Page 225 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 19 : Expenditure Reducing and Expenditure Switching Policies

Now suppose that for some extraneous reason, export of country A declines, resulting in fall in Notes
output, employment and in incomes. As a result, aggregate demand curve AD shifts downward to
AD’ shifting the equilibrium point to E’. This leads to fall in the imports and exports of the country.
Consequently, the external balance curve EB shifts downward to the position of EB’. However, as
shown in Figure 19.6, country A is in equilibrium at point E’. Note that point E’ happens to fall above
the EB’ curve. It means that at point E’, there is external imbalance with a trade deficit.
Let country A now devalue its currency. As a result, prices of its imports increase and prices of its
export goods decrease. Assuming imports and exports are both price-elastic, imports of the country
would decline and its exports would increase. As a result, its external balance curve EB’ would shift
upward to its original position of EB passing through equilibrium point E. Trade deficits would be
wiped out. This marks the restoration of both internal and external balance. Whether devaluation of
currency alone restores the internal and external balance in reality depends on a number of internal
and external factors, like trade policy of other countries, reaction of other countries to devaluation by
a country, the elasticity of exports and imports etc. These factors are discussed in the following section.
The Effectiveness of Devaluation : The Marshall-Lerner Condition

It may appear from the foregoing analysis that devaluation is a sure cure of BOP deficit. It may
however not be true in reality. The effectiveness of devaluation depends on certain conditions. For
example, decrease in imports due do devaluation depends on price and income elasticity of imports,
availability of substitutes, and customs. However, the most important condition of the effectiveness
of devaluation is, what is called, the Marshall-Lerner condition. The Marshall–Lerner condition
states that when the sum of the price-elasticities of the demand for imports of any two countries trading their
goods between them is greater than unity, then devaluation (or exchange depreciation) increases exports and
decreases imports. In our example of countries A and B, the effect of devaluation on country A’s BOP
can now be summarized in terms of Marshall-Lerner condition as follows.
(i) Devaluation reduces BOP deficit when the sum of price-elasticity of A’s demand for imports and price-
elasticity of B’s demand for A’s exportables, in absolute terms, is greater than unity. This condition is
satisfied by the demand curves given in Figure 19.5. Therefore, devaluation reduces the BOP
deficit.
(ii) Devaluation increases BOP deficits when the sum of price-elasticity of demand for imports of country A
and the price-elasticity of demand for its exportable, in absolute terms, is less than unity. To prove this
point, let us look back at Figure 19.5. In case A’s demand for Y is perfectly inelastic, then the
devaluation would shift the equilibrium from point K to M in panel (a) of Figure 19.5. This
indicates no change in A’s imports. At point M, demand exceeds supply by LM. Therefore,
import price moves up to point K. It means that devaluation is ineffective under this condition.
On the other hand, if B’s demand for X is perfectly inelastic, devaluation will make equilibrium
shift from point R to H which means that A’s export does not change. But, export price goes
down from B 60 to B 37. As a result, A’s export earning decreases. The final position is that A’s
c c
import bill does not decrease and export earnings decrease. Consequently, A’s BOP deficit
increase due to devaluation.
(iii) When the sum of price-elasticity of demand for importable of country A and the price-elasticity of demand
for its exportable, in absolute terms, equals one, then devaluation leaves the trade balance of country A
unchanged and hence the BOP remains unaffected.
The Empirical Evidence and the J-Curve Effect
The empirical evidence shows the Marshall-Lerner condition (i) holds, in general, for all industrial
nations, except for Australia and the UK. That is, the sum of price-elasticities of imports and exports for
the industrialized nations have been found to be considerably higher than unity. It may, therefore, be
concluded that devaluation is an effective method of correcting adverse BOP in the developed countries.
However, further emprical evidences show that this conclusion holds in the long run, not in the short
run. In the short run, devaluation causes a deterioration in the BOP. The short-run deterioration in
BOP is caused by the tendency of import prices to increase faster in the domestic market immediately
after devaluation than the export prices, without much change in the quantities imported and exported.

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