Sunday, March 8, 2009

Does Weaker Exchange Rate Improves BOP?

At AS level, students were taught that weakening exchange rate be it depreciation or devaluation can help in narrowing down the current account deficit.

How does that suppose to work?

Say the exchange rate between dollar & pound used to be $1.53 per £1. Now it stands at $1.33 per £1. This clearly shows that dollar has strengthened against pound or we can also say that pound has weakened against the dollar. To purchase the SAME £1, the Americans used to need $1.53, but now they only need $1.33. So weakening of pound here is something like British goods are given discount

So weakening pound will cause the demand for UK goods to increase. As a result, exports (X) increase. At the same time, weaker pound means more expensive for Britons to purchase American-made goods. So demand for imports (M) will fall. The widening gap between exports & imports will lead to increase in the value of net exports (X-M). This not only improve the standing of the current account deficit but also sets to boost economic growth as (X-M) is a component of aggregate demand (AD)

Is it true all the times?

Well, not necessary. It depends on both the price elasticity of demand (PED) for export & import. In most cases, PED for exports & imports tend to be inelastic in the SHORT TERM. This means, weakening exchange rate which translates to cheaper price will only help to increase demand for British goods by a small proportion. Total value of exports will fall.

Simultaneously, weaker exchange rate translates to more expensive American goods. So British will need to pay higher to acquire these goods. Since the demand curve is inelastic, an increase in price will lead to just a minimal fall in the quantity. However this translates to increase in total expenditure on imported goods

Hence, due to factor of inelasticity current account deficit will initially widen. The phenomenon is called J-curve

Souce of diagram: bized

Why inelastic?

Companies or countries have entered into an agreement to import & export stipulated amount of goods

It takes time for US consumers to switch from local goods to cheaper imported British goods. On the other hand, British people may take some time to adapt from more expensive American goods to cheaper home-made goods

Due to this reasons, weakening of exchange rate will always cause the current account to be temporary in deficit, before moving towards surplus

This is embodied under Marshall Lerner condition that states:

"Provided that the elasticities of both demand for exports & imports are greater than 1, fall in the exchange rate will reduce a deficit & a rise will reduce surplus"

If the condition is not met as I have discussed earlier, then the deteriorating pound will lead to the worsening of current account deficit

Source of diagram: tutor2u

UK experience?

From the diagram, there is some evidence that suggests that Marshall Lerner condition is applicable to UK context. In 1992, when UK exited the ERM (Exchange Rate Mechanism) & pound was devalued by 16%, the current account deficit widens

Only at later stage somewhere 1993-1994, the deficit narrowed down significantly. Also when pound further fell in 1995, the value of current account deficit widens again before the narrowing down of deficit. However, this time the effect is short-lived

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