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IB Economics Paper 1: evaluate the view that a depreciation of the exchange rate is beneficial for an economy.
IB Economics · Paper 1 — exchange rates · exam essay
Part (a): Explain how a depreciation of a country’s currency might affect its balance of trade. [10 marks]
Part (b): Using real-world examples, evaluate the view that a depreciation of the exchange rate is beneficial for an economy. [15 marks]
A top-band (grade 7) model answer with a criterion-by-criterion breakdown is below.
1 answer
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Part (a): Explain how a depreciation of a country’s currency might affect its balance of trade. [10 marks]
A currency depreciation is a decrease in the value of a country's currency in a floating exchange rate system, meaning it can buy less of another currency. The balance of trade (BOT) is a component of the current account, measuring the difference between the value of a country's exports of goods and services and its imports of goods and services over a period of time (BOT = Export Revenue - Import Expenditure).
A depreciation affects the BOT by altering the international price competitiveness of a country's exports and imports. When a currency depreciates, the price of its exports in foreign currency falls. For example, if the US dollar depreciates from £1 = 1.50, a 62.50 would now cost $75 in the US. This higher price should decrease the quantity of imports demanded.
However, an improvement in the BOT is not guaranteed. The overall impact depends on the price elasticity of demand (PED) for exports and imports. The Marshall-Lerner condition states that for a currency depreciation to lead to an improvement in the balance of trade, the sum of the price elasticities of demand for exports (PEDx) and imports (PEDm) must be greater than one (i.e., |PEDx + PEDm| > 1).
If the condition holds, the increase in export quantity will be proportionally larger than the decrease in export price, leading to a rise in total export revenue. Simultaneously, the decrease in import quantity will be proportionally larger than the increase in import price, leading to a fall in total import expenditure. The combined effect is an improvement in the BOT.
In the short term, the Marshall-Lerner condition may not hold. This gives rise to the J-curve effect. This can be illustrated with a diagram showing the balance of trade on the y-axis against time on the x-axis, with the curve starting from a deficit position. Immediately following a depreciation, demand for both exports and imports tends to be price inelastic. Consumers and firms may have pre-existing contracts, brand loyalty, or a lack of immediate awareness of price changes. As a result, the quantity of imports demanded falls only slightly, but the expenditure on them rises due to the higher price. Meanwhile, export revenue may not increase significantly. This causes the balance of trade to worsen initially, creating the initial downward hook of the 'J'.
Over time, as consumers and firms adjust their behaviour, find new suppliers, and form new habits, the demand for exports and imports becomes more price elastic. The Marshall-Lerner condition is more likely to be met. Export revenues begin to rise significantly, and import expenditures fall, leading to a sustained improvement in the balance of trade. This traces the upward-sloping part of the 'J', eventually moving the BOT into a surplus or a smaller deficit than before the depreciation.
Part (b): Using real-world examples, evaluate the view that a depreciation of the exchange rate is beneficial for an economy. [15 marks]
The view that a currency depreciation is beneficial for an economy is a contentious one, as it creates both winners and losers and involves significant trade-offs. While it can stimulate economic growth and employment, it can also trigger harmful inflation and reduce living standards.
Potential Benefits of Depreciation:
The primary benefit, as explained in part (a), is a potential improvement in the balance of trade, provided the Marshall-Lerner condition holds. An increase in net exports (X-M) is an injection into the circular flow of income, causing a rightward shift in the Aggregate Demand (AD) curve. This can be illustrated on an AD/AS diagram. A shift from AD1 to AD2 leads to an increase in real GDP from Y1 to Y2, stimulating economic growth and reducing demand-deficient unemployment. For an economy operating with a negative output gap, this boost to AD can be highly beneficial.
Furthermore, a weaker currency can make a country's assets (e.g., property, companies) appear cheaper to foreign investors, potentially encouraging an inflow of Foreign Direct Investment (FDI), which can further boost long-run productive capacity.
Drawbacks and Limitations of Depreciation:
Despite these benefits, a depreciation has significant drawbacks. The most prominent is the risk of inflation.
- Demand-pull inflation: The rightward shift of the AD curve (from AD1 to AD2) will lead to a higher average price level (from PL1 to PL2), particularly if the economy is operating near its full employment level.
