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Exam (elaborations) ECS3703 - International Finance (ECS3703)
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Exam (elaborations) ECS3703 - International Finance (ECS3703) EXAM PACK MAYJUNE 2022
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ECS3703EXAM PACK
MAY\JUNE 2022
,Question 1
Generally, elasticity is defined as the responsiveness of quantities demanded to
change in the determinants of demand such as prices, incomes and changes in the
market for other (related) goods. The concept of elasticity can also be applied to the
foreign exchange markets, where currencies trade with (and for) currencies, such that
the price of a currency (exchanges rate) is determined against another currency. The
concept is used in devaluation (strategic policy/action taken by the monetary
authorities to reduce the value of the domestic currency against foreign current) or
revaluation (deliberate increase of a country’s currency against other countries’
currencies) to respond to the shocks on the international market that affect the balance
of payments into deficit (exports lower than imports) or surplus (exports higher than
imports).
Given a deficit, the authorities may deliberately reduce the value of a currency
(currency devaluation), as a way of making the country’s goods become more or
relatively cheaper to foreigners who will need to give up less of their currency (than
before) to get the same amount of goods they were getting before the manipulation.
As the goods (exports) become relatively cheaper, they become attractive to foreign
consumer, who then increase their demand hence the country sells more goods to the
foreigners. However, this is greatly affected by the responsiveness/elasticity of
demand for (and supply of) the country’s goods (exports) on the international market.
Following the above argument, deficit is more likely to be eliminated from devaluation
given more elastic demand such that international consumers significantly response
to the fall in price by buying more quantity when prices is effectively low, due to lower
exchange rate. With this outcome, as export volumes increase, so is export revenue
hence a significant growth in exports, cateris paribus. However, if the elasticity of
demand for the country’s goods is inelastic, then devaluation can not give the desired
outcome since exports are less responsive to the fall in price due to currency
devaluation.
However, demand elasticity is not enough, the responsiveness of supply is equally
important. There must be enough elasticity of supply to match the international
demand. Failure to which may render the policy ineffective.
, Also, when the country devalues its currency, the purchasing power of local
consumers fall, hence render their incomes weaker. The authorities can therefore use
devaluation to discourage importation. When a currency is devalued, imports become
relatively expensive such that domestic consumers become less able to imports. This
follows the argument that imports are dependent on incomes.
However, while devaluation discourages imports, this also depends on the income
elasticity of importation. When consumers are less responsive such that even when
their incomes fall, they will continue to import the same amount, then a devaluation
may be ineffective, while elastic demand gives significant benefits in fighting a deficit
using currency devaluation.
A recession can be identified as a period when the economy has lower output, lower
employment that even reduced not only through country’s GDP, but also the exports
of the country, hence leading to unfavourable BOP. An economy can thus use the
fiscal or monetary policies to pull itself from the situation. These are expenditure and
interests’ rate (money supply) mechanisms meant to alter the country’s income and
output.
Using fiscal policy, the government can increase its expenditures in order to increase
domestic demand and increase the resources to its citizens hence increase the
aggregate demand in the economy thereby increasing the equilibrium.
On the other hand, monetary policies can be implemented through increasing the open
market operations in which it sells the domestic currency on the open window o(buying
government securities and bonds), as well as reducing the interest r ates.
However these actions are affected by the mobility of capital in the economy and the
exchange rate regime.
However, ways of correcting the recession without expansionary policies include
improvements in the quality and quantity of labour, natural resources and technology
results in the LRAS curve moves to the right. With this initiative, the full employment
level of income will be above the initial equilibrium. Short run aggregate supply
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