Question

During the 1997–1998 Asian crisis, the exchange rates of Asian currencies declined substantially against the dollar, which caused the prices of Asian products to decline from the perspective of the United States and many other countries. Consequently, the demand for Asian products increased and sometimes replaced the demand for products of other countries. For example, the weakness of the Thai baht during this period caused an increase in the global demand for fish frome Thailand and a decline in the demand for similar products from the United States (Seattle). Therefore, we can conclude that a strong local currency is expected to reduce the current account balance if the traded goods are price-inelastic (not sensitive to price changes). Do you agree with this statement? Please comment on effects of price sensitivity on the movement of exchange rates in both importing and exporting countries.

Answer 1

How depreciation may affect the current account?

If there is a depreciation in the exchange rate. Then that particular country will experience a fall in the foreign price of its exports. It will appear more competitive and therefore there will be a rise in the quantity of exports.
Assuming demand for exports is relatively elastic then a depreciation will lead to an increase in the value of exports and therefore improve the current account deficit.
Similarly, a depreciation of the exchange rate will also lead to an increase in the cost of buying imports. This will lead to a fall in demand for imports and also help to reduce the current account deficit.
Therefore, in theory, a depreciation in the exchange rate should improve the current account
An appreciation should worsen the current account.

The exchange rate will play an important role for firms who export goods and import raw materials. Essentially:

A depreciation (devaluation) will make exports cheaper and exporting firms will benefit.
However, firms importing raw materials will face higher costs of imports.
An appreciation makes exports more expensive and reduces the competitiveness of exporting firms.
However, at least raw materials (e.g. oil) will be cheaper following an appreciation.

Evaluation of changes in the exchange rate on business
The effect of the exchange rate on business depends on several factors.

1. Elasticity of demand. If there is a depreciation in the value of the Pound, the impact depends on the elasticity of demand. If UK firms are selling goods which are price inelastic, then the fall in their foreign price will only have a relatively small increase in demand. If exports are price sensitive, then there will be a bigger percentage increase in demand. Evidence suggests that British goods are increasingly price inelastic and after a depreciation, there is a relatively small increase in demand.

2. Economic growth in other countries. In 2009/10, there was a significant depreciation in the value of the Pound. However, the global economy (and EU in particular) was in recession, therefore, demand for UK exports remained weak – despite the lower price.

3. Depends on the percentage of raw materials imported. If a UK firm imports raw materials and sells to the domestic market, it may lose out from a depreciation. If a firm imports only a small percentage of raw materials from abroad and sells to Europe, then it will benefit more from a depreciation.

4. It depends why there was an appreciation/depreciation. If there is an appreciation in the Pound because UK labour productivity is increasing, then firms are likely to be able to absorb the stronger Pound. However, if the Pound rises due to speculation or weakness of other countries (e.g. Euro crisis in 2011) then firms may become uncompetitive because the rise in the value of Pound is not related to increased productivity and competitiveness.

5. Inflation: One possible problem of a depreciation is that it could cause inflation. (for more details see whether depreciation causes inflation) If inflation does result, then firms could face costs, such as greater uncertainty.

6. Fixed contracts. Many business use fixed contracts for buying imported raw materials. This means temporary fluctuations in the exchange rate will have little effect. The price of buying imports will be set for up to 12 or 18 months ahead. Exporters may also use future options to hedge against dramatic movements in the exchange rate. These fixed contracts help to reduce the uncertainty around exchange rate movements and mean there can be time lags between changes in the exchange rate and changing costs for business.

Elasticity of demand for imports and exports
A favourable movement in the terms of trade may have an unfavourable effect on the trade balance, while an unfavourable movement in the terms of trade may favourably affect the trade balance. This is because the terms of trade records relative price movements of exports and imports, while the current account of the balance of payments is concerned with export and import values (price x quantity bought / sold).

The impact of a change in the terms of trade on the trade balance will largely depend on the price elasticity of demand for exports and imports.

An improvement (favourable movement) in the terms of trade may worsen the trade balance - this will occur when the demand for exports and imports is price elastic.

An improvement in the terms of trade means that the price of exports increases relative to the price of imports.

A deterioration (unfavourable movement) in the terms of trade may improve the trade balance. This will occur when the demand for exports and imports is price elastic.

A worsening of the terms of trade means that the price of imports increases relative to the price of exports.

The overall impact on the balance of payments of a change in the terms of trade depends on the combined price elasticities of demand for imports and exports. So:

An improvement in the terms of trade will worsen the balance of payments if the demand for exports and imports is price elastic, and improve it if demand for exports and imports is price inelastic.
A deterioration in the terms of trade will worsen the balance of payments if the demand for exports and imports is price inelastic and improve it if demand is price elastic.
Given that the developing countries' demand for exports and imports is relatively price inelastic, they have faced ever worsening balance of payments situations in response to their deteriorating terms of trade.