EXCHANGE RATES
LESSON ON INTERNATIONAL TRADE
1. Explain how the effects of devaluation on the level economic activity differ from those
of a deflation. [8]
Devaluation is the lowering by the government of a currency’s international value under a fixed
exchange rate system. Deflation refers to a persistent fall in the general price level or a lower
level of economic activity possibly resulting from government policy. Devaluation should
improve the current account and boost the economy with higher demand, employment and
growth. Deflation harms confidence, reduces spending and increases unemployment.
Understanding of devaluation and deflation 4 marks
Explanation of the different effects 4 marks
2. Discuss whether inflation can be both the cause and the result of fluctuations in an
economy’s exchange rate. [12]
Higher inflation than trading partners may mean a fall in the exchange rate because of increased
supply and reduced demand for the currency. This will result from fewer exports, more imports,
reduced confidence and outflows of investment. Overall it would mean a worsening of the
balance of payments.
A fall in the exchange rate will increase the cost of imports (cost push inflation) and increase the
demand for exports (demand pull inflation). A rise in the exchange rate would reduce
inflationary pressure.
Whether these effects occur will depend upon the rate of inflation, the relative rates of inflation,
the government’s ability to control inflation, the nature of the exchange rate system and the
direction of the change in the exchange rate.
Understanding of inflation and the exchange rate 2 marks
Analysis of the impact of the changes up to 6 marks
Discussion of the conditions affecting the process up to 6 marks
1. Max. 10
3. Discuss whether an economy will benefit from a fall in its exchange rate. [6]
Benefits: improved balance of trade; more competitive industry; higher employment and
income; increased growth
Drawbacks: only works with Marshall-Lerner condition and elasticity of supply; generates
inflationary pressure; undermined by retaliation; reduced purchasing power of currency
Max. 4 marks for one side only
4. Explain the limitations of the theory of comparative advantage in accounting for of a
country’s pattern of trade. [8]
Comparative advantage is found when a country can produce at a lower opportunity cost than
another. This reflects the country’s factor endowment. It is the basis for specialization, increased
output and the benefits of trade. The theory is based on some restrictive assumptions which limit
its explanatory value. These include bilateral rather than multilateral trade, absence of transport
costs, and mobility of factors, constant returns, full employment and reciprocal demand. These
assumptions may not exist in practice.
Understanding of comparative advantage 4 marks
1. Explanation of the limitations of the theory of comparative advantage 4 marks
5. Discuss whether the introduction of trade barriers to imports can be justified. [12]
Trade barriers include tariffs, quotas, export subsidies, misaligned exchange rates, administrative
restrictions, exchange control etc. These are intended to reduce imports and the corresponding
outflow of currency. Barriers can be justified in terms of protection of infant industries,
prevention of dumping, raising revenue, short-run employment protection, improving the terms
of trade and avoiding overspecialization. On the other hand, barriers will prevent the benefits of
international trade which include lower prices, more choice, more efficiency and higher living
standards. Barriers may face retaliation and breach international obligations e.g. those of the
World Trade Organisation.
Understanding of the types and purpose of trade barriers 4 marks
Discussion of the benefits of trade barriers 4 marks
Discussion of the drawbacks of trade barriers 4 marks
6. The difference between expenditure-dampening and expenditure-switching trade
policies. [8]
Expenditure-dampening intends to lower the total level of spending within an economy by
raising taxes and interest rates to reduce imports and raise exports. Expenditure switching
attempts to get foreign and domestic consumers to purchase the country’s goods rather than rival
countries by tariffs, quotas and devaluation.
7. Discuss whether a balance of payments current account deficit necessarily indicates a
weak economy. [12]
The balance of payments current account includes balances of goods, services, transfers and
income. A deficit means outflows exceed inflows. Whether a deficit is a serious matter and
indicates weakness depends upon its size (minimal or excessive), its continuity (how long has it
run? is it continuous?), the cause of the deficit (buying consumer or investment goods?), its
affordability (level of reserves, ease of borrowing), the effect it is having on the economy
(running up debt, need for restrictive policies) and the nature of the deficit (which part of the
account is causing the problem?), whether the deficit is structural or cyclical.
Depending which of these conditions apply, it may or may not indicate a weak economy.
