Correcting a BoP Deficit Fixed Rate: Automatic Adjustment Buy $ with reserves … M 

Correcting a BoP Deficit Fixed Rate  Automatic Adjustment Buy $ with reserves … M  … P  … X  Flex Rate … or Devalue Adjustable Peg Depreciation  X  ???Im  ??? –Depends on foreign elasticity of demand for your exports –Depends on your elasticity of demand for imports

Marshall – Lerner Condition: The Impact of Devaluation on Balance of Trade Balance of Trade = P X – ER ( P* Im ) = 0 initially When ER = ($/£)  [$ devalued] D{BoT} = P {d X} + ER P* {d Im} – d{ER} P* Im = Increased exports (in $) + Decreased imports (in £, translated to $ at ER) - Increased $ paid for initial imports … since ($/£)  If X don’t rise much (low elasticity of demand for X) and/or Im don’t fall much (low elasticity of demand for Im) –Devaluation may worsen BoT

The J – Curve Responses to price changes take time –Elasticities are low in short – run –Elasticities are high in long – run In long – run, devaluation “improves” balance of trade –But in short – run, balance of trade may worsen  J - Curve

Other Complications Devaluation increases costs of imports Higher costs of imported components  Higher costs of exports  Higher prices of exports  Less exports than otherwise  Things may get worse before they get better … if they get better at all