The Effect Of Exchange Rate Movement On Trade Balance In Ethiopia
Transcript Of The Effect Of Exchange Rate Movement On Trade Balance In Ethiopia
THE EFFECT OF EXCHANGE RATE MOVEMENT ON TRADE BALANCE IN ETHIOPIA
AUTHOR: Borena Dessalegn Lencho Submitted: To Professor Nobuhiro HIWATARI, THE University Of Tokyo, In Fulfillment for: International Political Economy Class.
July, 2013 1
Executive Summary
Despite the existence of multiples of theoretical and empirical studies that have examined the relationship between exchange rate devaluation and trade balance, there are still heated debates among scholars over the impact of devaluation on trade balance both in developed and developing countries. Since the significance of our study lies in understanding how changes in the exchange rate affects the balance of trade in the long run and the short run, we examined the evaluation of this relationship. Accordingly, in the long run, we found that depreciation succeeds in improving trade balance deficit of Ethiopia. Similarly, the short run dynamic error correction model indicated that changes in trade balance in the short run is explained by changes in Real Effective Exchange rate and by two years lagged changes in same variable. Moreover, Ethiopia’s export is characterized by high commodity and geographic concentration, by high susceptibility to external shocks, high dependence on agricultural export that in turn depends on vagaries of nature, high price and low income elasticity of demand, and low supply response. On the other hand, imports intrinsically are highly price inelastic which are either necessities in production or consumption or very strategic commodity and are invariably required by the country. Therefore, the gap between export-import leads to a persistent deficit trade balance in the country. Finally, we wrapped up our argument by concluding that the existence of persistent trade balance deficit is fundamentally structural in nature in Ethiopia, because imports are essential in nature that they are price inelastic and therefore cannot simply be discouraged or easily substituted while exports are highly concentrated on agricultural primary commodities that are very sensitive to whether condition and price shocks.
2
Chapter One 1. Introduction
1.1 Statement of the Problem
The effectiveness of exchange rate depreciation in improving the trade balance has long been an issue of considerable interest to economists and policy makers. Especially, since the break down of the Bretton Woods Accord in 1973, and the advent of floating exchange rates, there has been renewed interest on the effect of devaluation on the trade balance of both developed and developing countries. The mixed empirical support of the relationship between trade balance and changes in exchange rate provides the impetus for investigation of the relationship. Developing countries failing to meet their development plan have lurched from one development paradigm to another: from industrialization to import substitution, to export promotion, to Structural Adjustment Program (Rawlins and Praven, 1993).
Structural Adjustment Program (SAP) is a term used by the IMF for the changes it recommends for developing countries so that they could get loans with certain conditionality. In implementing one of the essential components(conditions) of the SAP, less developed countries (LDCs) facing balance of payment problems due to expansionary financial policies, a deterioration in terms of trade, price distortions, high debt servicing or combination of these factors have often resorted to devaluing their currencies (Nashashibi, 1983).
Ethiopia, being one of the LDCs, faced various problems including some of the fore mentioned ones and others which were the root causes of poor economic performance of the 1970s and 1980s. Even though the causes of poor economic performance were numerous and various, poor macro-economic policies were the prominent ones. Thus, need for comprehensive, compatible, timely and sequential policy restructuring was indisputable for reliable and sustained growth and development and for maintenance of both external and internal balance of the country. In order to do that Ethiopia has undergone various policy and structural reforms both at micro-and macrolevel of the economy in the form of implementing Structural Adjustment Program (SAP), which
3
began in 1992, after the fall of the Derg regime1. As part of these overall reform program, on October 1, 1992, Ethiopian Birr devalued from its nominal level of 2.07 Birr per US dollar to 5.00 Birr per US dollar depreciation by about 142 percent. When the Structural Adjustment Program was introduced in October 1992, the nominal exchange rate of Birr vis-a-vis the US Dollar had been fixed for nearly three decades, except the revaluation of 1971, 1972, and 1973 with cumulative nominal revaluation of 17 percent. Such a passive exchange rate policy, coupled with expansive monetary and fiscal policies, led to continuous overvaluation (Alem, 1996). Despite the fact that the rate was fixed against the dollar for this period, it was floating against all other major currencies, following the fluctuation of US dollar against these currencies (Befekadu and Berhanu, 1999/00). After the massive devaluation of 1992, the Ethiopian Birr has consistently been depreciating in nominal terms from year to year and by the year 2012/13, the average nominal exchange rate stood at 18.6518 Birr per US dollar (depreciation of about 274 percent compared to the 1992, 5.0 Birr per USD).
