1. Describe the factors that lead to changes in exchange rates.

2. Evaluate the possible economic consequences of a change in the value of a currency.

ANS 1) Exchange refers to the value of one currency in terms of another currency.

Factors that determine Exchange rates include-

1)Demand for imports and exports – The demand for imports and exports has a direct impact on
the purchase of currency and thus alters the exchange rate, When the demand for country’s
exports increases ,it increases demand for the currency itself. To buy the exports, the importers
first need to
buy the exporting country’s currency to pay for them. For example - . If there is an increase in
demand for the American pharmaceuticals, importers first need to but American dollars .
Demand for a country’s currency is partially derived from the relative demand for its exports
compared to that of the trading country. For example – an increase in Indian demand for the
American goods will increase the demand for American dollars and will result in an appreciation
of American dollars in terms of Indian Rupee.

2)Interest Rates and Inflation – Inflation, Interest rates and exchanges rate are highly related.
Central banks changes interest rates in order to control exchange rates and inflation because
interest rates have direct impact on exchange rates and inflation. Higher interest rates offers a
higher return to the lenders. Therefore, higher interest rates attracts foreign investors which
results in an increase in interest rates
Countries with lower relative inflation rate experiences an appreciation in their currency
whereas the countries with higher inflation rate experiences a depreciation in their currency.
Higher relative inflation makes exports expensive and less desirable. It will also result in tade
deficit.

3) Changes in income – When the income earned by residents of a country increases, the demand
for imports also increases and this will result in an increase in the supply of that country’s
currency which results in depreciation of the currency.
4)Speculation – Speculation refers to buying and selling of currencies in order to make profit
from changes in exchange rates. Foreign currency holders speculate the currency. If they expect
a currency to appreciate, then they will buy it in the hope of selling it after its appreciation. If
they expect a currency to depreciate, then they will sell it in the hope of buying it after its
depreciation. However, selling a currency increases the supply of currency and will result in
depreciation.

Ans 2)
An increase in the value of one currency against another is called appreciation and a relative
decrease in the value of one currency against another is called depreciation. For an exchange rate
to appreciate either there must be an increase in demand for the currency or decrease in supply of
the currency. And for an exchange rate to depreciate either there must be a decrease in demand
for the currency or an increase in supply of the currency.
Advantages to appreciation on economic activity-
 Imports become cheaper- When the value of the currency appreciates it means that
importing goods is relatively cheaper than before. This is beneficial to the firms that
import raw materials, reducing the cost of production. The country’s ability to buy
cheaper capital goods and energy resources increases. Appreciation results in lower
inflationary pressure.
 Domestic firms are compelled to seek out new ways of cutting costs and innovating in
order to compete with the foreign exporters.
 Currency appreciation causes the value of foreign debt to fall

Disadvantages to appreciation on economic activity-

 There is a decrease in exports and aggregate demand due to appreciation and this
will result in recessionary gap and further lead to cyclic unemployment if the
economy is begins at potential output. There is a large drop in sales revenue as a
result of fall in exports.
  The domestic producers who do not export may suffer due to an increase in
imports. If they cannot match the discounted price their market share and sales
drop.
Advantages of depreciation on economic activity –
 Depreciation increases exports because foreign consumers find the goods
relatively cheaper and demand for imports increases in their country which will
result in an increase in exports and aggregate demand in the country where the
currency has depreciated. This results in greater employment and causes a fall in
cyclical unemployment if the economy is in a recessionary gap.
 As depreciation results in an increase in exports over imports, the trade deficit is
likely to become smaller over a period of time.

disadvantages of depreciation on economic activity-

 Currency depreciation results in an increase in foreign debt.

 Imports become expensive. If the currency depreciates this can lead to inflation if goods
are produced using other imported products. And the cost of production increases which
results in cost push inflation.