Exchange rate adjustment

Definition

Exchange rate adjustment refers to the process of changing the value of a country's currency in relation to other currencies. This can occur due to market forces or government intervention and has significant implications for international trade and investment, particularly in addressing current account imbalances.

5 Must Know Facts For Your Next Test

1. Exchange rate adjustments can help correct trade imbalances by making a country's exports cheaper and imports more expensive.
2. These adjustments can occur through flexible exchange rate systems or through fixed exchange rate systems when a government decides to peg its currency.
3. Changes in exchange rates can influence inflation rates, as imported goods become more or less expensive depending on currency values.
4. Central banks may intervene in the foreign exchange market to stabilize or influence their currency's value, particularly during periods of volatility.
5. Long-term exchange rate adjustments can impact economic growth by influencing investment decisions and capital flows between countries.

Review Questions

• How does exchange rate adjustment play a role in correcting current account imbalances?
  • Exchange rate adjustment is crucial for correcting current account imbalances as it directly influences the relative prices of exports and imports. When a country experiences a trade deficit, a depreciation of its currency makes its exports cheaper for foreign buyers while making imports more expensive for domestic consumers. This change encourages increased demand for local goods and reduces reliance on foreign products, ultimately helping to restore balance in the current account.
• Evaluate the impact of currency depreciation on a country's economy in terms of trade balance and inflation.
  • Currency depreciation can lead to an improved trade balance by boosting export competitiveness while reducing import demand due to higher prices. However, this increase in demand for exports can lead to inflationary pressures as producers raise prices in response to heightened demand. Additionally, the cost of imported goods rises, contributing further to inflation. Therefore, while depreciation may enhance short-term trade conditions, it could also trigger longer-term economic challenges through inflationary effects.
• Assess how central bank interventions in the foreign exchange market can influence exchange rate adjustments and their subsequent economic outcomes.
  • Central bank interventions in the foreign exchange market can significantly impact exchange rate adjustments by either stabilizing or altering the currency's value. When a central bank buys or sells its own currency, it can counteract excessive volatility or guide the exchange rate towards desired levels. However, such interventions can have varied economic outcomes; while they might temporarily address imbalances or stabilize inflation, persistent intervention may lead to market distortions, potential retaliatory actions from trading partners, and longer-term reliance on artificial support rather than fundamental economic adjustments.

Related terms

current account:

A component of a country's balance of payments that includes the trade balance, net income from abroad, and net current transfers.

currency depreciation:

A decrease in the value of a currency relative to other currencies, often making exports cheaper and imports more expensive.

foreign exchange market: A global decentralized market for trading currencies, where exchange rates are determined by supply and demand.