A Depreciation of the Domestic Currency Will Unambiguously Improve a Countrys Trade Balance - Essay Example

Running header: Currency Depreciation Student’s name: Instructor’s name Subject code: Date of submission A depreciation of the domestic currency will unambiguously improve a country’s trade balance (with specific reference to the US) Introduction It has been argued that a depreciation of the domestic currency will unambiguously improve a country’s trade balance. This is based on the fact that with depreciation, the local currency will be able to purchase less foreign goods and services and thus decreased imports. On the other hand, the local goods will become cheaper leading to more exports. This will thus lead to an improved trade balance. But is this always the case? For a long time, the US had a positive trade balance until 1976 when for the first time; it experienced a negative trade balance with the deficit reaching 3% of the GDP in 1985 when the dollar was deprecated following the plaza accord. The US trade balance has continued to deteriorate with it reaching $759 billion or 6% of GDP in 2006 (Mulik, 2009). In response to this issue of trade balance, analysts and policy makers have fronted currency depreciation mechanism as a tool of improving trade balance and hence improve international competitiveness of US goods. As stated above, this has been based on the fact that if the dollar is depreciated against other currencies, it will reduce US demand for imports while increasing demand for US goods. However, available data has no strong evidence to support the claim. Though depreciation of the dollar is expected to lead to reduced imports and hence narrow the trade deficit, this ignores other factors implying that although depreciation of the domestic currency (dollar) may lead to improved trade balance; it may not do so single-handedly. This paper looks at dollar depreciation and US trade balance and argue that depreciation of the domestic currency do not always unambiguously lead to improved trade balance. The model: The Marshal –Lerner condition In determining whether the depreciation of the US dollar actually unambiguously leads to improvement of trade balance, the model suggested in the Marshal-Lerner condition is used. The model assumes that depreciation of domestic currency will lead to improvement of a country’s competitiveness by making exports cheaper while imports become more expensive. This increases the country’s relative competitiveness position of domestic producers (Petrovic, 2008). The assumptions of the Marshal-Lerner condition include; -there are no capital inflows and only two goods are traded with balance of payment being equal to trade balance. - Only prices matter as income is constant with consumers being interested in the price of domestic or foreign goods expressed in their domestic currency (Rokicki, 2014). -Supply of domestic and foreign goods is infinitely elastic and hence output is determined by demand. As such, the condition holds that for a depreciation of the domestic currency to lead to an increase in foreign exchange earnings and hence an improvement in trade balance, the effects of falling imports and rising exports have to be larger than the valuation effect of the devalued currency (Valentino, 2001). This is the precise statement of the Marshal-Lerner condition. The condition states that given that given an initial position of trade balance, depreciation in domestic currency will lead to improved trade balance given the import and export elasticities of demand add to more than unity. In other words, EX + eM is greater than 1 In this regard, EX is the real exchange rate elasticity of demand for export while eM is the real exchange rate elasticity of demand for imports. Thus supposing X and M are completely unresponsive to change in relative prices, a 1% rise in exchange rate would lead to 1% fall in the value of exports hence deteriorating the trade balance (Tejvan, 2005). The fall can then be offset by a corresponding 1% rise in the quantity exported. Beginning with balance trade so that imports equals exports, then the price effect could be offset by a 1% corresponding decrease in imports value that can be achieved by a 1% decrease in the quantity exported. In short, when the trade balance is zero and hence the current account is in equilibrium, a depreciation of the local currency leads to improved trade balance where the sum of the export and import elasticities is greater than unity (Chung, 2004). However, with an initial trade deficit, the Marshal Lerner condition becomes too weak to secure that depreciation would lead to improved trade balance. On the other hand, with initial trade surplus, the Marshal-Lerner condition is too strong for trade balance improvement. Based on the Marshal-Lerner model therefore, the depreciation of the dollar is supposed to lead to an improvement in the trade balance. However, as discussed below, it will be revealed that this might not always be the case. Does domestic currency depreciation lead to improved trade balance? In this section, it is proved that depreciation of domestic currency does not necessarily lead to