Explain why a depreciation of a country’s exchange rate may not always lead to an improvement in its current account of the balance of payments.

Posted by: 11cresma on: January 19, 2011

• In: Section 5 - Development Economics
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1. Demands of the question (M08)
   1.  10 marks (paper 2)
   2. 20 minutes on it
   3. Explain how depreciation may lead to an improvement in its current account, and how it may not lead to it
2. Definition
   1. Exchange rate: An exchange rate is the price of one currency expressed in terms of another. An exchange rate system is the way in which the exchange rate is determined (fixed, floating, managed)
   2. Depreciation: downward movement in a floating exchange rate
   3. Balance of payments: measure the international trade performance of an economy and show how well it is managing to match imports and exports of goods and services and the flows of investment in and out of the country.
   4. Current account: records imports and exports of goods (sometimes known as the ‘balance of trade’ or ‘visible trade’) and imports and exports of services (sometimes known as ‘invisible trade’).
3. Triple A
   1. Floating exchange rate: this is an exchange rate which accepts that market forces will determine rates based on how they view a country’s trade performance and its economic and political stability. These systems cost less to maintain but can result in vast swings and changes in currency values. This can seriously affect trade performance and confidence
   2. Overall the balance of payments accounts will always balance (hence the name), although there may be deficits or surpluses on the various sections within the overall accounts. They must balance as any flows of foreign exchange into and out of the country must ultimately match. If there is a deficit in trade on goods and services, then this must be compensated by an inflow of investment funds
   3. The balance of trade in goods is often known simply as the ‘balance of trade’ and this represents visible exports minus visible imports. The current account balance is the net balance of all of these items – the net balance of trade in goods and the net balance of trade in services and net income flows
4. Bullet points
   1.  
5. PowerPoint slides

1. Diagrams

 

• Evaluation

Consequences of current account deficit (devaluation will reduce those):

•A persistent and large deficit (high percentage of GDP) is perceived as economic weakness.

•Preference for foreign good

•Domestic goods not competitive in price or quality

•High exchange rates makes imports cheap and exports expensive

•No domestic capacity to meet demand

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Pros and Cons on PowerPoint