AS Level Economics 9708: Floating Exchange Rate Appreciation and Currency Conversion

Rivandia operates a freely floating exchange rate for its currency, the riven, against the US dollar. Rivandia's main export is a specialty coffee bean. After a successful international marketing campaign, global demand for Rivandia's coffee exports rises sharply.

(a) Explain, using demand and supply analysis, how this increase in foreign demand for Rivandia's coffee exports is likely to affect the exchange rate of the riven. [3]

(b) State whether the riven has appreciated or depreciated as a result of this change. [1]

(c) Before the change, the exchange rate was $1 = 5.00 rivens. After the change, it becomes $1 = 4.00 rivens. A separate Rivandian export, a batch of textiles, is priced at 200 rivens. Calculate the price of this textile export in US dollars (i) before and (ii) after the change in the exchange rate. [2]

(d) An imported machine component is priced at $10 in the United States. Calculate its price in rivens (i) before and (ii) after the change in the exchange rate. [2]

(e) Using your results from (c) and (d), explain the likely effect of this exchange-rate change on the price competitiveness of Rivandia's exports and imports. [2]

Part (a): How a rise in export demand affects a floating exchange rate

Under a freely floating exchange rate, the price of the riven is determined purely by the demand for and supply of rivens in the foreign exchange market, with no government intervention. When global demand for Rivandia’s coffee exports rises, foreign buyers need to acquire more rivens to pay Rivandian coffee producers, so the demand curve for rivens shifts to the right. The supply of rivens (driven mainly by Rivandians wanting to buy foreign currency, e.g. to pay for imports) is unaffected. At the new intersection of the (unchanged) supply curve and the new, further-right demand curve, the equilibrium price of the riven, how many dollars one riven is worth, is higher than before.

Part (b): Appreciation or depreciation?

Since the equilibrium price of the riven has risen, the riven has appreciated.

Part (c): Price of the textile export in US dollars

Before the change, $1 = 5.00 rivens, so a good priced at 200 rivens costs, in dollars: $200 \div 5 = 40$ i.e. $40.

After the change, $1 = 4.00 rivens, so the same 200-riven good now costs, in dollars: $200 \div 4 = 50$ i.e. $50.

The appreciation has raised the dollar price of this Rivandian export from $40 to $50, even though its riven price (200 rivens) has not changed at all.

Part (d): Price of the imported machine component in rivens

Before the change, converting the $10 import price into rivens: $10 \times 5 = 50 \text{ rivens}$

After the change: $10 \times 4 = 40 \text{ rivens}$

The appreciation has lowered the riven price of this import from 50 rivens to 40 rivens, even though its dollar price ($10) has not changed at all.

Part (e): Effect on price competitiveness

The appreciation works in opposite directions for exports and imports. Rivandia’s textile export has become more expensive to foreign (dollar-holding) buyers, rising from $40 to $50 (making Rivandian exports less price-competitive abroad. At the same time, the imported machine component has become cheaper in riven terms, falling from 50 rivens to 40 rivens) making imports more attractively priced for Rivandian buyers. If exporters’ foreign customers and Rivandian importers respond to these price changes, export volumes are likely to fall and import volumes are likely to rise, other things equal.

Final answers

(a) Rising foreign demand for coffee exports shifts the demand curve for rivens rightward, raising the equilibrium price of the riven
(b) The riven has appreciated
(c) Textile export price in dollars: $40 before, $50 after
(d) Machine component price in rivens: 50 rivens before, 40 rivens after
(e) Exports become less price-competitive abroad and imports become more attractively priced at home, tending to reduce export volumes and raise import volumes