Question

What are the implications of changes in the exchange rate on the predictions for an economy?

Answer 1

Under the recent economic reforms , we liberalised the Industrial sector but have also opened up the economy, made our currency convertible and allowed exchange rate to adjust freely. It is important to understand the full implications of opening up the economy and allowing our currency to ‘float’.It is worthwhile to note that under a fixed exchange rate system when citizens of a country spend some of their income on imports it reduces the value of multiplier because imports, like savings and taxes, serve as a leakage from the circular flow of income. On the other hand, exports, like investment and Government expenditure, raise the aggregate demand for domestically pro­duced goods and services and thereby cause an expansion in output through a multiplier process.However, under a variable or floating exchange rate system, the effect of imports and exports on real output is highly complicated. First, the volume of imports and exports depends not only on income, price level, interest rate but also on the exchange rates themselves.

Thus when due to some factors, foreign exchange rate changes, it will have an effect on the level of GNP and the price level. Further, exchange rates themselves will adjust to the changes in the economy. We discuss below the effects of changes in the exchange rate, especially of depreciations and devaluation of the exchange rate, on exports, imports, national income, balance of payments and the price level in the economy.From our foregoing discussion of determination of exchange rate through demand and supply curves of foreign exchange it follows that when a currency of a country, say Indian rupee, depreci­ates as a result of demand and supply conditions or is devalued by the Government, the prices of Indian exports in terms of foreign currency (say dollar) will fall.

This will cause the increase in quantity demanded of Indian exports. As a result, Indian exports will increase. On the other hand, depreciation or -devaluation of Indian rupee will make the imports from foreign countries more expensive in terms of rupees (for example, a dollar’s worth of US goods will cost more in terms of the Indian rupee) when the Indian rupee depreciates or is devalued.Besides, due to higher prices of imported goods, people of a country tend to substitute domestically produced goods for the now more expensive imports. As a result, the aggregate demand or expenditure on domestically produced goods and services will increase causing either expansion in output of goods or rise in their prices or both. However, if the economy is working close to the capacity output, the effect will be more on raising prices of goods.