BoP: Devaluation or Currency Depreciation as an Expenditure-Switching Policy

Question 1

What is the Exchange Rate?

Answer 1

The value of one currency in terms of another

For example, how many units of one currency are required to buy a unit of another currency.

Question 2

What does Devaluation refer to in a fixed exchange rate system?

Answer 2

An official lowering of the value of a currency

Often initiated by the central bank.

Question 3

What is an Adjustment Peg?

Answer 3

A method where countries with a fixed or adjustable peg exchange rate may devalue by reducing the official value of their currency

This adjustment is in relation to other currencies.

Question 4

What is Depreciation in a floating exchange rate system?

Answer 4

A natural decline in the value of the currency through market forces

This occurs relative to other currencies.

Question 5

How do depreciation or devaluation affect the domestic currency?

Answer 5

Makes the domestic currency cheaper relative to foreign currencies

This is true in both fixed and floating exchange rate systems.

Question 6

What is Internal Depreciation?

Answer 6

A fall in the currency’s purchasing power within the domestic economy

Often caused by inflation, differing from external depreciation.

Question 7

What is Revaluation in a fixed exchange rate system?

Answer 7

An increase in the value of a currency

This is the opposite of devaluation.

Question 8

What is Appreciation in a floating exchange rate system?

Answer 8

An increase in the value of a currency

This occurs naturally through market dynamics.

Question 9

What is Expenditure-Switching Policy?

Answer 9

A policy aimed at shifting spending from imports to domestically produced goods

This can help address a current account deficit by improving the trade balance.

Question 10

What is one method of implementing an Expenditure-Switching Policy?

Answer 10

Devaluation

This method helps make domestic goods more competitive.

Question 11

What happens to exports after devaluation?

Answer 11

Exports become cheaper in foreign markets

Question 12

How does a weaker domestic currency affect imports?

Answer 12

Imports become more expensive for domestic consumers

Question 13

What is the effect of currency depreciation on the trade balance?

Answer 13

Improvement in trade balance

Question 14

What happens to demand for foreign goods after devaluation?

Answer 14

Demand for foreign goods may decrease

Question 15

Fill in the blank: After devaluation, exports become more _______ internationally.

Answer 15

competitive

Question 16

True or False: A weaker domestic currency can lead to an increase in imports.

Answer 16

False

Question 17

What is one outcome of increased exports and reduced imports over time?

Answer 17

Improvement in trade balance

Question 18

What mechanism causes exports to become cheaper for foreign buyers?

Answer 18

Currency depreciation

Question 19

What is the impact of increased import prices after devaluation?

Answer 19

Reduced demand for foreign goods and services

Question 20

What is one advantage of devaluation related to export competitiveness?

Answer 20

The cheaper domestic currency makes exports more attractive to foreign buyers, potentially boosting export demand and improving the balance of payments (BoP).

Question 21

How does devaluation affect import demand?

Answer 21

As imports become more expensive, domestic consumers may shift to locally produced goods, leading to a reduction in the import bill.

Question 22

What is the impact of devaluation on the trade balance?

Answer 22

Increased exports and reduced imports often result in an improved current account balance, making the economy less reliant on foreign borrowing and supporting BoP stability.

Question 23

What inflationary pressure is caused by currency depreciation?

Answer 23

Depreciation increases the price of imports, which can cause imported inflation, leading to higher overall price levels and reducing the purchasing power of domestic consumers.

Question 24

How can inflation diminish the benefits of devaluation?

Answer 24

If inflation rises faster than the gain from increased exports, the inflationary effects may diminish the long-term benefits of devaluation.

Question 25

What is a potential negative effect of relying heavily on imports after devaluation?

Answer 25

The rise in import costs can offset the benefits of increased export demand, leading to a deterioration in terms of trade.

Question 26

What does loss of investor confidence indicate in the context of devaluation?

Answer 26

Devaluation may signal currency instability, potentially reducing foreign investment and leading to capital flight.

Question 27

What long-term issues may arise from devaluation?

Answer 27

Inflationary pressures and potential negative effects on investor confidence may undermine long-term economic stability.

Question 28

Fill in the blank: Devaluation can lead to a reduction in the _______ bill.

Answer 28

import

Question 29

True or False: Devaluation guarantees long-term stability in an economy.

Answer 29

False

Question 30

What is the Bretton Woods System?

Answer 30

A historic system of fixed exchange rates, with currencies pegged to the U.S. dollar, which itself was pegged to gold.

Question 31

What does the Marshall-Lerner Condition state?

Answer 31

Devaluation will only improve the trade balance if the sum of the price elasticities of demand for exports and imports is greater than 1.

Question 32

What is the J-Curve Effect?

Answer 32

After devaluation, the trade balance may initially worsen before improving over time as exports become more competitive.

Question 33

What does the Absorption Approach propose?

Answer 33

A country must reduce domestic spending to reduce a current account deficit, with devaluation making domestic goods more attractive.

Question 34

What are the short-term effects of devaluation?

Answer 34

Can improve the current account by making exports more competitive and reducing imports.

Question 35

What are the long-term risks associated with devaluation?

Answer 35

Inflation, worsening terms of trade, and reduced investor confidence.

Question 36

What factors determine the overall effectiveness of devaluation?

Answer 36

Elasticity of demand for exports and imports, reliance on imports, and broader economic context.

Question 37

True or False: Devaluation is always beneficial for an economy.

Answer 37

False.

Question 38

Fill in the blank: The Marshall-Lerner Condition requires the sum of price elasticities to be greater than _______.

Answer 38

1.

Question 39

What shape does the trade balance form over time after devaluation according to the J-Curve Effect?

Answer 39

A 'J' shaped curve.

Question 40

Fill in the blank: The Absorption Approach is focused on reducing _______ to address current account deficits.

Answer 40

domestic spending.

Question 41

What must be carefully managed to avoid inflationary spirals and long-term economic instability?

Answer 41

Devaluation.