2016 H2 Economics Paper 2 Essay 6: Suggested Answers

The current account records trade in goods and services, income flows and transfers with the rest of the world. An appreciation means the currency rises in value against others, which changes the prices of exports and imports and so affects the current account.

The direct effect. When the currency appreciates, exports become more expensive for foreign buyers, who must pay more in their own currency, so the quantity of exports demanded tends to fall and export revenue declines. At the same time imports become cheaper for domestic buyers, encouraging more import spending. Falling exports and rising imports reduce net exports (X minus M) and tend to worsen the current account.

What modifies the effect. The size of the deterioration depends on the price elasticity of demand for exports and imports. If both are elastic, export revenue falls sharply and import spending rises sharply, worsening the account. If both are inelastic, as with oil exporters whose exports are price inelastic, a higher foreign price brings a less than proportionate fall in quantity, so export revenue can even rise. For an economy such as Singapore that relies on imported inputs, an appreciation lowers import costs, reducing production costs and helping firms stay competitive, which limits the damage. In the short run the account may worsen because contracts and quantities take time to adjust, but over time volumes respond, a delayed adjustment known as the J-curve effect.