The Exchange Rate and the Balance of Payments

You are here

The Exchange Rate and the Balance of Payments

For those of you who have not read the previous Learn-It, here is a quick recap. Theoretically, a current account deficit should cause the value of the pound to fall. In this case, the value of imports into the UK is higher than the value of exports sold to foreigners. Hence, the demand for foreign currencies to buy these imports is higher than the demand for the pound to by our exports. Simple supply and demand analysis, therefore, suggests that the value of the pound should fall. For a current account surplus, simply reverse the above explanation.

In the case of a deficit, the subsequent lower value of the pound will make exports relatively cheaper and imports relatively more expensive. The value of exports sold should rise and the value of imports bought should fall. The deficit should be eliminated automatically (again, reverse the explanation for a surplus).

This story worked well until the controls on the world capital markets were lifted. Once capital could go wherever it wanted, currency transactions for investment and speculative purposes took over. A country's trade position is no longer relevant. If an economy is doing well, which usually means that consumer spending is high (spending on imports in particular), a current account deficit is expected. Perversely, instead of the currency falling for the reasons outlined above, the currency is as likely to rise, because investors and speculators like to place their money on 'winners' (for example, economies that are doing well). In fact, a currency may even rise following a cut in interest rates (which would normally cause the currency to fall following the outflow of money trying to find better rates elsewhere) because the markets may take it as a sign that the economy will improve in the future! See the previous Learn-It for more discussion on the determination of the exchange rate.

In the rest of this Learn-It, we shall be looking at the theoretical relationship between a change in the exchange rate and current account disequilibria.

Assume that the UK has a current account deficit (which is not hard to do!). If the pound were to devalue (a large drop in its value) then one would expect the deficit to reduce. Why? Because exports will become relatively cheaper, and so their demand should rise in foreign markets, and imports will become relatively more expensive, so their demand should fall in the UK.

But will this always be the case? The success of a devaluation of the pound in terms of reducing a current account deficit will depend on foreigners' elasticity of demand for British exports and UK consumer's elasticity of demand for foreign imports.

The Marshall Lerner condition states that for a devaluation to be successful in terms of a reduced current account deficit, the sum of the two elasticities, must be greater than one.

To illustrate that this should be true, let's look at exports and imports separately.

Export elasticity

If you think about it, UK exporters can't go wrong if the pound falls in value. How ever small the depreciation in the pound is, and however low the elasticity for their exports is, the revenue they will receive will have to rise.

For example, let's take a car company that is exporting cars to the USA whose price is £10,000 in the UK. Let us also assume that the exchange rate between these two countries is £1 = $2. These cars will have a price of $20,000 in the USA. Now assume that the pound devalues by 10% so that the new exchange rate is £1 = $1.80. The price in the USA is now $18,000. Unless the elasticity of demand for these cars in the USA is zero (highly unlikely) then the demand for these cars in the USA will increase. Although American consumers now only have to pay $18,000, the British car company still receives £10,000 for each sale. However large or small the fall in the value of the pound is, the sterling price of the car stays the same. Even if this company only sells one extra car, they will still receive an extra £10,000.

In summary, for export revenue to rise following a devaluation of the pound, the elasticity of demand for these exports simply has to be greater than zero (which is perfectly inelastic demand). Obviously, the higher the elasticity the bigger the increase in export revenue, but anything over zero will help reduce the current account deficit.

Import elasticity

In the case of imports the situation is a little less favourable. A devaluation of the pound will cause the price of imports into the UK to rise. The demand for these imports will fall, but the revenue that the foreign producers receive will not necessarily fall.

For example, assume that an American car company exports their cars into the UK. The price for these cars in the USA is $30,000. Again, assume that the initial exchange rate is £1 = $2. This means that the price of these cars in the UK will be £15,000. Now assume that the pound devalues by 25% giving an exchange rate of £1 = $1.50. Swapping this exchange rate around to give the price of dollars in terms of pounds, we have $1 = £0.67. So now the American cars are priced at £20,000 in the UK. The change in the revenue received by the American car company will depend on the elasticity of demand for their cars in the UK.

Assume that the elasticity is 1.5, which is relatively elastic. As you will know from the topic called 'Elasticities', if demand is relatively elastic and the price rises, the decrease in demand will be relatively larger. This means that the loss in revenue from the decrease in demand is higher than the gain in revenue on each unit due to the higher price. The diagram below helps to explain:

Import elasticity

Note that the elastic demand curve is relatively flat, so that when the price rises, the fall in demand is relatively larger, and the 'gain' box is much smaller than the 'loss' box. The more elastic the demand for UK imports is, the more successful a devaluation will be in terms of reducing import revenues (which go out of the country) and the bigger the reduction in the current account deficit.

