Explain how a fall in its foreign exchange rate will be a disadvantage to an economy.
A fall in the foreign exchange rate may nevertheless have several downsides.
·A fall in exchange rate is likely to cause inflation
This is because net export will increase in price and aggregate demand will rise. There will be demand pull inflation .
The cost of imported raw material may also rise . If a country is operating at full employment, it may not be possible to produce more substitutes for imports . Furthermore, if imported finished products may not be replaced by domestic products , there may be cost-push inflation .
The purchasing power of domestic citizens will fall
Domestic citizens may be able to purchase fewer imports and this leads to lower living standards.
A devaluation or depreciation will reduce real wages.
In a period of low wage growth, a devaluation which causes rising import prices will make many consumers feel worse off. This was an issue in the UK during the period 2007-2018.
A large and rapid devaluation may scare off international investors.
It makes investors less willing to hold government debt because the devaluation is effectively reducing the real value of their holdings. In some cases, rapid devaluation can trigger capital flight.
If consumers have debts, e.g. mortgages in foreign currency – after a devaluation, they will see a sharp rise in the cost of their debt repayments.
This occurred in Hungary when many had taken out a mortgage in foreign currency and after the devaluation it became very expensive to pay off Euro denominated mortgages.
There may be retaliation.
If the fall is used as a way to capture markets abroad or protect domestic industries other countries may retaliate