How can currency depreciation stimulate an increase in net exports? 1. By reducing export costs 2. By reducing import prices Select the answer using the code given below:

Q: What is the answer to CDS (I) 2025 GK Q66?

A. Correct — A, 1 only. Net exports are exports minus imports, and depreciation works on both halves — but only in one direction each. Suppose the rupee weakens from 80 to 85 to the dollar. An Indian shirt priced at ₹1,700 now costs a foreign buyer 20 dollars instead of 21.25, so at unchanged rupee prices Indian goods become cheaper abroad and foreign demand for them grows. That is the sense in which statement 1 is right, though its wording repays care: depreciation does not lower the exporter's cost of production, it lowers the price foreigners pay in their own money, which is why the effect shows up as stronger export demand. Statement 2 has the sign backwards. The same movement makes every dollar of imports cost 85 rupees instead of 80, so imported crude, electronics and edible oil become dearer at home, not cheaper. That is still helpful for net exports, because dearer imports mean India buys fewer of them — but the mechanism is rising import prices, and the statement as printed says the opposite. So exactly one of the two channels described is real, and the answer is 1 only. (Provisional — pending the official UPSC key.)

(a)1 only
(b)2 only
(c)Both 1 and 2
(d)Neither 1 nor 2

Answer

Why

Correct — A, 1 only. Net exports are exports minus imports, and depreciation works on both halves — but only in one direction each. Suppose the rupee weakens from 80 to 85 to the dollar. An Indian shirt priced at ₹1,700 now costs a foreign buyer 20 dollars instead of 21.25, so at unchanged rupee prices Indian goods become cheaper abroad and foreign demand for them grows. That is the sense in which statement 1 is right, though its wording repays care: depreciation does not lower the exporter's cost of production, it lowers the price foreigners pay in their own money, which is why the effect shows up as stronger export demand. Statement 2 has the sign backwards. The same movement makes every dollar of imports cost 85 rupees instead of 80, so imported crude, electronics and edible oil become dearer at home, not cheaper. That is still helpful for net exports, because dearer imports mean India buys fewer of them — but the mechanism is rising import prices, and the statement as printed says the opposite. So exactly one of the two channels described is real, and the answer is 1 only.

Why the others are wrong

(b)2 only — Reverses both halves. Import prices rise on depreciation rather than fall, and the export channel it discards is the one that genuinely operates.
(c)Both 1 and 2 — The tempting all-of-them answer, since both statements sound like good news for net exports. But a currency cannot make home goods cheaper abroad and foreign goods cheaper at home at the same time; the exchange rate moves the two in opposite directions.
(d)Neither 1 nor 2 — Denies the standard expenditure-switching channel. A weaker currency lowering the foreign-currency price of exports is the textbook route from depreciation to higher net exports.

Concept

Depreciation is a fall in a currency's market value against others under a floating regime; devaluation is the same fall ordered by the authorities under a fixed or managed regime. Either way, a weaker home currency lowers the foreign-currency price of home goods and raises the home-currency price of foreign goods. Economists call the resulting shift in demand expenditure switching: buyers at home and abroad move towards home-produced goods, so exports rise, imports fall, and net exports improve. The gain is not free. Because India imports crude oil, coal, electronics and edible oil in large volume, a weaker rupee feeds straight into domestic costs, so depreciation is also inflationary — which is why the same officially keyed CDS item that credits depreciation with raising exports and cutting imports also credits it with raising domestic inflation.

Two-statement items of this kind are usually decided by checking the sign of each channel rather than by weighing importance, and the second statement here has an obvious sign error once you translate it into rupees. The subtler point is in the first statement. 'Reducing export costs' is loose language: nothing about the exchange rate changes what it costs an Indian factory to make a shirt. What changes is the price a foreign buyer sees, and if the exporter chooses to leave the foreign-currency price alone and pocket the difference instead, the rupee revenue per shirt rises rather than the volume sold. Both routes help exporters, but only the first raises export volumes. It is also worth knowing that the improvement is not instant. In the months after a depreciation, contracted import volumes still have to be paid for at the new, worse rate while export volumes take time to respond, so the trade balance often worsens before it improves — the J-curve. In practice the size of the whole effect depends on how price-sensitive demand is on both sides.