Examples can support the judgment.
Understanding of a current account deficit 4 marks
Discussion of conditions showing weakness 4 marks
Discussion of conditions showing ability to cope 4 marks
8. Discuss whether trade arrangements, such as the European Union and the South
Asian Free Trade Area, encourage or discourage the benefits of free trade. [12]
Free trade encourages competition and efficiency, lowers prices, increases choice and raises
living standards. Trade arrangements may vary from relatively loose free trade areas to very
structured economic unions. The effects of membership involve trade creation and trade
diversion. As a member a country would hope to benefit although this may involve the need for
restructuring with short-term costs. The number of trading arrangements has been increasing so
extending the benefits. For non- members there is reduced opportunity to experience free trade
and its benefits although some countries may feel that the benefits of free trade are not shared
equally among participants and may undermine domestic industries and employment.
Understanding of the types of trade arrangement up to 4 marks
Discussion of the benefits of trade up to 6 marks
Discussion of the drawbacks of trade arrangements up to 6 marks
To max
10 marks
9. Discuss whether the formation of regional trading groups, such as SADC and
COMESA is desirable. [12]
Regional blocs may be free trade areas, customs unions or economic unions. They encourage
free trade between member states and can be bilateral or multilateral. The benefits should be
more trade, more choice, lower costs and higher living standards. However small scale
agreements may have limited impact may prevent more beneficial, large scale agreements and
cause trade diversion. Smaller members may be at a disadvantage, as May infant industries, to
more powerful members and there may be problems with complicated regulations. While these
agreements may be better than facing global barriers they may be inferior to wider global
agreements.
Understanding of regional trade blocs up to 4 marks
Analysis of the effects of agreements up to 6 marks} max of
Discussion of the overall impact of agreements up to 6 marks} 10 marks
Advantages of an appreciation in the currency
Cheaper imports for consumers: A high dollar leads to lower import prices – this
boosts the real living standards of consumers at least in the short run – for example an
increase in the real purchasing power of Zimbabwean residents when travelling overseas
or the chance to buy cheaper computers or motor vehicles from the United States or
Europe.
Lower costs for producers: When the dollar exchange rate is high, it is cheaper to
import raw materials, component parts and capital inputs such as plant and equipment –
this is good news for businesses that rely on imported components or who are wishing to
increase their investment of new technology from overseas countries. A fall in import
prices has the effect of causing an outward shift in the short run aggregate supply curve.
And if a country can now import more productive technology, the LRAS curve may shift
out.
Lower inflation: A strong exchange rate helps to control the rate of inflation because
domestic suppliers now face stiffer international competition from cheaper imports and
will look to cut their costs and prices accordingly in order not to suffer from a loss of
international competitiveness. Cheaper prices of imported foodstuffs and beverages will
also have a negative effect on the rate of consumer price inflation.
If inflation is lower, then interest rates will be lower than if the exchange rate was
weaker – and cheaper money will eventually stimulate higher consumer spending and
capital spending in the circular flow
Disadvantages of a Strong Dollar
Increase in the trade deficit: The lower price of imports leads to consumers increasing
their demand and this can cause a large trade deficit. Exporters lose price
competitiveness because they will find it more expensive to sell in foreign markets and
face losing market share – this can damage profits and employment in some sectors and
industries.
Slower economic growth: If exports fall, this causes a reduction in aggregate demand
and reduces the short-term rate economic growth as measured by the % change in real
GDP. Some regions of the economy are affected by this more than others. In the North
east for example, manufacturing industry accounts for over 28% of regional GDP
whereas the percentage for the UK as a whole is just 19%.
If exports fall, then so will business confidence and capital investment – because
investment is partly dependent on the strength of demand
Determinants of Exchange Rates
Numerous factors determine exchange rates, and all are related to the trading relationship
between two countries. Remember, exchange rates are relative, and are expressed as a
comparison of the currencies of two countries. The following are some of the principal
determinants of the exchange rate between two countries. Note that these factors are in no
particular order; like many aspects of economics, the relative importance of these factors is
subject to much debate.
