Explain the effect of exchange rates on trade flows and capital flows
The idea
A depreciation makes exports cheaper abroad and imports dearer at home, which should improve the trade balance — but not immediately. Contracts and habits take time to adjust, so in the short run the higher cost of the same import volume worsens the balance before volumes respond. That pattern is the J-curve. Whether the eventual improvement arrives depends on how responsive import and export volumes are to price, the condition summarised by the Marshall-Lerner rule. Capital flows can overwhelm all of this, since interest-rate differentials move money far faster than trade adjusts.
A practice question
A country's currency depreciates. What is the expected effect on its exports?
- They become cheaper to foreign buyers and should rise — correct
- They become more expensive abroad and should fallWhy not: A weaker home currency buys fewer foreign goods but makes home goods cheaper to foreigners, which is the opposite direction.
- They are unaffected by exchange ratesWhy not: The rate is the price at which foreign buyers convert to pay, so it is directly part of what they face.
A weaker currency lowers the foreign-currency price of exports, which should lift volumes. The mirror effect makes imports dearer at home.
A harder one
Why does the trade balance worsen first after a depreciation?
- Because exporters raise their pricesWhy not: Pass-through can offset part of the gain, but the initial worsening comes from the import bill on volumes already contracted.
- Because reserves are spent defending the currencyWhy not: Reserve spending affects the capital account and the central bank's balance sheet, not the trade balance.
- Because the same imports now cost more — correct
Contracts and habits take time to adjust, so volumes do not fall at once. The price effect is immediate and the volume effect is not, so for a while only one of them is operating.
The hardest tier
Why can a depreciation fail to improve a country's trade balance at all?
- Because exporters always raise prices to offset itWhy not: Some pass-through occurs, but it is partial and varies. The condition that decides the outcome is how volumes respond.
- Because capital flows are unaffected by exchange ratesWhy not: Capital flows respond strongly to currency moves, and in any case the trade balance turns on trade volumes.
- Because volumes may respond weakly to price — correct
If both import and export volumes are inelastic, the worse terms of trade dominate. The Marshall-Lerner condition requires the combined elasticities to exceed one; where demand is inelastic on both sides, paying more for much the same import volume outweighs any gain in exports.
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