The Effect of Currency Depreciation on International Trade

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This article is published in collaboration with VoxEU. Exchange rate movements have been unusually large and have sparked some controversy as to their likely effect on exports and imports. Some suggest that exchange rates currency devaluation and international trade far less than they used to, and may have disconnected from trade entirely. These days, the disconnect argument is often based on the observation that production has become fragmented across countries in global value chains.

Smart phones assembled in China using parts from multiple countries are one such example. A rising share of exports consists of components imported from abroad foreign value contentand a currency depreciation should thus provide a more limited boost to exports. A disconnect of exchange rates from trade would complicate policymaking. It would weaken a key channel for the transmission of monetary policy and make it currency devaluation and international trade to reduce trade imbalances via the adjustment of exchange rates.

Concerns that exchange rates may have disconnected from trade have been assuaged in the past. In the s, the US dollar depreciated and the yen appreciated sharply after the Plaza Accord, but trade volumes were initially slow to adjust. Some commentators then suggested a disconnect between exchange rates and trade. By the early s, however, US and Japanese trade balances had adjusted, largely in line with the predictions of currency devaluation and international trade models Krugman The question is whether this time will be different, or whether the relationship between exchange rates and trade remains strong.

We use data for more than 50 advanced and emerging market and developing economies over the past three decades. The growing importance of emerging markets in world trade justifies this broad country coverage, which goes beyond the group of countries typically examined in related studies. Our currency devaluation and international trade approach employs both standard trade equations following the pricing-to-market literature recently reviewed in Burstein and Gopinath and an event analysis of historical episodes of large exchange rate depreciations.

This allows us to measure the strength of the links between exchange rates and the relative prices of exports and imports, as well as the links between these relative trade prices changes and movements in export and import volumes.

This impact varies widely across economies Figure 1. Much, though not all of the adjustment, occurs within a year. Our analysis of historically large exchange rate movements, which include, for example, economies affected by the European Exchange Rate Mechanism crisis, or the devaluation of the Chinese yuan infurther supports the notion that exchange rate depreciations raise exports.

It also suggests that, among economies experiencing currency depreciation, the rise in exports is greatest for those with slack in the domestic economy and with financial systems operating normally. Figure shows long-term effect on level of net exports in percent of GDP based on country-specific import- and export-to-GDP ratios and average cross-country trade elasticities. We also find little evidence of a general disconnect in the relationship between exchange rates and exports and imports over time.

This finding is especially relevant for economies that have substantially increased their participation in global value chains, such as, for example, Hungary and Romania. It is also consistent with the findings of Ahmed et al. But it is important to keep this result in perspective.

Global value chain-related trade has generally increased only gradually through the decades and appears to have slowed in recent years Constantinescu et al.

Furthermore, other developments, including declining barriers to trade movements, may have strengthened the effects of exchange rates on exports and imports. And currency devaluation and international trade is worth recalling that even a decline in trade elasticities could, at least in principle, be consistent with greater economic significance of exchange rate movements, given the rising size of exports and imports in percent of Currency devaluation and international trade.

Solid lines denote the average. Dashed lines denote 25th and 75th percentiles. When we test the stability of the relationship between exchange rates and total trade, we find little evidence of the links weakening over time.

Rolling regressions and structural break tests do not support the notion of a general disconnect for different country groups. As for the puzzling weakness of exports in Japan, our analysis suggests that this reflects a number of Japan-specific factors.

Export growth has been weaker than could be expected based on exchange rate and trading partner growth developments. The study by Ahmed et al. When we replicate the analysis for the economies examined in that study, we find that the evidence of a drop in the effectiveness of exchange rate movements over time currency devaluation and international trade fragile.

The estimated drop largely disappears after controlling for a small number of influential currency devaluation and international trade observations. The same applies after computing real exports by deflating nominal exports using export prices rather than the CPI as in the study. The argument is based on the apparent lack of a correlation between exports and US dollar exchange rates for emerging markets since However, since the cross-section scatter plots presented there do not control for other factors that drive exports, including shifts in trading partner demand, they are affected by omitted variables and reverse-causality problems.

