Question

Which of the following statements is correct? Devaluation is most effective when: (a) a country has a small export and import sector, since higher import prices then have little effect; (b) domestic wages and prices are very flexible; (c) nominal wages and prices adjust slowly; (d) the country is already at potential output.

Short answer

The correct statement is (c): nominal wages and prices adjust slowly.

Step-by-step solution

Understand the Problem

Devaluation refers to the reduction in the value of a country's currency relative to other currencies. It is typically used to make a country's exports cheaper and imports more expensive, thereby improving its trade balance. The question asks which condition makes devaluation most effective.

Analyze Each Option

Consider each option: (a) A country with a small export and import sector might see little impact from devaluation since it doesn't rely heavily on international trade. (b) If domestic wages and prices are very flexible, devaluation effects could be quickly absorbed, leading to less impact. (c) Slow adjustment of nominal wages and prices might mean that the effects of devaluation, like increased competitiveness abroad, last longer. (d) If the country is at potential output, it has little capacity to increase production further, so devaluation might not lead to higher output.

Evaluate Ideal Conditions for Devaluation

Devaluation aims to make exports cheaper and imports more expensive, thus increasing demand for domestically produced goods. This process is most effective when there are no immediate offsetting price or wage increases, so the lower currency value translates directly into price competitiveness.

Conclude Based on Analysis

Given that devaluation works best with sustained competitive pricing, option (c) - where nominal wages and prices adjust slowly - ensures prolonged competitiveness of exports and disincentive for imports.

Key concepts

Trade Balance

Trade balance refers to the difference between the value of a country's exports and imports. A positive trade balance, or a surplus, occurs when a country exports more than it imports. Conversely, a trade deficit happens when imports exceed exports.
Devaluation can affect trade balance significantly by making exports cheaper and imports more expensive.
This happens because a lower currency value reduces the price of goods sold abroad, making them more appealing to foreign buyers.
Consequently, this boosts export volumes.
At the same time, imports become pricier, discouraging domestic consumers from buying foreign goods.
This situation can help improve the trade balance, as it encourages national production and consumption of local goods.

Exchange Rate

The exchange rate is the value of one currency in relation to another. It dictates how much of one currency is needed to buy a unit of another currency.
Fluctuating exchange rates can significantly impact the economy, especially international trade.
When a country devalues its currency, it lowers the exchange rate.
This deliberate change means more local currency is needed to purchase foreign goods, while foreign buyers get more value when purchasing local goods.
The intent behind devaluation often involves boosting exports, as local products become cheaper for foreigners.

• This can aid industries focused on global markets.
• It can also lead to a rise in demand from foreign buyers, stimulating local economic activity.

However, it can also mean imported goods become more expensive, which might lead to inflation.

Currency Value

Currency value is the worth of one currency against others and is a crucial part of international economic transactions.
A country's currency can depreciate or devalue based on various factors, including government policies or market forces.
When a currency is devalued, it intentionally decreases in value compared to other currencies.
This situation is designed to stimulate economic growth by making exports cheaper and imports more costly.

• A decrease in currency value can make a country's products more competitive abroad.
• However, it also affects the purchasing power for consumers who rely on imported goods or services.

It is essential to maintain a balance, as excessive devaluation might lead to decreased consumer purchasing power within the country.

Wage Flexibility

Wage flexibility refers to how easily wages adjust in response to economic conditions.
This flexibility is vital when considering the effects of devaluation on the economy.
If wages are highly flexible, they can quickly respond to changes, absorbing impacts like increased import costs.
In a situation where wages adjust slowly (less flexibility), the benefits of devaluation, like improved competitiveness of exports, tend to last longer.

• Slow wage adjustment means prolonged low cost of production, fostering increased demand for exports.
• Such slow adjustment can prevent rapid inflation that normally offset devaluation gains.

Therefore, understanding wage flexibility is key to determining how effective a devaluation strategy will be in improving a country's trade balance.