Economic activity is the totality of individual and business activities performed in a country. When economic activity increases, an economy experiences growth. When economic activity decreases, an economy undergoes a recession. Growth has a positive impact on demand. Recession, on the other hand, has a negative impact on demand. Since economic activity in an open economy includes demand for foreign products, an increase in demand will lead to an increase in imports which, in turn, will lead to an increase in demand for foreign money. Because the demand for the national currency will remain the same or even decline, the supply of the national currency will increase. The end result will be a depreciation of the currency's value.
Part b of Figure 8.1 shows the effect of an increase in economic activity on the exchange rate. With demand represented by curve D 1 and supply by curve SI, the cost of one deutsche mark will be $0.40. If an economic boom in the United States shifts demand to curve D2, the new equilibrium will be at point E2. Now the cost of one deutsche mark will be $0.45. Thus, the deutsche mark will appreciate by $0.05, as a result of the greater demand for marks and the accompanying greater supply of U.S. dollars.
In general, the Economic Activity Theory holds that a country's imports will rise quickly when the country experiences a boom and that this growth stimulated increase in imports will lead to a depreciation of the country's currency, due to an increase in the demand for foreign currency to pay for the imports.
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