Page 224 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes What happens to A’s exports after devaluation ? Due to devaluation of A’s currency (A ), B’s currency
c
2
is automatically appreciated. The rate of appreciation equals 28.58%. It means that A’s exportable
(commodity X) becomes cheaper by 28.58% in terms of B’s currency (B ). As a result, A’s supply curve
c
shifts rightward as shown in panel (b). B’s demand schedule for X remaining the same, A’s new
supply schedule intersects B’s demand schedule at point T. The new equilibrium point shows decrease
in the price of A’s exportable (X) from B 60 to B 45. Consequently, B’s demand for A’s exportable X
c
c
increases from 100 units to 150 units.
Let us now find the post-devaluation trade balance and the effect of devaluation on BOP deficit.
Post-devaluation Trade Balance
A’s import = 300 (Y) × B 25 = B 7,500
c c
A’s export = 150 (X) × B 45 = B 6,750
c c
Post-devaluation trade deficit = B 750
c
We can now find the effect of devaluation on A’s BOP deficit by comparing the trade balance before
and after devaluation. Our calculations show that devaluation reduces the trade deficit from B 4500
c
to B 750. It reduces, thereby, BOP deficit to the same extent.
c
Devaluation and Internal-External Balance
In the preceding section, we have shown how devaluation switches the domestic expenditure from
imported goods to domestic goods; how it reduces imports and increases exports; and how it restores
external balance. However, restoring external balance alone is not enough : external balance must coincide
with internal balance. For, if there is internal imbalance, it may create conditions for decline in income
and employment which may lead to external imbalance. In this section, we explain how devaluation—
the expenditure switching policy instrument—can help restoring external balance with internal balance.
The process of restoration of internal and external balance is illustrated in Figure 19.6 in AD-AS
model. Let us suppose that the aggregate demand (AD) and aggregate supply (AS) curves of a country,
say A, are given as AD and AS curves in Figure 19.6 and country A in equilibrium at point E. Note
that the external balance curve EB passes through the equilibrium point E. It means that country A
has attained both internal and external balance at equilibrium point E.

AS

Price Level E E

AD
AD
EB
EB

O
Ye Y
Output ( Income)
Figure 19.6: Devaluation and Internal-External Balance
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2. The rate of appreciation = (100) = 28.58.
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