6.4 - Exchange Rate Changes - Aprpreciation

Question 1

1) What are the consequences of a strong exchange rate on the trade balance?

Answer 1

A strong exchange rate leads to a deterioration in the trade balance of the current account. This is because it makes exports more expensive and imports cheaper. According to economic theory, the demand for imports increases, leading to an increase in import expenditure. On the other hand, the demand for exports decreases, resulting in a decrease in export revenue. Both effects contribute to a worsening trade balance, which can lead to an increase in the current account deficit or a reduction in a surplus.

Question 2

2) How does a strong exchange rate impact economic growth and unemployment?

Answer 2

A strong exchange rate can reduce economic growth and increase unemployment. As the demand for imports increases and the demand for exports decreases due to the strong exchange rate, aggregate demand (AD) decreases. This shift in AD from AD1 to AD2 leads to a decrease in economic growth from Y1 to Y2. Since labor is a derived demand, meaning it is derived from the demand for goods and services, less employment will be needed to produce the reduced quantity of goods and services demanded. Moreover, with decreased revenue earned by firms, they may choose to reduce their workforce to control costs and maintain profitability, resulting in increased unemployment in the economy.

Question 3

1) How does exchange rate appreciation impact inflation?

Answer 3

Exchange rate appreciation tends to reduce inflation. Demand-pull inflation is likely to decrease as aggregate demand (AD) decreases. With lower AD, there is less pressure on existing factors of production, leading to a decrease in their prices. This decrease in prices is reflected in a shift in the aggregate supply (AS) curve from SRAS1 to SRAS2, causing a decrease in prices from P1 to P2. Additionally, cost-push inflation decreases as firms pay less for imported raw materials, which have become cheaper due to the stronger currency. As a result, the costs of production for firms decrease, leading to lower prices and reducing cost-push inflation from P1 to P2.

Question 4

2) What are the benefits of exchange rate appreciation in terms of competitiveness?

Answer 4

Exchange rate appreciation can drive an increase in competitiveness. When the domestic currency strengthens, exporters are compelled to improve the competitiveness of their goods and services in order to maintain strong export sales and revenue. This can involve various strategies such as implementing training programs to enhance staff productivity, capitalizing on economies of scale, negotiating better deals with raw material suppliers, and making investments in new capital. If such efforts spread across the economy, both short-term and long-run growth can be stimulated. Persistent increases in net exports and improvements in competitiveness can lead to increases in aggregate demand (AD) and long-run aggregate supply (LAS), promoting economic growth.