And since the study only considers years sinceit cannot shed light on whether the links between exchange rates and exports have weakened over time. Overall, we conclude that the relation between exchange rates and trade remains strong and that reports of a disconnect have been overstated.

Our evidence suggests that recent currency movements imply a substantial redistribution of real net exports across economies, from the US and economies whose currencies move with the dollar to economies whose currencies have depreciated. Beyond these direct effects, observed changes in trade also reflect shifts in the underlying fundamentals driving exchange rates themselves.

From a policy standpoint, our results confirm that exchange rate movements can still help to reduce trade imbalances. Exchange rate movements also continue to have currency devaluation and international trade strong bearing on export and import prices, with implications for inflation dynamics and the transmission of monetary policy.

However, our research currency devaluation and international trade not address the desirability of any specific exchange rate change or any particular policy stance in any specific country. The views expressed in this article are the sole responsibility of the authors and should not be attributed to the International Monetary Fund, its Executive Board, or its management. Policy Analyses in International Economics. Institute for International Economics. The views expressed in this article are those of the author alone and not currency devaluation and international trade World Economic Forum.

We are using cookies to give you the best experience on our site. By continuing to use our site, currency devaluation and international trade are agreeing currency devaluation and international trade our use of cookies. You're rubbish at spotting mistakes. More on the agenda. Explore the latest strategic trends, research and analysis. Contrary to the currency devaluation and international trade of disconnect, we find a strong link between exchange rates and trade.

Little sign of disconnect over time We also find little evidence of a general disconnect in the relationship between exchange rates and exports and imports over time.

Relation to existing work The study by Ahmed et al. Policy implications Our evidence suggests that recent currency movements imply a substantial redistribution of real net exports across economies, from the US and economies whose currencies move with the dollar to economies whose currencies have depreciated. Publication does not imply endorsement of views by the World Economic Forum.

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Lerner is the condition that an exchange rate devaluation or depreciation will only cause a balance of trade improvement if the absolute sum of the long-term export and import demand elasticities is greater than unity. Initially, there will be a deterioration of the trade balance which can be attributed to lags in recognition of the changed situation, lags in the decision to change real variables, lags in delivery time, lags in replacement of inventories and materials and lags in production.

In the long-term though, when the prices become flexible, there will be a positive quantity effect on the balance of trade because domestic consumers will buy fewer imports and foreign consumers will buy more of our exports; but offsetting this is a negative cost effect on the balance of trade, since the relative cost of imports will be higher.

Whether the net effect on the trade balance is positive or negative depends on whether or not the quantity effect outweighs the cost effect; if the quantity effect is greater, then it is said that the Marshall—Lerner condition is met. Essentially, the Marshall—Lerner condition is an extension of Marshall's theory of the price elasticity of demand to foreign trade. Formally, the condition states that, for a currency devaluation to have a positive impact on the trade balance , the sum of the price elasticities of exports and imports in absolute value must be greater than 1.

The net effect on the trade balance will depend on price elasticities. If goods exported are elastic with respect to price, their quantity demanded will increase proportionately more than the decrease in price, and total export revenue will increase. Similarly, if goods imported are price elastic, total import expenditure will decrease.

Both will improve the trade balance. Empirically, it has been found that trade in goods tends to be inelastic in the short term, as it takes time to change consuming patterns and trade contracts. In the long term, consumers will adjust to the new prices, and the trade balance will improve. This effect is called the J-curve effect. For example, assume a country is a net importer of oil and a net producer of ships. Initially, the devaluation immediately increases the price of oil, and as consumption patterns remain the same in the short term, an increased sum is spent on imported oil, worsening the deficit on the import side.

Meanwhile, it takes some time for the shipbuilder's sales department to exploit the lower price and secure new contracts. Only the funds acquired from previously agreed contracts, now devalued by the currency devaluation, are immediately available, again worsening the deficit on the export side. Using this definition, the trade balance denominated in domestic currency with domestic and foreign prices normalized to one is given by:.

In order for a fall in the relative value of a country's currency i. From Wikipedia, the free encyclopedia. Using this definition, the trade balance denominated in domestic currency with domestic and foreign prices normalized to one is given by: Differentiating with respect to e gives: Retrieved from " https: Views Read Edit View history.

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