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Difficulty: MediumForeign Exchange Market, Systems, and Exchange Rate Determination

Under a flexible (floating) exchange rate system, if a sudden fall in world market prices for a country's primary export reduces foreign demand for its currency, what is the immediate market outcome for the domestic currency?

  1. A decrease in foreign exchange value known as depreciationAnswer
  2. B
    An official reduction in currency value known as devaluation
  3. C
    An increase in foreign exchange value known as appreciation
  4. D
    An automatic revaluation of the currency by the central bank

Answer

A decrease in foreign exchange value known as depreciation
In a flexible (floating) exchange rate system, exchange rates are determined strictly by the market forces of demand and supply. A decrease in export earnings reduces foreign demand for the local currency, causing its price relative to foreign currencies to drop. A market-driven decline in the value of a currency is known as currency depreciation.

Step-by-Step Solution

1
Identify the exchange rate system in operation.
The economy operates under a flexible (floating) exchange rate system where rates are determined by market forces of supply and demand.
Understanding the regime determines whether price adjustments occur through market forces or official government policy.
2
Analyze the impact of reduced export demand on the foreign exchange market.
Lower foreign demand for exports reduces foreign demand for the domestic currency needed to buy those exports, shifting the demand curve for the domestic currency to the left.
Exports generate foreign demand for domestic currency.
3
Determine the resulting change in currency value and terminology.
The equilibrium price of the domestic currency falls relative to foreign currencies, which is classified as market depreciation.
Market-driven decreases in currency value under floating systems are called depreciation, whereas deliberate official reductions under fixed systems are called devaluation.

Key Concept

Market determination of exchange rates and the distinction between floating rate depreciation and fixed rate devaluation
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Topics

Foreign Exchange Market, Systems, and Exchange Rate Determination

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