Devaluation and Balance of Payment Improvement
Devaluation is the deliberate downward adjustment of a country's currency value relative to other currencies. Its impact on the balance of payments (BOP) deficit depends on the price elasticities of demand for its exports and imports.
Marshall-Lerner Condition
The widely accepted condition for devaluation to successfully reduce a BOP deficit is the Marshall-Lerner condition. This condition states that the sum of the price elasticities of demand for a country's exports and imports must be greater than one.
Let:
- $E_x$ = Price elasticity of demand for exports
- $E_m$ = Price elasticity of demand for imports
According to the Marshall-Lerner condition, for a devaluation to improve the balance of payments (i.e., reduce the deficit or increase the surplus), the following must hold:
$ E_x + E_m > 1 $
Explanation
- If $E_x + E_m > 1$, a depreciation leads to a proportionally larger increase in the volume of exports demanded than the volume of imports demanded (when measured in foreign currency). This results in an improvement in the trade balance and thus the BOP.
- If $E_x + E_m < 1$, the depreciation will worsen the BOP deficit.
- If $E_x + E_m = 1$, the BOP deficit remains unchanged.
- If $E_x + E_m < 0$ (negative), it implies that demand for exports and imports is positively sloped, which is highly unusual. In this scenario, devaluation would likely worsen the deficit significantly.
Therefore, for devaluation to improve the balance of payment deficit, the sum of the elasticity of exports and imports must be greater than unity.
Important Questions from Balance of payments (BOP)
- If there is a balance of payments deficit then in a floating exchange rate system :
Match the following :
List – I List – II a. Sum of price elasticity of demand for exports and imports greater than unity. 1. J-curve effect b. Balance of Payments is the difference between National Income and expenditure 2. Import quota systems c. Empirical evidence showing lower short run price elasticities of exports and imports. 3. Marshall-Lerner condition d. Method to cut down imports 4. Absorption approach
Select correct code :
Codes :
- Which amongst the following is included in the Capital account of the Balance of payments ?
I. Foreign loans
II. Foreign Direct Investment
III. Private Remittances
Choose the correct answer from the codes below :
Codes : - A deficit or surplus in the India’s balance of payments is measured by the net balance of
Match the items of List I with the items of List II and choose the correct answer from the code given below.
List I
List II
(a)
Balance of trade
(i)
Imports and exports of goods and services
and unilateral transfer of goods and services(b)
Current account
(ii)
Transactions leading to changes in the
financial assets and liabilities of a country(c)
Balance of payments
(iii)
All economic transactions between a country's
residents and residents of other countries(d)
Capital account
(iv)
Value of exports and imports of country