Key facts

Net exports are exports minus imports, so depreciation can improve them from either side.
Depreciation lowers the foreign-currency price of home goods, which raises foreign demand for exports.
Depreciation raises the home-currency price of imports; it does not lower import prices.
Fewer imports being bought because they have become dearer is a genuine second channel — but it works through higher import prices, not lower ones.
The shift of demand towards home-produced goods after a currency movement is called expenditure switching.
For an import-dependent economy depreciation is inflationary, which is the standing cost set against the export gain.
The trade balance often deteriorates before it improves after a depreciation, a pattern known as the J-curve.

What depreciation does to each side of net exports

Exports→Home goods become CHEAPER in foreign currency. A ₹1,700 shirt costs a buyer 20 dollars at ₹85 instead of 21.25 dollars at ₹80. Foreign demand rises — statement 1 is the real channel.

Imports→Foreign goods become DEARER in home currency. Every dollar of imports now costs ₹85 instead of ₹80. Import prices rise, so statement 2 has the sign backwards.

Why imports still fall→Dearer imports mean fewer are bought — a genuine second channel to higher net exports, but it works through rising import prices, not falling ones.

The cost of the policy→For an economy importing crude oil, coal and electronics, a weaker currency pushes domestic prices up. Depreciation supports exports and stokes inflation together.

Timing→Volumes take time to adjust, so the trade balance often worsens before it improves — the J-curve.

One currency movement, two opposite price effects. Only the export side matches what the paper claims.

Study next

Depreciation versus devaluation, and appreciation versus revaluationExpenditure switching and the Marshall-Lerner condition — when depreciation actually improves the trade balanceThe J-curve effect and the lag between a currency movement and the trade responseImported inflation and the pass-through from the exchange rate to domestic pricesHow the RBI manages rupee volatility through foreign exchange reserves

Common traps

Reading 'cheaper exports' and 'cheaper imports' as though a currency could do both at once; the exchange rate moves the two in opposite directions.
Taking 'reducing export costs' literally, as though depreciation lowered the factory's cost of production rather than the foreign-currency price of the good.
Assuming the improvement in the trade balance is immediate, when the J-curve says it is usually delayed.

As a two-statement channel question like this one, as a list of effects of devaluation to be sorted true from false, or through the J-curve and the Marshall-Lerner condition at a higher level.

Related PYQs

CDS_GK_2023_II_Q322023Open & attempt →

Which of the following is/are the effects of devaluation or depreciation of currency? 1. It leads to increase in imports and decrease in exports. 2. It leads to increase in exports and decrease in imports. 3. It leads to increase in domestic inflation. 4. It leads to decrease in domestic inflation. Select the correct answer using the code given below:

(a) 1 and 3 only
(b) 1 and 4 only
(c) 2 and 3 only
(d) 3 only

Answer(c) 2 and 3 only

The same mechanism on an officially keyed paper, and it settles the direction beyond argument: a weaker currency raises exports, lowers imports and pushes domestic inflation up. That last part is the cost this card's question leaves out.

Practice

practice — not a real PYQ
If the rupee depreciates against the US dollar, which one of the following is most likely?
- (a)Indian exports become cheaper for foreign buyers and imports dearer at home
- (b)Indian exports become dearer for foreign buyers and imports cheaper at home
- (c)Both exports and imports become cheaper
- (d)Neither exports nor imports are affected
Answer(a) Indian exports become cheaper for foreign buyers and imports dearer at home — the two effects always run in opposite directions.
practice — not a real PYQ
The tendency of a country's trade balance to worsen for a period immediately after a currency depreciation before improving is known as which one of the following?
- (a)The J-curve effect
- (b)The Laffer curve effect
- (c)The Phillips curve effect
- (d)The Engel curve effect
Answer(a) The J-curve effect — import and export volumes take time to adjust, so for a while the higher price of already-contracted imports dominates.