The effect of exchange rate changes on the current account

Overview

Effect of a depreciation on a country's terms of trade and nominal and the real exchange rate.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Analyse the effect of a currency depreciation on the current account of a country whose imports are mainly food, fuel and essential components.

   Model answer

   Demand for these imports is highly price inelastic, because there are few substitutes and the goods are necessary for consumption and production, so volumes barely fall while every unit costs substantially more in domestic currency. Import spending therefore rises sharply. Unless the country's exports are unusually price elastic, the sum of the elasticities will fall short of one and the current account will worsen rather than improve. The depreciation also raises domestic costs across the economy, so it imports inflation while failing to deliver the external improvement it was supposed to produce.

2. 2

   Analyse the effect of a currency depreciation on the current account of a country whose exports are highly differentiated and sold on quality rather than price.

   Model answer

   Where buyers choose the product for its design, technology, reliability or brand rather than its price, demand for exports is price inelastic, so a fall in the foreign currency price generates only a modest rise in volume. The exporter may respond by holding the foreign currency price constant and taking the depreciation as a higher domestic currency margin instead, which raises profits but leaves export volumes and the trade balance unchanged. The Marshall-Lerner condition is therefore less likely to be satisfied through the export side, so such a country cannot rely on depreciation to improve its external position.

3. 3

   Explain how the pass-through of a depreciation into import prices affects the size of the current account response.

   Model answer

   Pass-through is the extent to which a fall in the currency raises the domestic price of imports. If foreign exporters absorb part of the change in their own margins to protect their market share, the domestic price of imports rises by less than the depreciation, so the adverse price effect on the current account is smaller, but the incentive for domestic buyers to switch away from imports is also weaker. Incomplete pass-through therefore reduces both the initial deterioration and the eventual improvement, flattening the J-curve in both directions.

4. 4

   Explain the role of domestic spare capacity in determining whether a depreciation improves the current account.

   Model answer

   A depreciation raises foreign demand for the country's exports and domestic demand for import substitutes, but this extra demand can only be met if there are unemployed workers and idle capital available to produce more. Where the economy is already at full capacity, the extra demand raises domestic prices instead of output, so export volumes cannot rise and the competitiveness gain is quickly inflated away. Spare capacity is therefore a precondition for the volume responses that the Marshall-Lerner condition requires.

5. 5

   Analyse the effect of a depreciation on a country's terms of trade.

   Model answer

   The terms of trade are the ratio of export prices to import prices. A depreciation lowers the foreign currency price of exports and raises the domestic currency price of imports, so measured in a consistent currency the country now receives less per unit exported relative to what it pays per unit imported, and the terms of trade worsen. The country must therefore export a greater volume to obtain the same volume of imports, which is a real loss of national income even when the current account improves. This is the sense in which a depreciation makes a country poorer while making it more competitive.

6. 6

   Explain how a depreciation affects inflation and why this matters for its effect on the current account.

   Model answer

   A depreciation raises the domestic price of imported finished goods, food, fuel and components, which feeds directly into consumer prices and into firms' costs. Higher prices then prompt higher wage claims, and if these are granted, domestic costs rise across the economy. This matters because the competitiveness gain from a depreciation is a gain in relative prices, so as domestic prices rise the real exchange rate returns towards where it started and the advantage disappears. A depreciation therefore buys a window of improved competitiveness rather than a permanent change, and the window is shorter the faster domestic costs respond.

Other ways to work this

The same content, four other ways.

What is inside Levo

Six ways to work the same material.