Exchange rates and the balance of payments
Introduced| English | Meaning |
|---|---|
| devaluation/diːˌvæljuːˈeɪʃn/ | A government lowering the value of a fixed exchange rate. |
| J-curve/dʒeɪ kɜːv/ | A pattern in which a currency depreciation initially worsens the trade balance before it improves as quantities adjust. |
A decision you can investigate
- A country’s currency has just fallen sharply against the dollar.
- Will its trade balance improve at once?
Build the explanation
- A floating exchange rate is set by currency markets; a fixed rate is held by the central bank, and a managed rate lies between. An official cut in a fixed rate is a devaluation 法定贬值; a market-driven fall in a floating rate is a depreciation, and revaluation pairs with appreciation.
- A cheaper currency makes exports cheaper and imports dearer, but the trade balance improves only if the Marshall-Lerner condition holds (the sum of export and import demand elasticities exceeds 1); because volumes adjust slowly, the balance usually worsens first, which is the J-curve J曲线.
Work through the evidence
- The current account records trade in goods and services plus income and transfers; the capital and financial accounts record asset flows, so a persistent deficit must be financed by selling assets or borrowing abroad.
- Measures to reduce a deficit divide into expenditure-reducing policy (higher tax, lower spending, higher interest rates), expenditure-switching policy (a lower exchange rate, protectionism) and supply-side policy (education, infrastructure, research incentives) that raises competitiveness over time.
A central bank officially lowers its fixed exchange rate. This is called…
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Fixed rates are devalued or revalued by the authorities; floating rates depreciate or appreciate in the market.
Test the limits
- Deflation cuts imports but costs output and jobs; depreciation fails when exports are raw materials with inelastic demand; tariffs invite retaliation and breach WTO rules. Supply-side policies take years.
- Currency intervention has limits: reserves run out, and competitive devaluations invite copycat rounds that shrink world trade.
Why does a depreciation usually worsen the trade balance at first?
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In the short run quantities barely move, so the import price effect dominates; Marshall-Lerner governs the later improvement, not the early dip.
A depreciation improves the trade balance immediately.
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The J-curve rules out an immediate improvement, and the Marshall-Lerner condition can fail entirely.
Apply and explain your answer
- A central bank lowers its fixed exchange rate against the dollar. Is that a depreciation?
- No: an official cut in a fixed rate is a devaluation; depreciation is the market-driven fall of a floating currency.
Which financing must cover a persistent current-account deficit?
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The balance of payments balances: the deficit is financed through the financial account.
Use the terms precisely
- devaluation: An official reduction of a fixed exchange rate.
- J-curve: The trade balance’s typical path of worsening before improving after a depreciation.
Match the terms to their meanings.
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Use each term for its stated economic relationship.
The current account records trade in goods and services plus income and transfers; the capital and financial accounts record asset flows, so a persistent deficit must be financed by selling assets or borrowing abroad. Measures to reduce a deficit divide into expenditure-reducing policy (higher tax, lower spending, higher interest rates), expenditure-switching policy (a lower exchange rate, protectionism) and supply-side policy (education, infrastructure, research incentives) that raises competitiveness over time.
Deflation cuts imports but costs output and jobs; depreciation fails when exports are raw materials with inelastic demand; tariffs invite retaliation and breach WTO rules. Supply-side policies take years. Currency intervention has limits: reserves run out, and competitive devaluations invite copycat rounds that shrink world trade.
A floating exchange rate is set by currency markets; a fixed rate is held by the central bank, and a managed rate lies between. An official cut in a fixed rate is a devaluation; a market-driven fall in a floating rate is a depreciation, and revaluation pairs with appreciation.
Write from a deficit of 40
- A current-account deficit is 40. The capital and financial accounts have to finance it.
- Separate a higher tax, a lower exchange rate and a training programme.
A current-account deficit is 40. How is it financed in this simple account, and which of a higher tax, a lower exchange rate and a training programme is expenditure-reducing, expenditure-switching or supply-side?
The accounts record different flows. A policy label follows whether it cuts spending, switches spending or raises later productive capacity.
How is a current-account deficit of 40 financed in this simple account?
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The capital and financial accounts cover the deficit. The exchange rate and training are policy types, not the financing total.