Question

Suppose that a country has a flexible exchange rate. Also suppose that at the current exchange rate, the country is experiencing a balance-of-payments deficit. Then would it be true or false that a sufficiently large depreciation of the local currency could eliminate the balance-of-payments deficit. \(L O 39.3\)

Short answer

True, a sufficiently large depreciation of the local currency could eliminate the balance-of-payments deficit.

Step-by-step solution

Understand the Balance-of-Payments Deficit

A balance-of-payments deficit occurs when a country's total international payments exceed its total international receipts. This may be due to various factors, such as a higher import value compared to export value, capital outflows, or other financial account deficits.

Role of Exchange Rate Depreciation

Depreciation in the local currency means that the currency's value decreases relative to other currencies. This makes exports cheaper and imports more expensive. As a result, exports can increase and imports can decrease, potentially reducing or eliminating a balance-of-payments deficit if the change is large enough.

Analyze the Impact

As the local currency depreciates, the demand for cheaper exports may rise, improving the trade balance (part of the current account) by increasing receipts. Simultaneously, more expensive imports may reduce the outflow of payments. This shift can help eliminate or reduce the deficit.

Consider Other Factors

While depreciation can help address a balance-of-payments deficit, other factors like foreign investor confidence, inflation, and necessary economic adjustments should be considered. The success of eliminating the deficit through depreciation depends on the response of these factors as well.

Conclusion

A sufficiently large depreciation of the local currency is likely to eliminate the balance-of-payments deficit, assuming other factors remain conducive to this shift. However, economic conditions and responses from trading partners play significant roles.

Key concepts

Exchange Rate Depreciation

Exchange rate depreciation is when a country's currency loses its value compared to another currency. Imagine you have a dollar, and today it's worth fewer euros or yen than yesterday. This change affects international trade significantly.

• Cheaper Exports: When the local currency depreciates, products made in that country cost less for people in other countries. This makes local goods more attractive to foreign buyers, boosting demand for exports.
• Costlier Imports: With a weaker local currency, goods from foreign countries become more expensive. This can prompt consumers and businesses to buy fewer imported products.

Depreciation can have a ripple effect, influencing both the trade balance and broader economic indicators.

Trade Balance

The trade balance is the difference between a country's exports and imports of goods and services. It's a key part of the balance of payments, directly impacted by exchange rate changes.

• Trade Surplus: This occurs when exports exceed imports. A strong currency can lead to reduced demand for exports, but when depreciation occurs, exports become cheaper and more competitive globally.
• Trade Deficit: This happens when imports outweigh exports. Depreciation can help by making imports expensive and less attractive, encouraging local consumption.

A positive trade balance can contribute to resolving a balance-of-payments deficit, as it indicates more money flowing into the economy from international buyers.

Current Account

The current account is a comprehensive measure that includes the trade balance, net income from abroad, and net current transfers. It's a broader scope within the balance of payments.

• Trade Component: Trade balance is a primary component of the current account. Improvements in trade balance, thanks to export boosts and reduced imports, can positively impact the current account.
• Other Influences: Besides trade, the current account also considers factor incomes like dividends and interest from investments abroad. Currency depreciation can influence these factors too, as it might affect returns on foreign investments.

A healthy current account is essential for economic stability and can help mitigate a balance-of-payments deficit.

International Payments

International payments refer to transactions where money crosses borders for trade, investment, and other economic activities. These payments shape the balance of payments.

• Inflows and Outflows: Payments into a country arise from exports and foreign investments, while outflows occur due to imports and capital invested abroad. Balancing these is vital for economic health.
• Effect of Depreciation: Exchange rate depreciation can sway international payments by boosting exports (increasing inflows) and lowering imports (reducing outflows), helping counteract a deficit.

Monitoring international payments helps a country manage its external economic relationships effectively, ensuring sustainable growth.