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Currency depreciation: good or bad?

Currency depreciation increases the price of foreign goods in the country while making its outputs less expensive in foreign nations. Beyond this established fact lies debate about its consequences to the economy as a whole and to individual industries and consumer groups. Consider the worst case where unambiguously the depreciation fails to improve the trade balance: industries and consumers are not able to cut back their reliance on imported goods and the reduction in prices of domestic products in foreign currencies did not lead to an increase the countrys exports. It arises when quantities of imports and exports are non-responsive to price change. Policy makers who subscribe to the unresponsiveness of trade prices are said to suffer from excessive elasticity pessimism, elasticity being a measure of the responsiveness of quantity demanded or supplies as price changes.1. While no country has experienced such an extreme, those in charge of trade policies in many countries have held that both imports and exports are inelastic. Behind this belief are two facts. The responsiveness depends on time. A price increase will not immediately lead to a decrease in quantity demanded but will so over a period of time. The import of oil in deficit countries did not immediately respond to increase in oil prices since 1973-74. Over time individuals reduced their driving and took more to public transportation while the industrial sector produced energy efficient machineries and vehicles. Such substitutions are observed all over the world. A United Nations calculation shows that between 1990 and 2009, energy needed to produce $1,000 of Gross Domestic Product at constant prices decreased by 29 per cent in Germany and the United States and by 35 per cent in India. Still in 2009 India uses 195 kg oil equivalent to produce $1,000 of GDP as compared to Germany usage of 121 kg oil equivalent .2. As currency depreciates, exports of all industries will not increase in proportion. Greece will not export passenger planes even if it left Euro and depreciates its currency. But other industries, olive oil bottling for example, will do so; it will create additional employment and improve the balance of payment. Policy makers use the time delay in response to price change and inability of certain production sectors to expand as an excuse for elasticity pessimism. Today economies under stress fall into one of three groups: those who cannot depreciate even if they want to, those who deliberately try to devalue their currency and those who consider depreciation as an evil. The European nations in the Mediterranean rim are countries that are committed to use Euro even though their exports are noncompetitive given the low productivity of their economies. In contrast, the current Japanese expansionary policy is taken as a tool to lower the value of Yen and make Japanese exports competitive. This was a policy they followed successfully after the Second World War. Initially their exports were cheap plastic products but they worked their way up the product ladder.

Indian policy in the aftermath of its Independence was dictated by elasticity pessimism. The Government claimed that depreciation of currency will increase the cost of imports and hurt economic growth. A rate of Rs.4 per dollar was maintained by an extremely convoluted exchange control. Industries found it profitable to game for import licenses than compete in the export market. Recently within two years, the exchange rate fell from around Rs. 45 to Rs. 58 per dollar. Part of it due to tax uncertainty that the Government of India created by imposing retrospective taxation. Inflow of financial investment stopped and outflow began. As a consequence, oil prices have gone up but it will induce needed energy savings. Meanwhile export oriented industries like IT were facing cost pressures and depreciation will give them some relief. As with any policy change, cost will fall sharply on a few who will protest vehemently while benefits are diffused among a broader group. Depreciation is a change in one price - that of the currency and is neither good nor bad. The rest of the economy will adjust to the change and careful calculation is needed to determine whether the net outcome is favorable or not. Rama V. Ramachandran
http://www.visualeconomicanalysis.info/index.html Facebook: Ramanomics
Copyright 2012 Rama V. Ramachandran

Footnotes.
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http://www.scribd.com/doc/49513234/Opportunities-and-Choices, pp.93-4. http://unstats.un.org/unsd/mdg/SeriesDetail.aspx?srid=648