As vividly explained in Reinhart (1995), devaluations have often been used by developing countries to reduce large external imbalances, correct perceived "overvaluations" of the real exchange rate, increase international competitiveness, and promote export growth. However, devaluation can only accomplish these tasks if it translates in to a real devaluation and if trade flows respond to relative prices in significant and predictable manner. This shows that nominal devaluation is not a goal in itself.
However, it is discussed in Edwards (1989) that in theory and under most common conditions, nominal devaluation will affect an economy in three main ways. First, devaluation will usually have an expenditure reducing effects. To the extent that as a result of devaluation the domestic price level goes up, there will a negative wealth effect that will reduce the real value of domestic currency dominated nominal assets, including domestic money. A lower real value of assets will reduce expenditure on all goods. Second, it will tend to have an expenditure switching effect. This involves shifts in the pattern of domestic demand from tradable towards non-tradable, and the pattern of domestic production from non-tradable to tradable. The combined effect of expenditure reducing and expenditure switching will, of course, improve the external situation of the country. Third, devaluation will increase the domestic price of imported intermediate inputs
1 Military Junta that governed Ethiopia from 1974 to 1991
4
and imported capital goods. This will increase the cost of production and results in a contraction of real output or aggregate supply, including non-tradable. Although economic theory posits that devaluation of a country's currency will likely improve the trade balance, there are conflicting theories about the effect of devaluation on trade balance. Empirical findings of Rose (1990), Dhakal D. (1997) both suggested mixed results.
1.2 Objectives of the study
The general objective of this research is to scrutinize the impacts of changes in exchange rate movement on trade balance, i.e., whether depreciation improves trade balance or not. More specifically, the study attempts:
To briefly look at exchange rate regimes and developments in Ethiopia Briefly investigate the structures and trends of import and export situation in Ethiopia. To empirically investigate the short run and long run impact of change in exchange rate
of Birr on trade balance of Ethiopia To make conclusions and policy implications
1.3 Definition
An exchange rate is the price of one nation’s currency in terms of another nation’s currency. Changes in exchange rates are given various names depending on the kind exchange rate regime prevailing. Under the floating-rate system, a fall in the market price (the exchange rate value) of a currency is called a depreciation of that currency; a rise is an appreciation. We refer to a discrete official reduction in the otherwise fixed par value of a currency as devaluation; revaluation is the antonym describing a discrete rising of the official par (Pugel and Lindert, 2000). Appreciation/revaluation is a rise in the price of a country's currency in terms of foreign currency while depreciation/devaluation is a fall in the price of a country's currency in terms of foreign currency. Devaluation and depreciation are similar: devaluation is generally used for discrete change in the exchange rate brought about as a matter of policy, whereas depreciation occurs gradually through the working of the foreign exchange market. Revaluation and
5
appreciation are antonyms for devaluation and depreciation respectively. From these definitions one can easily understand that devaluation/depreciation means an increase in nominal or real exchange rate while revaluation/appreciation means decrease in nominal or real exchange rate regardless of how they come about. Therefore, devaluation and depreciation and also revaluation and appreciation could often be used interchangeably. In this study, exchange rate is defined as the units of the home currency per a unit of the foreign currency. Therefore, depreciation/devaluation is an increase in exchange rate (for instance, increase in Birr/USD ratio) and appreciation/revaluation is a fall in exchange rate (for instance, decrease in Birr2/USD ratio).
1.4 Significance of the study
To the best of the author’s understanding, there are limited studies that have examined the impact of changes in the exchange rate on trade balance of Ethiopia. The importance of this paper, thus, lies in contributing to the existing literature and also in contributing to the definitive understanding of how changes in the exchange rate affects trade balance that could have vast implications to the endeavor to improve the country’s competitiveness and to promote export, and so to formulate good policy that could help improving the persistent trade deficit.
1.5 Data source and methodology of the study
The data source for this study include different annual publications of the National Bank of Ethiopia, International Financial Statistics (IFS) publications, The IMF and World Bank data bases, Ethiopian Macro model data base, direction of trade publications and other relevant sources and covers a period of roughly 38 years. The employed model is believed to be appropriate and simple to examine the relationship between exchange rate changes and trade balance. Utmost effort is made to use latest econometric techniques of analysis3.
