Floating Exchange Rate Economy
TITLE
An economy adopts a freely floating exchange rate.
ESSAY
🌟Title: The Impact of Higher Domestic Inflation on a Freely Floating Exchange Rate🌟
🌟Introduction:🌟
In a freely floating exchange rate system, the value of a currency is determined by market forces of demand and supply, without government intervention. Exchange rates play a crucial role in facilitating international trade and investment by influencing the relative prices of goods and services between countries.
🌟Effect of Higher Domestic Inflation on Exchange Rate:🌟
When a country experiences much higher inflation rates compared to its trading partners, the exchange rate of its currency is likely to be affected. This can be explained through the impact on imports and exports:
🌟Effect on Imports:🌟
1. Lower overseas inflation rates make imports relatively cheaper compared to domestically produced goods.
2. This leads to a rise in demand for imports, as consumers and businesses seek cost💥effective options.
3. The increased demand for imports results in an increase in the supply of the domestic currency in the foreign exchange market.
🌟Result:🌟The higher supply of the domestic currency in the foreign exchange market leads to a fall or depreciation in the exchange rate.
🌟Effect on Exports:🌟
1. Lower overseas inflation rates make exports more expensive for foreign buyers.
2. This leads to a fall in demand for exports as foreign consumers prefer cheaper options from countries with lower inflation rates.
3. The reduced demand for exports results in a decrease in the demand for the domestic currency in the foreign exchange market.
🌟Result:🌟The decrease in demand for the domestic currency in the foreign exchange market also leads to a fall or depreciation in the exchange rate.
🌟Conclusion:🌟
In conclusion, a country with much higher inflation rates than its trading partners is likely to experience a depreciating exchange rate in a freely floating exchange rate system. This depreciation is driven by the increased supply of the domestic currency due to higher demand for imports and reduced demand for exports, influenced by the relative price competitiveness in international trade.
This essay has demonstrated an understanding of how varying inflation rates impact exports, imports, and the exchange rate in the context of a freely floating exchange rate regime.
SUBJECT
ECONOMICS
PAPER
A level and AS level
NOTES
An economy adopts a freely floating exchange rate. This means that the exchange rate is determined by market forces of demand and supply for the currency and is not fixed by the government. When the inflation rate in this economy is much higher than the inflation rates in its trading partners, it is likely to have an impact on the exchange rate.
The lower inflation rates in its trading partners would lead to a rise in demand for imports, increasing the supply of the domestic currency and causing a fall or depreciation in the exchange rate.
Conversely, the lower overseas inflation rates would result in a fall in demand for exports, reducing the demand for the domestic currency and also leading to a fall or depreciation in the exchange rate.
Candidates should demonstrate knowledge of how varying inflation rates affect exports and imports, and the subsequent impact on the foreign exchange market.