How can currency depreciation stimulate an increase in net exports?

1. By reducing export costs

2. By reducing import prices

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UPSC CDS-I 2025 (General Studies) Official Paper (Held On: 13 Apr, 2025)
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  1. 1 only
  2. 2 only
  3. Both 1 and 2
  4. Neither 1 nor 2

Answer (Detailed Solution Below)

Option 1 : 1 only
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Detailed Solution

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The correct answer is Option 1.

Key Points

  • Currency depreciation makes exports cheaper for foreign buyers, increasing demand for exported goods and services.
  • Lower export costs improve competitiveness in international markets, driving up net exports.
  • Depreciation increases the price of imports for domestic consumers, reducing import demand and further boosting net exports.
  • Net exports (exports minus imports) tend to rise as a result of the combined effect of higher export volumes and reduced import volumes.
  • This phenomenon is often referred to as the "exchange rate effect" on trade balances.

Additional Information

  • Currency Depreciation: Refers to a decline in the value of a country's currency relative to foreign currencies, often influenced by market demand and supply dynamics.
  • Impact on Trade Balance: Depreciation improves the trade balance by increasing exports and decreasing imports, provided that demand for goods is elastic.
  • Elasticity of Demand: For currency depreciation to effectively impact net exports, the price elasticity of demand for exports and imports must be high (responsive to price changes).
  • Marshall-Lerner Condition: States that currency depreciation will improve the trade balance if the sum of the absolute price elasticity of exports and imports is greater than one.
  • Risk Factors: Excessive depreciation can lead to inflationary pressures and increased costs for imported raw materials, potentially offsetting export gains.
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