2 Birr is the name of Ethiopian currency for transaction 3 All the econometrics techniques and procedures followed are explained under chapter 4.
6
1.6 Organization of the Paper
The paper is organized in five chapters. The first chapter presents introductory part of the study. The second chapter deals with the review of theoretical and empirical literature on the research topic. The third chapter presents a brief look at the structure of and trends in exports and imports. The fourth chapter presents the model to be used in the analyses and presents the empirical results of the study. The last chapter presents conclusion and policy implications.
Chapter Two 2 Review of Theoretical and Empirical Literatures 2.1 Theoretical Literature 2.1.1 The different approaches to the relationship between exchange rate changes and trade balance
Despite the existence of plethora of theoretical and empirical studies that have examined the relationship between exchange rate devaluation and trade balance, there are still heated debates over the impact of devaluation on trade balance both in the case of developed and developing countries (Ahmad, J. & Yang, J. 2004). Since the significance of our study lies in understanding how changes in the exchange rate can affect the balance of trade in the long run and the short run, we need to assess the different approaches in the evaluation of this relationship. Generally, ever since the failure of the presumption of automatic adjustment of the balance of payments, three approaches have been developed in investigating the impact of exchange rate changes on balance of payments. These are the Elasticity approach, the Absorption approach and the Monetary approach to be discussed in detail below.
7
2.1.1.1 The Elasticity Approach
This approach provides an analysis of what happens to trade balance when a country devalues its currency and conditions that must prevail in the foreign exchange market for a devaluation or depreciation of the currency to improve the trade balance starting from equilibrium (Pongsak Hoontrakul( 1999). According to Sugman (2005), the analysis was developed by Alfred Marshall, Abba-Lerner and later extended by Joan Robinson (1937) and Fritz Machlup (1955).
At the outset, the model makes some simplifying assumptions. It is partial equilibrium analysis – holding constant everything else that may affect the supply of and demand for foreign or domestic currency, except the change in the relative price of foreign and domestic goods arising from the change in the exchange rate itself. The approach focuses on demand conditions and assumes the supply elasticities for the domestic export goods and foreign import goods are infinite, i.e. perfectly elastic so that changes in demand volumes have no effect on prices (the domestic price of exports, the foreign price of imports and prices of import and export substitutes are constant). In effect these assumptions mean that domestic and foreign prices are fixed so that changes in relative prices are caused by changes in the nominal exchange rate.
Under these assumptions, the condition for a devaluation to improve the trade balance which directly contributes to the improvement of the balance of payments (starting from equilibrium) is known as the Marshall-Lerner condition. It states that devaluation will improve the balance of payments on trade balance if the sum of the foreign price elasticity of demand for exports (ηx) and domestic price elasticity of demand for imports (ηm) exceeds unity, in absolute value, i.e. if:
│ + │ > 1 -------------------------------------------------------------- (2.1) Consider a small one percent devaluation which leads to a one percent fall in the foreign price of domestic exports. If the demand for exports rises by less than one percent, foreign exchange earnings will fall; if demand rises by more than one percent foreign exchange earnings will rise, and if demand rises by exactly one percent, foreign exchange earnings will remain the same. In this last case of unitary elasticity of demand, it would then only require a minute cutback in import demand (an elasticity of demand for imports slightly above zero; > 0) for foreign exchange earnings to improve in total. Any combination of price elasticity of demand for
8
exports and imports will improve foreign exchange earnings provided that they sum to greater than unity. Starting from equilibrium, the improvement in the trade balance (∆TB) is measured as:
dTB= X ( + -1) dE ------------------------------------------------------(2.2) where X is the initial level of exports (= imports), and dE is the instantaneous change in the exchange rate (measured as the domestic price of a unit of foreign currency).
In keeping with Pugel and Lindert (2000), the central message of the elasticity approach is that there are two direct effects of devaluation on trade balance one which works to reduce and the other one works to worsen. These two effects are the price effect and the volume effect. The price effect clearly contributes to the worsening of trade balance because exports become cheaper measured in foreign currency and imports become expensive measured in the home currency. The volume effect obviously contributes to the improving of trade balance. This is because of the fact that exports become cheaper should encourage an increased volume of exports and the fact that imports become expensive should lead to a decreased volume of imports. The net effect depends upon whether volume or price effect dominates.
