Quiz 2 Ana Lia Barragán Echenique The effects of an undervalued currency Undervaluation vs. Depreciation Undervaluation and depreciation are often confused; however, they have two very different meanings. Depreciation is defined as the increase or decrease of a currency’s price, in terms of another currency. This happens in the free market due to forces of supply and demand. (Baumol and Blinder). To exemplify this phenomenon, let’s pretend that the supply of US-dollars increases or demand for this currency decreases. The result would be the depreciation of the US-dollar in terms of other currencies like the Euro or the Renminbi. In contrast, the low value of a currency because of undervaluation does not happen because of market forces. This is due to the active manipulation of a currency and is act of government intervention. As a consequence the currency has a value underneath its official exchange rate (Baumol and Blinder). The consequence of undervaluation: Inflation Even though it is important to distinguish between both terms, the effects caused by depreciation help understand the effects caused by undervaluation. Depreciation reduces the value of a currency in relation to another. In our example, a weaker US-dollar leads to cheaper exports. The aggregate demand for these products will increase, because consumers everywhere will buy more of the less expensive products. This is a direct application of the law of demand (Baumol and Blinder). American exports would experience an increased demand in the foreign markets and this would in turn lead to growth in the USA. But as a coin has two sides, so does depreciation. The depreciated US-dollar loses its purchasing power and suddenly imported inputs and goods from countries with higher exchange rates become more expensive for American consumer. This will 10/28/2013

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Quiz 2 Ana Lia Barragán Echenique