Model Answer
0 min readIntroduction
The elasticity of demand for foreign exchange refers to the responsiveness of the quantity of foreign exchange demanded to a change in the exchange rate. It is a crucial determinant of the effectiveness of exchange rate policy and a country’s ability to adjust to external shocks. This elasticity isn’t a single, monolithic value; it’s influenced by several factors, most notably the elasticity of demand for imports and the elasticity of supply of export-competing goods. Understanding these relationships is vital for policymakers aiming to manage exchange rates and maintain external stability. A higher elasticity implies a greater impact of exchange rate changes on the balance of payments, while a lower elasticity suggests a more limited impact.
Understanding the Elasticity of Demand for Foreign Exchange
The overall elasticity of demand for foreign exchange (Edx) can be understood as a composite of several underlying elasticities. It represents the total change in the demand for foreign exchange resulting from a change in the exchange rate. This demand arises primarily from the need to pay for imports, invest abroad, and speculate in foreign exchange markets.
Influence of Elasticity of Home Demand for Imports (Em)
The elasticity of home demand for imports (Em) measures the responsiveness of the quantity of imports demanded to a change in the exchange rate.
- Mechanism: A depreciation of the home currency makes imports more expensive. If the demand for imports is highly elastic (Em > 1), a small increase in the price of imports due to depreciation will lead to a relatively large decrease in the quantity of imports demanded. This reduces the demand for foreign exchange.
- Impact on Edx: A higher Em contributes to a higher Edx. This is because a given depreciation will lead to a larger reduction in import demand, lessening the need for foreign exchange.
- Factors affecting Em: The availability of close substitutes for imports, the proportion of income spent on imports, and the time horizon all influence Em. For example, if a country imports a necessity like oil, Em will be relatively inelastic.
Influence of Elasticity of Home Supply of Import-Competing Goods (Es)
The elasticity of home supply of import-competing goods (Es) measures the responsiveness of the quantity of domestically produced goods that compete with imports to a change in the exchange rate.
- Mechanism: A depreciation of the home currency makes domestically produced import-competing goods relatively cheaper compared to imports. If the supply of these goods is highly elastic (Es > 1), domestic producers will be able to increase their output significantly in response to the price change, substituting for imports.
- Impact on Edx: A higher Es contributes to a lower Edx. This is because increased domestic supply reduces the need for imports, thereby decreasing the demand for foreign exchange.
- Factors affecting Es: The availability of productive capacity, the ease of shifting resources between sectors, and the time horizon all influence Es. If domestic industries face capacity constraints, Es will be relatively inelastic.
The Combined Effect & Marshall-Lerner Condition
The overall elasticity of demand for foreign exchange is a function of both Em and Es. A simplified representation can be shown as:
Edx = Em + Es (This is a simplified representation, ignoring other factors)
However, the Marshall-Lerner condition provides a more comprehensive framework. It states that for a depreciation to improve the balance of payments, the sum of the price elasticities of demand for exports and imports must be greater than one. This condition highlights the importance of both import and export elasticities in determining the effectiveness of exchange rate adjustments.
Illustrative Example: India and Oil Imports
Consider India's oil imports. The demand for oil is relatively inelastic (Em < 1) because oil is a crucial energy source with few short-term substitutes. However, India is increasing its domestic production of renewable energy sources (solar, wind). If the supply of renewable energy increases significantly (Es > 1), it can substitute for oil imports, reducing the demand for foreign exchange. This demonstrates how a higher Es can offset a lower Em.
| Elasticity | Impact on Edx | Effect on Balance of Payments (after depreciation) |
|---|---|---|
| High Em | Increases Edx | Larger reduction in imports, potentially improving BOP |
| High Es | Decreases Edx | Larger substitution for imports, improving BOP |
| Low Em & Low Es | Low Edx | Limited impact on BOP, depreciation may worsen it |
Conclusion
In conclusion, the elasticity of demand for foreign exchange is a complex phenomenon influenced significantly by the elasticity of home demand for imports and the elasticity of home supply of import-competing goods. A higher elasticity of import demand reduces the need for foreign exchange following a depreciation, while a higher elasticity of supply of import-competing goods substitutes for imports, also lessening the demand for foreign exchange. Policymakers must consider these elasticities when formulating exchange rate policies, recognizing that the effectiveness of depreciation depends on the responsiveness of both import demand and domestic supply. Furthermore, structural reforms aimed at increasing domestic production capacity and diversifying import sources can enhance the effectiveness of exchange rate adjustments.
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.