Question

Petro Mar is a small country rich in oil reserves. About %75 of Petro Mar's exports consist of crude oil. The currency in Petro Mar is called Petro (P). The Petro's exchange rate is determined by the free forces of oil currency supply and demand.

a)How would a sharp rise in the price of oil impact Petro Mar's exchange rate?

b) How would the change in exchange rate impact Petro Mar's industrial sectors that are not oil related?

Answer 1

a. With the sharp rise in the prices of oil, the demand for the crude oil will decline. The less demand means a lesser demand for the currency of Petro Mar, basically the Petro. The lesser demand as against the unchanged supply will shift the Petro demand curve downward to the left, causing a decline in exchange rate or say the currency has depreciated.

b. A decline in the exchange rate has a number of implications for the domestic industry. Depreciation of currency makes the imports costlier, which will increase the domestic demand of the same good as people would substitute or shift their demand from a foreign product to the domestic product. This will increase the sales of the domestic industry. Second, the costlier imports if consist of the raw materials for the domestic industry, then it will negatively affect the domestic industry. The results will be the net of them. On the other hand, the exports become cheaper, which again will boost the domestic industry due to their higher foreign demand as compared to pre depreciation demand.

Besides trade, the exchange rate depreciation also affects the inflation in an economy. The higher demand due to expensive imports may lead to demand-pull inflation if the industry is running at its capacity.