Theory question 105
Balance of Payments and Exchange RatesSection B
What is devaluation? Under what conditions will devaluation improve a country's balance of payment position?
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Devaluation: an official reduction by government of the value of its currency in terms of other currencies (e.g. from N1 = $1 to N2 = $1). Exports become cheaper to foreigners and imports dearer at home.
Conditions for success:
1. Demand for the country's exports must be elastic, so export earnings rise.
2. Demand for imports must be elastic, so spending on imports falls.
3. The sum of the two elasticities should exceed one (Marshall-Lerner condition).
4. Supply of exports must be elastic so that extra demand can be met.
5. Trading partners must not retaliate by devaluing too.
6. Domestic inflation must be controlled so that the price advantage is not lost.
7. Local substitutes for imports should be available.
The elasticity conditions are the key points.