improvement in the trade balance. This is not to imply that depreciation is not beneficial to trade balance. However, depreciation alone is not affective tool for leading to improved trade balance. In this regard, the history of US trade balance as well as dollar strength is analyzed. The data attached in the appendix has been used to demonstrate this. As can be seen, the US trade deficit was worsening between 1995 and 2004 even as the dollar continued to depreciate. Between 1995 and 2001, there was relative dollar appreciation coupled with a stable trade balance compared with the period between 2002 to 2004 (Census.gov, 2014). In this regard, appreciation of the dollar is seen to keep the trade balance from improving and in fact affects the worsening trade balance. Between 2002 and 2004, the trade balance deteriorates despite the fact that the dollar considerably depreciated. It is also worth noting that from 2001 to 2005, there was considerable dollar depreciation and corresponding euro appreciation. For instance, a Euro was valued at 88 cents in 2002 compared to 121 cents in January 2006. Ideally, this was supposed to help reduce the US trade deficit within the period. However, this was not the case indicating that the dollar tumbling did not have correcting power and hence the euro appreciating relative to the dollar did not help improve the widening US trade balance. This could be explained by the fact that the dollar depreciation was so weak to have caused any improvement in the trade balance. Thus, it can be noted that the trade balance continued to deteriorate despite the depreciation of the dollar (Federalreserve.gov, 2014). And hence one can conclude that considerable dollar depreciation does not necessarily lead to improvement in the country’s trade balance with Germany (Pettinger, 2014). As has been stated by Shriven and Wilbrate (1997), dollar depreciation may or may not improve the US trade balance depending on whether its relative import elasticities conform to the Marshall-Lerner condition. According to (Hacker, 2004), depreciation of a nation’s currency improves its trade balance only if it meets the Marshall Learner condition or if the combined elasticities of demand for exports and imports is elastic. In US, the Marshall-Lerner condition was met in US in 2006 when exports increased by 12% when the dollar depreciated by 6% indicating a price elasticity of two. According to Linda (2007), the increased exports led to declining trade deficit. However, Linda and Dillon note that such a depreciation of dollar cannot close the ever increasing trade deficit since there are no relationship between movements in exchange rates and the trade balance. Sadao (2008) suggests that dollar depreciation has two fold effects on the US trade balance with one effect being increase in dollar value of imports compared to the exports which would further worsen the trade balance.as opposed to improving it (Federalreserve.gov, 2014). This is related to the J-Curve effect indicating that if short run price elasticities are small, a depreciated dollar leads to deteriorating trade balance in the short run. In the long run however, the trade balance may improve and thus an improvement of US trade balance will follow the J-effect and will only appear after a substantial time period. Thus, whether or not dollar depreciation leads to improved trade balance is dependent on how locals and foreigners react to the depreciation. Furthermore, dollar depreciation does not always lead to an equal reaction on the export and import side. For instance, 10% dollar depreciation may boost exports by 10% while only causing a 1% decline in imports. Thus, the US dollar depreciation mechanism may lead to improved trade balance but only through US export stimulation. The tables below shows demand adjustment to a 10% dollar depreciation. The table was suggested by Linda and Dillon (2007) in their attempt to explain why a dollar mechanism may not necessarily lead to improvement of US trade deficit. United states Foreign markets Change in home currency price of bilateral imports +4 -7 Change in bilateral demand for imports -1 +10 Conclusion This paper has used US to demonstrate that depreciation of domestic currency does not necessarily lead to improvement of trade deficit. As it has been observed, the depreciation may or may not lead to the improvement of the country’s trade deficit. While theoretically depreciation in the domestic currency is expected to automatically lead to increased exports and decreased imports and hence lead to improved trade balance, the mechanism is not as simple in practice (William, 2006). For one, a country usually has multiple trade partners and depreciation in the currency may result in a completely different outcome from theoretical claims. Using US as an example, it has been observed that depreciation may lead to improved trade balance through mainly stimulating exports provided that the currency has been depreciated against all other currency of the country’s trade partners. The paper thus makes a finding that though depreciation of the local currency has a role to play in improving the country’s trade