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Open Economy Macroeconomics

Question
CBSEENEC12013452
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Recently Government of India has doubled the import duty on gold. What impact is it likely to have on foreign exchange rate and how?

Solution

With a rise in the import duty of gold, the cost of gold increases and thereby the import of gold will fall. This reduces the demand for foreign currency. With the supply of foreign currency remaining same, the foreign exchange rate would fall. This implies appreciation of rupees. This can be explained with the help of the following diagram.

In the diagram, DD and SS are the initial demand curve and supply curve for foreign currency respectively. E is the initial equilibrium point, with OR as the equilibrium exchange rate. A fall in the demand for foreign currencies (due to a fall in imports) shifts the demand curve from DD to D' D'. With the shift in demand curve, new equilibrium is established at point E, where the exchange rate falls from OR to OR1. A fall in the exchange rate implies currency appreciation.

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