1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies. During the last half of the
twentieth century, the countries with low inflation included Japan, Germany and Switzerland,
while the U.S. and Canada achieved low inflation only later. Those countries with higher
inflation typically see depreciation in their currency in relation to the currencies of their trading
partners. This is also usually accompanied by higher interest rates. (To learn more, see Cost-
Push Inflation Versus Demand-Pull Inflation.)
2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest
rates, central banks exert influence over both inflation and exchange rates, and changing interest
rates impact inflation and currency values. Higher interest rates offer lenders in an economy a
higher return relative to other countries. Therefore, higher interest rates attract foreign capital
and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if
inflation in the country is much higher than in others, or if additional factors serve to drive the
currency down. The opposite relationship exists for decreasing interest rates - that is, lower
interest rates tend to decrease exchange rates. (For further reading, see What Is Fiscal Policy?)
Free Trading Guide - GFT
3. Current-Account Deficits
The current account is the balance of trade between a country and its trading partners, reflecting
all payments between countries for goods, services, interest and dividends. A deficit in the
current account shows the country is spending more on foreign trade than it is earning, and that it
is borrowing capital from foreign sources to make up the deficit. In other words, the country
requires more foreign currency than it receives through sales of exports, and it supplies more of
its own currency than foreigners demand for its products. The excess demand for foreign
currency lowers the country's exchange rate until domestic goods and services are cheap enough
for foreigners, and foreign assets are too expensive to generate sales for domestic interests. (For
more, see Understanding The Current Account In The Balance Of Payments.)
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding. While such activity stimulates the domestic economy, nations with large
public deficits and debts are less attractive to foreign investors. The reason? A large debt
encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off
with cheaper real dollars in the future.
In the worst case scenario, a government may print money to pay part of a large debt, but
increasing the money supply inevitably causes inflation. Moreover, if a government is not able to
service its deficit through domestic means (selling domestic bonds, increasing the money
supply), then it must increase the supply of securities for sale to foreigners, thereby lowering
their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country
risks defaulting on its obligations. Foreigners will be less willing to own securities denominated
in that currency if the risk of default is great. For this reason, the country's debt rating (as
determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its
exchange rate.
5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current accounts
and the balance of payments. If the price of a country's exports rises by a greater rate than that of
its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater
demand for the country's exports. This, in turn, results in rising revenues from exports, which
provides increased demand for the country's currency (and an increase in the currency's value). If
the price of exports rises by a smaller rate than that of its imports, the currency's value will
decrease in relation to its trading partners.
6. Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic performance in
which to invest their capital. A country with such positive attributes will draw investment funds
away from other countries perceived to have more political and economic risk. Political turmoil,
for example, can cause a loss of confidence in a currency and a movement of capital to the
currencies of more stable countries.
Conclusion
The exchange rate of the currency in which a portfolio holds the bulk of its investments
determines that portfolio's real return. A declining exchange rate obviously decreases the
purchasing power of income and capital gains derived from any returns. Moreover, the exchange
rate influences other income factors such as interest rates, inflation and even capital gains from
domestic securities. While exchange rates are determined by numerous complex factors that
often leave even the most experienced economists flummoxed, investors should still have some
understanding of how currency values and exchange rates play an important role in the rate of
return on their investments.
Effects of a Floating Exchange Rate System
Next theory - The Marshall-Lerner Condition >>
On taking power in 1991 the government of President Chiluba made a number of trade reforms.
Perhaps the most important was the floating of the Zambian currency - the Kwacha. Two
questions should be considered
1. Why were the government of President Chiluba and the multilateral agencies assisting
Zambia's economic reforms such as the IMF such keen advocates of a freely floating
exchange rate system?
2. What are the potential hazards of such a exchange rate regime?
Arguments in favour of floating exchange rates for LDCs
1. Balance of Payments on current account disequilibrium will automatically be restored to
equilibrium.
A balance of payments deficit caused by a decrease in the demand for Zambian exports
would lead to a shortage of foreign currency as the amount of foreign currency available
falls - shown by a shift to the left of the supply curve for foreign currency. This would
push up its price from P1 to P2 and hence lead to a depreciation of the Kwacha. This is
shown below.