balance, it cannot do so single-handedly but other factors also have to come into play. References: Mulik, K (2009), Exchange rate dynamics and the bilateral trade balance: The case of US agriculture, Agricultural and Resource Economics Review. Rokicki, B2014, The Marshall-Lerner condition, Retrieved on 9th October 2014, from; http://coin.wne.uw.edu.pl/brokicki/wsp_images/oem___lecture_9.pdf Linda, M& Dillon, B2007, Why a dollar deficit may not close the US trade deficit, Current Issues, Federal Bank of New York, vol. 13, no. 5 June 2007. Federalreserve.gov, 2014, Foreign Exchange Rates, Retrieved on 9th October 2014, from; http://www.federalreserve.gov/releases/g5/1997.htm Shriven, N&, Wilbrate, K1997, The relationship between the real exchange rate and the trade balance: An empirical presentation, International Economic Journal, vol. 11 no. 1, pp. 25-35. Census.gov, 2014, Foreign trade: Trade in goods with Germany, Retrieved on 9th October 2014, from; http://www.census.gov/foreign-trade/balance/c4280.html#2005 Sadao, N2008, The J-curve effect and the US balance of payment, New York, Taylor& Francis. Chung, Y2014, Does a currency depreciation cause a worsening of a county’s balance of trade, Retrieved on 9th October 2014, from; http://economics.about.com/od/moffattprize/a/trade_balance_2.htm Census.gov2005, Top trading partners- Total trade, exports, imports, Retrieved on 9th October, 2014, from; http://www.census.gov/foreign-trade/statistics/highlights/top/top0512.html Hacker, R2004, The effect of exchange rate changes on trade balances in the short and long run: Evidence from German trade with transitional central European Economies, Economics of Transition, vol. 12, no. 4, pp. 777-799. Pettinger, T2014, Why has depreciation in pound not improved UK current account? Retrieved on 9th October, 2014, from; http://www.economicshelp.org/blog/9123/trade/depreciation-pound-improved-uk- current-account Valentino, P2001, Exchange rate, International economics Journal, vol. 25, no. 2, pp. 56-568. William, M2006, Dollar slide poses a currency conundrum, The Moscow Times, 11th May 2006. Petrovic, P2008, Exchange rate and trade balance: J-Curve effect, London, Rutledge. Tejvan, P2005, Terms of trade effect, Retrieved on 9th October 2014, from; http://www.economicshelp.org/blog/2016/economics/terms-of-trade-effect/ Appendix: 1995: U.S. trade in goods with Germany NOTE: All figures are in millions of U.S. dollars on a nominal basis, not seasonally adjusted unless otherwise specified. Details may not equal totals due to rounding. Month Exports Imports Balance January 1995 1,708.9 2,688.7 -979.8 February 1995 1,740.0 2,575.7 -835.7 March 1995 1,905.6 3,005.5 -1,099.9 April 1995 1,943.7 3,245.5 -1,301.8 May 1995 1,824.8 3,116.1 -1,291.3 June 1995 1,755.7 3,305.6 -1,549.9 July 1995 1,699.2 3,632.5 -1,933.3 August 1995 1,760.3 2,991.6 -1,231.3 September 1995 1,912.3 2,665.3 -753.0 October 1995 2,069.6 2,937.0 -867.4 November 1995 1,913.8 3,160.5 -1,246.7 December 1995 2,160.4 3,519.9 1998 : U.S. trade in goods with Germany NOTE: All figures are in millions of U.S. dollars on a nominal basis, not seasonally adjusted unless otherwise specified. Details may not equal totals due to rounding. Month Exports Imports Balance January 1998 1,979.6 3,290.9 -1,311.3 February 1998 2,139.2 3,509.8 -1,370.6 March 1998 2,329.2 4,692.1 -2,362.9 April 1998 2,192.8 4,315.4 -2,122.6 May 1998 2,148.4 4,046.9 -1,898.5 June 1998 2,291.1 4,022.3 -1,731.2 July 1998 2,046.8 4,290.5 -2,243.7 August 1998 2,032.6 4,029.9 -1,997.3 September 1998 2,263.7 3,759.2 -1,495.5 October 1998 2,559.4 4,643.3 -2,083.9 November 1998 2,216.5 4,323.2 -2,106.7 December 1998 2,457.9 4,918.4 -2,460.5 TOTAL 1998 26,657.2 49,841.9 -23,184.7 2001 : U.S. trade in goods with Germany NOTE: All figures are in millions of U.S. dollars on a nominal basis, not seasonally adjusted unless otherwise specified. Details may not equal totals due to rounding. Month Exports Imports Balance January 2001 2,546.3 4,875.0 -2,328.7 February 2001 2,928.4 4,846.0 -1,917.6 March 2001 2,892.4 5,344.8 -2,452.4 April 2001 2,507.6 5,377.7 -2,870.1 May 2001 2,604.5 5,219.3 -2,614.8 June 2001 2,431.7 4,783.2 -2,351.5 July 2001 2,443.4 5,422.7 -2,979.3 August 2001 2,389.2 5,055.2 -2,666.0 September 2001 2,255.1 4,147.3 -1,892.2 October 2001 2,370.8 5,037.2 -2,666.4 November 2001 2,173.1 4,581.6 -2,408.5 December 2001 2,452.9 4,386.6 -1,933.7 TOTAL 2001 29,995.4 59,076.6 -29,081.2 2004 : U.S. trade in goods with Germany NOTE: All figures are in millions of U.S. dollars on a nominal basis, not seasonally adjusted unless otherwise specified. Details may not equal totals due to rounding. Month Exports Imports Balance January 2004 2,309.7 5,013.1 -2,703.4 February 2004 2,502.7 5,988.4 -3,485.7 March 2004 2,838.2 6,790.9 -3,952.6 April 2004 2,557.7 6,621.3 -4,063.6 May 2004 2,723.5 6,615.7 -3,892.2 June 2004 2,492.5 6,064.5 -3,572.0 July 2004 2,420.5 6,705.1 -4,284.6 August 2004 2,618.4 6,487.8 -3,869.4 September 2004 2,779.7 5,994.4 -3,214.7 October 2004 2,862.2 7,033.9 -4,171.6 November 2004 2,572.9 6,958.7 -4,385.8 December 2004 2,737.9 6,992.0 -4,254.2 TOTAL 2004 31,415.9 77,265.6 -45,849.7 Read More