1.
Bringing out the difference between depreciation and devaluation of a currency, explain how
they affect foreign trade of a country.
Approach:
Briefly discuss the meaning of depreciation and devaluation of a currency.
Highlight the key differences between depreciation and devaluation of a currency.
Bring out their effect on the foreign trade of a country.
Answer:
Both depreciation and devaluation highlight the economic condition where there is a decrease in
the value of a domestic currency in comparison to any other currency, leading to a decline in the
currency’s purchasing power. However, the manner in which they occur are different. The
differences between depreciation and devaluation are:
Depreciation happens in the floating exchange rate regime, in which the market forces
determine the value of a country’s currency. On the other hand, devaluation is associated with
the fixed/pegged exchange rate regime.
Depreciation is a decrease in the value of domestic currency due to the market forces of
demand and supply. Whereas, in case of devaluation, the Central bank deliberately makes
downward adjustment of the value of the domestic currency vis-a-vis any other
currency.Depreciation can occur on a daily basis, while devaluation is usually done
occasionally by the Central bank.
Effects of depreciation and devaluation on the foreign trade of a country are:
Reducing trade deficit: Both depreciation and devaluation make imports expensive. Hence,
residents often buy fewer imported goods. On the other hand, exported goods become less
costly for international buyers, thereby, growing demand for exports. Thus, fewer imports and
more exports will reduce the trade deficit and could also lead to surplus. However, the trade
deficit may not reduce as much as expected or even increase if imports constitute essential
commodities that are difficult to replace with domestic products.
Reduced foreign investment: Both depreciation and devaluation are viewed as a sign of
economic weakness, therefore, the creditworthiness of the nation may be jeopardized. It may
dampen investor confidence in the country’s economy and hurt the country’s ability to secure
foreign investment. However, if the increased aggregate demand for domestic goods, owing to
reduced imports and more external demand, leads to higher inflation and in turn higher interest
rates, then it may also attract foreign investment.
Instability in the global markets: Trading partners may become concerned that it might
negatively affect their export industries. Also, neighboring countries might devalue their own
currencies to offset the effects of their trading partner’s devaluation. Such competitive
devaluations tend to exacerbate economic difficulties by creating instability in the global
financial markets.
In a free market economy, devaluation should be used sparingly. While the negative effects of
depreciation can be countered by focusing on long term measures like improving export
competitiveness, increasing efficiency of supply chains and pro-active government policies
2.
Explain the mechanism of credit creation by the banking system in an economy. What are the
factors that limit such credit creation?
Approach:
Introduce with a brief note on credit creation.
Discuss the factors important in determining credit creation.
Explain the process of credit creation in detail.
Discuss the factors limiting creation of credit by the banks.
Conclude on the basis of the above points.
Answer:
Credit creation refers to the ability of the commercial banks to multiply loans and advances by
creating deposits. Commercial banks create credit by advancing loans and purchasing securities.
The money lent to individuals and businesses comes from deposits of the public held by these
banks. The banks are required to reserve a certain portion of these deposits with it, to serve cash
requirements of depositors and lend only the remaining portion of public deposits.
Mechanism of credit creation:
Suppose a customer of Bank X deposits an amount of Rs. 1000 in this bank. Bank X keeps a cash
reserve of 20 per cent, i.e. Rs. 200 and uses the excess reserve i.e. Rs. 800 in advancing loan to one of
its customers by opening an account in his name. This borrower from Bank X uses this amount in
buying goods from some trader and makes payment by drawing a cheque on Bank X. Suppose this
trader has his account in Bank Y. It will deposit this cheque of Rs 800 in Bank Y to be collected from
Bank X.
Thus, Rs. 800 will be transferred from Bank X to Y. Bank Y also keeps 20 per cent, i.e. Rs. 160 and is
left with an excess reserve of Rs 640, which it lends to another customer. Another such transaction,
say with Bank Z, will leave it with Rs. 512. Thus an initial deposit of Rs. 1000 has resulted in the
creation of deposits by three banks amounting to Rs. (1000+800+640+512) = Rs. 2952. This is how
the entire banking system will be able to create new deposits and hence credit creation happens.
The bank’s credit creation process is based on the assumption that during any time interval, only a
fraction of its customers genuinely need cash. Also, the bank assumes that all its customers would
not turn up demanding cash against their deposits at one point in time.
Factors limiting credit creation:
Higher the cash with the commercial banks in the form of public deposits, more will be the
credit creation.
The cash reserve ratio affects the credit creation. The lower is the ratio, the greater is the
ability to create credit.
The process of credit creation gets started only when borrowers come to a bank for loan
purposes. So, the number of reliable borrowers affects the credit creation.
A commercial bank lends money against accepted securities. Also, the value of the securities
must be equal to the amount of the loan. Even if the bank has a large cash base for creating
credit, it will not lend money if it does not get acceptable security.
The credit creation process may suffer from cash leakages in the form of excess reserves or
currency drain.
Business conditions of the banks like inflation, depression, etc. also affect the credit creation
process.
