Question

1. “The direction of the effects of an expected future depreciation of the currency on domestic real GDP depends on whether a country is maintaining fixed or floating exchange rates.” Do you agree or disagree? Explain.

Answer 1

Yes, the statement that “the direction of the effects of an expected future depreciation of the currency on domestic real GDP depends on whether a country is maintaining fixed or floating exchange rates,” is True.

Floating exchange rate: In the case of floating exchange rate an expected future depreciation of the currency will cause the currency to depreciate in reality. Due to the expectation of future depreciation there will be a capital outflow from the economy, as investors will not wait for the currency to depreciate to take their money out. This is because if the currency depreciates then there will be a capital loss to the investors as they will get lesser amount of foreign currency while exchanging domestic currency in case they want to exit. So, they will exit the country even before actual depreciation takes place.

When there is a capital outflow then the currency will depreciate in reality as the demand for foreign currency will increase while that of domestic currency will fall. Depreciation of currency will make exports of the country competitive or cheaper in the international market, while imports of the country will become expensive. As a result, the domestic real GDP will increase due to the boost provided by the depreciation to the country’s exports.

Fixed exchange rate: In the case of fixed exchange rate although an expected future depreciation of the currency will put pressure on the currency to depreciate, the central bank of the country will intervene to prevent the currency from depreciating. Due to the expectation of future depreciation there will be a capital outflow from the economy, as investors will not wait for the currency to depreciate to take their money out. This is because if the currency depreciates then there will be a capital loss to the investors as they will get lesser amount of foreign currency while exchanging domestic currency in case they want to exit. So, they will exit the country even before actual depreciation takes place.

When there is a capital outflow then the currency will depreciate in reality as the demand for foreign currency will increase while that of domestic currency will fall. However, in the case of fixed exchange rate the central bank will intervene in the foreign exchange market by supplying foreign exchange ad buying domestic currency to prevent the depreciation.

While doing this the central bank will in effect reduce the money supply in the economy. This will reduce the aggregate demand by increasing the interest rate and thereby investment. So, in the case of fixed exchange rate an expected future depreciation of the currency will cause the GDP to decline due to decline in aggregate demand.