Does depreciation or devaluation (by the way, they mean different things) always work to correct a BOP or Current Account Deficit??
Well, assuming Marshall Lerner condition applies, it works – but only in the long term.
Why does this happen?
Let’s take the example of Singapore, which buys raw materials from China, and sells the finished products to USA.
China and Singapore
Let’s say before depreciation of Sing dollar, the exchange rate was 5RMB to 1SGD; after the depreciation, it was 4RMB to 1SGD.
This means that previously, 1SGD can buy 5RMB worth of goods, but now? Only 4RMB. There is a decrease in the external value of Sing dollar.
Still, due to contractual obligations, Singapore firms must continue buying from China until the contract expires. Furthermore, the Chinese will still want to be paid at 5RMB – the previously agreed upon terms. (It’s a bit like giving tuition to foreign students – no matter what the exchange rate in their country is, high or low, the tutor still gets the same fixed, agreed upon fees.)
But previously, Singapore firms were forking out only 1SGD for 5RMB, now they have to fork out 5/4*1 = 1.25 SGD instead – to buy the SAME AMOUNT OF RAW MATERIALS from China.
Imagine Singapore firms paying Chinese partners SGD 1m in the past – that means a whopping 1.25m now! Another $250,000 more! Due to depreciation!
THIS APPLIES TO THE IMPORT SECTOR OF S'PORE! THUS THE DEMAND FOR IMPORTS IS PRICE INELASTIC IN THE SHORT RUN
Singapore and USA
Let’s say before depreciation, the exchange rate was 1SGD to 0.75 USD; after the depreciation, it was 1SGD to 0.5 USD.
The Americans need to pay so much less in order to pay us the same 1SGD (remember, they always pay us in SGD – and to do so, they convert their currency into our currency).
Buying goods from Singapore is so much cheaper now for Americans. Obviously, they are going to demand more since lower prices mean A LOT MORE quantity demanded (it’s technically called more than proportionate – remember, I assumed ML condition holds).
But the problem is, it takes time for the new contracts to be drafted, and it also takes time for the Singapore firms to pool resources e.g. hire more people to meet the new orders (in short run, supply is inelastic).
THIS APPLIES TO THE EXPORT SECTOR OF S'PORE! THUS THE SUPPLY OF EXPORTS IS PRICE INELASTIC IN THE SHORT RUN
So that means, in the short term:
1) We are converting more Singapore dollars to pay China, honouring our contractual obligations.
2) We are still selling the same amount of goods to USA, hence getting the same number of Sing dollars (not more).
Obviously there will be a worsening in the current acc deficit in the short run.
In the long run, however, Singapore firms will be negotiating to decrease raw materials costs (or changing the Chinese suppliers to find cheaper alternatives), and increasing the output to meet new demand from USA.
Thus, assuming Marshal Lerner condition holds, depreciation will improve current account deficit, but only in the long run.
Special thanks to aceitall.wordpress.com
Labels: my life as a student
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