Balance of Payments Analysis

a) Under what microeconomic elasticities and macroeconomic (absorption or aggregate demand) conditions will a devaluation improve the trade balance?

The balance of payments account is divided into two parts: the current account and the capital account. The former measures trade in tangible, visible items such as cars and manufactured goods; the trade balance is the surplus or deficit between exports and imports. The capital account measures flows of money, and we will assume that there is no trade of this sort to simplify the model.
A devaluation of a currency is the reduction in the exchange rates between the currency of the domestic country and a foreign one. In a free-market exchange system with no government intervention in the foreign exchange market, this will be achieved purely through the forces of supply and demand; if there is a fixed exchange rate system, the devaluation will be carried out by the government or central bank intervening to maintain the exchange rate at the new, lower level by way of buying or selling currency to make up for any excess of supply or demand. In the situation we are considering, there is a current account deficit, i.e. the country is importing more than it is exporting. The devaluation will intend to raise the price of imports, thus causing demand to fall for foreign imports, and increase the competitiveness of exports, as they will be cheaper in foreign markets. For example, if the original exchange rate was $2 = �1, and then there was a devaluation to $1.50 = �1, American goods would become more expensive for British consumers, but British goods would become more attractive to American consumers. Hence, exports should rise, and imports should fall, thus correcting the deficit, and bringing the balance of payments back into equilibrium.
This is what one would hope would happen in the short-run. However, there are two points that might prevent this from happening immediately. Firstly, contracts have already been signed at the previous exchange rate, and it will take time for people to adjust to the new exchange rate. It may also take time to move resources into the domestic industries that will expand production either to meet the increased export demand, or producing substitutes for goods that were previously imported. Secondly, devaluation in the short-run may worsen the current account deficit. If exports are slow to increase and imports slow to decrease, yet have already increased in price, then the value of imports in pounds will have risen, and the trade balance will have worsened.
Indeed, dependent on the elasticities of demand for imports and exports, this condition may persist in the longer term. The devaluation will raise the price of imports and lower the price of exports. However, if both of the elasticities for these goods are inelastic, then the current account deficit will be worsened. The price of exports to Americans may not encourage the overall amount they spend on our goods to rise, and similarly, the rise in price of their goods may result in a higher value of spending on American goods by Britons. Thus if the decrease in value of exports is greater than the rise in value of imports, then the trade balance will have worsened. This can be summarised by the Marshall-Lerner condition that states that in order for a devaluation to improve the trade balance, the sum of demand elasticities for exports and imports for any country must be greater than one (or -1, as elasticities of demand are technically always negative).
This is a microeconomic analysis of the effects of price changes on exports and imports. We must now also examine the effects of absorption (or aggregate demand) which calculates the effects on imports and exports from changes in income. A devaluation will increase the balance of exports over imports, which will shift the aggregate demand function upwards, and hence the level of national income. However, if the economy is initially at the full employment level of outcome, the economy will not be able to increase output to cope with the increase in aggregate demand. Thus prices and wages will be bid up, and eventually will rise by such an amount that they cancel out the effect of the initial devaluation. Not only this, but some of the increase in national income would be spent on imports. In order to prevent this, the government must tighten fiscal policy in the form of higher taxes in order that the increase for exports is not accompanied by an increase in aggregate demand. Thus the increase in competitiveness that resulted from the devaluation can be maintained.
However, we can conclude that a devaluation will not result in a permanent increase in international competitiveness. This is because of the supply side effects on prices, which we have not yet considered. Domestic companies that use foreign imports of raw materials will be faced with increase prices for these, and will want to pass this on in the form of higher prices. Workers who buy foreign goods will notice the price increases, and will conclude that the cost of living has increased; they will therefore demand an increase in their wages, which will lead to an inflationary wage-price spiral. This will erode the competitiveness of the currency to its level before devaluation. Thus, the benefits of a devaluation cannot be sustained in the long term. This is not to say that it is a futile policy measure, however; it is useful when the alternative is a deflationary policy at home that leads to domestic recession.
To conclude, in order for a devaluation to be successful, the elasticities of demand for foreign imports and domestic exports must be greater than one, otherwise the rise in value of exports will be not be offset by the fall in value of imports. Secondly, the government must also tighten fiscal policy if the economy is at full employment, or the result will be an inflationary period that will negate the effects of the devaluation and cause an increase in imports.

b) When will the achievement of both internal and external balance require both deflationary policies and a lower exchange rate?

Internal and external balance are two ways of representing long-run equilibrium in an economy. A country is in long-run equilibrium when it has attained both internal and external balance. The condition for internal balance is that the equilibrium level of national income must be at the full-employment level of income, i.e. firms actual output is the same as the potential level of output, and they demand as much labour as workers are willing to supply. The condition for external balance is that the current account on the balance of payments must balance, i.e. there is neither a surplus nor a deficit. Because the balance of payments account must always add up to zero, this means that the capital account also balances. The different combinations of disequilibrium can be shown on diagram 1, where the target of internal and external balance is where the two axes cross at the point E. There are four areas of disequilibrium: Zone I, where there exist simultaneously a balance of payments surplus and high unemployment (characteristic of the Great Depression of the 1930s); Zone II where there is inflation and a current account deficit; Zone III where there is a deficit and inflation (characteristic of European countries in the years following W.W.II); and Zone IV which represents unemployment and a balance of payments deficit.
We want to find out which zone the economy is in such that it will require a devaluation and a decrease in aggregate demand in order to restore internal and external balance. To do this we can look at Diagram 2, which show combinations of exchange rates and government expenditure patterns that result in equilibrium. The line YY represents various combinations of exchange rate and government expenditure that result in internal balance, while the line BB shows the combinations that result in external balance. The equilibrium point is where the two lines cross at E. Again we have the four zones of disequilibrium.
We noted that we required a point such that both a devaluation and a decrease in government expenditure are required to restore internal and external balance. This implies that we have a current account deficit, and thus need to lower the exchange rate to compensate for this. It also implies that we are above the full employment level of income and are experiencing inflationary pressure. Thus we can conclude that we are in Zone III, say at the point a in diagram 2. The combination of policies should move us towards the point E in the diagram, where we want to be.
It may also be the case that we are initially at internal balance as indicated by the point b on the line YY. This is because a devaluation is inflationary, because it boosts exports and, as the economy is initially at full employment, the demand for labour to increase output to meet the greater export demand and import-substitutes demand bids up wages and prices. Thus in order to combat the inflation that the devaluation produces, the government must also cut expenditure (or raise taxes) to reduce aggregate demand to the full employment level, otherwise the movement from b towards E along the line YY will not occur, and the direction of travel will be as indicated by the dotted line into Zone III.
In summary then the combination of devaluation and deflationary policies are needed when the economy is experiencing a current account deficit, possibly combined with inflationary pressures. This would occur when the domestic economy was experiencing a boom, as output would be close to the full employment level, and demand for imports would be high, thus creating the current account surplus.