Question

When a country depreciates its currency then _ in the short run. A.)imports will decrease and exports will decrease. B.) imports will increase and exports will increase. C.) imports will decrease and exports will increase. D.) exports will increase but imports will not be affected.

Answer 1

ANSWER : (C) imports will decrease and exports will increase.

The explanation for the above-mentioned Answers as follows:-

Effects of a depreciation of the currency:-

1. Exports cheaper. A devaluation of the exchange rate will make exports more competitive and appear cheaper to foreigners. This will increase demand for exports. Also, after a devaluation, US assets become more attractive; for example, a devaluation in the USD can make US property appear cheaper to foreigners.

2. Imports more expensive. A devaluation means imports, such as petrol, food and raw materials will become more expensive. This will reduce the demand for imports. It may also encourage US tourists to take a holiday in the US, rather than the UK – which now appears more expensive.

3. Increased aggregate demand (AD). A devaluation could cause higher economic growth. In normal circumstances, higher AD is likely to cause higher real GDP and inflation.

4. Inflation is likely to occur following a devaluation because:

* Imports are more expensive – causing cost-push inflation.

* AD is increasing causing demand-pull inflation

* With exports becoming cheaper, manufacturers may have less incentive to cut costs and become more efficient. Therefore over time, costs may increase

5. Improvement in the current account. With exports more competitive and imports more expensive, we should see higher exports and lower imports, which will reduce the current account deficit.

6. Wages. A devaluation in the USD makes the US less attractive for foreign workers. For example, with fall in the value of the USD, migrant workers from Europe may prefer to work in Germany than the US. Similarly, it becomes more attractive for US workers to get a job in the UK because a Pound wage will go further.

7. Falling real wages. In a period of stagnant wage growth, devaluation can cause a fall in real wages. This is because devaluation causes inflation, but if the inflation rate is higher than wage increases, then real wages will fall.