Economics Worksheet 3.2.

2 Exchange Rates
5) May 2010 SL Paper 2 #4

India faces rising currency

a) i)

Infrastructure is physical capital typically provided by the government to

make economic activity possible, e.g. roads, airports, sewage treatment,
water systems, railways, telephone and other utilities.
ii) Interest rates are the cost of borrowing money and the return of saving
money in banks.

b) Increased foreign investment inflows have caused an increase in the demand for
the Indian rupee from D1 to D2, leading to an appreciation of the currency from
ER1 to ER2.

c)

Strong exports will increase net exports (exports minus imports) and contribute
to a growth in aggregate demand from AD1 to AD2, and hence in national output
from Y1 to Y2, which is economic growth.

d) Appreciation is the value of a currency rises in a floating exchange rate regime. It

may bring benefit to the Indian economy in a couple of ways.
First, imported goods and services will be cheaper, including some used in the
production process, hence reducing cost-push inflationary pressures. Indias
inflation accelerated at 7 % in February.
Second, consumers are able enjoy more imported goods and services, which
implies higher living standards.
On the other hand, currency appreciation may bring more harm to the Indian
economy.
First, domestic goods and services will become less competitive with imports.
Exports will be more expensive and demand may decline causing a reduction in
export earnings.
Second, if export revenue decreases, domestic employment and incomes may
decline, especially in Indias labour-intensive manufacturing industries.
Third, a rising currency may endanger the recent record of high economic
growth. The Indian government is actually counting on strong exports to
support economic growth.
Fourth, if the Indian central bank attempts to control the rising currency through
lower interest rates, it may worsen inflation.
Last but not least, a rising currency, together with high inflation, may discourage
foreign investment, which is also an important source of growth for India.

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Economics Worksheet 3.2.2 Exchange Rates

6) May 2013 SL Paper 2 #1
a) i)
ii)

Boom or bust

Appreciation is the value of a currency rises in a floating exchange rate

regime.
Inflation is a persistent increase in the average price level in an economy.

b)

The increasing demand for Australian exported commodities will lead to an

increase in the demand for the Australian dollar from D1 to D2, leading to an
appreciation of the currency from ER1 to ER2.

c)

The higher Australian dollar will make imported resources and consumer goods
cheaper. Hence, it will reduce the costs of production for Australian producers as
well as consumer prices. This is represented by a rightward shift of the SRAS
curve from SRAS1 to SRAS2, leading to a reduction in the price level from P1 to P2.
Inflationary pressure is thus eased.

d)

The appreciating Australian dollar will have positive as well as negative effects
on the Australian economy.
First, on the bright side, the Australian consumers will certainly benefit. They
enjoy cheaper overseas holidays and cheaper imported goods, which is a boost
to their living standards.
Second, for the producers, imported capital goods become cheaper,
encouraging domestic investment and potentially increasing productivity.
Third, inflationary pressure is reduced through lower import prices.
Fourth, it may permit the Australian central bank to lower interest rates, which
is likely to have an expansionary effect on the economy.
On the other hand, the harms of appreciation cannot be overlooked.
First, local exporters in the manufacturing and services sectors suffer because
Australian exports become less competitive.
Second, there will be an increase in unemployment in export sector as demand
for exports falls.
Third, there will be fewer foreign students studying in Australia, causing a fall in
revenue for some Australian schools and universities. There will also be fewer
tourists coming to Australia.
Fourth, foreign investment may be discouraged as the cost of investment
measured in foreign currency increases.
Last but not least, there will be greater dependence on a narrow range of
commodity exports which may lead to vulnerability to external shocks.
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Economics Worksheet 3.2.2 Exchange Rates

7) May 2011 HL Paper 3 #4

Thai finance minister happy with exchange rate

a) i) Exchange rate is the value of one currency expressed in terms of another.

ii) Interest rate is the cost of borrowing money and the reward of saving
money.
b) Thailands central bank might intervene by selling the Thai baht on the foreign
exchange market. This will increase the supply of its currency from S1 to S2,
causing the currency to depreciate from ER1 to ER2.

c)

A further cut in interest rates may result in an increase in consumption and

investment. This will lead to an increase in aggregate demand from AD1 to AD2
and an increase in real output from Y1 to Y2.

