Understanding Balance of Payments Deficit Corrections: Fixed vs. Flexible Exchange Rates

1. Correcting a BoP Deficit • Fixed Rate: Automatic Adjustment • Buy $ with reserves … M 

2. Correcting a BoP Deficit Fixed Rate  Automatic Adjustment • Buy $ with reserves … M … P  … X  Flex Rate … or Devalue Adjustable Peg • Depreciation  X  ??? Im  ??? • Depends on foreign elasticity of demand for your exports • Depends on your elasticity of demand for imports

3. Marshall – Lerner Condition:The Impact of Devaluation on Balance of Trade Balance of Trade = P X – ER ( P* Im ) = 0 initially When ER = ($/£)  [$ devalued] D{BoT} = P {d X} + ER P* {d Im} – d{ER} P* Im = Increased exports (in $) + Decreased imports (in £, translated to $ at ER) - Increased $ paid for initial imports … since ($/£)  If X don’t rise much (low elasticity of demand for X) and/or Im don’t fall much (low elasticity of demand for Im) • Devaluation may worsen BoT

4. The J – Curve Responses to price changes take time • Elasticities are low in short – run • Elasticities are high in long – run In long – run, devaluation “improves” balance of trade • But in short – run, balance of trade may worsen  J - Curve

5. Other Complications Devaluation increases costs of imports Higher costs of imported components  Higher costs of exports  Higher prices of exports • Less exports than otherwise • Things may get worse before they get better … if they get better at all