The fall in the value of Kwacha causes the price of Zambian exports to decrease and the
price of foreign imports to increase. Consequently the demand for Zambian exports
increases and the demand for foreign imports decreases. The deficit shrinks and the
balance of payments returns to equilibrium assuming the Marshall Lerner Condition is
satisfactorily met.
Thus, in theory, governments need not worry about having to manage their balance of
payments situation. If the exchange rate is allowed to fluctuate freely any disequilibrium
will automatically be restored to equilibrium. The need to resort to overseas borrowing to
finance balance of payments deficits (adding to the burden of Zambia's existing debt) is
therefore less. The attention of government can then be focused on achieving other
government objectives such as inflation, unemployment, economic growth and poverty
reduction.
2. Reduces inflationary pressures and international uncompetitiveness
One argument is that a floating exchange rate will reduce the level of inflation. Zambia
has suffered from high levels of inflation. Allowing the exchange rate to float freely
should ensure that Zambian exports do not become uncompetitive. This is embodied in
the Purchasing Power Parity theory. A high rate of inflation in Zambia would tend to
make Zambian exports uncompetitive. Their demand would fall and the foreign exchange
flowing into the country would also fall. The supply curve of available foreign currency
would in turn shift to the left causing its value to increase and the corresponding value of
the Kwacha to depreciate. This would, assuming the Marshall Lerner condition was met,
lower the price of Zambian exports making them more competitive.
Arguments against floating exchange rates
1. The Marshall Lerner Condition is not necessarily met
The problem for countries such as Zambia and many other LDCs is that the link between
the exchange rate adjustment and the balance of payments improvement is not as straight
forward as the above would suggest. Some economists would argue with the idea that
balance of payments deficits would automatically be returned to equilibrium under a
floating exchange rate system. They argue that the Marshall Lerner conditions are not
met.
2. Abolition of exchange controls causes capital flight
The introduction of a floating exchange rate and the abolition of exchange controls lead
to substantial capital flight as wealthy Zambians and Zambian firms attempted to move
their finances abroad and convert their savings of Kwacha into hard currencies held in
overseas banks. This leads to purchasing of foreign currencies reducing the amount
available, pushing up its value, and leading to a substantial depreciation of the Kwacha.
3. Cost Push Inflationary Pressures
A depreciating currency will help a country's exporting sector. However, the cost of
imports will invariably rise leading to cost push inflationary pressures. Those people
whose livelihoods rely on the consumption of goods with a high import content will
experience hardship.
4. Uncertainty
A wildly fluctuating exchange rate at the mercy of national and international currency
speculators introduces considerable uncertainty to export and import prices and
consequently to economic development.
International trade Notes
How to correct the Balance of Payment ?
Solution to correct balance of payment disequilibrium lies in earning more foreign exchange
through additional exports or reducing imports. Quantitative changes in exports and imports
require policy changes. Such policy measures are in the form of monetary, fiscal and non-
monetary measures.
Image Credits © SteveFiji.
Monetary Measures for Correcting the BoP ↓
The monetary methods for correcting disequilibrium in the balance of payment are as follows :-
1. Deflation
Deflation means falling prices. Deflation has been used as a measure to correct deficit
disequilibrium. A country faces deficit when its imports exceeds exports.
Deflation is brought through monetary measures like bank rate policy, open market operations,
etc or through fiscal measures like higher taxation, reduction in public expenditure, etc. Deflation
would make our items cheaper in foreign market resulting a rise in our exports. At the same time
the demands for imports fall due to higher taxation and reduced income. This would built a
favourable atmosphere in the balance of payment position. However Deflation can be successful
when the exchange rate remains fixed.
2. Exchange Depreciation
Exchange depreciation means decline in the rate of exchange of domestic currency in terms of
foreign currency. This device implies that a country has adopted a flexible exchange rate policy.
Suppose the rate of exchange between Indian rupee and US dollar is $1 = Rs. 40. If India
experiences an adverse balance of payments with regard to U.S.A, the Indian demand for US
dollar will rise. The price of dollar in terms of rupee will rise. Hence, dollar will appreciate in
external value and rupee will depreciate in external value. The new rate of exchange may be say
$1 = Rs. 50. This means 25% exchange depreciation of the Indian currency.
Exchange depreciation will stimulate exports and reduce imports because exports will become
cheaper and imports costlier. Hence, a favourable balance of payments would emerge to pay off
the deficit.
