Model Answer
0 min readIntroduction
Currency depreciation refers to a decline in the value of a country’s currency relative to other currencies. While often seen as a tool to boost exports, depreciation frequently leads to inflationary pressures within the economy. This is because a weaker currency makes imports more expensive, impacting both consumers and producers. The recent volatility in the Indian Rupee against the US Dollar, for instance, has raised concerns about imported inflation, particularly regarding essential commodities like crude oil and edible oils. Understanding the mechanisms through which depreciation translates into inflation is vital for effective macroeconomic management.
Mechanisms of Inflationary Impact
Currency depreciation is inflationary through several interconnected channels:
1. Cost-Push Inflation
- Increased Import Costs: A depreciated currency directly increases the domestic currency price of imported goods and raw materials. This is particularly significant for economies heavily reliant on imports for essential inputs like crude oil, fertilizers, and machinery.
- Production Costs: Higher import costs translate into increased production costs for domestic firms that use imported inputs. These increased costs are often passed on to consumers in the form of higher prices, leading to cost-push inflation.
- Example: In 2022, the depreciation of the Indian Rupee against the US Dollar led to a rise in the cost of imported crude oil, contributing to higher petrol and diesel prices, and subsequently, increased transportation costs across the economy.
2. Demand-Pull Inflation
- Increased Aggregate Demand: Depreciation makes exports cheaper for foreign buyers, leading to an increase in export demand. Simultaneously, imports become more expensive, reducing import demand. This net increase in aggregate demand can exert upward pressure on prices, especially if the economy is operating close to its full capacity.
- Terms of Trade Improvement: While beneficial in some respects, an improvement in the terms of trade (export prices rising relative to import prices) can also contribute to demand-pull inflation if the increased export earnings are not offset by reduced import spending.
- Exchange Rate Pass-Through: The extent to which depreciation translates into higher import prices depends on the ‘exchange rate pass-through’ coefficient. A higher pass-through means a larger impact on import prices.
3. Expectations and Second-Round Effects
- Inflationary Expectations: Persistent currency depreciation can lead to expectations of future inflation. This can prompt workers to demand higher wages and firms to raise prices preemptively, creating a self-fulfilling prophecy of inflation.
- Wage-Price Spiral: If wages increase in response to higher prices, this further increases production costs and fuels another round of price increases, leading to a wage-price spiral.
4. Impact on Specific Sectors
- Import-Competing Industries: While depreciation can benefit import-competing industries by making their products relatively cheaper, it can also lead to higher input costs for these industries if they rely on imported raw materials.
- Export-Oriented Industries: Export-oriented industries generally benefit from depreciation as their products become more competitive in international markets. However, they may face higher costs for imported inputs.
| Inflation Type | Mechanism | Impact |
|---|---|---|
| Cost-Push | Increased import costs -> Higher production costs -> Increased prices | Supply-side driven inflation |
| Demand-Pull | Increased exports, decreased imports -> Higher aggregate demand -> Increased prices | Demand-side driven inflation |
Conclusion
In conclusion, currency depreciation is inherently inflationary due to its impact on import prices, aggregate demand, and inflationary expectations. The magnitude of the inflationary effect depends on factors such as the size of the depreciation, the economy’s import dependence, the exchange rate pass-through coefficient, and the overall state of the economy. While depreciation can offer short-term benefits to export sectors, policymakers must carefully manage the associated inflationary risks through appropriate monetary and fiscal policies, including managing liquidity and controlling government spending, to maintain price stability.
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.