Model Answer
0 min readIntroduction
The Keynesian economic framework emphasizes the role of aggregate demand in determining output and employment levels. Devaluation, a deliberate downward adjustment of a country’s currency relative to others under a fixed exchange rate regime, is often considered as a tool to improve the trade balance. However, its success in creating a trade surplus and boosting output isn’t automatic. The effectiveness of devaluation hinges on specific conditions related to the price elasticity of demand for a nation’s exports and imports, as well as the initial state of the economy. This answer will explore these conditions within the simple Keynesian model.
The Simple Keynesian Framework and Devaluation
The simple Keynesian model posits that aggregate demand (AD) is the primary driver of economic activity. AD is composed of Consumption (C), Investment (I), Government Spending (G), and Net Exports (NX = Exports - Imports). Devaluation aims to increase NX, thereby boosting AD and output.
The Marshall-Lerner Condition
The key condition for devaluation to improve the trade balance is the Marshall-Lerner condition. This condition states that the sum of the price elasticities of demand for exports and imports must be greater than one (i.e., |εx| + |εm| > 1). Here, εx represents the price elasticity of demand for exports, and εm represents the price elasticity of demand for imports.
Conditions for Trade Surplus and Increased Output
- Elasticity of Demand: If the Marshall-Lerner condition holds, devaluation will lead to an improvement in the trade balance.
- Exports: If demand for exports is price elastic (εx < -1), a fall in the price of exports (due to devaluation) will lead to a proportionally larger increase in the quantity of exports demanded.
- Imports: If demand for imports is price elastic (εm < -1), a rise in the price of imports (due to devaluation) will lead to a proportionally larger decrease in the quantity of imports demanded.
- Initial Economic Conditions: The initial state of the economy is crucial.
- Underutilized Capacity: Devaluation is most effective when the economy has spare capacity (i.e., unemployment exists). Increased exports due to devaluation can be met without causing inflation.
- Low Inflation: If the economy is already experiencing high inflation, devaluation can exacerbate inflationary pressures, potentially offsetting the benefits of increased exports.
- J-Curve Effect: In the short run, devaluation may initially worsen the trade balance before improving it. This is known as the J-curve effect. This happens because import contracts are often fixed in the short run, and it takes time for export volumes to respond to the price change.
- Exchange Rate Regime: The effectiveness of devaluation is also dependent on the exchange rate regime. In a fixed exchange rate regime, the devaluation is a deliberate policy action. However, in a floating exchange rate regime, market forces may counteract the effects of devaluation.
Illustrative Example
Consider a country with initial exports of $100 billion and imports of $120 billion, resulting in a trade deficit of $20 billion. If the country devalues its currency by 10%, and the price elasticity of demand for exports is -2 and the price elasticity of demand for imports is -1.5, the Marshall-Lerner condition is satisfied (| -2 | + | -1.5 | = 3.5 > 1). This suggests that devaluation will lead to an increase in exports and a decrease in imports, eventually leading to a trade surplus and increased output.
| Factor | Condition for Success |
|---|---|
| Price Elasticity of Exports | Elastic (εx < -1) |
| Price Elasticity of Imports | Elastic (εm < -1) |
| Economic Capacity | Underutilized capacity, low inflation |
| Time Horizon | Long enough to overcome the J-curve effect |
Conclusion
In conclusion, devaluation can create a trade surplus and increase output within the simple Keynesian framework, but only under specific conditions. The Marshall-Lerner condition, relating to the price elasticity of demand for exports and imports, is paramount. Furthermore, the initial state of the economy – particularly the presence of underutilized capacity and low inflation – significantly influences the outcome. Policymakers must carefully consider these factors before implementing devaluation as a policy tool, recognizing the potential for short-run adverse effects like the J-curve.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.