Readers Question: Discuss the circumstances in which reducing the exchange rate and introducing quotas are effective policies to tackle a trade deficit.
Reducing the exchange rate. i.e. devaluing the exchange rate can help to reduce a trade deficit. When the value of the Pound falls. It makes UK exports more competitive, increasing quantity demanded. A depreciation also makes imports more expensive reducing demand for imports and foreign holidays. Therefore, we would expect a depreciation to improve the trade deficit.
However, it is not that simple. It depends upon the elasticity of demand.
- If demand for exports is very inelastic. A fall in price (10%) may lead to only a small fall in demand (1%). Therefore, the value of exports will decrease because the lower price decreases revenue.
- However, if demand for exports is elastic. then a fall in price will lead to a bigger % increase in demand. Therefore, there will be an increase in export revenue.
- The Marshall lerner conditition states that a depreciation in the exchange rate will improve the current account deficit IF PED x + PED M >1
The effect of a depreciation also depends on other things.
- Inflation? If a depreciation causes inflation, then exports may not become more competitive. Therefore, demand will not increase
- Global Recession. If the global economy is in recession, demand for exports will fall, even if the Pound depreciates. Alternatively, if UK is in a boom our demand for imports will keep rising.
- At the moment the Pound is depreciating, so it will be interesting to see whether the UK trade deficit actually improves.
Quotas to Reduce Trade Deficit
Import quotas may reduce value of imports. But, the key question is whether other countries retaliate by placing import quotas on UK exports
1 comment so far ↓
Hey, I am from the Unite States and have thought about the use of quotas as a way to decrease the trade deficit that my country has issues with. I think they are a good temporary idea. I think that the United States should tell the countries we have the large trade deficits with that they will go away as soon as we have an equal flow of goods going both ways. The quotas would temporarily keep the flow of goods even. The would only limit the flow of goods into the country to an equal footing to the flow of goods going into the country we have a trade deficit with. So, if they let more of our goods in then we let more of their goods into our country. That is just off the top of my head. I would love to hear your input. Please feel free to email me sometime with your thoughts.
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