A-Level Economics May/June 2024 Q1(c): Consider the extent to which depreciation of the Sri Lankan rupee could improve the cou…

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  A depreciation of the Sri Lankan rupee is a fall in its external value against other currencies under a floating exchange rate system. For example, the rupee might fall from LKR 300 per US dollar to LKR 350 per US dollar.

  This depreciation would make Sri Lankan exports cheaper for foreign buyers, as they would need less of their own currency to purchase a given amount of Sri Lankan goods. Conversely, imports into Sri Lanka would become more expensive for domestic consumers, as more rupees would be needed to buy a given amount of foreign goods.

  Assuming a rational response to price changes, the lower price of exports should lead to an increase in the quantity demanded for Sri Lankan exports, increasing export revenue. The higher price of imports should lead to a decrease in the quantity demanded for imports, reducing import expenditure. The combined effect of rising export revenue and falling import expenditure would lead to an improvement in the country's balance of trade in goods and services (i.e., a reduction in a trade deficit or an increase in a trade surplus).

  However, the extent to which the balance of trade improves depends critically on the price elasticity of demand (PED) for both exports and imports. The Marshall-Lerner condition states that for a currency depreciation to improve the balance of trade, the sum of the PED for exports and the PED for imports must be greater than one ($|PED_x + PED_m| > 1$). If the combined elasticities are less than one (i.e., demand is price inelastic), the fall in export prices will not be offset by a sufficiently large rise in quantity, leading to a fall in export revenue. Similarly, the rise in import prices will not lead to a significant fall in quantity demanded, potentially increasing total import expenditure. In this scenario, a depreciation could worsen the balance of trade, at least in the short run.

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  How the marks are awarded

  • M1 — The first sentence clearly defines depreciation as a fall in the currency's value in a floating exchange rate system.
  • M1 — The second paragraph explains that depreciation causes a fall in the relative price of exports and a rise in the relative price of imports.
  • M1 — The third paragraph links the price changes to the expected changes in quantities demanded of exports and imports, and the resulting improvement in the balance of trade.
  • E1 — The final paragraph provides evaluation by explaining that the outcome depends on the price elasticities of demand for exports and imports, explicitly stating and explaining the Marshall-Lerner condition.

  Common mistakes

  • Confusing depreciation (market-determined fall in a floating system) with devaluation (official government act in a fixed system).
  • Stating that the balance of trade will definitely improve without considering any evaluating factors.
  • Failing to explain the mechanism: simply saying 'exports get cheaper' without explaining it is because foreigners' currency is now stronger relative to the rupee.
  • Incorrectly stating the Marshall-Lerner condition, for example by saying that the PED for exports and the PED for imports must each be greater than 1, rather than their sum.

  Examiner tip: For any question that includes the phrase 'to what extent', ensure your answer moves beyond simple explanation to evaluate the conditions under which the stated economic theory holds true.

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