How does currency depreciation affect net exports and why might it occur?

• A. Depreciation raises the price of domestic goods in foreign currency terms, reducing exports
• B. Depreciation has no effect on net exports
• C. Depreciation increases imports more than exports
• D. Depreciation lowers the price of domestic goods in foreign currency terms, boosting exports and reducing imports, increasing net exports; it can occur due to monetary policy, interest rate differentials, or changes in expectations

Answer: (D)

When a currency depreciates, it becomes cheaper for foreigners to buy domestically produced goods. In foreign currency terms, the price of domestically produced goods falls, so exports rise because foreign buyers can purchase more with their money. At the same time, imports become more expensive in domestic currency terms, since domestic buyers must spend more of their currency to buy foreign goods, so imports fall. The combination of rising exports and falling imports increases net exports.

Why depreciation happens can vary: expansionary monetary policy that increases the money supply tends to push the currency down, broader interest rate differences between countries can shift funds and alter exchange rates, and changes in expectations about future inflation or exchange rates can also cause a currency to depreciate. In the short run, the magnitude of the net export response depends on how sensitive buyers are to price changes (elasticities), but the basic mechanism remains that a weaker domestic currency makes exports cheaper for foreigners and imports more expensive for domestic residents, boosting net exports.