Page 223 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 19 : Expenditure Reducing and Expenditure Switching Policies

(i) There are only two countries, A and B, with currencies A and B , respectively; Notes
c c
(ii) There are only two goods, X and Y, involved in the foreign trade between the countries A
and B.
(iii) Country A exports X to country B and imports Y, and country B exports Y and imports X from
country A.
(iv) There is no capital movement between the two countries, A and B.
The mechanism by which devaluation eliminates the BOP deficit is illustrated in Figure 19.5. Panel
(a) shows the trade in commodity Y. Suppose that the exchange rate between A’s currency (A ) and
c
B’s currency (B ) is given as B 1 = A 5. Given the exchange rate, A’s demand for B’s exportable Y and
c c c
B’s supply schedule for Y are given as shown in panel (a). Note that A’s demand schedule and B’s
supply schedule intersect at point K. Thus, the trade equilibrium between the two countries in respect
of commodity Y is determined at 350 units of Y at price 30 B per unit.
c
Likewise, panel (b) shows the trade in commodity X between the two countries. At exchange rate B
c
1 = A 5, country B’s demand schedule and country A’s supply intersect at point R determining
c
export and import of commodity X at 100 units at price 60 B per unit.
c
We can now work out pre-devaluation trade balance for country A from data given in panels (a) and
(b) of Figure 19.5.
Pre-devaluation Trade Balance of Country A
A’s import = 350 (Y) × B 30 = B 10,500
c
c
A’s export = 100 (X) × B 60 = B 6,000
c c
Pre-devaluation trade deficit = B 4,500
c
(a) (b)

70 105

60 B c A’s Demand for Y 90 B 1=A 5 c
50 1=A c 7 ) 75 c A’s Supply of X
) 40 B c B’s Supply of Y 60 R
Price of Y (in B c 30 1=A c 5 N J K Price of X (in B C 45 B 1=A 7 c

c
B’s Demand
37
25
L
M
20
30
21.3 H for X
10 15
350
0 0
100 200 300 400 500 600 50 100 150 200 250 300
B’s Exportable (Y) A’s Exportable (X)
Figure 19.5: The Effects of Devaluation on Imports and Exports
Since, by assumption, there is no capital movement between the two countries, trade deficit equals the
BOP deficit. As shown in pre-devaluation trade balance accounting, country A is thus faced with a
BOP deficit of B 4,500. Now let us suppose that country A decides to use devaluation to correct its
c
BOP deficit and devalues its currency by, say, 40% so that a new exchange rate is fixed at B 1 = A 7.
c
c
The immediate effect of devaluation is the increase in the price of commodity Y (A’s importable) in
terms of A’s currency. For example, the equilibrium price increases from A 150 (= 30 B × 5) to A 210 (=
c c c
30 B × 7). Assuming that A’s demand for Y is price-elastic, its demand for Y decreases by NK as shown
c
in panel (a). Since this applies to all the prices, A’s demand schedule for Y shifts downward as shown
in panel (a). As a result of shift in A’s demand schedule (B’s supply schedule remaining the same) trade
is determined at point J. It shows that A’s import of Y decreases from 350 units to 300 units.

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