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Homework answers / question archive / The appreciation of the currency generates a decrease in the real exchange rate, which translates into an increase in exports and a decrease in imports, which means an increase in the country's economic activity

The appreciation of the currency generates a decrease in the real exchange rate, which translates into an increase in exports and a decrease in imports, which means an increase in the country's economic activity

Economics

The appreciation of the currency generates a decrease in the real exchange rate, which translates into an increase in exports and a decrease in imports, which means an increase in the country's economic activity. Comment and graph (Foreign Trade Models and IS-LM)

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Greetings for the day,

 

First, we will understand the concept of currency appreciation and how they affect our economy:

Currency appreciation is an increase in the value of one currency in relation to another currency. Currencies appreciate against each other for a variety of reasons, including the government policy, interest rates, trade balances and business cycles.

In a floating rate exchange system, the value of a currency constantly changes based on supply and demand in the forex market. The fluctuation in values allows traders and firms to increase or decrease their holdings and profit off them.

Appreciation is directly linked to demand. If the value appreciates (or goes up), demand for the currency also rises. In contrast, if a currency depreciates, it loses value against the currency against which it is being traded.

 

Effects of currency appreciation:

 

  • Export costs rise: If the U.S. dollar appreciates, foreigners will find American goods more expensive because they have to spend more for those goods in USD. That means that with a higher price, the number of U.S. goods being exported will likely drop. This eventually leads to a reduction in the gross domestic product (GDP), which is definitely not a benefit.
  • Cheaper imports: If American goods become more expensive on the foreign market, foreign goods, or imports, will become cheaper in the U.S. The length to which $1 will stretch will go further, meaning you can buy more goods imported from abroad. That translates to a benefit of lower prices, leading to lower overall inflation.

 

Currency impact on economy:

A currency's level directly impacts the economy in the following ways:

 

Merchandise Trade:

This refers to a nation's imports and exports. In general, a weaker currency makes imports more expensive, while stimulating exports by making them cheaper for overseas customers to buy. A weak or strong currency can contribute to a nation's trade deficit or trade surplus over time.

Economic Growth:

The basic formula for an economy’s GDP is:

GDP=C+I+G+(X−M)

Where: C=Consumption or consumer spending, the biggest component of an economy

I= capital investment by business and household

G= Government spending

(X-M)= export-import

From this equation, it is clear that the higher the value of net exports, the higher a nation's GDP. As discussed earlier, net exports have an inverse correlation with the strength of the domestic currency.

 

Now we will see the IS-LM model:

The IS-LM model, which stands for "investment-savings" (IS) and "liquidity preference-money supply" (LM) is a Keynesian macroeconomic model that shows how the market for economic goods (IS) interacts with the loanable funds market (LM) or money market. It is represented as a graph in which the IS and LM curves intersect to show the short-run equilibrium between interest rates and output.

IS (investment–saving) curve:

The IS curve shows the causation from interest rates to planned investment to national income and output.

For the investment–saving curve, the independent variable is the interest rate and the dependent variable is the level of income

The IS curve represents the locus where total spending (consumer spending + planned private investment + government purchases + net exports) equals total output (real income, Y, or GDP).

LM curve:

The LM curve shows the combinations of interest rates and levels of real income for which the money market is in equilibrium. It shows where money demand equals money supply. For the LM curve, the independent variable is income and the dependent variable is the interest rate.


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