Recently, we looked at whether a strong currency would help the economy – Is a strong currency a good thing?
The other side of the equation is – to what extent will a devaluation will help an economy? Commentators frequently write that devaluation (1) should help ‘rebalance’ the economy and help create an export led recovery. But, since 2008, we’ve seen a 25-30% devaluation in Sterling and we are left with only very weak recovery, cost push inflation and a surprisingly large current account deficit. It seems the depreciation in the pound has done very little to help the UK economy. (This all makes a very good A – Level question – discuss the macroeconomic effects of a depreciation in the exchange rate? – because there’s plenty of scope for evaluation.
In theory, a devaluation will cause the following to happen:
- The price of UK exports will be lower in foreign currencies. This will increase the competitiveness of UK exports and should cause an increase in demand for UK exports.
- The price of imported goods into the UK will increase. This will reduce our spending on imports and instead we will be more likely to buy domestic goods.
- The increase in (X-M) should cause an increase in AD, economic growth and cause a reduction in unemployment.
- The increased competitiveness should cause an improvement in the current account.
What has happened in the UK since late 2007?
The pound has fallen considerably against the Euro.
1. Economic growth. In terms of economic growth, the past five years have been worse than the great depression. The devaluation hasn’t really caused any significant export led growth.
2. Current account deficit. The current account deficit has actually got bigger.
In 2008, the current account deficit was less than 2% of GDP. At the end of 2012, this current account is getting close to 5% of GDP. (more at current account balance of payments) This seems to contradict economic theory – you would expect a devaluation to improve the current account not worsen it.
How do we explain failure of devaluation to rebalance the economy?
1. Inelastic demand for exports and imports Evidence suggests that demand for UK exports is relatively inelastic. UK exports have become less price competitive as we’ve moved away from low-cost manufacturers to a variety of services and high-tech manufacturing; these goods tend to have relatively few close substitutes. Therefore, even if the price falls, the increase in demand is relatively low. Similarly, demand for imports is relatively inelastic meaning we continue to pay the higher price. (The Marshall-Lerner condition states a devaluation will worsen the current account if PEDx + PEDm >1)