Question 1

Isn't a strong currency always good for an economy?

Accepted Answer

Not necessarily. While a strong currency (appreciation) makes imports cheaper for consumers and firms, reducing cost-push inflation, it also makes exports more expensive for foreigners. This can harm export-oriented industries, reduce international competitiveness, worsen the current account deficit, and potentially lead to job losses in those sectors. The 'best' level for a currency depends on a country's specific economic objectives at the time.

Question 2

What is the difference between depreciation and devaluation?

Accepted Answer

The key difference lies in the exchange rate system. 'Depreciation' is a fall in a currency's value due to market forces of supply and demand in a floating system. 'Devaluation' is a fall in a currency's value as a result of a deliberate policy decision by the government or central bank in a fixed exchange rate system. The terms are not interchangeable and using them correctly demonstrates precise economic knowledge.

Question 3

If a country's exchange rate depreciates, will its trade balance automatically improve?

Accepted Answer

Not automatically. The improvement depends on the Marshall-Lerner condition (PEDx + PEDm > 1). If the demand for both exports and imports is price inelastic, a depreciation will worsen the trade balance, as the increased cost of imports outweighs the revenue gain from slightly more exports. In the short run, demand is often inelastic, leading to an initial worsening of the trade balance before it improves as consumers and firms adjust. This phenomenon is known as the J-Curve effect.

Exchange rates

What you need to know

Exchange rates