(a) Explain three factors which may cause changes to occur in a country’s exchange rate under a floating exchange rate system.
(b) Evaluate the likely impact on a country’s economic performance of a substantial depreciation of its exchange rate.
1. The question (a) is asking for three factors that affects the floating exchange rate system. Also, the question (b) is asking the test taker to evaluate on the effect due to the depreciation of the exchange rate.
2. Floating Exchange Rate: Where the exchange rate is floating (as are all major currencies in the world), it will be determined by market forces – that is supply and demand. As in any other market, the rate will change constantly to reflect how much of the currency is being traded. However, what determines the supply and demand for the currency? Let’s take the Baht (the Thai currency) as an example and look at the factors that affect supply and demand and therefore the equilibrium exchange rate. (Triple A)
3. Governments can use exchange rates to affect economic performance. A rising exchange rate, which is often linked to an increase in base interest rates, leads to exports becoming more expensive but imports falling in price. This would reduce part of the inflationary pressure within an economy. A fall in the exchange rate would lead to the reverse and might help domestic businesses export more. (Triple A)
- Floating Exchange Rate: the exchange rate system is affected by the supply and demand of the currency exchange market.
- Depreciation of the Exchange Rate: this usually occurs when either the supply of the currency increases or the demand of the currency decreases.
This is the diagram for the depreciation of the currency as a result of the increase in the supply of the currency from S1 to S2. The quantity of the currency increases from Q1 to Q2, however, the value of the currency in terms of another currency goes down. This is why the currency depreciates when the supply of the currency increases.
The currency can depreciate also when the demand for the currency decreases from D2 to D1. The quantity of the currency demanded decreases from Q2 to Q1 and the value of the currency decreases from $0.35 to $0.25. This is why the currency depreciates when the demand for the currency decreases.
As the currency depreciates, the exports will increase and the imports will decrease. This will balance of payment and decrease the current account. The country will be in the trade surplus, however.