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The currency in country X is the Krone while country Y uses the Euro. Country Y has recently experienced an increase in its exchange rate with country X. Which of the following effects is likely to result in country Y?
A. A stimulus to exports in country Y
B. An increase in the costs of imports from country X
C. Reducing demand for imports from country X
D. A reduction in the rate of cost push inflation
The options B and C are very confusing to me but the correct answer is D. Their explanation is:
An increase in the exchange rate makes a country’s exports more expensive to overseas buyer, and imports cheaper: it therefore has the opposite of the first three effects. The lower costs of imports, however, is likely to reduce the rate of domestic inflation.
Can someone explain to me why B and C is not correct? Thank you.
Make up some numbers and try it out, and you’ll see why B and C are incorrect.
So you’re in country Y, which uses the Euro, and the exchange rate with Country X, which uses the Krone, has increased. Let’s say the rate has increased from 2 Krone per Euro to 3 Krone per Euro.
Let’s say you were importing a product from country X which costs 300 Krone. At 2 Krone per Euro, it used to cost you 150 Euros to buy it.
Now the rate has increased to 3 Krone per Euro, buying something for 300 Krone would only cost you 100 Euros. Therefore you can see that imports from country X have got cheaper as a result of the exchange rate increasing, and therefore B is incorrect.
As they are cheaper, demand will rise, so C is also incorrect.
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