There is a general consensus by most economists that elasticity are lower in the short- run than in the long -run, in which case Marshal -Lerner condition may only hold in the medium to longrun. The possibility that in the short run, Marshal-Lerner may not be fulfilled although it generally holds over the long run leads to the phenomenon of what is popularly known as the Jcurve effect. The idea underlying the J-curve effect is that in the short run export volumes and import volumes do not change much, so that the price effect outweighs the volume effect leading to deterioration in trade balance. Three of the most important reasons advanced in explaining the J-curve effect are time lag both in producers and consumers response and imperfect competition.
Driskell, Robert A. (1981), made a refinement of the elasticity approach by incorporating income effects into the analysis. According to them, if autonomous money expenditure remains constant, allowing for income effects does not alter the Marshall-Lerner condition for a successful devaluation, but the magnitude of the effect on the balance of payments is altered. With this effect equation (2.2) becomes:
9
dTB =
X ( + -1) dE ----------------------------------------------------------------------(2.3)
where s is the propensity to save and m is the propensity to import. Since s/(s + m) is a fraction, the change in the balance of payments is smaller with income effects than without (becomes less stringent).
According to same source, a seemingly contrary result was derived by Harberger (1983). His models hold real expenditure constant implying a rise in autonomous expenditure in money terms, which suggests that the income effects of devaluation alter the Marshall-Lerner condition, making it more stringent. According to these models the condition for trade balance improvement becomes: │ + │ > 1 + m1 + m2 ---------------------------------------------------------------------------(2.4) Where m1 is the marginal propensity to import of the devaluing country and m2 is the marginal propensity to import of the other countries. Which model specification should be preferred depends on whether a successful devaluation is interpreted to mean one which improves the balance of payments with real income falling or without real income falling.
Mariana Colacelli (2006) argued that outside of the confines of the partial equilibrium framework adopted by the elasticity approach, supply elasticity matter both in themselves, and as determinants of the terms of trade. What happens to expenditure (or absorption) as the terms of trade change also matters. It can be shown, for example, that if the product of the supply elasticity of exports and imports exceed the product of the demand elasticity, the terms of trade will decline, and if expenditure does not fall by as much as real income, the balance of payments will worsen.
In general, there is highly held view that this approach made very simplistic assumption and it is by no means certain that in practice the elasticity condition are satisfied, or that, by the time they are satisfied the competitive advantage gained by depreciation has not been eroded by the induced price rise.
10
AUTHOR: Borena Dessalegn Lencho Submitted: To Professor Nobuhiro HIWATARI, THE University Of Tokyo, In Fulfillment for: International Political Economy Class.
July, 2013 1
Executive Summary
Despite the existence of multiples of theoretical and empirical studies that have examined the relationship between exchange rate devaluation and trade balance, there are still heated debates among scholars over the impact of devaluation on trade balance both in developed and developing countries. Since the significance of our study lies in understanding how changes in the exchange rate affects the balance of trade in the long run and the short run, we examined the evaluation of this relationship. Accordingly, in the long run, we found that depreciation succeeds in improving trade balance deficit of Ethiopia. Similarly, the short run dynamic error correction model indicated that changes in trade balance in the short run is explained by changes in Real Effective Exchange rate and by two years lagged changes in same variable. Moreover, Ethiopia’s export is characterized by high commodity and geographic concentration, by high susceptibility to external shocks, high dependence on agricultural export that in turn depends on vagaries of nature, high price and low income elasticity of demand, and low supply response. On the other hand, imports intrinsically are highly price inelastic which are either necessities in production or consumption or very strategic commodity and are invariably required by the country. Therefore, the gap between export-import leads to a persistent deficit trade balance in the country. Finally, we wrapped up our argument by concluding that the existence of persistent trade balance deficit is fundamentally structural in nature in Ethiopia, because imports are essential in nature that they are price inelastic and therefore cannot simply be discouraged or easily substituted while exports are highly concentrated on agricultural primary commodities that are very sensitive to whether condition and price shocks.
2
Chapter One 1. Introduction
1.1 Statement of the Problem
The effectiveness of exchange rate depreciation in improving the trade balance has long been an issue of considerable interest to economists and policy makers. Especially, since the break down of the Bretton Woods Accord in 1973, and the advent of floating exchange rates, there has been renewed interest on the effect of devaluation on the trade balance of both developed and developing countries. The mixed empirical support of the relationship between trade balance and changes in exchange rate provides the impetus for investigation of the relationship. Developing countries failing to meet their development plan have lurched from one development paradigm to another: from industrialization to import substitution, to export promotion, to Structural Adjustment Program (Rawlins and Praven, 1993).
