6.3 Exchange Rate Changes Flashcards
1) What is one advantage of a weak exchange rate through depreciation or devaluation?
Improved Trade Balance. A weak exchange rate makes exports cheaper and imports dearer. Economic theory suggests that the demand for imports and therefore the expenditure on imports will decrease whereas the demand for exports and therefore the revenue generated by exports will increase. Both effects will lead to an improvement in the trade balance of the current account and reduce a current account deficit or move it to surplus. This will be true especially if a country is suffering from large trade in goods and trade in services deficits.
2) How does a weak exchange rate contribute to increased growth and reduced unemployment?
A weak exchange rate makes exports cheaper and imports dearer. Economic theory suggests that the demand for imports and therefore the expenditure on imports will decrease whereas the demand for exports and therefore the revenue generated by exports will increase. Both effects will lead to an improvement in the trade balance of the current account and reduce a current account deficit or move it to surplus. As (X-M) is a component of aggregate demand, AD will rise from AD1 to AD2 increasing economic growth from Y1 to Y2. As labour is a derived demand, derived from the demand for goods and services, more employment will be needed to produce the extra goods and services demanded thus reducing unemployment in the economy.
What are the effects of a depreciation/devaluation of the exchange rate on inflation?
Depreciation/devaluation of the exchange rate can lead to both demand-pull and cost-push inflation. Demand-pull inflation is likely to increase as aggregate demand (AD) in the economy rises, putting pressure on existing factors of production and increasing their prices. This increase in prices will then lead to higher overall prices from P1 to P2. Additionally, cost-push inflation will also increase as firms now have to pay more for imported raw materials, which have become more expensive due to the weaker currency. Consequently, the costs of production for firms will rise, shifting the short-run aggregate supply (SRAS) curve to the left from SRASI to SRAS2. Firms will pass on these extra costs through higher prices, causing cost-push inflation from P1 to P2. For nations heavily dependent on imported commodities and raw materials, this can significantly dampen economic growth from Y1 to Y2, potentially even leading to a recession, alongside higher than target inflation. This phenomenon is known as stagflation.
1) What does the exchange rate depreciation depend on?
The exchange rate depreciation depends on whether the Marshall-Lerner condition is satisfied. If the PEDX + PEDm > 1, export revenue in domestic currency terms will always rise when export prices fall. However, if the demand for imports is price inelastic, import expenditure will increase as import prices rise, requiring greater export revenue to offset the increase. If the Marshall-Lerner condition is not satisfied, there will be a net increase in import expenditure relative to export revenue, worsening the trade balance and current account deficit. This may not increase AD, affect unemployment, or cause demand-pull inflation as expected. The condition is unlikely to be achieved in the short run due to price inelastic demand, contractual agreements, and time lags.
evaluation: Does exchange rate depreciation always lead to the expected outcomes?
No, exchange rate depreciation may not always lead to the expected outcomes. If the Marshall-Lerner condition is not satisfied, it can worsen the trade balance and current account deficit, contrary to theory. In the short run, the condition is unlikely to be achieved due to factors such as price inelastic demand, contractual agreements, and time lags. Therefore, the effects of exchange rate depreciation on AD, unemployment, and inflation may not align with expectations.
2) What does the impact of exchange rate depreciation on exports depend on?
The impact of exchange rate depreciation on exports depends on the severity of trade restrictions imposed by foreign governments. If foreign governments have strict controls limiting the quantity of domestic exports, a fall in the exchange rate may have limited impact on export revenue. However, with the decrease in trade barriers globally, exchange rate depreciation is more likely to increase overall export revenue as trade becomes more open and free.
3) How does the size of the depreciation affect demand for exports and inflation?
A large depreciation is likely to significantly increase the demand for exports as the price of exports drops, making them more competitive. However, this may lead to inflation worsening in the economy. As aggregate demand (AD) increases and the economy reaches full employment, excess resources diminish, increasing demand-pull inflationary pressure. Additionally, a large depreciation will cause import prices to rise, increasing firms’ production costs and further contributing to cost-push inflationary pressure.
4) Does a weak exchange rate always rectify a current account deficit?
No, whether a weak exchange rate will rectify a current account deficit depends on income and demand overseas. If major trading economies are experiencing a recession and demand overseas is weak, a fall in export prices via a weak exchange rate may not increase export revenues, leading to no improvement in the current account deficit.
5) Does a weak exchange rate always rectify a current account deficit?
No, whether a weak exchange rate will rectify a current account deficit depends on income and demand at home. If domestic demand is strong due to a boom, a rise in import prices via a weak exchange rate may not decrease import expenditure, resulting in no improvement in the current account deficit.
6) How does the initial level of economic activity impact the effects of exchange rate depreciation on output, employment, and inflation?
The effects of exchange rate depreciation on output, employment, and inflation depend on the initial level of economic activity. If the economy has a large level of spare capacity, an increase in aggregate demand (AD) due to a weak exchange rate can lead to a larger increase in output and decrease in unemployment. Firms can easily expand production by utilizing excess labor and capital. Inflationary pressure may be limited due to the lack of pressure on factors of production. However, with low levels of spare capacity, the economy is close to fully utilizing available factors of production. It becomes difficult for firms to find new workers or increase capital, limiting the increase in output and employment. This situation can lead to a greater rise in demand-pu
