Devaluation and the J-curve

Devaluation of a currency is one of several policies deigned to remedy a trade deficit, and stimulate economic growth.

A trade deficit can be caused by several factors, including:

1. Excessive growth in the domestic economy - growth larger than the long term trend rate.
2. Domestic inflation relative to the rest of the world, which encourages cheaper imports and discourages exports,
3. An over-valued currency.
4. Long-term de-industrialisation, which erodes the manufacturing base of an economy.
5. Unfair competition, which can destroy domestic firms.
6. Trade barriers, which make exports difficult.

Devaluation in general terms means a situation where a country's currency is deliberately pushed down as a result of intervention by a central bank - this contrasts with 'depreciation' which is when a currency falls as a result of increased supply or reduced demand in the foreign exchange market.

The aim of devaluation is to reduce import spending and increase export revenue.

How does devaluation work?

Devaluation works through a process called 'expenditure switching' which means that a fall in a currency value will cause domestic consumers to switch to their own country's goods and services, and overseas consumers to switch towards the cheaper exports of the devaluing country.

Is it effective?

For devaluation to work the response of consumers ay home and abroad must be relatively elastic. More specifically, it will only work if the Marshall-Lerner condition is met [which is, that the sum of PEDs for exports and imports is greater than 1.]

This is unlikely in the short-run as demand tends to be inelastic. There are several reasons for this.

1. Firstly, some consumers may have bought goods on a contract basis (such as a 'futures' contract) and any change in current prices takes a while to impact demand.
2. Secondly, some consumers prefer to 'wait and see' what the impact of any currency devaluation will be before committing to altering their demand.
3. Thirdly, 'price' is only one determinant of demand - while a currency devaluation reduced price, price may not feature strongly in determining demand.
4. Finally, some consumers may simply be ignorant of the devaluation, and its impact on price.

However, in the longer run demand tends to adjust more to price, and the Marshall-Lerner condition may be satisfied.

This explains the ‘J-curve’ path following a devaluation, indicating the Marshall-Lerner condition is not met in the short-run, and devaluation causes any trade deficit to worsen.

Although not conclusive, a good deal of research has been undertaken, which supports the general conclusion that, at least in the long-run, the Marshall-Learner conditions is satisfied (see research on exchange rates in India).