Discuss to what extent the depreciation of a currency is likely to be effective in reducing the

balance of trade deficit.

The depreciation is when the value of a currency falls relative to another country’s currency,
in the floating exchange rate. Basically, it means there is a reduction in the value of exchange rate. It
is in contrast with devaluation which only occur in a fixed exchange rate system. Depreciation is
often done to reduce the balance of trade deficit because the effect of depreciation is to make
exports cheaper and imports more expensive. It will help to make exports more internationally
competitive.

The balance of trade deficit occurs when the value of outflows is greater than the value of
inflows, with the result that the net effect is negative. The depreciation of a currency will only be
effective if both the price elasticity of demand for exports and the price elasticity of demand for
imports are elastic. This is because when demand is elastic, a small percentage change in price will
lead to a greater change in quantity demanded. Hence, there will be a greater effect on reducing the
balance of trade deficit. If a good is elastic, it means that consumers can look for another close
substitute to purchase if the price increase. Hence, when there is a reduction in the price of
domestic goods, it is likely for consumers to switch from consuming imported goods to consuming
local products. This is because the lower price of exports will be likely to increase the demand for
them and the higher price of imports is likely to decrease demand for them, thus reducing the trade
deficit.

According to the Marshall learner condition, a reduction in a currency only improves the
balance of trade if the absolute sum of long run export and import demand elasticities is greater
than one. It will have a significant improvement in the balance of trade deficit. If the absolute sum of
long run export and import demand elasticities is equal to one, it will leave the balance of trade
unchanged. When the absolute sum of PED of long run export and import is less than one, it will
worsen the current account deficit because a large percentage change in price will only lead to a
smaller percentage change in quantity demanded so it is hard for government to correct current
account deficit. Hence, depreciation of currency will not be effective when PED is less than one.

However, although the depreciation is likely to be effective over a period, it could lead to a
worsening of the situation immediately after the depreciation. The J-curve can show the effect over
time.
It can be seen in the graph that initially the current account worsens as a result of the reduction in
the external value of the currency, and the situation only improves after a certain period of time has
elapsed.

At the beginning, the depreciation of currency will cause the imports to become more
expensive so the total value of imports will increase which causes current account deficit to worsen.
Eventually, the value of exports will increase when the demand of exports increase. This will lead to
a reduction in balance of trade deficit. When the currency has depreciated, there may be a time lag
in changing the volume of exports and imports. This could be due to trade contracts and the price
inelasticity of demand for imports in short run, whilst consumers search for alternatives. In the long
run, consumers might start purchasing domestic product, for example, which helps to improve the
deficit of current account. From the graph, initially the current account situation worsens because of
the reduction in external value of currency and the situation only improves after a certain period has
elapsed and turn into current account surplus.

In conclusion, the depreciation of a currency is very likely to be effective to reduce a balance

of trade deficit in long term if it fulfils the Marshall-Lerner condition.