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With devaluation, inflation can be caused in the LR:

Devaluation → net exports rise → AD rise → AD shifts to the right

If economy is at intermediate range (from AD1 to AD2) or full employment (AD2 to AD3) → PL rise → causing demand-pull inflation

Devaluation → Pm rise → M expensive → COP rise (on raw materials) → causing cost-push inflation

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Devaluation

Value of a currency falls compared to other currencies

X cheaper, M ex

BOP deficit

M exp > X rev

Inflation

PL of goods & services rise in an economy over time

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With devaluation, BOP cannot be improved in the SR (D inelastic)

• X cheaper → Dx rise → X rev fall

• M expensive → Dm fall → M exp rise

Therefore, M exp > X rev → worsens BOP deficit

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With devaluation, BOP can be improved in the LR (D elastic)

• X cheaper → Dx rise → X rev rise

• M expensive → Dm fall → M exp fall

Therefore, X rev > M exp → improves BOP deficit

This can be illustrated using the J-curve effect

Marshall-lerner condition → Dx + Dm > 1 → improves BOP deficit

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Devaluation does not necessarily reduce BOP deficit in the SR:

J-curve effect shows that BOP worsens in the short run due to demand inelastic

Devaluation may not necessarily cause inflation in the LR:

If economy is at spare capacity → PL will stay constant → devaluation will not cause inflation

Therefore, devaluation can reduce BOP deficit but it is not a guaranteed solution for a persistent BOP deficit and inflation in the long run depends on the stage of the economy is in.

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In the short run -> INELASTIC S -> as X cheaper -> firms hope to sell more -> however, due to S being inelastic (Full employment, limited labour supply, little to no access of raw materials) -> this limits the firms to be responsive to supply. Hence, X revenue is limited as firms are unable to sell more -> X revenue fall.

On the other hand, M being expensive and D inelastic in the SR -> M expenditure rises. In the short run, deficit in the current account will worsen.

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In the long run -> ELASTIC S -> as X cheaper -> firms hope to sell more -> S being elastic (spare capacity, large pool supply of labour, access to raw materials) -> firms can be responsive to supply. Hence, X revenue can increase.

On the other hand, M being expensive and D elastic in the LR

-> M expenditure fall. In the long run, deficit in the current account will improve.