Theoriesof

devaluation

INTERNATIONAL TRADETopic-6

The elasticity approach,Marshall Lerner condition,J.curve

,absorption approach and exp switching policy.

.DEVALUEATION THEORIES

5.Expenditure

switching policy

4.The

absorption

approach

1.The

elasticity

approach

2.Marshall

Lerner

condition

3.J.curve

effect

1.The elasticity approach

This approach also known as- Lerner and

Marshall approach.

Acc. To them – devaluation can be improve BOP deficit

by price elasticity of demand and supply of imports and

export of devaluating country.

1..If demand for export of devaluing country is less than

unity, then

Devaluation will not reduce Bop Deficit.

On the side of export

2..elasticity of export more than unity

Devaluation bring reduction in BoP deficit.

Raise the volume of export.

On the side of import

1. Elasticity for import is more than one. (EM>1).

Devaluation will lead to improve in BoP.

Due to devaluation import prices may increase and it will

lead to decrease in import.(BOP improved)

Import payment reduce than before.

2..if elasticity for import is less elastic(EM<1)

Devaluation will lead to Worsened in BoP.

After devaluation net increase in payment.

2.Marshall- Lerner conditions

According to Marshall and Lerner devaluation can

improve both – BOP and BOT.

M-L condition based on three aspects.

1. If sum of the elasticity of demand for export and

import is greater than unity devaluation will improve the

BOP.

ED>1- BOP improve.

2. If sum of the elasticity of demand for export and

import is less than unity devaluation will woresening the

BOP.

ED<1- BOP worsening.

3. If sum of the elasticity of demand for export and

import is equal to unity devaluation will unchanged in

BOP.

ED=1- BOP unchanged.

According to Marshall and Lerner EX and EM are

perfectly elastic(horizontal)

In M-L theory conditions are analysis in term of the

currency of devaluation country or in terms of foreign

currency but not in terms of both.

The net change in Bop due to change in rate of exchange

has been expressed by - Metzler

3. The J-Curve effect

The J-Curve shows devaluation worsening the BoP in

short run and improve BOP in long run due to

devaluation.

J-Curve introduced by- S.P.Magee

0

su

rplu

sd

efi

cit

T

Time

In the short run devaluation make import costly ,

So,, large payment for import.- therefore BoP worsening.

4.The absorption approach.

This approach given by- Sydeney Alexander

Acc. To him devaluation can effect domestic consumption

,investment and govt spending.

State of eqm= C+I+G(X-M)

The aggregate domestic spending is (C+I+G)

It is called absorption(expenditure).

Sum of a and b is called marginal propensity to

absorption.

e= a+b

Larger the value of e, lower the success of devaluation .

There are three possibilities.

If e<1 – improve the trade balance.

If e=1 – neither improve nor worsening trade balance.

If e>1 –worsening the trade balance.

Acc.to Alexander- to reduce absorption govt should

adopt – expenditure reducing policy.

5,Expenditure switching policy

Given by H.G .Johnson

It means switching expenditure from foreign produced

goods to home produced goods.

Due to it – marginal propensity to spend will be less than

unity . It will bring improve in BOP.

Acc.to him – devaluation swithes both expenditure ie

foreign and domestic toward domestic production..

Devaluation and its effect taken in partial eqm analysis.

It doesn’t adopt cut in expenditure..

This policy also implies export promotion..

This theory assume that export will be unaffected.

Some imp. Points.

Acc. To Keynes adjustment in BOP is possible through-

income

Acc. To classical adjustment in BOP is possible through-

deflation and exchange depreciation.

Acc. To modern economist. adjustment in BOP is

possible through- income, output, and expenditure.

Foreign .. exchange..

INTERNATIONAL TRADETopic-7

Spot rate, forward exchange rate, currency swap,

speculation, hedging and some imp points