Now assume that the elasticity is 0.5, which is relatively inelastic. Again, you should know that, in this case, when the price rises, the decrease in demand in relatively smaller. This means that the loss in revenue from the decrease in demand is lower than the gain in revenue on each unit due to the higher price:

Import elasticity

This demand curve is relatively inelastic, and so is fairly steep. You can see that the price rise is proportionately much larger than the fall in demand, so the 'gain' box is much larger than the 'loss' box. If the demand for UK imports is relatively inelastic then devaluation will result in increasing import revenues (which go out of the country), which contribute to a larger current account deficit.

Putting exports and imports together

So, the condition for exports and imports separately can be summarised as follows:

Eex > 0 for a devaluation to increase export revenues

Eim > 1 for a devaluation to reduce foreigners import revenue

By adding the zero and the one, we get the following overall condition:

Eex + Eim > 1 For a devaluation to be successful in terms of reducing a current account deficit.

Note that, overall, as long as the two elasticities add up to more than one the devaluation will reduce the deficit, even if the two individual conditions above are not satisfied. For example, if Eex = 0.6 and Eim = 0.6, import revenue will rise following a devaluation, but this will be more than compensated for by a larger rise in export revenue. The elasticities add up to 1.2, which is more than one, so overall the situation improves. Obviously, the higher both elasticities are, the more successful devaluation will be in terms of reducing the current account deficit.

As the title suggests, this is a curve that is shaped like a 'J'. Look at the diagram below:

The J-curve

Let us assume that the economy is at point A, experiencing a current account deficit. The government decides to devalue the pound to help eliminate this deficit. The J-curve shows that, in the short term, the deficit may get bigger before, eventually, it starts to reduce. In other words, the Marshall Lerner condition is not satisfied in the short run, even though it will be in the medium to long term.

Why might this be the case? The main reason is time lags. It takes time for producers and consumers to adjust their purchases to the changed prices brought about by the devalued exchange rate. Certainly, firms will have orders planned in advance, and will not react to the price changes for a number of months.

Exports revenues may not rise immediately, but they will not fall either, but foreign import revenues may well rise, as increased import prices are combined with static, or at least very inelastic, demand. The current account deficit will probably get worse. After a period of time, foreigners will react to the lower export prices and UK firms and consumers will react to the higher import prices. The Marshall Lerner condition should be satisfied as demand for both exports and imports become more elastic and the deficit should start to fall.

Remember that higher import prices will feed through to higher inflation eventually. This will reduce the competitiveness of British industry causing long-term problems for the current account. This is why many politicians see devaluation as failure. Once the economy is past the trough of the J-curve and the deficit is falling, the devaluation may seem like a good idea. But the subsequent rise in inflation (the government's number one macroeconomic objective nowadays) and its implications for competitiveness mean that devaluation is never a good long-term solution. British exporters complain of the high pound, but devaluation will not necessarily do them any favours.

It should be noted that in today's world of free flowing capital, it is very hard (some would say impossible) for a government to actually implement a policy of devaluation. The markets decide the country's exchange rate. When the UK was part of the Bretton Woods fixed exchange rate system, occasional 'realignments' would occur (i.e. devaluations). Now that the pound floats on the foreign exchange markets, the currency might appreciate (rise gently in value) or depreciate (fall gently in value) but big, one off drops in the value of the currency do not really happen. The last big devaluation was when the pound fell out of the ERM and the pound fell by around 15% in one day.

The 'upside down' J-curve

The analysis above can work for countries with persistent current account surpluses that they want to eliminate. Look at the diagram below:

The 'upside down' J-curve

Assume that the economy is at point B, experiencing a current account surplus. Rather than devaluation, the government will want to revalue their currency to make exports relatively more expensive (reducing their demand) and imports relatively cheaper (increasing their demand). Again, there will be time lags. Consumers and producers will not react to these changes immediately. The demand for both exports and imports will be relatively inelastic in the short run. Export revenues will not change (a fixed UK price, remember) but the revenue paid for foreign imports will fall. This will make the current account surplus get even bigger in the short run.

In the medium term, firms and consumers will adjust their purchases in line with the changed prices. The demand for both exports and imports will become more elastic and the surplus will eventually start to fall. The result is an upside down J-curve!