Currency Depreciation: A Critical Essay Evaluate The 394465

Currency Depreciationin A Critical Essay Evaluate The Three Major App

Currency Depreciation In a critical essay, evaluate the three major approaches to analyzing the economic impact of currency depreciation: 1- the elasticities approach, 2- the absorption approach, 3- and the monetary approach. 4- Compare and contrast the three approaches and provide examples which distinguish them from each other.

Paper For Above instruction

Currency depreciation represents a significant macroeconomic phenomenon with far-reaching implications for a country's trade balance, inflation rates, and overall economic stability. To understand and analyze the impact of currency depreciation, economists have developed various approaches, primarily the elasticities approach, the absorption approach, and the monetary approach. Each methodology offers unique insights into how currency depreciation influences economic variables, but they also differ in assumptions, analytical focus, and policy implications. This essay critically evaluates these three approaches, highlighting their distinctive features, strengths, limitations, and providing illustrative examples to demonstrate their application.

The Elasticities Approach

The elasticities approach, rooted in the traditional Marshall-Lerner condition, emphasizes the responsiveness of export and import elasticities to exchange rate changes. It posits that the overall trade balance will improve following currency depreciation if the sum of the price elasticities of exports and imports exceeds one. Essentially, if consumers significantly alter their import and export volumes in response to changes in relative prices, currency depreciation can enhance a country's trade balance. For instance, in a scenario where the elasticity of exports is high and that of imports is moderate, depreciation would likely lead to increased export revenues and reduced import expenditures, thereby improving the current account deficit.

This approach assumes that markets are highly responsive and that prices are flexible, which might not always hold true in real-world contexts where adjustment lags or structural rigidities exist. Nevertheless, its strength lies in its clear quantitative criterion, making it useful for policymakers to predict the short-term effects of exchange rate changes based on empirical elasticities.

The Absorption Approach

The absorption approach shifts focus from trade flows to domestic economic activities, particularly national income and expenditure. It asserts that currency depreciation affects the current account through changes in domestic absorption—comprising consumption, investment, and government spending—relative to domestic output. A depreciation tends to increase the domestic price level and import prices, which can lead to inflationary pressures and shift domestic resources toward more expensive imports, potentially worsening the current account if the income effect dominates.

In this framework, a country’s trade balance is considered an outcome of the relationship between domestic income and the economy’s capacity to absorb foreign goods. For example, in a situation where a depreciation causes inflation that reduces real income, the resulting decline in domestic absorption could offset the initial improvement in the trade balance. The absorption approach emphasizes the importance of fiscal and monetary policies in managing the effects of currency depreciation, recognizing that the impact on the trade balance is mediated by domestic economic responses (Hussain & Malik, 2018).

The Monetary Approach

The monetary approach centers on the link between exchange rates and relative prices driven by monetary policies and the balance of payments. It suggests that currency depreciation influences the exchange rate through considerations of money supply, inflation, and capital flows. Under the assumption of perfect capital mobility, this approach maintains that monetary shocks and monetary policy adjustments are fundamental in determining exchange rate movements and their subsequent impact on the economy.

According to this perspective, depreciation could reflect monetary expansion, which may lead to inflation and larger capital outflows if not contained. Conversely, a well-managed monetary policy could mitigate adverse effects, stabilizing the currency and supporting economic stability. The monetary approach is particularly useful in analyzing long-term exchange rate equilibrium, emphasizing the primacy of monetary factors over real variables (Krugman & Obstfeld, 2020).

Comparison and Contrast of the Approaches

While each approach provides a lens through which to analyze currency depreciation, they differ markedly in assumptions, focus, and implications. The elasticities approach is predominantly market-oriented, emphasizing responsiveness of trade flows to price changes, and is especially relevant in the short term. In contrast, the absorption approach contextualizes currency depreciation within the macroeconomic management of domestic income and expenditure, emphasizing policy responses and structural factors. The monetary approach links exchange rates with monetary policies and capital flows, offering insights into long-term equilibrium conditions.

For instance, during the Asian financial crisis in 1997-1998, the elasticities approach could analyze the short-term impacts on export and import volumes, whereas the absorption approach would examine how domestic inflation and fiscal policy contributed to economic downturns. Meanwhile, the monetary approach would focus on capital flight and monetary expansion as determinants of currency depreciation (Eichengreen & Bayoumi, 1999).

Despite their differences, these approaches can complement each other. A comprehensive analysis of currency depreciation’s impact often involves integrating insights from all three, considering market responsiveness, macroeconomic stability, and monetary policy frameworks.

Examples and Policy Implications

For example, in the recent depreciation of the Turkish lira, the elasticities approach highlighted the limited responsiveness of exports and the stagnation of imports, leading to a minimal short-term improvement in the trade balance. The absorption approach revealed that inflationary pressures and rising fiscal deficits worsened economic stability, counteracting potential gains. Meanwhile, the monetary approach underscored the role of monetary expansion and capital outflows driving the depreciation, emphasizing the importance of monetary tightening to restore equilibrium (Turkish Central Bank, 2022).

These examples illustrate the importance of selecting appropriate analytical frameworks based on the economic context and policy objectives. Policymakers should understand that focusing solely on trade elasticities might overlook domestic macroeconomic vulnerabilities, while neglecting monetary factors could lead to policy missteps.

Conclusion

In conclusion, the elasticities, absorption, and monetary approaches offer valuable perspectives on the economic impacts of currency depreciation, each with distinct theoretical foundations and practical applications. The elasticities approach emphasizes market responsiveness in the short run, the absorption approach highlights domestic macroeconomic adjustments, and the monetary approach underscores the role of monetary policy and long-term equilibria. A comprehensive understanding of currency depreciation's effects necessitates integrating these perspectives, recognizing their assumptions and limitations, and tailoring policies accordingly to stabilize economies and promote sustainable growth.

References

• Eichengreen, B., & Bayoumi, T. (1999). The Asian Crises: Causes and Consequences. IMF Staff Papers, 46(2), 269-319.
• Hussain, I., & Malik, M. I. (2018). Macroeconomic Effects of Exchange Rate Movements: An Empirical Analysis. International Journal of Economics and Financial Issues, 8(2), 33-41.
• Krugman, P., & Obstfeld, M. (2020). International Economics (11th ed.). Pearson.
• Turkish Central Bank. (2022). Annual Report on Exchange Rate Policies and Economic Stability. Central Bank Publications.