IBDP Economics 4.5 Exchange rates HL Paper 1- New Syllabus
Question
(a) Explain two implications of a persistent deficit on the current account of a country’s balance of payments. [10]
(b) Using real-world examples, evaluate the view that a country’s deficit on the current account of its balance of payments can best be corrected through a fall in its exchange rate. [15]
Most-appropriate topic code (CED):
• TOPIC 4.5: Exchange rates
▶️ Answer/Explanation
(a) Answer:
The current account records transactions involving trade in goods and services, primary income and secondary income between a country and the rest of the world. A current account deficit occurs when the value of current account payments exceeds receipts. If the deficit is persistent, it can have several important implications for the economy.
1. Pressure on the exchange rate
A persistent current account deficit means that the country is spending more foreign currency on imports and other current account payments than it receives from exports and other receipts. This creates a greater demand for foreign currency and supply of the domestic currency in the foreign exchange market.
Under a floating exchange rate, this may place downward pressure on the value of the domestic currency, causing a depreciation. A weaker currency makes imports more expensive in domestic currency terms and can make the country’s exports cheaper to foreign buyers.
However, the extent to which the depreciation corrects the deficit depends on factors such as the price elasticities of demand for exports and imports. If demand is sufficiently elastic, the lower relative price of exports and higher relative price of imports can eventually improve the current account balance.
2. Increased foreign ownership and external debt
A persistent current account deficit must be financed through corresponding financial-account inflows, such as foreign direct investment, portfolio investment or borrowing from abroad. As a result, a country may accumulate greater external liabilities or experience increased foreign ownership of domestic assets.
For example, foreign investors may purchase domestic companies, property or government securities to provide the capital needed to finance the deficit. While these inflows can finance investment and economic activity, a prolonged dependence on foreign finance can increase debt-servicing obligations and make the economy more vulnerable to changes in investor confidence.
Therefore, a persistent current account deficit may put downward pressure on the exchange rate and increase a country’s dependence on foreign capital and external financing. The consequences depend on how the deficit is financed and whether the borrowed or foreign-funded resources contribute to productive investment.
(b) Answer:
A current account deficit occurs when a country’s payments on the current account exceed its receipts. A fall in the exchange rate, particularly a depreciation under a floating exchange rate system, can potentially correct the deficit by changing the relative prices of exports and imports.
How depreciation can correct a current account deficit
When a country’s currency depreciates, its exports become cheaper in terms of foreign currency, while imports become more expensive in terms of domestic currency. This can increase the quantity demanded for exports and decrease the quantity demanded for imports.
Therefore, export revenues may increase while import expenditure falls, improving the current account balance. This is known as an expenditure-switching policy because expenditure is shifted away from foreign goods towards domestically produced goods.
Depreciation can also increase aggregate demand (AD). Higher exports increase the export component of AD, while lower import demand reduces import expenditure. Consequently, net exports may increase and AD may shift to the right, potentially increasing real output and employment.
However, the effectiveness of depreciation depends on the Marshall-Lerner condition. For a depreciation to improve the current account balance in the longer term, the sum of the absolute values of the price elasticities of demand for exports and imports generally needs to be greater than one.
If export and import demand are sufficiently price elastic, the quantities traded respond strongly to changes in relative prices and the current account is more likely to improve. If demand is price inelastic, the value of imports may rise significantly while the quantity demanded changes little, potentially worsening the deficit.
The J-curve effect also means that depreciation may initially worsen the current account balance before improving it. In the short run, contracts and existing trading relationships mean that quantities of imports and exports may not adjust immediately. Because imports become more expensive immediately, the value of import expenditure can rise before quantities respond. Over time, consumers and firms may adjust their demand, allowing the current account balance to improve.
Real-world example: Japan
Japan has experienced periods of significant yen depreciation. A weaker yen can improve the international competitiveness of Japanese exports and increase the domestic-currency value of foreign earnings. However, Japan also relies on imported energy and raw materials, so depreciation can substantially increase import costs. This illustrates that depreciation can improve export competitiveness while simultaneously increasing the cost of imports.
Inflationary consequences
A depreciation increases the domestic price of imported goods and raw materials. This can create cost-push inflation, particularly in economies that depend heavily on imported energy, food or intermediate goods.
Higher import prices reduce the purchasing power of households and increase production costs for firms. Therefore, although depreciation may improve the current account, it can conflict with the government’s objective of maintaining low and stable inflation.
Impact on different sectors and stakeholders
Export-oriented firms are likely to benefit because their products become more price competitive in international markets. Import-dependent firms, however, face higher costs for foreign inputs. Consumers may also lose from higher prices of imported goods.
