ChainWhat it assumes · how to break it
Start
The pound depreciates against the currencies of the UK's main trading partners, as it did in 2008 and again in 2016.
1
As a result, UK exports become cheaper in foreign currency and imports become dearer in pounds.
SPICED
SPICED
Assumes: Firms pass the exchange rate change into prices.
But: Exporters may hold their foreign prices and take higher sterling margins, so export volumes do not rise.
2
In the short run, volumes barely change because orders and contracts are already agreed, so the UK pays more pounds for the same imports and the trade balance worsens.
J-curve
J-curve
Assumes: Demand for exports and imports is price inelastic in the short run.
But: Some spending responds quickly, such as tourists choosing a UK holiday, so the initial worsening may be small.
3
Over time, foreign buyers switch to UK exports and UK buyers switch to domestic substitutes as contracts end and new suppliers are found.
expenditure switching · PED
expenditure switching · PED
Assumes: Close substitutes are available at home and abroad.
But: The UK imports much food, energy and components for which there are few domestic substitutes.
4
Therefore, if the combined price elasticities of demand for exports and imports exceed one, export revenue rises by more than spending on imports, so the trade balance improves.
Marshall–Lerner condition
Marshall–Lerner condition
Best link to attack
Assumes: The Marshall–Lerner condition holds.
Assumes: The Marshall–Lerner condition holds.
But: Many UK exports compete on quality rather than price, and many use imported components whose cost rises with the depreciation, so elasticities may be too low.
End
The trade balance worsens at first and then improves, if the Marshall–Lerner condition holds.
Evaluation chain
- E1However, the improvement depends on the Marshall–Lerner condition holding, so that demand for exports and imports is price elastic enough.
- E2Because much of what the UK imports has no close domestic substitute and many UK exports compete on quality or contain imported components,
- E3so the rise in sterling spending on imports can match the rise in export revenue, even after volumes have adjusted.
- E4So the trade balance may improve only a little, as after the large fall in sterling in 2008, or not at all; a depreciation is a weak cure for a deficit caused by low non-price competitiveness.
Another way to attack it: A depreciation raises UK incomes through higher net exports, which raises spending on imports and offsets part of the improvement. Imported inflation may also erode the competitive gain if UK costs and wages rise.
The J-curve means the improvement typically takes one to two years to appear.
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Questions this answers
- Explain the J-curve effect of a depreciation on the current account.
- Assess whether a depreciation of sterling will reduce the UK current account deficit.
- Explain the Marshall–Lerner condition.
Diagram
J-curve: the trade balance plotted against time, falling just after the depreciation and then rising above its starting level.
Reverse and related
Appreciation → trade balance may improve briefly, then worsens as volumes respond (reverse J-curve).