Structural Adjustment Program (SAP) is a term used by the IMF for the changes it recommends for developing countries so that they could get loans with certain conditionality. In implementing one of the essential components(conditions) of the SAP, less developed countries (LDCs) facing balance of payment problems due to expansionary financial policies, a deterioration in terms of trade, price distortions, high debt servicing or combination of these factors have often resorted to devaluing their currencies (Nashashibi, 1983).
Ethiopia, being one of the LDCs, faced various problems including some of the fore mentioned ones and others which were the root causes of poor economic performance of the 1970s and 1980s. Even though the causes of poor economic performance were numerous and various, poor macro-economic policies were the prominent ones. Thus, need for comprehensive, compatible, timely and sequential policy restructuring was indisputable for reliable and sustained growth and development and for maintenance of both external and internal balance of the country. In order to do that Ethiopia has undergone various policy and structural reforms both at micro-and macrolevel of the economy in the form of implementing Structural Adjustment Program (SAP), which
3
began in 1992, after the fall of the Derg regime1. As part of these overall reform program, on October 1, 1992, Ethiopian Birr devalued from its nominal level of 2.07 Birr per US dollar to 5.00 Birr per US dollar depreciation by about 142 percent. When the Structural Adjustment Program was introduced in October 1992, the nominal exchange rate of Birr vis-a-vis the US Dollar had been fixed for nearly three decades, except the revaluation of 1971, 1972, and 1973 with cumulative nominal revaluation of 17 percent. Such a passive exchange rate policy, coupled with expansive monetary and fiscal policies, led to continuous overvaluation (Alem, 1996). Despite the fact that the rate was fixed against the dollar for this period, it was floating against all other major currencies, following the fluctuation of US dollar against these currencies (Befekadu and Berhanu, 1999/00). After the massive devaluation of 1992, the Ethiopian Birr has consistently been depreciating in nominal terms from year to year and by the year 2012/13, the average nominal exchange rate stood at 18.6518 Birr per US dollar (depreciation of about 274 percent compared to the 1992, 5.0 Birr per USD).
As vividly explained in Reinhart (1995), devaluations have often been used by developing countries to reduce large external imbalances, correct perceived "overvaluations" of the real exchange rate, increase international competitiveness, and promote export growth. However, devaluation can only accomplish these tasks if it translates in to a real devaluation and if trade flows respond to relative prices in significant and predictable manner. This shows that nominal devaluation is not a goal in itself.
However, it is discussed in Edwards (1989) that in theory and under most common conditions, nominal devaluation will affect an economy in three main ways. First, devaluation will usually have an expenditure reducing effects. To the extent that as a result of devaluation the domestic price level goes up, there will a negative wealth effect that will reduce the real value of domestic currency dominated nominal assets, including domestic money. A lower real value of assets will reduce expenditure on all goods. Second, it will tend to have an expenditure switching effect. This involves shifts in the pattern of domestic demand from tradable towards non-tradable, and the pattern of domestic production from non-tradable to tradable. The combined effect of expenditure reducing and expenditure switching will, of course, improve the external situation of the country. Third, devaluation will increase the domestic price of imported intermediate inputs
1 Military Junta that governed Ethiopia from 1974 to 1991
4
and imported capital goods. This will increase the cost of production and results in a contraction of real output or aggregate supply, including non-tradable. Although economic theory posits that devaluation of a country's currency will likely improve the trade balance, there are conflicting theories about the effect of devaluation on trade balance. Empirical findings of Rose (1990), Dhakal D. (1997) both suggested mixed results.
