Balance of Payments and Exchange Rates: Question 4

Worked solution

Part (a): Effect of depreciation on export and import prices

A depreciation is a fall in the market-determined value of the dovar against other currencies. This makes Doverna’s exports cheaper in foreign-currency terms (a foreign buyer now needs less of their own currency to buy the same dovar-priced good, so Doverna’s exports become more price-competitive abroad. At the same time, it makes Doverna’s imports more expensive in dovars) a good priced in a foreign currency now costs more dovars to buy, so foreign goods become less attractively priced for Doverna’s own consumers and firms.

Part (b): AD/AS analysis of the short-run effect

Net exports (X − M) are a component of aggregate demand (AD = C + I + G + (X − M)). Since the price changes described in part (a) tend to raise export revenue (cheaper, more competitive exports sell in greater volume) and reduce import spending (dearer imports are bought in smaller volume), net exports rise. This shifts the whole AD curve to the right along the economy’s upward-sloping short-run aggregate supply (SRAS) curve.

At the new equilibrium, where the higher AD curve intersects SRAS further to the right, real output is higher than before, and since firms need more workers to produce this extra output, employment rises (unemployment falls). However, the price level also rises, for two reasons: the demand-pull effect of higher AD itself, and a direct cost-push effect, since the depreciation has also made imported raw materials, components and finished goods more expensive in dovars, raising firms’ costs and consumer prices directly.

Part (c): How far can depreciation alone correct the deficit?

Depreciation should, in principle, help correct Doverna’s deficit: cheaper exports and dearer imports (part (a)) are the right direction of change for narrowing a current account shortfall, and part (b) shows this raises net exports through the AD/AS mechanism. However, there are real reasons to doubt that depreciation alone will be enough.

First, time lags are likely: export and import contracts, consumer habits, and the search for alternative suppliers do not adjust instantly, so the improvement in trade volumes implied by the price changes may take many months to materialise fully.

Second, depreciation itself creates a cost: the rise in the domestic price level identified in part (b) partly works against the policy, since imported inflation raises the cost of living and squeezes real incomes, and may put Doverna’s government in conflict between its price-stability objective and its objective of a stable current account (6.5.1).

Third, if the deficit’s underlying causes are not primarily about price (for example, if Doverna depends on imported energy or raw materials for which there is little domestic alternative, or if domestic industry suffers from weak productivity or quality relative to foreign competitors) then even much cheaper exports and dearer imports may not shift trade volumes by very much, leaving the deficit largely intact.

For these reasons, depreciation is more likely to succeed as one part of a wider policy package (potentially alongside fiscal, monetary, supply-side or protectionist measures (6.5.2) that address demand and competitiveness directly) than as a single, sufficient cure taken in isolation.

Final answers

• (a) Exports become cheaper abroad (more competitive); imports become more expensive in dovars (less attractive)
• (b) Net exports rise, shifting AD rightward: real output and employment rise, but the price level also rises (demand-pull and imported cost-push inflation)
• (c) Depreciation helps but is unlikely to be sufficient alone, given adjustment time lags, the cost-push inflation it creates, and any structural (non-price) causes of the deficit. It is best combined with other current-account correction policies