ChainWhat it assumes · how to break it
Start
The pound appreciates against the currencies of the UK's main trading partners.
1
As a result, UK exports become dearer in foreign currency and imports become cheaper in pounds.
SPICED
SPICED
Assumes: Firms pass the exchange rate change into prices.
But: Exporters may cut their sterling prices to keep foreign prices steady, so export volumes hold up.
2
In the short run, volumes barely change because contracts are already agreed, so the UK pays fewer pounds for the same imports and the trade balance may improve at first.
J-curve (in reverse)
J-curve (in reverse)
Assumes: Demand for exports and imports is price inelastic in the short run.
But: Some spending responds quickly, such as UK tourists choosing cheaper holidays abroad.
3
Over time, foreign buyers switch away from UK exports and UK buyers switch to imports as contracts end.
expenditure switching · PED
expenditure switching · PED
Assumes: Close substitutes are available.
But: Specialised UK exports, such as aerospace parts and financial services, have few close substitutes.
4
Therefore, if the combined price elasticities of demand for exports and imports exceed one, export revenue falls by more than spending on imports, so the trade balance worsens.
Marshall–Lerner condition
Marshall–Lerner condition
Best link to attack
Assumes: The Marshall–Lerner condition holds.
Assumes: The Marshall–Lerner condition holds.
But: If UK exports compete mainly on quality, demand is price inelastic and export revenue in pounds falls only a little.
End
The trade balance worsens, after a possible brief improvement, if the Marshall–Lerner condition holds.
Evaluation chain
- E1However, the worsening depends on the Marshall–Lerner condition holding, so that demand for UK exports and imports is price elastic.
- E2When exports compete on quality, brand and specialist know-how rather than price,
- E3then foreign buyers keep buying despite the higher price, so export revenue holds up; economies such as Switzerland have kept current account surpluses despite strong currencies.
- E4So the trade balance worsens by less than expected, or barely at all, for an economy with strong non-price competitiveness; the damage is greatest where exports are price sensitive.
Another way to attack it: A stronger pound reduces AD and UK incomes, so households buy fewer imports. This income effect works against the price effect and may limit the worsening of the trade balance.
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Questions this answers
- Explain how an appreciation of the pound might affect the UK current account.
- Assess the impact of a strong pound on the UK balance of trade.
- Explain why the effect of an exchange rate change on the trade balance may differ in the short run and the long run.
Diagram
Reverse J-curve: the trade balance plotted against time, rising briefly after the appreciation and then falling below its starting level.
Reverse and related
Depreciation → J-curve → trade balance improves if Marshall–Lerner holds.