Question

Question 1 a) Discuss the exchange rates (real and nominal). b) Discuss what is an appreciation and what is a depreciation. c) Discuss how an appreciation of Euro can affect Irish current account surplus. What will happen to the NCO then? d) Can you explain what you are expecting to happen we have a depreciation of Euro? e) Connect you answers in (d) above with the IS-LM model. Show it in a graph. f) Briefly discuss what does the PPP theory say? Can you explain the limitations of PPP?

Answer 1

a.

Real exchange rate predicts how many times more or less goods and services can be purchased abroad compared to the domestic market for a given amount when it is converted into a foreign currency.

Real exchange rate= nominal exchange rate * foreign price/domestic price.

Nominal Exchange rate is ratio of value of currency of two countries. Therefore when nominal exchange rate increases, the domestic currency depreciates and foreign currency appreciates. Hence domestic goods become cheaper compare to foreign goods. Hence domestic currency buys fewer units of foreign currency and the domestic currency has depreciated.

b.

Appreciation means value of domestic currency increases relative to foreign currency.

Since when there is appreciation of any domestic currency, then the domestic currency can buy more of foreign currency with the same domestic currency and it means domestic currency has got strength against the foreign currency.

Depreciation means value of domestic currency decreases relative to foreign currency.

Since when there is depreciation of any domestic currency, then the domestic currency can buy less of foreign currency with the same domestic currency and it means domestic currency has become weaker the foreign currency.

c.

When there is an appreciation of Euro against Irish currency, then it means Irish currency depreciated. It means Irish currency can purchase fewer goods and services of European country and therefore import of Irish decreases. Since goods and services of Irish become cheaper, so export of Irish increases.

Since export increase and import decrease, so net export of Irish increases, it means there will be current account surplus.

Net capital outflow (NCO)

Current account surplus means export is greater than import. It means that net export is positive.

It means that Y> C+I+G

Hence it can be said that saving is greater than Investment. As a result net capital outflow (NCO) will be positive. It means net capital outflow (NCO) increases.

d.

When there is a depreciation of Euro, then goods and services of European country becomes cheaper, so export will increase and import will decrease. So there will be current account surplus.

Net capital outflow (NCO)

Current account surplus means export is greater than import. It means that net export is positive.

It means that Y> C+I+G

Hence it can be said that saving is greater than Investment. As a result net capital outflow (NCO) will be positive. It means net capital outflow (NCO) increases.