value of domestic currency is known as appreciation, where the value of domestic currency increases in terms of foreign currency. For example, if previously a country’s domestic currency X exchanged with USD at the rate $1= 20X and its current exchange rate is $1=15X then the domestic currency’s value is said to have increased or appreciated with respect to the foreign currency. This means that previously 1USD would fetch 20 units of X but after appreciation of X, 1USD fetches 15 units of X. This imlies that currency X just got more expensive. Revenue of a firm has two determinants- price and quantity sold. Thus a change in revenue will come about with a change in either of the two or both these determinants.

a) If a firm sells only domestically and there is no question of cross-border export or use of foreign exchange, then the exchange rate does not make any difference on the amount of output demanded and supplied or even the domestic price. Thus, an increase in the value of domestic currency has no direct effect on a firm’s revenue. However, indirectly a firm’s revenue can be affected. When domestic currency appreciates, imports become cheaper. This is because an import worth 1USD previously cost 20 units of X but now costs 15 units of X. As imports increase, the domestic supplier has to reduce its price to compete with imports. If domestic prices are not reduced, domestic sales fall and the firm’s revenue decreases.

b) If a firm purchases supplies from other countries, an increase in the value of domestic currency means foreign supplies become cheaper. The same logic applies where previously supplies worth 1USD made the firm spend 20X, but revised rates allow the firm to buy the same supplies at 15X. Thus, the firm’s cost of production falls which allows the firm to reduce the price of its commodities. A reduced price increases demand (assuming that demand is relatively elastic) and thus increases the firm’s revenue.

c) If the firm sells products domestically and abroad, the effect can be divided into two parts. Domestically as explained in part a), even though not directly, but an appreciation of domestic currency results in an indirect adverse effect on revenue. As for selling abroad, an appreciation makes the firm’s good more costly in the foreign country. This is because, if the foreign country imports goods worth 60X, then previously it had an exchange rate of 1USD=20X and paid 60/20 = $3 for imports. Currently at revised rates of 1USD=15X, the foreign country has to pay 60/15= $4 for the same import bundle. Thus, as their imports and the home country’s exports become more expensive, exports drop, thereby reducing revenue of the firm. Thus, the overall impact on the firm’s revenue is negative and revenues tend to decrease with appreciation of currency.

d) If the firm has manufacturing plants located in other countries, then the increased value of domestic currency will make those goods costlier than competing firms from other countries operating on the same geographical boundary. Therefore, quantity sold by the domestic firm will reduce following an increase in price of the commodities, which will further reduce revenue of the firm operating abroad.