Why does a trade deficit weaken the currency?
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This is an open access article distributed under the Creative Commons Attribution Licensewhich permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited. This paper evaluates the current state of the literature concerning the effects of exchange rate movements on trade balance. Thus, this paper is a review article and provides a survey of the alternative theories that focus on the effect of exchange rate changes on the trade balance.
It systemizes the literature into four distinct reviews and approaches following the chronological order. The study shows that higher attention should be given for the most plausible dynamic theory in this field, known as the J-Curve. As one of the widely used economic indicators, real exchange rate can be simply defined as the nominal exchange rate that takes inflation differentials among countries into account [ 1 ].
In international trade, its importance stems from the fact that it reflects the trade competitiveness [ 2 ]. However, it is still widely used in many fields of economics for purposes other than trade. Real exchange rate movements affect many economic variables; where some studies covered the relation with foreign direct investment [ 3 ], some other studies currency depreciation and trade balance on the effect on tourism [ 4 ] or, even more generally, on economic growth [ 5 ].
A change in real exchange rate leads to variations in short-run capital flows. As basically illustrated above, by controlling the real exchange rate, a chain of economic effects takes place. However, this study is chiefly concerned with its effects on international trade.
For a long time, economists have stressed on the relation between exchange rate and trade balance. However, since the middle of the twentieth century and due to the developments in macroeconomic and econometric analysis, some studies started to present some empirical results. Even with the presence of trade data, the issue has remained highly debated and no consensus was reached. This study investigates the state of the literature from a new perspective.
It systemizes the explanations provided in empirical studies into distinctive theoretical approaches. A special focus is given to the J-Curve phenomenon since it is accepted as the most plausible among all and provides indirect methods to test currency depreciation and trade balance other approaches [ 7 ].
This study is organized as follows: Section 2 opens by a concise recap of the definitions of real exchange rate; it then descends to the literature review of the topic following the chronological order whenever applicable. The study is concluded in Section 3. The various definitions of the real exchange rate can be mainly grouped into two main categories.
The first category of definitions is made currency depreciation and trade balance line with the purchasing power parity PPPwhile the second is based on the distinction between the tradable and the nontradable goods.
Although they might coincide in some very special cases, these definitions usually give different results when employed in empirical studies. According to the PPP-based definition, the real exchange rate is defined in the long-run as the nominal exchange rate after adjustment to the ratio of the foreign price level to the domestic price level.
Mathematically, it is given by In this definition, the decline in is interpreted as the real appreciation of the domestic currency, since it indicates that few currency depreciation and trade balance of the domestic currency are needed to purchase the same one unit of foreign currency.
The rationale behind this definition is currency depreciation and trade balance the cost differential between countries is interrelated with the relative price structures in these economies.
Thus, the fall of in this definition also indicates real appreciation of domestic currency [ 6 ]. Both definitions stated above rely on the currency depreciation and trade balance that home country has only one trading partner. However, in some empirical studies, such an assumption might be invalid. Currency depreciation and trade balance considering this fact, we can distinguish a third definition called currency depreciation and trade balance real effective exchange rate.
In REER definition, the real exchange rate corresponds to a group currency depreciation and trade balance countries instead of one partner only. Following some weighting criteria, the share of the bilateral trade to total trade volume or the share of the currencies used in the international trade transactions can be given as examples of these weighting criteria [ 8 ].
Currency depreciation and trade balance stating these differing definitions of real exchange rate, it should be noted that some studies have discussed the role of nominal exchange rate on trade balance instead of the real exchange rate.
This difference is mainly due to whether the country follows a pigged or free-floating exchange rate regime. Thus, the reader should understand the theories stated in this study in line with these definitions. Different empirical and theoretical studies have investigated the effect of exchange rate movements on trade balance. The next section systemizes these studies into four broad approaches to ease the understanding of the historical improvement of the topic.
This paper is theoretical in nature and specifically a review article on the determinants effect of exchange rate movement on the trade balance. It provides a survey of the alternative theories that focus on the effect of exchange rate changes currency depreciation and trade balance the trade balance.
Data and information are collected through the libraries and recognized journals both local and international. This simply suggests that secondary sources are predominantly used in the methodology of this study. The next section systemizes these studies into four different reviews and approaches of exchange rate movements on trade balance to ease the understanding of the historical improvement of the topic.
During the sixteenth to eighteenth centuries, Mercantilism was the dominant economic system of most industrial countries. The Mercantilist approach to international trade assumed that the wealth of a nation depends chiefly on its ability to possess currency depreciation and trade balance metals such as gold and silver. The possession of those metals took place through supporting exports and encouraging metal discoveries in the Americas and, on the other hand, suppressing imports through imposing excessive tariffs [ 9 ].
After almost three centuries of instability and economic failure, Mercantilism was strongly criticized by what became to be known later as the Standard Theory of International Trade [ 10 ]. The two books heralded the formulation of a theory of free trade, based on the unprecedented success of England in the respective fields of industry and trade [ 13 ]. Standard Trade Theory relates merchandise with the movements of real exchange rate following a simple common sense approach.
Setting all other variables fixed, a fluctuation in exchange rate affects both the value and volume of trade. If real exchange rate increases in home country, that is, real depreciation, the households can get less imported goods in exchange for a unit of domestic goods and services.
Thereby, a unit of imported goods would give higher number of units of domestic goods. Eventually, domestic households buy fewer imports while foreign households purchase relatively more domestic goods. Ultimately, the higher the real exchange rate for the home country, the more the trade surplus the country obtains [ 14 ].
Lerner further extended the typical trade theory by accounting for demand price elasticities of imports and exports as instrumental elements in measuring the effect of real exchange rate variations on trade balance. Thus, a rise in exports and a reduction in imports due to depreciation in real exchange rate do not necessarily mean a correction of trade balance deficit.
