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(b) Discuss whether a depreciation of currency would be of overall benefit to an economy. [15]

JPJC 2024

Introduction

A currency depreciation occurs when the value of a country's currency falls relative to others, making its goods and services cheaper for foreign buyers but raising the cost of imports. This has both potential benefits and drawbacks for an economy, depending on factors such as the structure of the economy, its reliance on imports, and how responsive exports and imports are to price changes. 

How depreciation would be of benefit

One of the main benefits of currency depreciation is that it improves the price competitiveness of a country’s exports. As the currency weakens, foreign buyers find it cheaper to purchase goods and services from the depreciating country. This can lead to an increase in the demand for exports, which improves the net exports component (X-M) of Aggregate Demand (AD). The increase in AD shifts the AD curve rightward, from AD0 to AD1, leading to higher real national income (Y) as the economy experiences growth.

Through the multiplier effect, this increase in demand for exports can generate further rounds of spending in the economy, as firms hire more workers and purchase more inputs to meet rising demand. This leads to job creation, reducing unemployment, and boosting income levels. Higher levels of output and employment contribute to an improvement in the overall standard of living for citizens, as more goods and services can be produced and consumed. Furthermore, as net exports improve, the country’s balance of trade (BOT) and overall balance of payments (BOP) may improve, reducing current account deficits.

How depreciation may cause issues

Despite these benefits, currency depreciation also presents several challenges. One of the most significant issues is that it makes imports more expensive. Since foreign goods now cost more in terms of the local currency, consumers and firms have to pay higher prices for imported goods. This is particularly problematic for economies that rely heavily on imports for essential goods such as food, fuel, and raw materials. As the prices of these goods rise, the country experiences imported inflation.

For businesses that depend on imported inputs for production, the rise in input costs can push up overall production costs. This causes a leftward shift in the short-run aggregate supply (SRAS) curve, from AS0 to AS1, leading to higher price levels from P0 to P1, causing cost-push inflation. As a result, firms may be forced to pass on these higher costs to consumers, reducing their purchasing power and causing a decline in the material standard of living.

Moreover, if the inflation caused by depreciation is significant, it could erode the gains in competitiveness that come from cheaper exports. For example, firms may find that while their products are initially more affordable to foreign buyers, the rising costs of production caused by expensive imported inputs could make them less competitive over time, negating the benefits of the depreciation.

Factors that influence the overall benefit of depreciation
Whether depreciation is ultimately beneficial for an economy depends on several factors.

First, the Marshall-Lerner condition must be considered. According to this condition, a depreciation will only improve the balance of trade if the sum of the price elasticities of demand for exports (PEDx) and imports (PEDm) is greater than one. In other words, the quantity demanded for exports and imports must be sufficiently responsive to changes in prices for the improvement in net exports to outweigh the rising cost of imports. If this condition is not met, depreciation may worsen the balance of trade, as the higher import costs could outweigh the gains from increased export demand.

Second, the nature of the economy is critical. In a country like Singapore, which is highly dependent on imported goods such as food and raw materials, the negative effects of depreciation may outweigh the benefits. While a depreciation might initially make exports cheaper for foreign buyers, the higher cost of imported inputs could increase the cost of producing those exports, diminishing any competitive advantage. Additionally, the rise in the cost of essential imports like food and energy would directly harm consumers, leading to a reduction in their standard of living.

Conclusion

In conclusion, currency depreciation can bring significant benefits to an economy by improving export competitiveness, stimulating economic growth, and reducing unemployment. However, these benefits are accompanied by challenges, particularly in the form of imported inflation and rising production costs. The overall effect of depreciation on an economy depends on factors such as the Marshall-Lerner condition and the country’s reliance on imports. For economies with high import dependency, like Singapore, the drawbacks of depreciation could outweigh the potential gains, while for more self-sufficient economies, the benefits may be more substantial. Therefore, whether depreciation is of overall benefit to an economy is context-dependent.