Correcting a Bo P Deficit Fixed Rate

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Correcting a Bo. P Deficit • Fixed Rate: Automatic Adjustment • Buy $ with reserves … M

Correcting a Bo. P 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

Marshall – Lerner Condition: The Impact of Devaluation on Balance of Trade = P X – ER ( P* Im ) = 0 initially When ER = ($/£) [$ devalued] Bo. T = P X + ER P* Im - 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 Bo. T

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

Other Complications Devaluation increases costs of imports Higher costs of imported components Higher costs of exports Higher prices of exports àLess exports than otherwise àThings may get worse before they get better … if they get better at all

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