Currency Depreciation and the Trade Balance - Chain of Reasoning

In this short revision video we walk through an example of how to build an analytical chain of reasoning for this question: Analyse how a depreciation of a nation’s currency might affect their trade balance.

Chain of analytical reasoning

• A depreciation is a fall in the external value of a currency within a floating exchange rate system. For example, sterling might fall against the US dollar.
• If a currency falls in value, the overseas price of exports is likely to fall. Consequently exports such as cars and pharmaceuticals become more price competitive
• As a result, export volumes should increase leading to an increase in the value of exports and therefore an improved trade balance
• And import prices will increase which can lead to a fall in import demand as buyers switch their spending towards domestically-produced output
• Thus, a depreciation of the exchange rate - ceteris paribus - should lead to an improvement in net trade for a country (X-M)

Brief evaluation perspective

1. The impact on the trade balance depends on price elasticity of demand for exports and imports. Only if the Marshall-Lerner condition holds (PEDX + PEDM > 1) will net trade improve
2. In the short-term, a depreciation might lead to a J curve effect
3. Many exports require imports, for example, farm exports might need imported fertiliser and animal feed, so a currency depreciation might increase costs and reduce the extent to which exports become more price competitive.