Economic Development and Globalisation: Question 1

Worked solution

Part (a): Devaluation versus depreciation

A devaluation is a deliberate, policy-driven reduction in the official value of a currency, carried out by a government or central bank operating a fixed or managed exchange rate. It is a conscious decision, not a market outcome.

A depreciation, by contrast, is a fall in a currency’s value that happens under a floating exchange rate, where the price of the currency is left entirely to the forces of demand and supply in the foreign exchange market. No government decision is involved, the currency simply weakens as market conditions change.

Vezmoor’s currency has been devalued, not depreciated, because the vezo operates under a managed system and its central bank has made a deliberate decision to lower its official value.

Part (b): The Marshall-Lerner condition

The Marshall-Lerner condition states that a devaluation (or depreciation) of a currency will lead to an improvement in the current account balance only if:

$|PED_x| + |PED_m| > 1$

where $PED_x$ is the price elasticity of demand for exports and $PED_m$ is the price elasticity of demand for imports. If the sum is exactly 1, the current account balance is unchanged; if it is less than 1, the devaluation actually worsens the current account.

Using the values given: $|{-0.7}| + |{-0.5}| = 0.7 + 0.5 = 1.2$

Since $1.2 > 1$, the Marshall-Lerner condition is satisfied. This means that, once export and import volumes have had time to adjust to the new, more competitive vezo, the combined effect (export revenue rising by proportionately more than import expenditure falls, roughly speaking) should be a long-run improvement in Vezmoor’s current account balance.

Part (c): J-curve analysis. Why the current account may worsen first

Even though the Marshall-Lerner condition holds in the long run, the current account balance often follows a J-curve pattern immediately after a devaluation: it dips below its original level before rising above it, tracing a shape resembling the letter J.

This happens because of short-run time lags on the volume side of trade:

• Many export and import contracts are already signed at the old prices and quantities, and cannot be renegotiated immediately.
• Consumers and firms take time to recognise the price change and to find or switch to alternative suppliers.
• Producers need time to expand output to meet any extra export demand.

Immediately after the devaluation, export and import volumes are therefore largely unchanged in the short run. However, the vezo price of imports has already risen (each unit of imports now costs more vezos), so Vezmoor’s import bill, measured in vezos, rises straight away, while export revenue has not yet risen enough to offset this, since export volumes have not yet responded. The current account balance can therefore worsen initially.

Only once time passes and export and import volumes fully adjust to the new relative prices, consistent with the combined elasticities of 1.2 found in part (b) being greater than 1, does the current account balance improve, eventually rising above its pre-devaluation level. This is the upward part of the J-curve.

Part (d): Managed versus floating exchange rate determination

Under Vezmoor’s managed exchange rate, the central bank does not leave the vezo’s value purely to market forces. Instead, it periodically intervenes (for example, by buying or selling foreign currency reserves in the foreign exchange market, or by adjusting domestic interest rates to affect capital flows) in order to influence the vezo’s value, perhaps keeping it within an informal target range.

Under a freely floating exchange rate, by contrast, there is no such intervention: the exchange rate is determined purely by the interaction of demand for and supply of the currency in the foreign exchange market, and it is left to move freely wherever these market forces take it.

Final answers

• (a) Devaluation = a deliberate official reduction of value under a fixed/managed system; depreciation = a market-driven fall under a floating system
• (b) Marshall-Lerner condition: $|PED_x|+|PED_m|>1$; here $0.7+0.5=1.2>1$, so the condition is satisfied
• (c) Short-run time lags mean volumes barely respond at first, so the current account can worsen initially (the J-curve), before improving once volumes adjust
• (d) A managed system involves deliberate central bank intervention to influence the exchange rate; a floating system leaves it entirely to market demand and supply