1.2 Objectives of the study
The general objective of this research is to scrutinize the impacts of changes in exchange rate movement on trade balance, i.e., whether depreciation improves trade balance or not. More specifically, the study attempts:
To briefly look at exchange rate regimes and developments in Ethiopia Briefly investigate the structures and trends of import and export situation in Ethiopia. To empirically investigate the short run and long run impact of change in exchange rate
of Birr on trade balance of Ethiopia To make conclusions and policy implications
1.3 Definition
An exchange rate is the price of one nation’s currency in terms of another nation’s currency. Changes in exchange rates are given various names depending on the kind exchange rate regime prevailing. Under the floating-rate system, a fall in the market price (the exchange rate value) of a currency is called a depreciation of that currency; a rise is an appreciation. We refer to a discrete official reduction in the otherwise fixed par value of a currency as devaluation; revaluation is the antonym describing a discrete rising of the official par (Pugel and Lindert, 2000). Appreciation/revaluation is a rise in the price of a country's currency in terms of foreign currency while depreciation/devaluation is a fall in the price of a country's currency in terms of foreign currency. Devaluation and depreciation are similar: devaluation is generally used for discrete change in the exchange rate brought about as a matter of policy, whereas depreciation occurs gradually through the working of the foreign exchange market. Revaluation and
5
appreciation are antonyms for devaluation and depreciation respectively. From these definitions one can easily understand that devaluation/depreciation means an increase in nominal or real exchange rate while revaluation/appreciation means decrease in nominal or real exchange rate regardless of how they come about. Therefore, devaluation and depreciation and also revaluation and appreciation could often be used interchangeably. In this study, exchange rate is defined as the units of the home currency per a unit of the foreign currency. Therefore, depreciation/devaluation is an increase in exchange rate (for instance, increase in Birr/USD ratio) and appreciation/revaluation is a fall in exchange rate (for instance, decrease in Birr2/USD ratio).
1.4 Significance of the study
To the best of the author’s understanding, there are limited studies that have examined the impact of changes in the exchange rate on trade balance of Ethiopia. The importance of this paper, thus, lies in contributing to the existing literature and also in contributing to the definitive understanding of how changes in the exchange rate affects trade balance that could have vast implications to the endeavor to improve the country’s competitiveness and to promote export, and so to formulate good policy that could help improving the persistent trade deficit.
1.5 Data source and methodology of the study
The data source for this study include different annual publications of the National Bank of Ethiopia, International Financial Statistics (IFS) publications, The IMF and World Bank data bases, Ethiopian Macro model data base, direction of trade publications and other relevant sources and covers a period of roughly 38 years. The employed model is believed to be appropriate and simple to examine the relationship between exchange rate changes and trade balance. Utmost effort is made to use latest econometric techniques of analysis3.
2 Birr is the name of Ethiopian currency for transaction 3 All the econometrics techniques and procedures followed are explained under chapter 4.
6
1.6 Organization of the Paper
The paper is organized in five chapters. The first chapter presents introductory part of the study. The second chapter deals with the review of theoretical and empirical literature on the research topic. The third chapter presents a brief look at the structure of and trends in exports and imports. The fourth chapter presents the model to be used in the analyses and presents the empirical results of the study. The last chapter presents conclusion and policy implications.
Chapter Two 2 Review of Theoretical and Empirical Literatures 2.1 Theoretical Literature 2.1.1 The different approaches to the relationship between exchange rate changes and trade balance
Despite the existence of plethora of theoretical and empirical studies that have examined the relationship between exchange rate devaluation and trade balance, there are still heated debates over the impact of devaluation on trade balance both in the case of developed and developing countries (Ahmad, J. & Yang, J. 2004). Since the significance of our study lies in understanding how changes in the exchange rate can affect the balance of trade in the long run and the short run, we need to assess the different approaches in the evaluation of this relationship. Generally, ever since the failure of the presumption of automatic adjustment of the balance of payments, three approaches have been developed in investigating the impact of exchange rate changes on balance of payments. These are the Elasticity approach, the Absorption approach and the Monetary approach to be discussed in detail below.
7
2.1.1.1 The Elasticity Approach
This approach provides an analysis of what happens to trade balance when a country devalues its currency and conditions that must prevail in the foreign exchange market for a devaluation or depreciation of the currency to improve the trade balance starting from equilibrium (Pongsak Hoontrakul( 1999). According to Sugman (2005), the analysis was developed by Alfred Marshall, Abba-Lerner and later extended by Joan Robinson (1937) and Fritz Machlup (1955).
At the outset, the model makes some simplifying assumptions. It is partial equilibrium analysis – holding constant everything else that may affect the supply of and demand for foreign or domestic currency, except the change in the relative price of foreign and domestic goods arising from the change in the exchange rate itself. The approach focuses on demand conditions and assumes the supply elasticities for the domestic export goods and foreign import goods are infinite, i.e. perfectly elastic so that changes in demand volumes have no effect on prices (the domestic price of exports, the foreign price of imports and prices of import and export substitutes are constant). In effect these assumptions mean that domestic and foreign prices are fixed so that changes in relative prices are caused by changes in the nominal exchange rate.
