Question

(a) Identify the factors that affect equilibrium exchange rate for any foreign currency of your choice. Use appropriate graphical illustrations to describe how two of the identified factors affect the equilibrium exchange rate.

(b)Explain the concept of the J-curve in the context of Balance of Trade deficit. In your explanation, state the significance of price elasticity of import demand.  

Answer 1

a)

Exchange rate refers to the value of one currency relative to other. Following factors affects the equilibrium exchange rate:

• Inflation rate.
• competitiveness of country
• interest rate
• Balance of trade
• Political stability.

Following is diagram:

Exchange rate is determined where demand and supply for currency are equal. Equilibrium currency and exchange rate are Q* and P*

Competitiveness of industry: Increase in competitiveness of industry increases demand for its products across the world, hence demand for currency rises and it shifts to right thereby appreciating currency.

Interest rate :  Higher interest rate invites foreing direct investment which lead to appreciation of domestic currency.

b)

J Curve:

Initially when currency is devaluated or depreciated, BOP becomes worse first and gradually starts improving. Economic system does not respond immediately to changed value of currency. Initially it is difficult to reduce the import and increase export. Export and imports systems are not elastic enough initially to adjust. It takes time get import and export manipulate according to currency value.

Following is diagram:

in above diagram, Trade balance deteriorate initially but get improved afterwards.