- Cost-push inflation: Many economies rely on imported raw materials, components, and energy. A depreciation makes these imported inputs more expensive for domestic firms. This increases the costs of production, leading to a leftward shift of the Short-Run Aggregate Supply (SRAS) curve. This cost-push inflation can be particularly damaging, as it leads to both higher prices and lower output (stagflation).
Additionally, a depreciation worsens the country's terms of trade, meaning it must export more goods to pay for the same quantity of imports. This can lead to a decline in national living standards, as consumers face higher prices for imported goods and foreign travel, reducing their real income and purchasing power. Finally, for firms or governments that have debt denominated in a foreign currency, a depreciation increases the real burden of that debt, potentially leading to financial distress.
Real-World Example: The UK after the 2016 Brexit Referendum
The depreciation of the British Pound (GBP) following the Brexit vote in June 2016 provides a compelling case study. The pound fell by approximately 15% against the US dollar and the Euro in the months following the vote.
In line with theory, there were some benefits. The UK's export sector, particularly in manufacturing and tourism, became more competitive. Tourism into the UK boomed as it became a cheaper destination. However, the anticipated major improvement in the overall balance of trade was muted, suggesting a prolonged J-curve effect or underlying structural weaknesses.
The negative consequences were more pronounced. The UK is a net importer of food and energy, and the depreciation led to a sharp increase in import costs. This triggered a wave of cost-push inflation, with the Consumer Price Index (CPI) rising from 0.5% in June 2016 to a peak of 3.1% in November 2017. This inflation outstripped wage growth, leading to a sustained squeeze on real incomes and a decline in living standards for many households. The Bank of England was eventually forced to raise interest rates to combat this inflation, which could have dampened investment and consumption.
Evaluation:
In conclusion, the view that a depreciation is beneficial is overly simplistic. The effect is highly dependent on the economic context. For the UK post-2016, the benefits of increased export competitiveness were largely outweighed by the costs of higher inflation and reduced real wages. The depreciation acted more as a source of stagflationary pressure than as a benign tool for rebalancing the economy.
The overall benefit of a depreciation hinges on several factors: the initial state of the economy (the impact is more positive if there is significant spare capacity), the economy's structure (it is more harmful for countries heavily reliant on imports), and the policy response from the central bank. Therefore, while a depreciation can be a useful automatic stabilizer in some circumstances, it is a double-edged sword that often imposes significant costs on consumers and can destabilize prices, as the UK example illustrates.
How it meets the IB criteria
- A — Part (a) [9-10 marks] — The response fully addresses the question by clearly defining depreciation and balance of trade. It explains the theoretical transmission mechanism through export and import prices and quantities. Crucially, it moves beyond a simple explanation by introducing and correctly explaining the Marshall-Lerner condition and the J-curve effect, which are essential for a top-band answer. All key economic terms are used appropriately, and the verbal description of the J-curve diagram is clear and accurate, satisfying the diagrammatic requirement.
- B — Part (b) [13-15 marks] — The response provides a well-structured and balanced evaluation, directly addressing the 'beneficial' aspect of the question. It explains relevant theory for both sides of the argument, describing the AD/AS model to illustrate benefits (growth) and drawbacks (demand-pull and cost-push inflation). The real-world example of the UK post-Brexit is not just mentioned but fully developed, with specific details (e.g., inflation figures) used to support the analysis of both the pros and cons. The conclusion provides an effective synthesis, offering a nuanced judgement that the overall effect is context-dependent and that the 'beneficial' view is too simple, thereby demonstrating strong evaluative skill.
Common ways to drop marks
- In Part (a), failing to explain the Marshall-Lerner condition and the J-curve effect, which results in an incomplete and overly simplistic answer.
- In Part (b), providing a one-sided argument that only lists the benefits of depreciation without discussing the significant drawbacks like cost-push inflation and worsening terms of trade.
- Using a real-world example superficially, such as just naming a country ('e.g., Japan') without providing specific details or linking it back to the economic theory being evaluated.
- Confusing depreciation (a fall in value in a floating system) with devaluation (an official lowering of value in a fixed system), or using the terms interchangeably without precision.
Examiner tip: For evaluation questions, always structure your answer around a central economic trade-off, using a specific, well-developed real-world example as the evidence to explore both sides of the argument.
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