Currency Depreciation and a Country's Balance of Trade

Does a Currency Depreciation Cause a Worsening of a Country's Balance of Trade?

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Balance of trade basically records the net exports of a nation (Exports-Imports). A worsening or a deficit of the Balance of trade means that the value of imports exceeds those of exports.

Terms of Trade

A worsening of the Terms of Trade, the index of the price of a country's in terms of its imports, could be caused by expenditure-reducing measures such as deflationary monetary or fiscal policy (that will cause a general fall in prices of G&S). Prices of would drop and would be relatively more expensive. Assuming the elasticity of and do not play a big role in these phenomena (perhaps if the sum of elasticity of both and added up to unity or a value of 1), Balance of trade may actually improve if increase and fall. However, it may be unnecessarily costly in terms of lost domestic employment and output.

Basically when a country’s Terms of Trade worsens, become more expensive relative to the price of exports. Assuming the quantity of and were the same, there would be a Balance of trade deficit when are more expensive than exports. However, that may not necessarily be the case. The outcome of the Balance of trade will largely depend on the Price Elasticity of Demand (PED) of both and exports. (PED is defined as the change in quantity demanded of a good to a change in its price)

When Terms of Trade worsens, let’s assume price of rise and price of fall. Let's assume that this was caused by a depreciation of the Exchange Rate. If and were relatively elastic, the Balance of trade would actually improve! How? If price of were to rise, quantity demanded would fall by a relatively bigger margin. This will cause a fall in total expenditure. On the other hand, when the price of drops, it will be followed by a relatively bigger rise in quantity demanded, causing a net rise in total revenue. As a result, there will be a Balance of trade surplus! This also applies if the and were relatively inelastic; leading to a worsening of the Balance of trade.

The Marshall-Lerner Condition

The Marshall-Lerner Condition provides us with a simple rule to assess whether a change in the exchange rate (Terms of Trade) will reduce Balance of trade disequilibria. It states that when the sum of the export and import price elasticity’s is greater than unity (1), a fall in exchange rates (Terms of Trade) will reduce a deficit. If the Marshall-Lerner Condition holds, total revenue from will rise and total expenditure from will fall when a devaluation of the exchange rate occurs.

However, the Marshall-Lerner Condition is only a necessary condition and NOT a sufficient condition for a fall in Exchange Rates to improve the Balance of Trade. In a nutshell, the occurrence of the Marshall-Lerner Condition does not mean a devaluation of the currency will necessarily improve the BOT. For it to be successful, domestic supply of output must be able to respond to meet the surge in demand caused by the fall of the Exchange Rate. Spare capacity is needed so that supply can be increased to meet the switching of overseas and domestic demand for locally produced substitutes. This brings us to the issue of using expenditure-reducing deflation and expenditure-switching devaluation as complementary policies rather than substitute policies. As deflation causes the actual output to drop, it may provide the spare capacity and conditions in which falling Exchange rates can improve a Balance of trade deficit.

Let's consider a developing country, Bangladesh, that has a comparative advantage (produce this good or service at a lower opportunity cost compared to another country) in the fishing industry. Should their Terms of Trade worsen, one could argue that the Marshall-Lerner Condition would work in their favor as fish is an elastic source of protein (could be substituted with chicken, beef, tofu, etc) while as a developing country, their of finished goods such as machinery, computers, handphones, technology, etc are just as elastic in demand. However, will the nature of fish allow Bangladesh to increase their supply to meet demand? The answer is highly unlikely as there is only so much fish in Bangladeshi waters at a certain time. Price Elasticity of Supply, PES, (responsiveness of quantity supplied to a change in price) would be relatively inelastic in the short-run. Besides that, Bangladesh would not over-fish as it might jeopardize their main source of revenue. This will not only hinder the production of that will probably improve Balance of trade, but excessive demand for fish relative to a slow-growing supply will push prices of fish up.

Terms of Trade will improve but it can be argued whether Balance of trade will change or not due to the uncertainty to traders caused by fluctuating prices of fish (prices fall due to a devaluation of currency followed by a demand-pull price increase).

If they should choose to specialize in finished products such as cars, machinery or mobile phones that can arguably have a more elastic supply than fish, they might not benefit from the comparative advantage of these products, Bangladesh being a developing country that has the comparative advantage in fish. The quality of these new products may not be up-to-standards of importers. This uncertainty of quality of will definitely affect the of the country.

Even if the Marshall-Lerner Condition is met and spare capacity exists in the economy, a country’s firms may not be able to immediately increase supply following a change in exchange rates. This is because, in the short-term, elasticity of demand for Goods and Services are considered relatively inelastic. In these instances, the Balance of trade may actually worsen before improving. This has occurred so often that it has a name; it is known as the J-Curve effect (when the devaluation causes the BOT first to deteriorate and then to improve).

Why do trade deficits increase initially? Remember these variables, Price (P) and Quantity (Q). When the Exchange Rate falls, the quantity of decrease and quantity of rise while the price of rises and the price of falls. In the short run, Price tends to predominate over the quantity effects, so the Balance of trade deficit becomes larger (or surplus reduces). Eventually, however, the quantity effects tend to predominate over the P effects, so the Balance of trade deficit gets smaller. This explains the initial increase in the Balance of trade deficit followed by a curve upwards.

At a certain period, the effects of a devaluation of Exchange Rate may be eroded away if increased import prices and cheaper cause demand for local goods (expenditure switching) and demand for to rise. Increased export earnings will serve as an injection into the domestic circular flow of income. Through the multiplier, it generates more income. Consumption and savings will increase, interest rates will fall. Investments will increase (due to the devaluation), giving the economy a push. Employment of resources will increase (shifting the PPF to a point on the curve or nearer to it) and the country enjoys a higher standard of living. If the country was already at a full employment and level of income, it would lead to inflation (general rise in the price of goods and services) that could once again shoot up prices, improving the Terms of Trade and affecting the Balance of trade again.

After a survey was done mainly in Asian countries, this trend was discovered and was named the S-Curve Effect as an extension of the J-Curve Effect (Backus, Kehoe and Kydland 1995). Notice the similar shape of the curve to a sin graph reflected off the x-axis; no relationship has been derived from these findings just yet I believe.

As a conclusion, we can only determine whether a worsening of the Terms of Trade results in the worsening of the Balance of trade if we take into account other factors such as elasticity of inflation rates both domestically and in foreign countries. It is up to the government to take certain steps and policies to manipulate Terms of Trade and Balance of trade to the greater benefit of the country.