Test A – Question 3

The sharp devaluation of the shekel exchange rate contributed to the acceleration of inflation.

1. Show and explain, using the supply and demand curves of the foreign exchange market, how public expectations of depreciation affect the exchange rate. Assume a free market for foreign exchange.
2. Present, with the help of a numerical example, a complete diagram of the balance of payments that has a current account deficit. Show and explain the effect of devaluation on the balance of payments. (Note: the balance of payments is always balanced).
3. What is the Consumer Price Index?

answer:

Section A:

The exchange rate indicates “how many shekels is one dollar worth” (or “how many shekels is one euro worth”, etc.). That is, the exchange rate is the price of one foreign currency in shekels.

When there is a free market for foreign currency, this price is determined at the intersection of the demand for foreign currency and the supply of foreign currency. In the initial situation, the equilibrium is at point 0 and the exchange rate is P ₀ .

When the public is said to “expect depreciation,” it means that the public expects the exchange rate to rise, meaning that one foreign currency will be worth more shekels. Due to these expectations, the public’s demand for foreign currency will increase, because the public will want to buy foreign currency now before its price increases. Therefore, the demand curve for foreign currency will shift to the right to D ₁ . As a result of the increase in demand, a new equilibrium is created at point 1 where the exchange rate rises to P ₁ .

In other words, the very expectations of depreciation themselves caused depreciation (an increase in the exchange rate).

Section B:

The balance of payments is a report that presents a consolidated picture of the inflow and outflow of foreign currency (= foreign exchange) into and out of Israel during a certain period (usually a year).

• When foreign currency enters the country – the amount is marked with a “+”.
• When foreign currency leaves the country, the amount is marked with a “-“.

The balance of payments – as its name suggests, includes the items in it that are supposed to balance with each other, namely: the current account + capital account and financial account + net reserve assets + statistical differences = 0.

After the devaluation, several changes occur:

1. The devaluation causes the import of goods to become more “expensive” (you pay more shekels for each dollar), so it is less profitable to import, and imports to Israel will decrease.
2. The devaluation makes the export of goods more profitable (you get more dollars for each shekel), so it is more profitable to export, and exports from Israel will increase.
3. Due to the reduction in the deficit, the economy will also be able to reduce loans taken from abroad, and therefore direct financial investments in Israel will decrease.
4. Due to these changes, the amount of foreign exchange entering the “Capital and Financial Account” will decrease.

In this example, it can be seen how the devaluation caused a decrease in the deficit in the “current account” and at the same time there was a decrease in the amounts of money that entered Israel in the “capital account and financial account.”

Section C:

The Consumer Price Index is a parameter by which we track changes in the prices of a specific group of products and services selected by the Central Bureau of Statistics and known as the “basket of products.” The basket of products includes all the products and services that an average urban family consumes during the course of a month. The Consumer Price Index is published monthly by the Central Bureau of Statistics. It is customary to refer to any index as an initial “base index,” against which we track changes in product prices in subsequent periods.

For example: If the index in January was 100 points and in February the index rose to 103 points, this means that during February the prices of the basket of goods increased by 3%. When the shekel depreciates, the price in shekels of imported goods increases. Since at least some of the imported goods are included in the basket of goods, the shekel depreciation causes the consumer price index to rise.

For example: Let’s assume that the price of an imported product is $2 and that product is included in the basket of products included in the Consumer Price Index. If the exchange rate is: $1 = 4 NIS, then for this product we actually paid 8 NIS (= 4×2 dollars). If the shekel subsequently depreciates and $1 = 4.5 NIS, then for the same product we actually pay 9 NIS (= 4.5×2 dollars), meaning that the price of the product in shekels has increased.

As a result, the consumer price index will rise, since that index contains several such (imported) products whose price depends on the dollar exchange rate.