CURRENCY DEPRIATION

Depreciation of Currency for Trade Balance Improvement

Depreciation of Currency for Trade Balance Improvement

Introduction

The primary purpose of this report is to determine the trade balance of a country with the depreciation in the domestic currency. The currency chosen for this analysis is US dollar. It will be worthwhile research which explains the improvement in the US economy which is the world's biggest economy with the depreciation in its currency. United States is the pioneer and leader in the information and technology. The idea of this paper is to prove that the depreciation of currency must result in the progress in the country's trade balance. This report analyzes the theories supported to the above idea and also presents the empirical researches.

Theoretical Approach to Dollar Depreciation and its impact on Trade Balance

This section represents the theories to understand the relationship between the depreciation of dollar and trade balance. The theories or approaches concerning to this topic includes elasticity, multiplier effect and absorption approach. These related theories and approaches will be evaluated to produce the result.

Features of Elasticity Approach

This theory defines that variation in the trade balance is observed upon the price elasticity of demand for exports and imports. The demand and supply elasticity is due to the quantity demand of goods and services. The analysis of the trade balance based upon the price elasticity of demand for exports and imports is called elasticity approach. The developer of this approach was Bickerdike-Robinson-Metzler who initiated it during the 20th century (Chee-Wooi & Tze-Haw, 2008). The price sensitivity of demand for different goods is responsible for the country's elasticity of demand for foreign goods. The elasticity supply of a country depends on country's production ability of goods and service demanded by domestic and foreign market.

Elasticity Approach

As a traditional approach to the balance of payments, elasticities approach assumes that capital flows occur only as a means of financing current account transactions.

Derivation of the Demand for Foreign Exchange:

The quantity of a currency demanded in the foreign exchange market is derived from the country's demand for imports.

Elasticity of Import Demand and the Elasticity of Foreign Exchange Demand.

Derivation of the Supply of Foreign Exchange

The supply of foreign exchange to a country results from its exports of goods and services.

Elasticity of Export Supply and the Elasticity of Foreign Exchange Supply.

The elasticity approach centers on changes in the prices of goods and services as the determinant of a country's balance of payments and the exchange value of its currency.

The Role of Elasticity

The elasticities of the supply of and demand for foreign exchange are fundamental determinants of adjustment to a balance-of-payments deficit.

Assumptions for the theory

Capital flows occur only as a means of financing current account transactions.

Trade balance exclusively represents the current account.

J-Curve Effect

A depreciation of the domestic currency is unlikely to immediately improve a country's balance-of-payments deficit. It is even possible that the depreciation could cause a country's balance of payments to worsen before it ...