Under these assumptions, the condition for a devaluation to improve the trade balance which directly contributes to the improvement of the balance of payments (starting from equilibrium) is known as the Marshall-Lerner condition. It states that devaluation will improve the balance of payments on trade balance if the sum of the foreign price elasticity of demand for exports (ηx) and domestic price elasticity of demand for imports (ηm) exceeds unity, in absolute value, i.e. if:
│ + │ > 1 -------------------------------------------------------------- (2.1) Consider a small one percent devaluation which leads to a one percent fall in the foreign price of domestic exports. If the demand for exports rises by less than one percent, foreign exchange earnings will fall; if demand rises by more than one percent foreign exchange earnings will rise, and if demand rises by exactly one percent, foreign exchange earnings will remain the same. In this last case of unitary elasticity of demand, it would then only require a minute cutback in import demand (an elasticity of demand for imports slightly above zero; > 0) for foreign exchange earnings to improve in total. Any combination of price elasticity of demand for
8
exports and imports will improve foreign exchange earnings provided that they sum to greater than unity. Starting from equilibrium, the improvement in the trade balance (∆TB) is measured as:
dTB= X ( + -1) dE ------------------------------------------------------(2.2) where X is the initial level of exports (= imports), and dE is the instantaneous change in the exchange rate (measured as the domestic price of a unit of foreign currency).
In keeping with Pugel and Lindert (2000), the central message of the elasticity approach is that there are two direct effects of devaluation on trade balance one which works to reduce and the other one works to worsen. These two effects are the price effect and the volume effect. The price effect clearly contributes to the worsening of trade balance because exports become cheaper measured in foreign currency and imports become expensive measured in the home currency. The volume effect obviously contributes to the improving of trade balance. This is because of the fact that exports become cheaper should encourage an increased volume of exports and the fact that imports become expensive should lead to a decreased volume of imports. The net effect depends upon whether volume or price effect dominates.
There is a general consensus by most economists that elasticity are lower in the short- run than in the long -run, in which case Marshal -Lerner condition may only hold in the medium to longrun. The possibility that in the short run, Marshal-Lerner may not be fulfilled although it generally holds over the long run leads to the phenomenon of what is popularly known as the Jcurve effect. The idea underlying the J-curve effect is that in the short run export volumes and import volumes do not change much, so that the price effect outweighs the volume effect leading to deterioration in trade balance. Three of the most important reasons advanced in explaining the J-curve effect are time lag both in producers and consumers response and imperfect competition.
Driskell, Robert A. (1981), made a refinement of the elasticity approach by incorporating income effects into the analysis. According to them, if autonomous money expenditure remains constant, allowing for income effects does not alter the Marshall-Lerner condition for a successful devaluation, but the magnitude of the effect on the balance of payments is altered. With this effect equation (2.2) becomes:
9
dTB =
X ( + -1) dE ----------------------------------------------------------------------(2.3)
where s is the propensity to save and m is the propensity to import. Since s/(s + m) is a fraction, the change in the balance of payments is smaller with income effects than without (becomes less stringent).
According to same source, a seemingly contrary result was derived by Harberger (1983). His models hold real expenditure constant implying a rise in autonomous expenditure in money terms, which suggests that the income effects of devaluation alter the Marshall-Lerner condition, making it more stringent. According to these models the condition for trade balance improvement becomes: │ + │ > 1 + m1 + m2 ---------------------------------------------------------------------------(2.4) Where m1 is the marginal propensity to import of the devaluing country and m2 is the marginal propensity to import of the other countries. Which model specification should be preferred depends on whether a successful devaluation is interpreted to mean one which improves the balance of payments with real income falling or without real income falling.
Mariana Colacelli (2006) argued that outside of the confines of the partial equilibrium framework adopted by the elasticity approach, supply elasticity matter both in themselves, and as determinants of the terms of trade. What happens to expenditure (or absorption) as the terms of trade change also matters. It can be shown, for example, that if the product of the supply elasticity of exports and imports exceed the product of the demand elasticity, the terms of trade will decline, and if expenditure does not fall by as much as real income, the balance of payments will worsen.
In general, there is highly held view that this approach made very simplistic assumption and it is by no means certain that in practice the elasticity condition are satisfied, or that, by the time they are satisfied the competitive advantage gained by depreciation has not been eroded by the induced price rise.
10