The effect of changes in exchange rates on a country’s trade balance can be analyzed using the following two approaches.
Goods having high elasticity of demand:
Goods having low elasticity of demand:
United Kingdom exports goods valued at £600 million and imports goods valued at £900 million from the United States. The demand elasticities for exports are 0.70 and imports are 0.60. Calculate the impact of a 10% depreciation of GBP (relative to us) on the overall trade deficit for the United Kingdom.
As GBP depreciates relative to USD by 10%, UK’s exports will now be cheaper to the US citizens. They will in turn increase consumption of the now cheaper UK goods. Demand elasticity of export of 0.70 tells us that for a 10% decrease in GBP rate, exported quantity to the US will increase by 7% (10% * 0.70).
Change in exports = currency change % * initial export value * demand elasticity for export
= 10%*600*0.70 = 600 * 7% = £42 Million
UK’s exports increases by £42 Million.
Note: While considering the impact of price depreciation/appreciation on total exported value, only the source of change is the quantity demanded in foreign country. Income earned by a UK citizen in GBP doesn’t change as the goods are still priced at the same GBP level as before (despite the change in the exchange rate).
As GBP depreciates relative to USD by 10%, imports from US will now be costlier to the UK citizens in GBP terms. They will decrease consumption of the now costlier US goods. Demand elasticity of import of 0.60 tells us that for a 10% decrease in GBP rate (i.e. US goods have become costlier by 10% for UK citizens in GBP terms), imported quantity of US goods to the UK will decrease by 6% (10% * 0.60).
Thus impact on imported value in UK is twofold: a) import prices of US goods increase by 10% in GBP terms b) Quantity demanded of US goods by UK citizens decreases by 6%.
Net impact is the imported value is that it increases by: = 10% – 6% = 4%.
Change in imports = currency change % * initial export value * (demand elasticity for import -1)
= 10%*900*0.40 = 900 * 4% = £36 Million
UK’s imports increases by £36 Million.
Note: While considering the impact of price depreciation/appreciation on total imported value, both the change in the import quantity demanded and change in the price level are sources of change. In our example, US goods became costlier by 10% and the quantity demanded declined by 6%. As the price level increase was larger than drop in quantity demanded, total imported value increased by 4%.
|From UK’s perspective:|
|Initial value (£)||Change (£)||Final value (£)|
Marshall-Lerner condition = ωX εX + ωM (εM − 1) = (600/1,500) * 0.7 + (900/1,500) * (0.6 – 1) = 0.04
Since, 0.04 > 0, a depreciation of the domestic currency will to increase in the trade balance towards surplus.
This value implies that, a 1% depreciation in domestic currency will increase trade balance by 0.04% of the total trade.
Thus in our example, for a 10% depreciation in GBP will increase trade balance by 0.4% of the total trade = 0.4% * 1,500,000,000 = £6,000,000.
|ωX εX + ωM (εM − 1) > 0
|ωX εX + ωM (εM − 1) < 0
Marshall-Lerner doesn’t hold.
|Domestic currency appreciates||Trade balance moves towards deficit. (X-M) decreases.||Trade balance moves towards surplus. (X–M) increases.|
|Domestic currency depreciates||Trade balance moves towards surplus. (X–M) increases.||Trade balance moves towards deficit. (X–M) decreases.|
Exports – imports = (private savings – physical capital investment) + (tax revenue – government spending)
X – M = (S – I) + (T – G)
X – M = S + T – (I + G)
This can be expressed as:
Balance of trade = national income – total expenditure
Total expenditure represents the absorption of goods and services in an economy.