Factors Leading to a Worsening Trade Balance Despite Exchange Rate Changes

1b) Analyse TWO possible reasons why changes in the effective exchange rate falled to have their "expected impact on the US current account deficit" (6 marks) This question was the joint worst done on the paper. (Across nearly all of the sets). 50% in D2. It should cry out to you to talk about the Marshall-Lerner condition and revision of this topic is needed if it did not. N.B. Always go for a definition at the start of 6 markers. In many papers this may nab you 1 mark. A few things to note: Context: 1. Current Account Deficit: Value of Imports exceeds the Value of Exports. Value being price x quantity. 2. Effective Exchange Rate: Effective Exchange Rate is an index that describes the relative strength of a currency relative to a basket of other currencies 3. Usually we would expect a depreciation (which occurs) to lead to an improvement in the Current Account by making exports more competitive. Instead the opposite occurs overall. US CA worsens. Potential Explanation: MOST IMPORTANT: Marshall-Lerner condition may not hold. That is PEDX and PEDM is not > 1. Therefore, inelastic response of quantity demanded to change in price, resulting in an overall fall in the value of revenue generated by imports and increased expenditure on exports. Maybe because US exports price inelastic luxury goods and also has a high MPM due to a low industrial base. Therefore making PED of M relatively inelastic. Other reasons are more basic AS-level analysis. All you need to do is think of why Exports may not improve (despite exchange rate) or why Imports may not fall (even if mare expensive), Importantly these need a DIRECTION i.e. why they led to a worsening. For example, reasons why Exports may not increase. 1. PRICE COMPETITIVENESS FELL FOR OTHER REASONS: a. Unit Labour Costs increased: Either because: 1. Productivity fell (output per worker per hour) Wages rose. (Increased minimum wage?) b. Higher costs of production for other reasons: 1. Corporation tax rose? Il. Regulations increased? These would lead to higher COP for the firm and potentially higher prices. The higher prices from these reasons may outweigh the increased price competitiveness from a depreciated currency. 2. COMPETITIVENESS FELL FOR NON-PRICE REASONS: Fall in quality. Resulted in fall in demand despite the lower price. 3. LOW DEMAND FROM ABROAD: a. World recovering from a recession. CA deficit initially improved in the recession (perhaps because US incomes fell and so their spending on imports fell). However, the US recovered quicker than most countries. Perhaps their incomes rose again, but world demand from exports remained low. Despite the higher price competitiveness from the depreciation, demand did not increase due to a fall in global incomes. A few common slip-ups: Exchange Rates: These are RECIPROCAL. If you have a bilateral exchange rate (just two countries) between the US and China, then if the Yuan appreciates, it implies the Dollar has depreciated. This is because an exchange rate is the price of one currency in terms of another. If the price of one currency is now more expensive (in terms of the other), it implies that the other currency is now cheaper (in terms of the other). The same applies to effective exchange rates. It cannot be the case that the effective exchange rate depreciates, but the currency appreciates against the other key trading partners. This is because the effective exchange rate takes into account all of the exchange rates of a countries key trading partners. Not so keen on J-curve analysis in this question. J curve is a SR phenomenon. CA deficit worsens Initially in the SR and then later improves. However, the deficit in the data gets worse for around 5 years. Would a J-curve effect last as long?