The overall effect therefore depends on the structure of the economy. An economy with a strong export sector and relatively low dependence on imported inputs may benefit more from depreciation than an economy heavily dependent on imported energy and raw materials.
Alternative policy: expenditure-reducing policies
A government could use contractionary fiscal policy to reduce a current account deficit. Higher taxes or lower government expenditure reduce aggregate demand and household incomes. This can reduce demand for imports and therefore reduce import expenditure.
However, this approach may reduce real output and increase unemployment. It can therefore correct the current account deficit at the expense of domestic economic activity.
Alternative policy: trade protection
Governments can impose tariffs, quotas or other trade restrictions to reduce imports directly. This may improve the current account balance by lowering import expenditure and protecting domestic producers.
However, protectionism can increase domestic prices, reduce consumer choice and cause retaliation from trading partners. Retaliatory measures may reduce the country’s exports, so protectionism is not necessarily an effective long-term solution.
Alternative policy: supply-side policies
Supply-side policies can increase productivity and reduce firms’ production costs. Improved productivity can make domestic goods more internationally competitive without requiring a depreciation of the currency. This can increase exports and reduce the need for imports over time.
However, supply-side policies can take considerable time to produce results and may require significant government expenditure, particularly when they involve education, infrastructure or research and development.
Real-world evaluation: The experience of countries with substantial currency depreciations demonstrates that a weaker exchange rate does not automatically eliminate a current account deficit. For example, if a country is highly dependent on imported fuel and other essential inputs, depreciation can increase the value of imports substantially. The improvement in exports may therefore be insufficient to offset the higher import bill.
Overall evaluation: A fall in the exchange rate can be an effective way to correct a current account deficit when export and import demand are sufficiently price elastic, domestic firms can respond to increased export demand and the economy has the capacity to expand production. The Marshall-Lerner condition and the J-curve effect are therefore crucial in determining its success.
However, depreciation is not necessarily the “best” solution. It may initially worsen the deficit, create cost-push inflation and reduce real household incomes. Its effectiveness is also limited when exports and imports are price inelastic or when the country relies heavily on imported inputs.
Therefore, depreciation can be an effective method of correcting a current account deficit, particularly in the long run when demand becomes more responsive to price changes, but it should not be regarded as universally the best policy. In many cases, a combination of depreciation with supply-side policies to improve international competitiveness is likely to provide a more sustainable solution, while expenditure-reducing policies may be appropriate where excessive domestic demand is the main cause of the deficit.
Question
(a) Explain the difference between a floating exchange rate system and a fixed exchange rate system. [10]
(b) Using real-world examples, discuss the consequences for an economy of a depreciation of its exchange rate. [15]
Most-appropriate topic code (CED):
▶️ Answer/Explanation
(a) Answer:
An exchange rate is the price of one currency expressed in terms of another currency. The key difference between a floating exchange rate system and a fixed exchange rate system is the way in which the exchange rate is determined and maintained.
Under a floating exchange rate system, the value of a currency is determined by the interaction of the demand for and supply of the currency in the foreign exchange market. If demand for a currency increases relative to its supply, the currency appreciates. If demand decreases or supply increases, the currency depreciates.
For example, if demand for a country’s exports increases, foreigners need more of that country’s currency to purchase the exports. This increases demand for the currency and may cause it to appreciate. Similarly, lower demand for exports or lower capital inflows may reduce demand for the currency and cause depreciation.
The main advantage of a floating exchange rate is that the exchange rate can adjust automatically to changes in market conditions. However, the exchange rate may fluctuate significantly, creating uncertainty for exporters, importers and investors.
Under a fixed exchange rate system, the government or central bank maintains the currency at a specified exchange rate against another currency or a basket of currencies. If market forces create pressure for the currency to move away from the target rate, the central bank intervenes in the foreign exchange market.
For example, if there is downward pressure on the currency, the central bank can use its foreign exchange reserves to purchase its own currency, increasing demand for it and supporting the fixed exchange rate. Maintaining a fixed exchange rate therefore requires sufficient foreign reserves and active government or central-bank intervention.
If the government deliberately changes the official value of a currency downward, this is known as a devaluation. Conversely, an official increase in the value of a currency under a fixed system is known as a revaluation.
In a floating exchange rate diagram, the equilibrium exchange rate is determined where demand for the currency intersects supply of the currency. A change in either demand or supply causes the equilibrium exchange rate to change. In a fixed system, the central bank intervenes to maintain the exchange rate at the chosen target.
Therefore, a floating exchange rate is primarily determined by market forces and can change through appreciation and depreciation, whereas a fixed exchange rate is maintained by government or central-bank intervention at a chosen rate. A floating system provides greater flexibility but can create more exchange-rate uncertainty, while a fixed system provides greater stability but requires foreign reserves and intervention.