Limitations of Exchange Depreciation
1. Exchange depreciation will be successful only if there is no retaliatory exchange
depreciation by other countries.
2. It is not suitable to a country desiring a fixed exchange rate system.
3. Exchange depreciation raises the prices of imports and reduces the prices of exports. So
the terms of trade will become unfavourable for the country adopting it.
4. It increases uncertainty & risks involved in foreign trade.
5. It may result in hyper-inflation causing further deficit in balance of payments.
3. Devaluation
Devaluation refers to deliberate attempt made by monetary authorities to bring down the value of
home currency against foreign currency. While depreciation is a spontaneous fall due to
interactions of market forces, devaluation is official act enforced by the monetary authority.
Generally the international monetary fund advocates the policy of devaluation as a corrective
measure of disequilibrium for the countries facing adverse balance of payment position. When
India's balance of payment worsened in 1991, IMF suggested devaluation. Accordingly, the
value of Indian currency has been reduced by 18 to 20% in terms of various currencies. The 1991
devaluation brought the desired effect. The very next year the import declined while exports
picked up.
When devaluation is effected, the value of home currency goes down against foreign currency,
Let us suppose the exchange rate remains $1 = Rs. 10 before devaluation. Let us suppose,
devaluation takes place which reduces the value of home currency and now the exchange rate
becomes $1 = Rs. 20. After such a change our goods becomes cheap in foreign market. This is
because, after devaluation, dollar is exchanged for more Indian currencies which push up the
demand for exports. At the same time, imports become costlier as Indians have to pay more
currencies to obtain one dollar. Thus demand for imports is reduced.
Generally devaluation is resorted to where there is serious adverse balance of payment problem.
Limitations of Devaluation
1. Devaluation is successful only when other country does not retaliate the same. If
both the countries go for the same, the effect is nil.
2. Devaluation is successful only when the demand for exports and imports is elastic.
In case it is inelastic, it may turn the situation worse.
3. Devaluation, though helps correcting disequilibrium, is considered to be a weakness for
the country.
4. Devaluation may bring inflation in the following conditions :-
i. Devaluation brings the imports down, When imports are reduced, the domestic
supply of such goods must be increased to the same extent. If not, scarcity of such
goods unleash inflationary trends.
ii. A growing country like India is capital thirsty. Due to non availability of capital
goods in India, we have no option but to continue imports at higher costs. This
will force the industries depending upon capital goods to push up their prices.
iii. When demand for our export rises, more and more goods produced in a country
would go for exports and thus creating shortage of such goods at the domestic
level. This results in rising prices and inflation.
iv. Devaluation may not be effective if the deficit arises due to cyclical or structural
changes.
4. Exchange Control
It is an extreme step taken by the monetary authority to enjoy complete control over the
exchange dealings. Under such a measure, the central bank directs all exporters to surrender their
foreign exchange to the central authority. Thus it leads to concentration of exchange reserves in
the hands of central authority. At the same time, the supply of foreign exchange is restricted only
for essential goods. It can only help controlling situation from turning worse. In short it is only a
temporary measure and not permanent remedy.
Non-Monetary Measures for Correcting the BoP ↓
A deficit country along with Monetary measures may adopt the following non-monetary
measures too which will either restrict imports or promote exports.
1. Tariffs
Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the prices of imports
would increase to the extent of tariff. The increased prices will reduced the demand for imported
goods and at the same time induce domestic producers to produce more of import substitutes.
Non-essential imports can be drastically reduced by imposing a very high rate of tariff.
Drawbacks of Tariffs :-
1. Tariffs bring equilibrium by reducing the volume of trade.
2. Tariffs obstruct the expansion of world trade and prosperity.
3. Tariffs need not necessarily reduce imports. Hence the effects of tariff on the balance of
payment position are uncertain.
4. Tariffs seek to establish equilibrium without removing the root causes of disequilibrium.
5. A new or a higher tariff may aggravate the disequilibrium in the balance of payments of a
country already having a surplus.
6. Tariffs to be successful require an efficient & honest administration which unfortunately
is difficult to have in most of the countries. Corruption among the administrative staff
will render tariffs ineffective.
