Page 222 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes Finally, Mundellian approach assumes (implicitly) that other countries are not affected by the
monetary-fiscal policy mix adopted by a country, and even if they are, they do not react. In reality,
however, a great deal of conflict arises between the nations. Finding an appropriate monetary-fiscal
mix compatible with that of other countries is rather an impossible task. And, even if a compatible
monetary-fiscal mix is somehow worked out by trial and error, it may push the economy away from
the equilibrium point rather than bringing it closer to the equilibrium.
19.2 The Expenditure Switching Policy : Devaluation

In the preceding section, we have discussed the expenditure changing policies, viz., monetary and fiscal
policies, aimed at changing the aggregate spending with the purpose of correcting the adverse BOP.
We have discussed also the practical problems associated with expenditure changing policies and
the problems related to monetary-fiscal mix. In this section, we discuss the expenditure switching policies
to solve the problem of BOP deficit and their effectiveness.
The expenditure-switching policy is one that aims at attaining the internal and external balance by
switching the domestic expenditure from imported to domestic goods or the other way round
depending on the need of the country. The expenditure-switching policy works through the change
in relative prices of imports and domestic goods. Under free market conditions, the relative prices of
imports and domestic goods change on their own either due to exchange depreciation or exchange
appreciation. Exchange depreciation or appreciation is the result of the market mechanism. The
market determined exchange appreciation is often a major cause of BOP deficit as it increases imports
and decreases exports. It does so because it makes imports cheaper than domestic goods. Therefore,
the nations suffering from BOP deficit are forced to adopt policy measures to reverse the process, i.e.,
to switch the domestic demand from foreign to domestic goods. The policy instrument that is generally
used for expenditure-switching is devaluation. Devaluation is a deliberate policy action taken by
the government to devalue the domestic currency in terms of gold or in terms of the foreign currency
to which the domestic currency is tied. Devaluation has, in fact, been used as a major policy tool for
expenditure switching combined, generally, with restrictive monetary and/or fiscal policy.
In this section, we discuss first the working mechanism of currency devaluation and then its
effectiveness. Since BOP deficit is the major concern of most countries, we confine our discussion to
how devaluation helps in eliminating BOP deficit. We discuss here the following aspects of devaluation
as an expenditure-switching policy measure.
(i) Working mechanism of devaluation,
(ii) BOP adjustment under devaluations,
(iii) Effectiveness of devaluation, and
(iv) Empirical evidence of its effectiveness.
Working Mechanism of Devaluation
When the central bank of a country (RBI in India) reduces the value of the domestic currency officially
in terms of foreign (reserve) currency, it is called devaluation. The objective of devaluation is to
reverse the flow of domestic consumer expenditure from imported to domestic goods. Devaluation
changes the exchange rate ipso facto. The immediate effect of change in the exchange rate is the change
in the relative prices of imports and domestic goods. In effect, devaluation increases the price of
imported goods in relation to the prices of domestic goods. Therefore, if demand for imports is price-
elastic, the demand for imported goods decreases and the demand for their domestic substitutes
increases. In the process, expenditure on imports decreases and that on the domestic goods increases.
This is what is called ‘expenditure-switching, i.e., consumer expenditure is switched from foreign
goods to domestic goods. Due to expenditure-switching, imports decrease in the devaluing country
and exports from the country increase. This reverses the trade balance. This is how devaluation is
supposed to correct the adverse BOP.
Let us now explain the mechanism by which devaluation helps in correcting BOP deficit in a two-
country model under the following simplifying assumptions.

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