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Does a Currency Depreciation Cause a Worsening of 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 is 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.

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 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 drop, 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 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.

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