2. Quotas
Under the quota system, the government may fix and permit the maximum quantity or value of a
commodity to be imported during a given period. By restricting imports through the quota
system, the deficit is reduced and the balance of payments position is improved.
Types of Quotas :-
1. the tariff or custom quota,
2. the unilateral quota,
3. the bilateral quota,
4. the mixing quota, and
5. import licensing.
Merits of Quotas :-
1. Quotas are more effective than tariffs as they are certain.
2. They are easy to implement.
3. They are more effective even when demand is inelastic, as no imports are possible above
the quotas.
4. More flexible than tariffs as they are subject to administrative decision. Tariffs on the
other hand are subject to legislative sanction.
Demerits of Quotas :-
1. They are not long-run solution as they do not tackle the real cause for disequilibrium.
2. Under the WTO quotas are discouraged.
3. Implements of quotas is open invitation to corruption.
3. Export Promotion
The government can adopt export promotion measures to correct disequilibrium in the balance of
payments. This includes substitutes, tax concessions to exporters, marketing facilities, credit and
incentives to exporters, etc.
The government may also help to promote export through exhibition, trade fairs; conducting
marketing research & by providing the required administrative and diplomatic help to tap the
potential markets.
4. Import Substitution
A country may resort to import substitution to reduce the volume of imports and make it self-
reliant. Fiscal and monetary measures may be adopted to encourage industries producing import
substitutes. Industries which produce import substitutes require special attention in the form of
various concessions, which include tax concession, technical assistance, subsidies, providing
scarce inputs, etc.
Non-monetary methods are more effective than monetary methods and are normally applicable
in correcting an adverse balance of payments.
Drawbacks of Import Substitution :-
1. Such industries may lose the spirit of competitiveness.
2. Domestic industries enjoying various incentives will develop vested interests and ask for
such concessions all the time.
3. Deliberate promotion of import substitute industries go against the principle of
comparative advantage.
Terms of trade
The terms of trade measures the rate of exchange of one good or service for another when two
countries trade with each other.
For international trade to be mutually beneficial for each country, the terms of trade must lie
within the opportunity cost ratios for both country.
We calculate the terms of trade as an index number using the following formula:
Terms of Trade Index
ToT = 100 x Average export price index / Average import price index
If export prices are rising faster than import prices, the terms of trade index will rise. This
means that fewer exports have to be given up in exchange for a given volume of imports.
If import prices rise faster than export prices, the terms of trade have deteriorated. A greater
volume of exports has to be sold to finance a given amount of imported goods and services.
The terms of trade fluctuate in line with changes in export and import prices. Clearly the
exchange rate and the rate of inflation can both influence the direction of any change in the terms
of trade.
OIL PRICES AND THE TERMS OF TRADE
Many developing countries are heavily dependent on exporting oil. And volatility in
international commodity markets create serious problems with these countries’ terms of trade. In
the chart below, notice how closely the annual % change in the terms of trade follows the
movement in oil export prices.
When oil values collapsed in 1998, developing countries faced the enormous problem of having
to export much more oil to pay for a given volume of imports. The worsening in the terms of
trade will have adversely affected living standards in these countries. There has been a sharp
rebound in global oil prices this year, helping to boost the terms of trade for oil exporters.
TERMS OF TRADE FOR DEVELOPING NATIONS
Developing countries can be caught in a trap where average price levels for their main exports
decline in the long run. This depressed the real value of their exports and worsens the terms of
trade. A greater volume of exports have to be given up to finance essential imports of raw
materials, components and fixed capital goods.
The problems intensified in 1998 with the collapse in the currencies of many Asian developing
countries. A big fall in the terms of trade signifies a reduction in real living standards since
imports of goods and services have become relatively more expensive.
TERMS OF TRADE AND COMPETITIVENESS
Consider the effects of a large fall in the value of the exchange rate. The effect should be a fall in
export prices and a rise in the cost of imports. This worsens the terms of trade index. But the
lower exchange rate restores competitiveness for a country since demand for exports should
grow and import demand from domestic consumers should slow down.
Much depends on how producers respond to the lower exchange rate. And for countries without
a diversified industrial base, the decline in earnings from each unit of exports has a damaging
effect on output, investment and employment.