• Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

What conditions are necessary for a devaluation to improve the BOP? Can a small open economy successfully devalue?

Extracts from this document...

Introduction

Nicola James Mary Gregory Week 2: Devaluation What conditions are necessary for a devaluation to improve the BOP? Can a small open economy successfully devalue? Devaluation happens when official action is taken to raise the domestic currency price of foreign currency under a fixed exchange rate environment. Under fixed exchange rates, central banks buy and sell foreign currency to peg the exchange rate. They do this by running down or adding to their reserves of foreign currency. This essay will explore the running of a devaluation and conclude that the Marshall-Lerner condition needs to be satisfied in order for a devaluation to improve the BOP. From the end of WW1 until 1973 many of the major countries in the world had fixed exchange rates. For example in the 1960s, the French central bank, the Banque de France was set at 4.90 FF (French Francs) per U.S. dollar and the German central bank, the Bundesbank was set at 4 DM (Deutche Marks) per U.S dollar. These currencies among most other major currencies were made flexible in 1973. However there are still some smaller countries with fixed exchange rates. The Balance of Payments (BOP) is the record of the transactions of the residents of a country with the rest of the world. ...read more.

Middle

If they were exactly equal to 1, then the BOP would be unchanged by a devaluation. If they were less than 1, then the BOP would have adverse affects. Nevertheless this condition is likely to be only satisfied in the median term. In the short-term the 'J-curve' affect may be observed. A diagram (Diagram 1) of the J-curve is shown below. It shows the impact of devaluation over time. It gets its name from the shape of the curve. Assume initially that the current account is in deficit, and as a result at time X the government decides that a devaluation should be implemented to correct this deficit. The immediate time period after a devaluation shows the current account deficit worsening, before the devaluation takes affect and the 'J' is fully painted. The J-curve effect was observed following Britain's exit from the Exchange Rate Mechanism (ERM) in 1992, where the current-account worsened initially before improving after approximately 18 months. The reasons for this short-term worsening will now be explored. Following the devaluation exporters may seek to expand production, in order to meet the increase in export demand. However since supply is relatively inelastic in the short-term, output may not expand greatly at first. ...read more.

Conclusion

- government tends to reassure the public that devaluations won't occur - preventing devaluation. However when a devaluation becomes necessary the government official's look foolish - and therefore another reason why they delay too long. Overall government's should bear all this analysis in mind, they should assess the elasticities of import and export demand to test the likelihood that the Marshall Lerner condition will hold. They should combine both expenditure reducing policies with the expenditure switching devaluation, in order to achieve both an external and internal balance. They should also avoid inflation. Open economies are economies that trade with others. Being open involves having trade and finance linkages with other economies. The countries in the world that currently have fixed exchange rates are all relatively small. It is natural to think that small economies actions won't affect the economy much, and therefore a devaluation will be unsuccessful. However many small economies specialise in a certain good or service, and therefore their actions will effect the world's prices and outputs in that commodity, which will then impact on the prices of the rest of the goods in that economy. In conclusion small open economies are able to successfully devalue their currency. This is not to say that all small open economies will be successful upon implementation. The above analysis of the Marshall Lerner Condition and the Internal-External Balance still applies. ...read more.

The above preview is unformatted text

This student written piece of work is one of many that can be found in our AS and A Level Macroeconomics section.

Found what you're looking for?

  • Start learning 29% faster today
  • 150,000+ documents available
  • Just £6.99 a month

Not the one? Search for your essay title...
  • Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

See related essaysSee related essays

Related AS and A Level Macroeconomics essays

  1. Peer reviewed

    Explain the possible impact of a world-wide recession on the components of the circular ...

    4 star(s)

    Therefore, the impact of a world-wide recession would adversely affect these components in Singapore. In a world-wide economic recession Singapore's export revenue would drop significantly. This is due to the fall in the aggregate demand for our domestically produced goods due to a lower income earned compared to previously.

  2. Peer reviewed

    Examine the factors which affect the international competitiveness of the UK's goods and services ...

    4 star(s)

    expensive for UK to buy goods from European countries as UK does not hold the same currency as them, which is a disadvantage to the UK. A fall in the exchange rate makes imported goods and services more expensive in the UK.

  1. How have the Rates of Inflation in the UK Changed Since the Monetary Policy ...

    It is this type of spending which causes the inflation and then the inability to control it which leads to continuing. This does not show any real differences to way the two have interacted since the MPC took over but as there have never been any real tests to the

  2. Budget 2004-05 and Economic Analysis of Pakistan

    The net proceeds of divisible pool are arrived at by deducting 5% collection charges (6% for income tax) by the federal government. The federal share in the net proceeds of divisible pool is 62.5%, with the remainder 37.5% going to the four provinces, under Distribution of Revenue and Grants-in-Aid Order, 1997.

  1. Governments set economic objectives - Discuss the relative importance of each of these objectives ...

    Although successive reforms of the tax and benefits system in the 1980s and 1990s led to some improvement in this situation, effective marginal rates of tax and withdrawals in benefits remained high at low incomes. Trade unions have also been blamed for creating real wage unemployment during the 1960s and 1970s.

  2. This report will highlight how Government policy could change to try to: Increase economic ...

    An appreciation of the exchange rate, a stronger pound reduces import prices. This makes firms' raw materials and components cheaper; therefore helping them control costs. This will also auger well for the economy as the Marginal Propensity to Import is 0.5, for every additional dollar increase in the National

  1. Australia's place in the global economy - "Explain the reasons for our current exchange ...

    This caused the demand for the Australian dollar to decrease and the U.S dollar to increase. "Rates rose around the world in 1999 and 2000". (Source: BRW: Growth party may be ending - Chris Richardson 12/1/01) mainly the US, then the rest of the world followed.

  2. Why does smoking lead to an external cost?

    Perhaps they could use the revenue that is collected from the tax on tobacco in the form of rehabilitation for patients to stop them from smoking or on other products that could encourage people to stop smoking such as nicotine i.e.

  • Over 160,000 pieces
    of student written work
  • Annotated by
    experienced teachers
  • Ideas and feedback to
    improve your own work