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. The BOP is split into two accounts. The current account describes the transactions in goods, services and transfers. The capital account covers transactions in assets. One of the main macroeconomic objectives of most economies is to run a small current account surplus. This essay will now explain why.
It is considered to be a bad sign to have a current account deficit. For example a current account deficit may be the result of a low saving rate, which results in a high current consumption leading to lower future consumption, implying that future generations bear the burden of low national saving. Other possible causes of a current account deficit include a declining comparative advantage, high propensity to buy imported goods, high dividend payments as a result of foreign investment in the domestic country, lack of productive capacity of domestic firms, falling surplus in an important resource or a high propensity to buy imported goods and services. Clearly these causes are all undesirable, and thus an economy should aim for a current account surplus. However the following analysis will explain why a large persistent current account surplus is undesirable.
One disadvantage of a current account surplus is that one country’s surplus is another’s deficit. The BOP for the world must balance; so all the countries cannot run surpluses simultaneously. If countries with persistently large surpluses do not try to reduce them, then deficit countries will not be able to reduce their deficits. Deficit countries may then resort to import controls, from which all countries will suffer. The Dutch Disease Effect is another disadvantage of a surplus. It gets its name from the discovery of large quantities of natural gas in the 1950s in the Netherlands. Most of this natural gas was exported, leading to a large, Dutch trade surplus. As a result the exchange rate rose, pricing Dutch manufactured goods out of export markets. Many economists believe that the discovery of North Sea oil by the UK has led to this effect in this country. Finally a large persistent surplus is highly likely to lead to domestic inflation. A surplus on the BOP tends to increase the money supply, causing the country’s currency to be in short supply on the foreign exchange markets, leading to a rise in the exchange rate. To prevent the exchange rate rising, the government must sell their own currency and buy other currencies, which are then added to the reserves. But because more of the country’s currency is issued, the money supply must >circulation (V) and Number of Transactions (T) are constant then explains that money price levels will rise, causing inflation.