Question

In: Economics

The COVID-19 pandemic and the need to control the spread of virus through social distancing has...

The COVID-19 pandemic and the need to control the spread of virus through social distancing has lowered the productivity of delivering non-tradable local services in all countries. This is unlikely to be a short-term phenomenon because even if a vaccine or herd immunity for the COVID-19 is developed, concerns about other deadly viruses that may emerge in the future may prompt people to exercise social distancing indefinitely. The extent and significance of such practices will vary among countries due to factors such as differences in the composition of production and the age-structure of population. As a result, some countries will experience larger increases in the cost of delivering non-tradable local services than others. As a result of this phenomenon, we should expect the currencies in countries with higher local costs to

a.

appreciate relative to currencies of other countries.

b.

depreciate relative to currencies of other countries.

c.

remain unchanged relative to currencies of other countries.

d.

appreciate or depreciate depending on the situation.

Solutions

Expert Solution

Hi,

Hope you are doing well!

Question:

Answer:

d. Appreciate or depreciate depending on the situation.

Non-tradable Local Services: The non-tradable sector consists of locally-rendered services, including health, education, retail and construction.

This time the world is facing the global pandemic due to Corona Virus.  The need to control the spread of virus through social distancing has lowered the productivity of delivering non-tradable local services in all countries. The extent and significance of such practices will vary among countries due to factors such as differences in the composition of production and the age-structure of population. As a result, some countries will experience larger increases in the cost of delivering non-tradable local services than others. Its will increase the price of the non-tradable local services that will increase the non-tradable inflation that more affected by changes in domestic conditions. The non-tradable inflation contribute major role in CPI calculation. In some countries the contribution of non-tradable inflation is more than tradable inflation in CPI calculation.

Situation 1:

When the CPI increase ( inflation increase) price of non-tradable local services will increase. Other side the CPI is the very important driver of the interest rate. The central bank implement monetary policy according to the inflation rate. When inflation rate is high in the economy the central bank reduce the money supply that is increased the interest rate and higher interest rate reduce the demand of money and consumption level that control or reduce the inflationary pressure.

In this case, larger increases in the cost of delivering non-tradable local services than others. Its will increase the price of the non-tradable local services that will increase the non-tradable inflation that more affected by changes in domestic condition. So, the central bank will reduce the money supply and it will increased the interest rate. Higher interest rates provide the opportunity for banks to charge more for loans, and other financial institutions to go long on local currency denominated assets. The overall effect translates into higher demand for local currency, hence its appreciation against other currency pairs.Because Theoretically, the CPI and local currency Index relationship is straightforward. If the CPI goes up, then the local currency also soars.

Situation 2:

Other side the situation is panic and global economy is facing a pandemic recession and GDP, consumer confidence, employment level, income level are very low. Its negatively affect the aggregate demand. We also know that this is not a demand-pull inflation so, in this, a central will not increase the interest rate to fight with non-tradable inflationary p;pressure. Most of the central bank is decreasing interest rate to boost the economy. So, lower the interest rate will not provide the opportunity for banks to charge more for loans, and other financial institutions to go long on local currency denominated assets. So, the overall effect will not translates into higher demand for local currency, hence it will not appreciation against other currency pairs.

Conclusion:

So there are two situation: one is theoretical and second is practical. So it will depend upon the current situation of the economy and the future forecast. So, the appreciation or depreciation will depend on the situation.

Thank You


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