Factors affecting exports and imports What happens to UK exports if the pound falls in value against other currencies UK goods would become cheaper in overseas markets. Demand will rise, and so exports would rise – improving the current account balance What happens to imports if the pound falls in value against other currencies Imported products will be more expensive, so demand will fall and so (the volume of) imports will fall But what happens to the value of imports? Are there any time lags?

Effect on Imports from fall in value of the Pound Price Is a+c > b+c (ie is a>b) Is d+e > e+f (ie is d>f) P2 P2,3 Supply of imports2 d a P1 Supply of imports1 Demand for imports2 e f c b Demand for imports1 Q3 Q2 Q1 Quantity

Marshall Lerner 10% fall in £ PED 0 PED 0.5 PED 1 PED>1 Export volume +5% +10% +>10% Import volume -5% -10% ->10% Export value Import value decrease Impact on C/A This is the worst case scenario, exports unchanged but imports rise by 10% No effect: same increase in the value of both exports and imports Reasonable Improvement. Exports increase by 10%, but the value of imports is unchanged Big improvement – exports rise sharply and imports fall

Marshall Lerner Condition If the PED for exports and imports is low, a depreciation can worsen the trade balance Which means lower output and higher prices. Not good If the PED for exports and imports is high, a depreciation will improve the trade balance Given certain assumptions, such as starting at balance on the trade account, the Marshall Lerner Condition states: As long as the sum of the price elasticities of demand for imports and demand for exports (in absolute value) is greater than 1, a devaluation/depreciation will improve the trade balance

Example of cars Starting exchange rate is $1.60/£ (each pound buys $1.60) Assume we export 2 million cars at £10,000 each, and import 2 million cars at $16,000 each (equivalent to £10,000) What is the value of exports and imports? £20 billion each Let us assume the pound falls in value (depreciates) by 5%, from $1.60 to $1.52 What do we need to know to work out what happens to the value of exports and imports? PED for exports and PED for imports Assume the price elasticity for both is -0.2. What happens to the value of exports and imports Exports rise to £20.2 billion Imports rise to £20.83 billion, so trade balance worsens Assume price elasticity is -0.7 for each. What happens now? Exports rise to £20.7 billion, imports rise to £20.28 billion; trade balance improves Price elasticity is -1.2 for each. What happens? Exports rise to £21.2 billion, imports fall to £19.72 billion; trade balance improves dramatically, by $2.4 billion

J Curve Are there any time lags involved if a currency falls in value (depreciates)? 2 time lags: In the short term contracts will have been agreed, so the new exchange rate will not apply to all exports and imports. Some will keep existing prices for a while Demand takes time to adjust to new prices. Consumer will not instantly switch from say BMW made overseas to a Jaguar made in the UK Can we think of this in terms of elasticity? Yes, elasticity increases over time

J curve