Readers Question: Can you please discuss the nature of the current account deficit and the exchange rate in the UK along with the theory that would suggest there is a relationship between the exchange rate and the current account.
In theory, the exchange rate will have an impact on the current account.
If there is a depreciation in the exchange rate. Then that particular country will experience a fall in the foreign price of its exports. It will appear more competitive and therefore there will be a rise in the quantity of exports.
Assuming demand for exports is relatively elastic then a depreciation will lead to an increase in the value of exports and therefore improve the current account deficit.
Similarly a depreciation of the exchange rate, will also lead to an increase in the cost of buying imports. This will lead to a fall in demand for imports and also help to reduce the current account deficit.
Therefore, in theory, a depreciation in the exchange rate should improve the current account and an appreciation should worsen the current account.
However, in practise this might not happen for a variety of reasons.
1. Elasticity of Demand. The impact of a depreciation depends on the elasticity of demand. The Marshall Lerner condition states that a depreciation in the exchange rate will only improve current account – if combined PEDx and PEDm is greater than 1.
e.g. if demand for UK exports is very inelastic. They a depreciation will lead to only a very small increase in demand.
2. Profit Margins. A depreciation means exports can be cheaper. However, a UK firm may decided to keep the same foreign price and just make a bigger profit margin. This often occurs in the short term. Firms don’t adjust prices to consumers but have exchange rate movements absorbed in their own margins. This is one reason why a movement in the exchange rate often takes time to effect the current account.
The J Curve effect states how a depreciation can worsen current account in short term because demand is inelastic, but, over time, demand becomes more elastic and therefore the current account improves.
See also: Terms of Trade – Using example of UK, a depreciation in the Pound did not effect the terms of trade as much as might be expected.
3. Global Demand.
During 2008-09, the depreciation in the Pound Sterling didn’t effect the UK current account deficit. One reason was the sluggish global growth. There was little foreign demand for UK exports despite the fall in price.