International Trade, Globalisation and Exchange Rates: Question 9

Worked solution

Part (a): Defining depreciation

A depreciation is a fall 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 depreciates, each unit of it can be exchanged for less of the other currency than before.

Part (b): Why the pama depreciates

To buy Bryndorian electronics, Solennan importers must pay in rings, since Bryndorian exporters expect to be paid in their own currency. Solennan importers obtain these rings by selling pamas in the foreign exchange market.

• A rise in Solennan demand for Bryndorian electronics means more Solennan importers want to buy rings to pay for these imports.
• This increases the supply of pamas being offered on the foreign exchange market (importers sell pamas to obtain rings), while the demand for pamas (for example, from Bryndorian buyers wanting to purchase Solennan goods) is unchanged.
• With the supply of pamas rising against an unchanged demand, the equilibrium price of the pama, measured in rings, falls: each pama now exchanges for fewer rings than before.

This fall in the value of the pama against the ring is a depreciation.

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

The Solennan firm keeps its export price fixed at 900 pamas. Converting this into rings at each exchange rate:

At the original rate ($1$ pama $=8$ rings): $900 \times 8 = 7200 \text{ rings}$

At the new rate ($1$ pama $=6$ rings): $900 \times 6 = 5400 \text{ rings}$

Even though the Solennan firm has not lowered its pama price at all, the furniture now costs Bryndorian buyers 1800 fewer rings than before, purely because of the depreciation. Since the export is now more price-competitive in Bryndor, Bryndorian demand for this Solennan export is likely to rise.

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

The Bryndorian firm keeps its export price fixed at 3600 rings. Converting this into pamas at each exchange rate:

At the original rate ($1$ pama $=8$ rings, so $1$ ring $=\tfrac{1}{8}$ pama): $3600 \div 8 = 450 \text{ pamas}$

At the new rate ($1$ pama $=6$ rings, so $1$ ring $=\tfrac{1}{6}$ pama): $3600 \div 6 = 600 \text{ pamas}$

Even though the Bryndorian firm has not raised its ring price at all, the electronics now cost Solennan buyers 150 more pamas than before, because the weaker pama now buys fewer rings for the same number of pamas spent. Since this import is now more expensive for Solennan buyers, Solennan demand for this Bryndorian import is likely to fall.

Final answers

• (a) Depreciation: a market-driven fall in the value of a currency under a floating exchange rate, so it now buys less of another currency than before.
• (b) A rise in Solennan demand for Bryndorian electronics increases the supply of pamas on the foreign exchange market; with demand unchanged, the equilibrium price of the pama falls against the ring, a depreciation.
• (c)(i) $900 \times 8 = 7200$ rings before, $900 \times 6 = \mathbf{5400}$ rings after. Export cheaper abroad, so Bryndorian demand is likely to rise.
• (c)(ii) $3600 \div 8 = 450$ pamas before, $3600 \div 6 = \mathbf{600}$ pamas after. Import dearer at home, so Solennan demand is likely to fall.