(b) Answer:
A depreciation is a fall in the value of a currency under a floating exchange rate system. It means that the currency buys fewer units of foreign currency than before. A depreciation can have significant effects on an economy’s inflation, economic growth, unemployment, living standards and current account balance.
Effect on aggregate demand and economic growth
A depreciation makes a country’s exports cheaper to foreign buyers while making imports more expensive to domestic consumers. If the demand for exports and imports responds sufficiently to these price changes, exports increase and imports decrease. Therefore, net exports increase.
Since net exports are a component of aggregate demand, an increase in net exports causes AD to shift to the right. This can increase real output and economic growth, particularly when the economy has spare productive capacity.
For example, a depreciation of the currency can make a country’s tourism, manufactured goods and other exports more price competitive internationally. Exporting firms may increase production to meet higher foreign demand, contributing to higher real GDP.
Effect on unemployment
The increase in exports and domestic production can increase the demand for labour. Firms may therefore hire additional workers, reducing cyclical unemployment.
For example, if a depreciation increases demand for a country’s manufactured exports, exporting firms may expand production and employment. Firms supplying inputs to these exporters may also increase employment through the multiplier effect.
However, the employment effect depends on the extent to which domestic firms actually respond to increased export competitiveness. If firms have spare capacity and can increase production, the effect may be relatively strong. If the economy is already close to full capacity, the main effect may instead be higher prices.
Effect on the current account
A depreciation can improve the current account balance because exports become cheaper and imports become more expensive. However, the improvement is not guaranteed.
The Marshall–Lerner condition states that a depreciation will improve the trade balance if the sum of the absolute values of the price elasticities of demand for exports and imports is greater than one.
If export and import demand are sufficiently elastic, the quantity of exports demanded rises significantly and the quantity of imports demanded falls significantly. The value of exports can therefore rise relative to the value of imports.
However, if demand is relatively inelastic, consumers and foreign buyers may respond only slightly to the price changes. The value of imports may remain high even though imports are more expensive, and the current account may not improve.
J-curve effect
In the short run, a depreciation may actually worsen the current account before it improves. Existing contracts and relatively inelastic demand mean that the price of imports rises immediately, while quantities of imports and exports may take longer to adjust.
This creates the J-curve effect: the current account initially deteriorates and may subsequently improve as consumers and firms adjust their consumption and production decisions.
Effect on inflation
A depreciation makes imported goods and imported raw materials more expensive in domestic currency. This creates imported inflation. Firms using imported inputs may face higher production costs and pass these costs on to consumers through higher prices.
Furthermore, if the depreciation increases AD through higher net exports, demand-pull inflation may also occur when the economy is operating close to full capacity.
For example, a country heavily dependent on imported energy may experience substantial inflation following a depreciation because the domestic-currency price of imported oil and gas increases.
Therefore, the inflationary effect depends partly on the economy’s dependence on imports and the extent of the depreciation. A large depreciation is more likely to create significant inflationary pressure than a small depreciation.
Effect on living standards
The effect on living standards is mixed. Exporting firms and workers may benefit from increased foreign demand and employment. However, households that consume imported goods face higher prices, reducing their real purchasing power.
Lower-income households may be particularly affected if imported necessities such as food and fuel account for a large proportion of their expenditure. Therefore, although a depreciation may support economic growth and employment, it can simultaneously reduce real household incomes through higher prices.
Real-world example: The depreciation of the British pound following the 2016 Brexit referendum illustrates these competing effects. The weaker pound increased the price of imports and contributed to inflationary pressure in the United Kingdom. At the same time, the weaker exchange rate improved the international price competitiveness of some UK exports and supported sectors such as tourism. However, the overall effect on the current account and economic growth depended on the responsiveness of export and import demand and other economic conditions.
Another consideration is the size and duration of the depreciation. A small, temporary depreciation may have limited effects on inflation and output. A large and persistent depreciation can create much stronger effects, particularly where the economy is highly dependent on imported energy, food or intermediate goods.
Overall evaluation: A depreciation can stimulate economic growth and reduce cyclical unemployment by increasing net exports and aggregate demand. It may also improve the current account if the Marshall–Lerner condition is satisfied. However, these benefits are not guaranteed.
The depreciation can create imported inflation, reduce households’ real purchasing power and initially worsen the current account through the J-curve effect. The final outcome depends on the size of the depreciation, the PED of exports and imports, the amount of spare capacity in the economy, the economy’s dependence on imports and the time period considered.
Therefore, a depreciation is likely to be most beneficial when an economy has spare capacity, export demand is sufficiently elastic and the country is not excessively dependent on imported necessities. In contrast, where import demand is inelastic and imported inputs are important, a depreciation may generate substantial inflation and reduce living standards, limiting its overall benefit to the economy.