International Trade, Globalisation and Exchange Rates: Question 4

Worked solution

Part (a): Defining appreciation

An appreciation is a rise in the value of one currency in terms of another, occurring in a floating exchange rate system where the rate is set purely by demand and supply in the foreign exchange market, with no direct government intervention. When a currency appreciates, each unit of it can be exchanged for more of the other currency than before.

Part (b): Why the veran appreciates

To buy Verantian machinery, buyers in other countries must first obtain verans, since Verantian exporters expect to be paid in their own currency. They do this by exchanging their own currency (kastors) for verans in the foreign exchange market.

• A rise in global demand for Verantian machinery means more foreign buyers want to purchase it.
• This increases the demand for verans in the foreign exchange market (buyers need verans to complete the purchase), while the supply of verans (verans being offered for sale, e.g. by Verantians wanting to buy foreign currency) is unchanged.
• With demand for verans rising against an unchanged supply, the equilibrium price of the veran, measured in kastors, rises: each veran now exchanges for more kastors than before.

This rise in the value of the veran against the kastor is an appreciation.

Part (c)(i): Effect on the machinery export

The Verantian firm keeps its export price fixed at 2000 verans. Converting this into kastors at each exchange rate:

Before the appreciation ($1$ veran $=4$ kastors): $2000 \times 4 = 8\,000 \text{ kastors}$

After the appreciation ($1$ veran $=5$ kastors): $2000 \times 5 = 10\,000 \text{ kastors}$

Even though the Verantian firm has not raised its veran price at all, the machinery now costs Kastorian buyers 2000 more kastors than before, purely because of the appreciation. Since the export is now less price-competitive in Kastoria, Kastorian demand for this Verantian export is likely to fall.

Part (c)(ii): Effect on the cloth import

The Kastorian firm keeps its export price fixed at 2500 kastors. Converting this into verans at each exchange rate:

Before the appreciation ($1$ veran $=4$ kastors, so $1$ kastor $=\tfrac{1}{4}$ veran): $2500 \div 4 = 625 \text{ verans}$

After the appreciation ($1$ veran $=5$ kastors, so $1$ kastor $=\tfrac{1}{5}$ veran): $2500 \div 5 = 500 \text{ verans}$

Even though the Kastorian firm has not lowered its kastor price at all, the cloth now costs Verantian buyers 125 fewer verans than before, because the stronger veran now buys more kastors for the same number of verans spent. Since this import is now cheaper for Verantian buyers, Verantian demand for this Kastorian import is likely to rise.

Final answers

• (a) Appreciation: a market-driven rise in the value of a currency under a floating exchange rate, so it now buys more of another currency than before.
• (b) Higher global demand for Verantian machinery raises demand for verans in the foreign exchange market; with supply unchanged, the equilibrium price of the veran rises against the kastor, an appreciation.
• (c)(i) $2000 \times 4 = 8\,000$ kastors before, $2000 \times 5 = \mathbf{10\,000}$ kastors after. Export dearer abroad, so Kastorian demand is likely to fall.
• (c)(ii) $2500 \div 4 = 625$ verans before, $2500 \div 5 = \mathbf{500}$ verans after. Import cheaper at home, so Verantian demand is likely to rise.