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Does depreciation ‘work’? Discuss with reference to the UK. (longer answer)
To discuss the impact of nominal exchange rate changes it is crucial to discuss two main questions as stated by Dornbusch (1996). First, are trade flows responsive to relative prices, and second, can nominal exchange rate changes change relative prices?
- real exchange rate changes (or relative price changes) and effects on trade flows
To evaluate whether real exchange rate changes influence trade flows, it is necessary to take a look at the initial Marshall-Lerner condition of whether the demand elasticities of imports and exports exceed unity, and then to compare trends in the real exchange rate with the current account.
There is strong empirical evidence for the Marshall-Lerner condition to hold. In his article Dornbusch states that “the elasticity of trade flows with respect to relative prices is far into the region where devaluation works! This is the case for the major industrialised countries, and it is presumably the case for all countries. (..) these estimates easily satisfy the famous Marshall-Lerner condition ..” Although he gives no data for the UK, it is possible to assume that Germany has probably higher, i.e. in absolute terms lower demand elasticities of imports and exports than the UK, as shown by Winters for the period 1954-70, and infer that the demand elasticities of import and exports for the UK are therefore below –1.56. Winters gives data for the UK in the period 1954-70 showing that the price elasticities of import and export together were –1.39, and therefore clearly fulfilling the Marshall-Lerner condition.
It is however important to stress some qualifications. Boltho (1996) mentions firstly the conditions of imperfect competition in either the import or the export markets, which could lead to the exchange rate changes having no effects on prices or quantity responses. Second, hysteresis effects could occur with the result that future depreciations become ineffective, if foreign firms install fixed inputs in times of an overvalued domestic currency. Also, if consumers have become used to certain imports, they often do not switch their demands back during depreciations. And third, in times of uncertain expectations of the future real exchange rate, possibly because of unstable inflation, firms may not commit themselves to the production of further goods, and instead just receive the higher sales.
- nominal exchange rate changes and real exchange rate changes (or relative price changes)
A depreciation can of course only be successful in lowering a trade deficit if the initial change in nominal exchange rate is passed over to a change in the real exchange rate, i.e. in relative prices which takes into account relative costs and is therefore mostly measured in relative unit labour costs, since material prices are assumed to be equal.
A useful model to analyse different outcomes with different assumptions about money wages is the one used by Dornbusch (1996). It analyses the effects of changes in the nominal exchange rate on the internal balance, i.e. the labour market, and on the external balance, i.e. trade deficit. Notice that W/e is the dollar wage, i.e. the real wage and H/e is the money stock in dollars, i.e. real balances. e is the exchange rate as measured in units of foreign currency per dollar.
The L-curve shows all combinations of real wages and real balances in which the labour market clears. A rise in the real wage hurts employment because it worsens international competitiveness. To maintain full employment more money has to be spend, hence real balances must increase. The L-curve is therefore upward sloping.
The T=0-curve shows all combinations in which trade is balanced, i.e. the trade deficit is zero. As above, a rise in real wages hurts competitiveness and leads to a trade deficit. An offsetting cut in real balances and spending is therefore necessary to balance trade. Thus, the T=0-curve slopes downward.
At point A neither internal nor external balance is in equilibrium. There is a trade deficit because at W/e1 there is too much real balance (H/e1 > H/eT) and domestic spending therefore exceeds output. And there is unemployment because at W/e1 there is not enough real balances (H/e1 < H/eL) to offset the high real wage, i.e. to generate additional spending.
Point A could represent the UK in the early 70s and 90s. The UK is running a trade deficit with high unemployment caused by a lack of demand and nominal wages, W are sticky. In that case, “devaluation is genuinely helpful: if money wages are sticky downwards but there is no real wage rigidity then devaluation can help. A devaluation cuts the wage in dollars, fosters competitiveness, and in that manner helps create employment and an improved external balance. It is the missing tool in a situation where internal balance calls for expansion, but the external constraint (and possibly the budget) stands in the way of tax cuts or other fiscal measures.” If devaluation is successful, the economy moves to the equilibrium point, B. The idea behind is that the depreciation, i.e. the increase in units of Pound per dollar, lowers the real wage and the real balances. Unemployment is being reduced because at W/eE money balances of H/eE are just sufficient to keep spending in line with output and employment. And trade is now balanced because at W/eE money balances of H/eE are sufficient to just balance spending with income.
Data for the real exchange rate of the Pound against the currencies of the main trading partners, notably USA, Germany, France, Italy and Japan have been calculated by Pratten (1990) for the period 1970-88 and can be compared with his data of the UK current account over the same period. Until the end of the 70s, the nominal exchange rate of the Pound was depreciating, but the real exchange rate depreciated only until ca. 1975, afterwards it was slightly appreciating, i.e. Britain was first gaining in competitiveness and then losing. The current account shows the same story: in 1971 Britain had a current account surplus of 1.9 per cent of GDP, in 1974 it had a deficit of 3.8 per cent. Why was that?
In the early 70s, depreciations caught many by surprise. Although inflation was slowly increasing, the oil shocks were still to come. Therefore, real wages could decline as shown in the model, unemployment went down in 1972-3, and trade balanced. Later on in the decade, however, inflation was high, people were expecting the Pound to depreciate and so, they arranged their nominal wage settlements with regard to a lower Pound in the next period. In the model, the nominal wage, W, now does not anymore stay constant, but changes. This led to ineffectiveness of exchange rate policy with the result that although the nominal exchange rate was falling, the real exchange rate was increasing, and Britain lost competitiveness, resulting in heavy current account deficits.
Conclusion: Britain today
With high unemployment, supply is elastic enough and with strong market forces acting via the impact of international competition prices will remain low. Low inflation and hardly anyone expecting a devaluation of the Pound would give the essential conditions for a successful devaluation. Britain should repeat the exercise of 1992 which reduced the real exchange rate even further than the nominal exchange rate and where the effect was lasting over the following four years. As Dornbusch puts it: “In sum, exchange rates are useful, they should be used, early and wisely.”
Like Japan and Belgium, Germany has an in absolute terms very low price elasticity of exports. That is probably because Germany is seen as an established exporting country and has possibly distribution facilities, networks, etc. installed abroad, or probably consumers prefer goods ‘made in Germany’. All of it would indicate strong hysteresis effects.
Dornbusch, Oxford Review of Economic Policy, 1996, p.29