With the aid of a diagram, explain one demand and one supply factor that would cause a depreciation of a country's currency.
Essay, part (a) [10] · H2 Economics
This model essay is by Mr Eugene Toh, author of the H1 and H2 A Level Economics TYS answer keys, published by SAP and sold at Popular, and of 50 Model Essays (Shing Lee).
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The model thesis in brief
A currency depreciates when its value falls in the foreign exchange market, which can be driven from either side of that market.
On the demand side, global economic uncertainty lowers foreign demand for a country's exports and assets, shifting the demand for its currency leftward. On the supply side, rising global commodity prices force an import-reliant country to sell more of its currency to pay for imports, shifting supply rightward. A 10 mark answer explains one of each with the foreign exchange diagram.
Examiner's note: what makes this an A
This is a 10 mark explain question that asks for a diagram, so the marks reward a correctly labelled foreign exchange market and one clean factor on each side. The answer separates a leftward shift of demand from a rightward shift of supply, both ending in a lower currency price.
Each factor is traced to a flow that uses the currency. Foreign buyers need yen to buy Japanese exports and assets, so weaker demand for those lowers demand for yen, while Japan needs foreign currency to pay for commodities, so it supplies more yen, which is the correct micro-foundation.
The price-inelastic demand for commodities is the key supporting point. Because Japan cannot easily cut its consumption of oil and food, higher prices force it to sell more yen, which is why the supply curve shifts and the depreciation follows.
Introduction
The depreciation of a country's currency can be caused by both demand-side and supply-side factors in the foreign exchange market. A depreciation occurs when the value of a currency falls relative to another, meaning more units of the depreciating currency are needed to buy the same amount of foreign currency. In the case of the Japanese yen's significant depreciation in 2022, commentators point to global economic uncertainty and rising global commodity prices as key contributing factors.
A demand-side factor: global economic uncertainty
One demand-side factor that can cause depreciation is global economic uncertainty. When uncertainty rises, such as during political instability, recession or geopolitical tension, consumers and firms become more cautious about spending and investing, which reduces demand for exports from countries like Japan. Because foreign consumers and firms need to buy yen to purchase Japanese exports, a fall in demand for Japanese goods lowers demand for the yen in the foreign exchange market. Uncertainty can also discourage foreign investors from buying Japanese assets such as stocks, bonds or real estate; since they would need to convert their home currency into yen to invest, greater perceived risk reduces their demand for the yen. This fall in demand shifts the demand curve for yen leftward, lowering the equilibrium price of the yen and causing a depreciation.
A supply-side factor: rising global commodity prices
On the supply side, rising global commodity prices can also cause depreciation. Commodities such as oil, natural gas and food are typically priced in a foreign currency such as the US dollar. When global commodity prices rise, a country like Japan, which relies heavily on imports for these essentials, must spend more yen to buy the same quantity of foreign goods. Because demand for commodities tends to be price inelastic, Japan cannot easily cut its consumption despite higher prices, so it must exchange more yen for foreign currencies to cover the higher cost. This increases the supply of yen in the foreign exchange market as Japanese firms and the government sell yen to buy foreign currency. The increase in supply shifts the supply curve for yen rightward, lowering the price of the yen and causing a depreciation.
Conclusion
A currency can depreciate from either side of the foreign exchange market. Global economic uncertainty lowers foreign demand for a country's exports and assets, shifting the demand for its currency leftward, while rising commodity prices force an import-dependent country to sell more of its currency, shifting supply rightward. In both cases the equilibrium price of the currency falls, producing the observed depreciation.
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A currency depreciates when its price falls in the foreign exchange market. On the demand side, global uncertainty lowers foreign demand for a country's exports and assets, shifting demand for its currency leftward. On the supply side, rising commodity prices force an import-reliant country to sell more of its currency to pay for imports, shifting supply rightward.
Are these the official answers?
No. This is a model essay by Mr Eugene Toh, author of the H1 and H2 A Level Economics TYS answer keys published by SAP and sold at Popular. Use it as a guide to structure and rigour, then write it in your own words.
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