The analysis of mechanism by which devaluation rectifies the deficit disequilibrium in a country’s BOP can be approached in three different ways:
(i) The elasticities approach,
(ii) The absorption approach and
(iii) The monetary approach.
These three approaches are complementary rather than competitive to each other.
(i) Elasticities Approach:
The immediate effect of devaluation is a change in relative prices. The traditional approach to the effects of devaluation on trade balance runs in terms of elasticites. The essence of this elasticities approach in contained in the so called Marshal-Lerner condition which states that the sum of the elasticities of demand for a country’s exports and its demand for imports has to be greater than unity if devaluation is to have a beneficial effect on a country’s trade balance. But if the sum of these elasticities is smaller than unity that a country can instead improve its balance of trade by revaluation.
But what the effect of this price increase will be depends on the elasticity of demand for imports. The value of the demand elasticity of imports depends largely on what type of goods the devaluing country imports. If the devaluing country mainly imports necessities and raw materials the demand elasticity of imports may be very low and a devaluation may not be an efficient measure of correcting a deficit disequilibrium.
After devaluation, the exporters of devaluing country receive more for every unit of foreign currency they earn and this being the case, they can now lower the price of their exports coupled in foreign currency. By lowering their prices they should be able to sell more. By how much the volume of exports increases depends on the foreigner’s demand elasticity for devaluing country’s exports. Moreover, it also depends to a large extent on the type of goods the country exports and the international market conditions.
The so called Marshall-Lerner condition is a necessary condition for the improvement of the balance of trade by devaluation, provided the supply elasticities (both exports and imports) are large. If the supply elasticities are relatively low the devaluation is an inefficient means of correcting the deficit.
If the elasticity of supply of exports is low, the price of exports lends to rise as the demand for them expands with devaluation and thus the foreign exchange earnings will not decline to the same extent as they would have done with a high or infinite supply elasticity. “This reduces the power of the Marshal-Lerner condition to one where it is a sufficient but not necessary condition for balance of payments improvement.
The sum of demand elasticities can be less than unity and still improve the trade balance if supply elasticities are low”. The Marshal-Lerner condition is a necessary condition only if elasticities of supply are infinite but the condition is weakened turning it from necessary to sufficient condition if the supply elasticities are low.
Another limitation on the Marshal-Lerner condition is that the Imbalance which is to be corrected is not too large that imports must not greatly exceed exports. If the initial deficit is very large, then much higher elasticities will be required to eliminate this deficit.
Thus, “the Marshal-Lerner condition has important theoretical implications. If it operates rigorously not only does it imply that price reductions, either directly or through exchange rate depreciation are ineffective in adjusting a BOP, but it points to the possibility that depreciation may even worsen the balance and that, in certain circumstance any movement away from exchange equilibrium will produce forces which serve to increase the disequilibrium rather than correct it”.
The elasticities approach takes into account the possibilities of substitution among commodities both in consumption and production induced by price changes brought about by devaluation. After devaluation the prices of foreign traded goods will rise in terms of devaluing country’s currency. This rise in price will divert purchases out of existing income to non-traded goods thereby reducing the domestic demand for imports and export goods releasing the later for sale abroad. A the same time increased profitability in the foreign trade sector arising from the fact that prices in domestic currency have risen more than domestic costs, will stimulate new production of exports and import competing goods and will draw resources into these industries.
The elasticities approach was a partial equilibrium approach in which the success of devaluation depended upon the reaction of demand for imports and exports to the change in their prices attendant upon devaluation.
(ii) The Absorption Approach:
The elasticities approach ignored the likelihood that devaluation might result in changes in income levels. The realization lead to the revision of the elasticities approach in an effort to enhance its realism and a new variant of the devaluation model the absorption approach gained its champions. Thus, an alternative approach to the effect of evaluation was first formulated by Sidney S. Alexander in a famous paper “Effects of a devaluation on a trade balance” published in 1952 which we have discussed above.
(iii) The Monetary Approach:
The monetary approach to devaluation focuses on the demand for money balances. Devaluation is equivalent to a decline in the money supply when measured in foreign currency. As the real value of money supply will be reduced by devaluation through price rise, the public will accordingly reduce its spending with a view to restoring the real value of its money and other financial asset holdings. This reduction in spending will produce the required improvement in the BOP.
An important implication of this approach is that the effects of devaluation on BOP will be undermined if the monetary authorities expand the money supply and credit following devaluation. All these three approaches elasticities approach, absorption approach and monetary approach are complementary rather than competitive to each other.