BoP: Devaluation or Currency Depreciation as an Expenditure-Switching Policy Flashcards
What is the Exchange Rate?
The value of one currency in terms of another
For example, how many units of one currency are required to buy a unit of another currency.
What does Devaluation refer to in a fixed exchange rate system?
An official lowering of the value of a currency
Often initiated by the central bank.
What is an Adjustment Peg?
A method where countries with a fixed or adjustable peg exchange rate may devalue by reducing the official value of their currency
This adjustment is in relation to other currencies.
What is Depreciation in a floating exchange rate system?
A natural decline in the value of the currency through market forces
This occurs relative to other currencies.
How do depreciation or devaluation affect the domestic currency?
Makes the domestic currency cheaper relative to foreign currencies
This is true in both fixed and floating exchange rate systems.
What is Internal Depreciation?
A fall in the currency’s purchasing power within the domestic economy
Often caused by inflation, differing from external depreciation.
What is Revaluation in a fixed exchange rate system?
An increase in the value of a currency
This is the opposite of devaluation.
What is Appreciation in a floating exchange rate system?
An increase in the value of a currency
This occurs naturally through market dynamics.
What is Expenditure-Switching Policy?
A policy aimed at shifting spending from imports to domestically produced goods
This can help address a current account deficit by improving the trade balance.
What is one method of implementing an Expenditure-Switching Policy?
Devaluation
This method helps make domestic goods more competitive.
What happens to exports after devaluation?
Exports become cheaper in foreign markets
How does a weaker domestic currency affect imports?
Imports become more expensive for domestic consumers
What is the effect of currency depreciation on the trade balance?
Improvement in trade balance
What happens to demand for foreign goods after devaluation?
Demand for foreign goods may decrease
Fill in the blank: After devaluation, exports become more _______ internationally.
competitive
True or False: A weaker domestic currency can lead to an increase in imports.
False
What is one outcome of increased exports and reduced imports over time?
Improvement in trade balance
What mechanism causes exports to become cheaper for foreign buyers?
Currency depreciation
What is the impact of increased import prices after devaluation?
Reduced demand for foreign goods and services
What is one advantage of devaluation related to export competitiveness?
The cheaper domestic currency makes exports more attractive to foreign buyers, potentially boosting export demand and improving the balance of payments (BoP).
How does devaluation affect import demand?
As imports become more expensive, domestic consumers may shift to locally produced goods, leading to a reduction in the import bill.
What is the impact of devaluation on the trade balance?
Increased exports and reduced imports often result in an improved current account balance, making the economy less reliant on foreign borrowing and supporting BoP stability.
What inflationary pressure is caused by currency depreciation?
Depreciation increases the price of imports, which can cause imported inflation, leading to higher overall price levels and reducing the purchasing power of domestic consumers.
How can inflation diminish the benefits of devaluation?
If inflation rises faster than the gain from increased exports, the inflationary effects may diminish the long-term benefits of devaluation.
What is a potential negative effect of relying heavily on imports after devaluation?
The rise in import costs can offset the benefits of increased export demand, leading to a deterioration in terms of trade.
What does loss of investor confidence indicate in the context of devaluation?
Devaluation may signal currency instability, potentially reducing foreign investment and leading to capital flight.
What long-term issues may arise from devaluation?
Inflationary pressures and potential negative effects on investor confidence may undermine long-term economic stability.
Fill in the blank: Devaluation can lead to a reduction in the _______ bill.
import
True or False: Devaluation guarantees long-term stability in an economy.
False
What is the Bretton Woods System?
A historic system of fixed exchange rates, with currencies pegged to the U.S. dollar, which itself was pegged to gold.
What does the Marshall-Lerner Condition state?
Devaluation will only improve the trade balance if the sum of the price elasticities of demand for exports and imports is greater than 1.
What is the J-Curve Effect?
After devaluation, the trade balance may initially worsen before improving over time as exports become more competitive.
What does the Absorption Approach propose?
A country must reduce domestic spending to reduce a current account deficit, with devaluation making domestic goods more attractive.
What are the short-term effects of devaluation?
Can improve the current account by making exports more competitive and reducing imports.
What are the long-term risks associated with devaluation?
Inflation, worsening terms of trade, and reduced investor confidence.
What factors determine the overall effectiveness of devaluation?
Elasticity of demand for exports and imports, reliance on imports, and broader economic context.
True or False: Devaluation is always beneficial for an economy.
False.
Fill in the blank: The Marshall-Lerner Condition requires the sum of price elasticities to be greater than _______.
1.
What shape does the trade balance form over time after devaluation according to the J-Curve Effect?
A ‘J’ shaped curve.
Fill in the blank: The Absorption Approach is focused on reducing _______ to address current account deficits.
domestic spending.
What must be carefully managed to avoid inflationary spirals and long-term economic instability?
Devaluation.
