Page 217 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes
Figure 12.1: Amount of Foreign Currency

Where DD and SS curves are inelastic, exchange depreciation involves a greater amount as
compared to the previous case. The elasticities of these curves would depend on many factors.
The elasticity of demand for foreign exchange will depend e.g., on nature of importable goods
(luxury or not), substitutability of importable goods and elasticity of supply of these goods in
the foreign country. Similarly, the elasticity of supply of foreign exchange will depend upon the
nature of exportable goods, elasticity of supply of exportable goods and time period.
Thus, in case of less elastic demand and supply of foreign exchange, BOP disequilibrium can be
corrected by heavy exchange appreciation or depreciation, which might affect the national
economy.

Advantages of Floating Exchange Rates

Automatic BOP Adjustments: If, at the existing rate of exchange, country’s BOP moves
into deficit, then the quantity of that country’s currency supplied to the foreign exchange
market will exceed the demand for it. The currency will, therefore, depreciate against
other currencies and, in consequence, demand for exports will increase (because they have
become cheaper abroad) while demand for imports will fall (because they have become
more expensive in the domestic economy). For a country whose BOP moves into surplus,
the mechanism works in reverse.

Freedom in Choice of Domestic Policies: Since BOP adjustment is automatic, the government
is free to pursue policies in the domestic economy independently of BOP consideration.

Disadvantages of Floating Exchange Rates

Reduced International Trade: This occurs because of uncertainty over what exchange rate
will exist in the future when contracts fall due for settlement.

Exchange Rate Instability: This is due to speculative pressures and will make it difficult
for firms to plan future output and investment levels.
Increased Inflational Pressure: Since equilibrium in the BOP is automatic, the element of
discipline on nations to avoid inflationary pressure is reduced. Further, countries whose
currencies depreciate will experience rising import prices and, where raw materials or
semi-finished products are imported, this implies rising final prices. This is a cost push
explanation of inflation.

212 LOVELY PROFESSIONAL UNIVERSITY