Devaluations-Elasticties Approach in Forex
Whether or not devaluation can cure disequilibrium in the balance of payments depends upon the shape of the demand and supply curves for foreign exchange.
The shape of the demand and supply curves for foreign exchange depends upon the nature of the underlying transactions. The demand for foreign currency, for instance, for paying interest on fixed-interest securities is of zero elasticity if the debt is expressed in terms of foreign currency and of unitary elasticity if the debt is expressed in terms of domestic currency and is payable in foreign currency.
The shape of the demand and supply curves for foreign exchange arising out of imports and exports of goods and services depends upon and is derived from the demand for and the supply of imports and exports at home and abroad. The effect of depreciation will differ, therefore, according to the shape of the demand and supply curves for imports and exports of goods and services at home and abroad.
Obviously, the volume of imports will fall and that of exports rise after the depreciation of the domestic currency. Before we discuss the effect of devaluation on the prices and value of imports and exports, we will have to decide the currency in terms of which we speak.
The effect of a variation in exchange rate on the price and value of imports and exports will be different in terms of• different currencies. Export and import prices after devaluation, for instance, will rise in terms of domestic currency and fall in terms of foreign currency.
Under certain conditions, it is possible that the balance of payments might improve in terms of one currency and deteriorate in terms of the other. If the interest lies, mainly, in examining the effect of devaluation on the domestic income and employment, it is better to work in terms of domestic currency while working in terms of foreign currency is preferable if the interest lies, mainly, in analyzing its impact on the balance of payments. Two pairs of figures are shown below to study the effect of devaluation in terms of foreign as well as in terms of domestic currency.
Lerner expressed the condition for an effective devaluation in terms of the elasticities of demand for imports and exports, The condition is that the sum of the elasticities of home demand for imports and the, foreign demand for exports must be greater than unity.
The Lerner condition is sufficient but not necessary. Devaluation will be effective if the Lerner condition is fulfilled. The Lerner condition becomes sufficient as well as necessary in the limiting case in which the elasticities of supply are infinite.
The navy in the Lerner condition is that it concentrates only on the elasticities of demand for exports and imports, The general condition mentioned earlier takes into account the elasticities of demand for as well as those of supply of exports and imports.
The magnitude of the supply elasticities exerts no influence if the demand elasticities are zero or unity. Barring these exceptional cases, the supply elasticities play an important role in determining the effect of depreciation on the balance of payments.