According to Lerner, trade balance is not concerned with the volume of physical goods but with their actual values currency depreciation and trade balance 15 ]. In elasticities approach, trade balance adjustment path is viewed on the basis of elasticities of demand for imports and exports. The elasticity of demand is defined as the quantity responsiveness of demanded goods or services to changes in price [ 16 ].
Although the Elasticity Approach is commonly known as Bickerdike-Robinson-Metzler Condition [ 17 ], Bickerdike [ 18 ] was actually the one who originally developed and laid the foundations of this approach by modeling nominal import and export prices as functions of import and export quantities [ 1920 ].
Bickerdike-Robinson-Metzler Condition implies that the change in the foreign currency value of the trade balance depends upon the import and export supply and demand elasticities and the initial volume of trade. As can be seen, all discussions in the elasticities approach revolve around the questions of volume and value responses to changes in real exchange rate. Figure 1 summarizes the case of domestic elasticity of supply in a devaluating country.
As shown, the same logic also applies to the domestic demand. However, as depicted in Figure 1lower prices in the domestic country as a result of currency devaluation will normally increase foreign demand for domestic goods, but only when foreign demand is elastic. On the other hand, if foreign demand elasticity for domestic goods is weak, the quantity of domestic currency depreciation and trade balance will not rise to the extent that it exceeds the decline in the value of exports caused by the cheaper prices [ 23 ].
Following the same notions, the case of domestic elasticity of demand can be understood in the same context. The consumers will then currency depreciation and trade balance by consuming domestic rather than foreign goods forcing the value of imports to decline. In summary, if the decline in value of domestic imports is greater than the decline currency depreciation and trade balance value of domestic exports, the trade balance will improve.
Policymakers apply the Elasticity Approach in reality when a country faces trade balance deficit. They would have to consider the responsiveness of imports and exports for a change in exchange rate to measure to which extent devaluation would affect the trade balance. However, if foreign and domestic demands for imports and exports are elastic, a small change in the spot exchange rate might have substantial impact on trade balance [ 24 ].
Marshall-Lerner Condition is a further extension of the elasticities approach. The condition could be seen as an implication of the work of Bickerdike [ 18 ]. Nevertheless, it was named after Alfred Marshall who was born in and died insince he is considered as the father of the elasticity as a concept and Lerner [ 15 ] for his later exposition of it [ 19 ].
Assuming trade in services, investment-income flows, and unilateral transfers are equal to zero, so that the trade account is equal to the current account, Marshall-Lerner Condition states that the sum of the absolute values of the two elasticities must exceed unity [ 25 ].
Conversely, if the sum is less than one, trade balance worsens when a depreciation takes place [ 15 ]. The first is that trade was initially balanced when exchange rate depreciation took place, so that the foreign currency value of exports equals the foreign currency value of imports. The effect can be explained as depicted in Figure 2. Following a currency depreciation, the trade balance is to improve only when the volume effect shown in A and Currency depreciation and trade balance outweighs the price currency depreciation and trade balance denoted as C.
However, the Marshall-Lerner Condition is also indicative currency depreciation and trade balance stability. If the sum of the two import and export demand elasticities does not exceed unity, the equilibrium is unstable and an economic model with an unstable equilibrium could be inefficient for measuring the outcome of exchange rate depreciation on trade [ 27 ].
Almost three decades after the generalization of the Marshall-Lerner Condition, the J-Curve theory came into existence. Thus, it is considered as a dynamic view of Marshall-Lerner Condition [ 29 ] or, more generally, the elasticities approach.
In the short-run, instantly after currency devaluation, domestic importers face inflated import prices as paid in domestic currency; thus, the net exports currency depreciation and trade balance. On the other hand, the domestic exporters in the devaluating country face lower export prices since the demand for exports and imports is fairly inelastic in the short-run.
In other words, in the short-run when prices are relatively constant the balance of trade faces a decline due to the stickiness of prices and sluggishness to demand change. Prices stickiness is when goods are still traded at the price levels prior to devaluation [ 30 ]. The trade balance worsens by the currency depreciation and trade balance of total imports in foreign currency multiplied by the magnitude of the rise in the price of foreign currency since contracts made before the depreciation force fixed prices and volumes.
Afterwards, domestic demand starts to shift from foreign to domestic production of substitution goods as a reaction to the higher prices of imports, causing a trade balance improvement. Furthermore, the markets in home country experience an increase in exports volume due to the decrease in exports currency depreciation and trade balance.
However, the J-Curve phenomenon predicts the trade balance to improve in the long-run to a higher level compared to its level before depreciation.
The dynamic reaction of trade balance as a short-run dip and long-run recovery takes the shape of the flattened J letter, hence the J-Curve phenomenon. The J-Curve is depicted in Figure 3.
As an implication on monetary policy, the exchange rate devaluation should be sufficiently large to have a favorable long-run impact on trade balance. In relation to Marshall-Lerner Condition, if trade balance improves in the long-run due to currency devaluation to a level higher than the level before devaluation under the J-Curve assumptions, we can consider the Marshall-Lerner Condition fully satisfied [ 7 ]. If not, the Marshall-Lerner Condition is not satisfied and the J-Curve is expected to flatten on lower level compared to the level before devaluation [ 32 ].
The time frame for the J-Curve, before the Marshall-Lerner Condition kicks in and improves the trade balance, is said to be anytime between a few months to two or three years [ 3033 ]. The approach of elasticity is mainly criticized for being a partial equilibrium approach which does account for the macroeconomic effects arising from price changes and production fluctuations in response to currency devaluation [ 34 ].