d) Depreciation is where the value of a currency falls in a floating exchange rate

regime. There are strong reasons why Thailands central bank should intervene in
the foreign exchange market in order to weaken the Thai baht.
First of all, the Thai economy has stagnated and the export sector has been
struggling. Exports have fallen 26.1%! A cheaper baht will help to boost
exports, and at the same time, discourage imports. An increase in net exports
simply implies an increase in aggregate demand and then in real output (as
illustrated in the diagram in (c) above.).
Meanwhile, it will keep unemployment rate from going up as more jobs become
available in the export industries. As said in the text, unemployment is expected
to rise to 2.5%, up from 1.4% in 2008.
Although a lower value of a currency can be inflationary, this does not seem to
be a problem in Thailand given that the economy is already shrinking. (Thailands
GDP fell 6.1 % in the last quarter of 2008, and could shrink by as much as 1% in
2009.) As shown in the diagram in (c) above, an increase in AD does not lead to
an increase in the average price level.
On the other hand, there are also arguments that speak against government
intervention in their exchange rate.
A lower value of the currency will be damaging to consumers of imported goods,
and will raise the costs of imported factors of production.
The theory of Marshall-Lerner condition suggests that currency depreciation
takes time to contribute to an improvement in export revenues. That means
even if the central bank does intervene, the lower value of the currency may not
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Economics Worksheet 3.2.2 Exchange Rates

have the desired effect of stimulating exports due to the inelastic demand in the
short run.
Some maintain that currencies should be left to market forces. Active
intervention by the central bank might invite retaliation and competitive
depreciation and/or trade protection from other countries.
In fact, as said by the finance minister, Thailands interest rates may continue to
fall so there is no need for the government to intervene. With lower interest
rates, the demand for Thai baht will also be lower.
Last but not least, it is widely believed that supply-side policies intended to
increase efficiency and flexibility may be preferable to exchange rate
manipulation in enhancing a countrys export competitiveness. For example, the
Thai government should invest in education and training of their workforce so
that they could become more productive.

8) Nov 2012 HL Paper 3 #4 Should Latvias currency be devalued?

a) i) Deflation is a persistent decrease in the average price level in the economy.
ii) Depreciation is the value of a currency falls in a floating exchange rate
regime.
b) The cut in wages lowers firms costs of production, allowing them to increase
supply from S1 to S2 and sell their output at a lower price (P2), thus increasing
Latvias export competitiveness.

c)

A lat devaluation can increase exports by lowering their price to foreigners or

reduce imports by increasing their price to domestic residents, (thus increasing
net exports) and causing AD to increase from AD1 to AD2, leading to an increased
level of real output from Y1 to Y2.

d) A fixed exchange rate is where the value of the currency is pegged to that of
another currency (or a basket of currencies) by the central bank. There are good
reasons why the Latvian government should or should not maintain the pegged
value of the lat.
As for advantages, the first one is that it is necessary to maintain the peg if
Latvia is to join the euro, since a stable currency relative to the euro is a
condition for future adoption of the euro.
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Economics Worksheet 3.2.2 Exchange Rates

Second, a stable currency helps maintain price stability and supports the
competitiveness of firms that are dependent on imported inputs.
Third, a stable currency would make the handling of foreign debt (in euros) more
manageable.
Fourth, a stable currency may prevent widespread bankruptcies which could put
a major strain on the financial and banking system. In Latvia, 85 % of consumer
borrowing is in euros, meaning that the real value of consumer debt would
increase if the lat is devalued.
Last but not least, a stable lat might help prevent a process of competitive
devaluations among currencies pegged to the euro, whereas potential benefits
from devaluation would be lost if countries like Bulgaria, Estonia and Lithuania
also devalue their currencies.
On the other hand, there are also strong reasons for giving up the peg.
First, the need to implement a highly restrictive fiscal policy (to qualify for IMF
and EU loans) requires cuts in spending on education and healthcare, with long
term implications for the population.
Second, because of the peg, the government is unable to use expansionary
monetary policy (lower interest rates) to help the economy come out of the
recession. In fact, the need to maintain interest rates at a relatively high level
restricts economic growth by raising the cost of borrowed money.
Third, the lower growth makes it hard to finance the public debt.
Fourth, the need to maintain high interest rates may be contributing to deflation
and may result in a deflationary spiral.
Lastly, the high value of the lat contributes to a continued trade deficit due to
uncompetitive exports and cheap imports.

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