Question

Define devaluation.

What is the impact on the exchange rate due to devaluation?

Based on the relationship between the exchange rate and the exports, imports and balance of trade observed in part c, what is the likely impact on Exports, Imports and Balance of Trade if the Government devalues the currency?

Is this in line with theoretical expectations? Why or Why not?

If the actual and theoretical relationship differs provide ONE possible explanation for the deviation.                              

Define Devaluation			1
Impact on Exchange Rate due to devaluation			1
Impact on Exports based on part c			1
In line with theory? Why or Why not?				2
ONE explanation for deviation				1
Impact on Imports based on part c			1
In line with theory? Why or Why not?				3
ONE explanation for deviation				2
Impact on Balance of Trade based on part c			1
In line with theory? Why or Why not?		2
ONE explanation for deviation		1
TOTAL			16 Marks

Answer 1

1.	Devaluation Devaluation is the deliberate reduction in the official exchange rate of a country’s currency by the monetary authority. Only under fixed exchange system the monetary authority can officially alter the exchange rate of a country. It can reduce the external value of the country’s currency or increase it. The reduction in official exchange rate is devaluation and increase in the official exchange rate is known as revaluation. A country’s currency is devaluated when its value depreciate in the foreign exchange market.
2.	Impact of devaluation. The key effect of devaluation is that it makes the domestic currency cheaper in the foreign exchange market relative to other national currencies. In other words the devaluation makes the domestic currency cheaper and foreign currency dearer in the foreign exchange market. Thus export become relatively less expensive and import more expensive. This will encourage more export and discourage imports. Thus to a great extend it helps to eliminate the balance of payment deficit.
3.	Impact on export. Export from the country increase due to the increased demand for domestic goods in the foreign market.
4.	Why export increase. Export increase due to the fact that domestic goods become cheaper to the foreign buyers This will increase the export from the country.
5.	Explanation for deviation. For example if the exchange rate between India and U.S is $1 = Rs. 80. When devaluation is applied the exchange rate supposed to become $1=Rs 100. Thus with $1 the U.S citizen can buy goods from the Indian market worth Rs. 100 by spending $1. The U.S citizens get more goods than earlier with $1.
6.	Impact on import. As a result of devaluation countries import decrease.
7.	Why import decrease. The decrease in the value of national currency makes the import costly. The domestic individual and firms have to pay more amount of domestic currency than earlier in order to get the same amount of goods. This will compel the citizens and firms to buy less foreign goods. This will cause a reduction in country’s import.
8	Explanation for deviation. For example if two country’s exchange rate namely India and U.S is Rs. 70=$1. The devaluation makes the exchange rate into Rs. 90 =$1. Thus the Indian citizen has to pay Rs. 90 in order to get goods worth $1. Thus it is not profitable for the Indians to buy U.S goods.
9.	Impact of devaluation on BOT. As a result of the import reduction and export promotion the country’s trade deficit decreases and it will enjoy a better balance of trade and balance of payment position.
10.	Why balance of trade increase? The devaluation cause increased outflow of domestic goods. Thus the country’s quantity of export increases. Similarly the inflow of foreign goods decrease. Thus the country’s quantity of import decreases. The net effect of this increased export and decreased import is the surplus in the balance of trade.
11	Explanation for deviation. The difference between the value of goods and services exported out of a country and the value of goods and services imported into the country is known as the balance of trade. In other words the balance of trade is the volume of export minus the volume of import. Under the devaluation the volume of export will be greater than the volume of import which cause net balance in BOT.