Devaluation results in expenditure switching.
Foreigners buy more of our exports and less of their own and other
countries’ production, whilst domestic producers buy fewer imports and more
domestically produced goods.
The extent to which exchange rates affect exports and
imports will depend upon the elasticity of demand for the products and the
nature of the contracts that have been agreed.
After a depreciation of the pound demand for exports
will grow faster if the demand for UK goods overseas is elastic.
a depreciation it may not be possible to switch away from imports as they
maybe part of a long term contract, essential for production or cannot be
made in the UK and have an inelastic demand.
Then we end up spending more when the exchange rate falls in value
causing the balance of payments to worsen in the short run a process known as
the J curve effect.
Assuming that the economy begins at position A with a
substantial current account deficit and there is then a fall in the value of
the exchange rate. Initially the volume of imports will remain steady partly
because contracts for imported goods will have been signed.
However, the depreciation raises the sterling price of
imports causing total spending on imports to rise. Export demand will also be
inelastic in response to the exchange rate change in the short term,
therefore the earnings from exports may be insufficient to compensate for
higher spending on imports. The current account deficit may worsen for some
months. This is shown by the movement from A to B on the diagram.
Providing that the elasticities of demand for imports
and exports are greater than one, in the longer term then the trade balance
will improve over time. This is known as the Marshall-Lerner condition.
In the diagram, as demand for exports picks up and domestic consumers
switch their spending away from imported goods and services, the overall
balance of payments starts to improve. This is shown by the movement A to C
on the diagram.