Question

1. a) How does a depreciation/devaluation of a nation’s currency operate to eliminate a deficit in its current account? (15 points)

b) How do you calculate that a particular currency is undervalued? Explain your answer with a numeric example. (15 points)

c) Explain the process how balance of payments deficit is eliminated in the long-run without government intervention both in the fixed (Central Bank keeping exchange rate fixed) and in the flexible exchange rates system. (20 points)

Answer 1

a] A country devalue its cureency to combat a trade imbalance, that is export increase and import decrease it favours a better balance of payment by shrinking trade deficits. It means s country that devalues its currency can reduce its deficits because of the strong demand for cheaper exports. When devaluation of exchange rate makes exports cheaper and imports more expensive. That make reduce domestic consumption and spending of imports.

b] A currency has low foreign exchange value, based on the current economic condition, that currency is undervalued. It means the rate at which it can be exchanged for other currencies is too low. If you buy a product made in foreign countries then currency values have real impact on your bank account. For example when the US dollar is undervalued, the cost of a basket of goods in the US is lower than the cost in Mexico when evaluated at the current exchange rate. To a US tourist, Mexican goods and service would seem more expensive on average.

c] Assuming no additional foreign demands for domestic currency on the financial account, keeping exchange rate fixed, the central bank would need to intervene by selling foreign currency in exchange for domestic currency. This would lead ro a reduction of foreign reserves and hence a balance of payments deficit.     In a flexible exchange rate, a change in a countries balance of payments can cause fluctuations in the exchange rate between its currency and foreign currencies.  The reverse is also true when a fluctuation in relative currency strength can alter the balance of payments. There are two different and interrelated markets at work; the market for all fincial transaction on the international market [balance of payment] and the supply and demand for a specific currency [exchange rate]. These condition only exist under a free or floating exchange rate regime.