SP 2023|4) ‘Devaluation of a country’s currency will reduce a persistent BOP deficit on its current account in goods and services in the short run but this will inevitably lead to high levels of inflation in the long run.’ Evaluate this statement. (20) by a’riesya

Definitions

beescuitse — 2025-08-05 10:11:08 UTC

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

In the short-run

beescuitse — 2025-08-05 10:12:46 UTC

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

In the long-run

beescuitse — 2025-08-05 10:13:27 UTC

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

ariesyazhafirahhalawi — 2025-08-05 11:08:18 UTC

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

ariesyazhafirahhalawi — 2025-08-05 11:08:58 UTC

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.

Regarding PES

JennyWee — 2025-09-02 05:32:22 UTC

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.

PES elastic

JennyWee — 2025-09-02 05:36:09 UTC

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.