Economics – Policies to correct disequilibrium in the balance of payments | e-Consult

Diagram:**

A standard supply and demand diagram for the exchange rate is used. The X-axis represents the quantity of domestic currency and the Y-axis represents the exchange rate (domestic currency per unit of foreign currency). The curve shows the supply and demand for the currency. A depreciation of the exchange rate shifts the supply curve to the right. This leads to a lower exchange rate (domestic currency becomes cheaper) and an increase in the quantity of domestic currency traded.

Impact on the Current Account:

1. Exports become cheaper: A lower exchange rate makes exports cheaper for foreign buyers, increasing export demand.
2. Imports become more expensive: A lower exchange rate makes imports more expensive for domestic consumers and businesses, decreasing import demand.
3. Current Account Improvement: The increased export demand and decreased import demand lead to an improvement in the current account balance (current account surplus). The magnitude of the improvement depends on the price elasticities of demand for exports and imports.

Limitations of Depreciation as an Expenditure-Switching Policy:

• Marshall-Lerner Condition: The policy only works if the combined price elasticities of demand for exports and imports are greater than one. If either elasticity is less than or equal to one, the depreciation may not improve the current account.
• Time Lags: It takes time for the effects of a depreciation to be fully felt. Consumers and businesses may not immediately adjust their spending patterns.
• Impact on Inflation: A depreciation can lead to imported inflation, which can reduce competitiveness.
• Potential for Retaliation: Other countries may devalue their own currencies in response, negating the benefits of the depreciation.
• Capital Flight: A depreciation can discourage foreign investment and lead to capital flight, which can worsen the economic situation.