Model Answer
0 min readIntroduction
The external value of a currency, reflecting its exchange rate against other currencies, plays a pivotal role in a country’s international economic transactions. Fluctuations in this value – depreciation (weakening) or appreciation (strengthening) – significantly impact a nation’s balance of payments (BoP), a systematic record of all economic transactions between a country and the rest of the world. Recent global events, including geopolitical tensions and varying monetary policies, have led to substantial currency volatility, making understanding these impacts crucial for policymakers. This answer will explore how depreciation and appreciation influence the BoP, focusing on both the current and capital accounts.
Understanding Depreciation and Appreciation
Depreciation refers to a decrease in the value of a currency relative to other currencies under a floating exchange rate system. Conversely, Appreciation signifies an increase in a currency’s value. These changes affect the price competitiveness of a country’s goods and services in the international market.
Impact on the Current Account
The current account comprises trade in goods and services, income, and current transfers. Currency fluctuations directly influence the trade balance, the largest component of the current account.
- Depreciation: A depreciating currency makes exports cheaper for foreign buyers and imports more expensive for domestic consumers. This theoretically leads to an increase in exports and a decrease in imports, improving the trade balance and potentially leading to a current account surplus. However, the J-curve effect suggests that in the short run, the value of imports may not fall immediately due to existing contracts, while export volumes take time to respond to price changes, initially worsening the trade balance.
- Appreciation: An appreciating currency makes exports more expensive and imports cheaper. This can lead to a decrease in exports and an increase in imports, worsening the trade balance and potentially leading to a current account deficit.
Impact on the Capital Account
The capital account records transactions related to financial assets, including foreign direct investment (FDI), portfolio investment, and other capital flows.
- Depreciation: Depreciation can attract foreign investment. A weaker currency makes assets in that country cheaper for foreign investors, potentially boosting FDI and portfolio inflows. However, concerns about economic instability due to depreciation might deter some investors.
- Appreciation: Appreciation can discourage foreign investment as assets become more expensive for foreign buyers. It may also encourage domestic investment abroad as domestic assets become relatively more valuable.
The Marshall-Lerner Condition
The effectiveness of depreciation in improving the trade balance depends on the Marshall-Lerner condition. This condition states that the sum of the price elasticities of demand for exports and imports must be greater than one for depreciation to improve the trade balance. If the condition is not met, depreciation may worsen the trade balance.
Example: The Indian Rupee and the US Dollar
In 2023, the Indian Rupee depreciated against the US Dollar due to global economic uncertainties and rising US interest rates. This depreciation made Indian exports more competitive, particularly in sectors like IT services and textiles. However, it also increased the cost of imported crude oil, impacting India’s import bill. The overall impact on the BoP was complex, influenced by both positive and negative effects.
| Currency Movement | Impact on Exports | Impact on Imports | Impact on Capital Account |
|---|---|---|---|
| Depreciation | Increases (becomes cheaper) | Decreases (becomes expensive) | Potential increase in inflows |
| Appreciation | Decreases (becomes expensive) | Increases (becomes cheaper) | Potential decrease in inflows |
Conclusion
In conclusion, depreciation and appreciation in a currency’s external value have complex and often offsetting effects on a country’s balance of payments. While depreciation can theoretically improve the current account by boosting exports and reducing imports, the J-curve effect and the Marshall-Lerner condition highlight the nuances involved. Similarly, appreciation can impact capital flows, but its overall effect depends on investor confidence and global economic conditions. Effective exchange rate management and a diversified economy are crucial for mitigating the risks associated with currency fluctuations and maintaining a stable BoP.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.