Worked example 1
Country A has a persistent current account deficit of 5% of GDP. Its currency is fixed but under pressure. PEDx = 0.8 and PEDm = 0.6. Inflation is 3% and unemployment is at the NAIRU.
Evaluate devaluation as a policy to correct the deficit. [12 marks]
Show solution outline
Marshall–Lerner check: PEDx + PEDm = 0.8 + 0.6 = 1.4 > 1 → condition satisfied → devaluation should eventually improve trade balance in volume terms.
Mechanism (expenditure-switching):
- Devaluation → exports cheaper abroad, imports dearer domestically.
- If volumes respond elastically enough, X rises, M falls → deficit narrows.
Arguments supporting devaluation:
- PED sum > 1 — technically effective medium term.
- Unemployment at NAIRU — economy not in recession, can absorb any temporary disruption.
- Corrects overvaluation that may have caused deficit.
Arguments against / limitations:
- J-curve: deficit may worsen initially — import prices rise immediately; export contracts fixed in foreign currency.
- Inflation at 3%: devaluation adds cost-push pressure — imported raw materials dearer → SRAS left → inflation rises further.
- PEDx only 0.8: export response may be weak if goods are low-value-added or face strong competition.
- Fixed rate: devaluation breaks peg — credibility loss, may trigger speculative outflows.
- Retaliation: trading partners may devalue or impose barriers.
Alternatives:
- Supply-side productivity improvements — less inflationary.
- Expenditure-reducing — inappropriate with unemployment already at NAIRU (would cause recession).
Judgement: Devaluation can work given Marshall–Lerner satisfied, but inflation risk is significant — may need monetary tightening to anchor expectations, creating internal trade-offs.