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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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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 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 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 favour 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, hand phones, 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 jeopardise 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 an demand-pull price increase).

If they should choose to specialise 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 comparative advantage of these products, Bangladesh being a developing country that has 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 of 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 deficit increase initially? Remember that a country’s and are determined by 2 variables, Price (P) and Quantity (Q). When the Exchange Rate falls, quantity of decrease and quantity of rise while the price of rise and the price of fall. 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.

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