Lesson 39 - Exchange Rate and the impact upon Balance of Payments

Question 1

Define the term currency appreciation?

Answer 1

Currency appreciation implies that the exchange rate of one currency has strengthened against others. One unit of one currency is worth more units of another currency.

Question 2

Give two ways in which the monetary authorities of a country might influence the value of its currency?

Answer 2

Changing the interest rate
Changing the money supply

Question 3

Give one positive of increasing the money supply?

Answer 3

Increasing the supply of currency weakens the exchange rate. This increases the desirability of exports.

Question 4

What are the positives of high interest rates?

Answer 4

Can help to lower inflation due to an increased incentive to save.

Question 5

Give one positive of low interest rates?

Answer 5

Higher consumer spending can stimulate economic growth.

Question 6

What are the consequences of a depreciation in the exchange rate?

Answer 6

Tends to increase the rate of economic growth and reduce unemployment.
Tends to benefit exporters, but makes imports more expensive.
Tends to cause inflation.
Tends to improve the current account deficit.

Question 7

Why does a depreciation in the exchange rate cause inflation?

Answer 7

Imports are more expensive
There is higher domestic demand
Firms have less incentives to cut costs

Question 8

Why will an exchange rate depreciation improve the balance of payments?

Answer 8

The value of exports will increase because they are now cheaper for foreign consumers so they will increase total spending on exports.
The value of imports will fall as they are more expensive for domestic consumers so they will decrease spending on imports.

Question 9

What is the J Curve effect?

Answer 9

It shows the time lags between a falling currency and an improved balance.

Question 10

What does the J Curve show will be the short term and long term impacts of currency depreciation?

Answer 10

In the short term a currency depreciation leads to a larger balance of payments deficit because demand is inelastic for imports and exports.
In the longer term the balance of payments will improve as demand becomes more elastic so that they value of exports increase and the value of imports decreases.