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Page 1 Devaluation and its Theories Institute of Life Long Learning, University of Delhi Paper: International Economics Lesson: Devaluation and its Theories Author: Sarbjeet Kaur College/Department: Rajdhani College Page 2 Devaluation and its Theories Institute of Life Long Learning, University of Delhi Paper: International Economics Lesson: Devaluation and its Theories Author: Sarbjeet Kaur College/Department: Rajdhani College Devaluation and its Theories Institute of Life Long Learning, University of Delhi Table of the Contents Chapter: Devaluation and its Theories 1. Foreign Trade Multiplier 1.1 Foreign Repercussions 2. Devaluation 2.1 objectives of devaluation 2.2 merits of devaluation 2.3 demerits of devaluation 2.4 Approaches of Devaluation 2.4.1 Elasticity Approach 2.4.1.1Marshal-Learner Condition 2.4.2 Absorption Approach 3. Exercise 4. References Page 3 Devaluation and its Theories Institute of Life Long Learning, University of Delhi Paper: International Economics Lesson: Devaluation and its Theories Author: Sarbjeet Kaur College/Department: Rajdhani College Devaluation and its Theories Institute of Life Long Learning, University of Delhi Table of the Contents Chapter: Devaluation and its Theories 1. Foreign Trade Multiplier 1.1 Foreign Repercussions 2. Devaluation 2.1 objectives of devaluation 2.2 merits of devaluation 2.3 demerits of devaluation 2.4 Approaches of Devaluation 2.4.1 Elasticity Approach 2.4.1.1Marshal-Learner Condition 2.4.2 Absorption Approach 3. Exercise 4. References Devaluation and its Theories Institute of Life Long Learning, University of Delhi Foreign Trade Multiplier Multiplier is a principal conception in economics, which study how the economic direction changes due to the changes in different factors. For instance, investment explains the change in equilibrium level of income and consumption due to changes in the level of investment. It explains as the level of investment increases with an increase in marginal propensity to consume(MPC), i.e. consumption is directly related with investment in two sector model. The FTM works like Keynesian multiplier. It can be defined as the change in national income due to changes in domestic investment on exports. The FTM works in four sector model of the economy or open economy.FTM is also called as export multiplier. With the increase in exports, there is an increase in aggregate demand (directly or indirectly), i.e. with an increase in exports, there is an increase in the domestic production in the foreign market; hence, there will be a boom in the industries and also employment opportunities will increase. Further, it will increase in the demand of the consumers and hence aggregate demand in the economy, this is called as the foreign trade multiplier effect. Therefore, FTM changes national income due to changes in investment and changes in exports. Hence, FTM is dependent upon two factors, a) MPS and b) MPM. Smaller the propensities, larger will be the value of multiplier and vice versa. Box 1 The foreign trade multiplier also known as the export multiplier operates like the investment multiplier of Keynes. It may be defined as the amount by which the national income of a nation will be raised by a unit increase in domestic investment Page 4 Devaluation and its Theories Institute of Life Long Learning, University of Delhi Paper: International Economics Lesson: Devaluation and its Theories Author: Sarbjeet Kaur College/Department: Rajdhani College Devaluation and its Theories Institute of Life Long Learning, University of Delhi Table of the Contents Chapter: Devaluation and its Theories 1. Foreign Trade Multiplier 1.1 Foreign Repercussions 2. Devaluation 2.1 objectives of devaluation 2.2 merits of devaluation 2.3 demerits of devaluation 2.4 Approaches of Devaluation 2.4.1 Elasticity Approach 2.4.1.1Marshal-Learner Condition 2.4.2 Absorption Approach 3. Exercise 4. References Devaluation and its Theories Institute of Life Long Learning, University of Delhi Foreign Trade Multiplier Multiplier is a principal conception in economics, which study how the economic direction changes due to the changes in different factors. For instance, investment explains the change in equilibrium level of income and consumption due to changes in the level of investment. It explains as the level of investment increases with an increase in marginal propensity to consume(MPC), i.e. consumption is directly related with investment in two sector model. The FTM works like Keynesian multiplier. It can be defined as the change in national income due to changes in domestic investment on exports. The FTM works in four sector model of the economy or open economy.FTM is also called as export multiplier. With the increase in exports, there is an increase in aggregate demand (directly or indirectly), i.e. with an increase in exports, there is an increase in the domestic production in the foreign market; hence, there will be a boom in the industries and also employment opportunities will increase. Further, it will increase in the demand of the consumers and hence aggregate demand in the economy, this is called as the foreign trade multiplier effect. Therefore, FTM changes national income due to changes in investment and changes in exports. Hence, FTM is dependent upon two factors, a) MPS and b) MPM. Smaller the propensities, larger will be the value of multiplier and vice versa. Box 1 The foreign trade multiplier also known as the export multiplier operates like the investment multiplier of Keynes. It may be defined as the amount by which the national income of a nation will be raised by a unit increase in domestic investment Devaluation and its Theories Institute of Life Long Learning, University of Delhi 1) MPS: It refers to increase in savings due to increase in national income. With the increase in exports, there is an increase in income. Hence, savings will increase because of increase in income, which will create negative impact. Because, savings is considering as a leakage in national income with the increase in income, if consumption increases (i.e. MPC increases), this creates the multiplier effect, hence there is a negative relation between increase in MPS and export multiplier. 2) MPM: As savings, imports are also leakage from the economy. With an increase in imports, there is a decrease in domestic wealth and hence national income; therefore, there is a negative relation between MPM and export multiplier. According to investment and saving approach, equilibrium level of national income is given by change in injections= changes in leakages In four sector model, ?I +?X= ?S + ?M. ?S= MPS. ?Y. ?I + ?X= MPS (?Y) + (MPM). ?Y ?I + ?X= (MPS+MPM) ?Y. ?Y= 1 ???????????? + ???????????? (?I + ?X) Hence k’= ?Y ?I+ ?X = 1 ???????????? + ???????????? Where k’ is FTM. Page 5 Devaluation and its Theories Institute of Life Long Learning, University of Delhi Paper: International Economics Lesson: Devaluation and its Theories Author: Sarbjeet Kaur College/Department: Rajdhani College Devaluation and its Theories Institute of Life Long Learning, University of Delhi Table of the Contents Chapter: Devaluation and its Theories 1. Foreign Trade Multiplier 1.1 Foreign Repercussions 2. Devaluation 2.1 objectives of devaluation 2.2 merits of devaluation 2.3 demerits of devaluation 2.4 Approaches of Devaluation 2.4.1 Elasticity Approach 2.4.1.1Marshal-Learner Condition 2.4.2 Absorption Approach 3. Exercise 4. References Devaluation and its Theories Institute of Life Long Learning, University of Delhi Foreign Trade Multiplier Multiplier is a principal conception in economics, which study how the economic direction changes due to the changes in different factors. For instance, investment explains the change in equilibrium level of income and consumption due to changes in the level of investment. It explains as the level of investment increases with an increase in marginal propensity to consume(MPC), i.e. consumption is directly related with investment in two sector model. The FTM works like Keynesian multiplier. It can be defined as the change in national income due to changes in domestic investment on exports. The FTM works in four sector model of the economy or open economy.FTM is also called as export multiplier. With the increase in exports, there is an increase in aggregate demand (directly or indirectly), i.e. with an increase in exports, there is an increase in the domestic production in the foreign market; hence, there will be a boom in the industries and also employment opportunities will increase. Further, it will increase in the demand of the consumers and hence aggregate demand in the economy, this is called as the foreign trade multiplier effect. Therefore, FTM changes national income due to changes in investment and changes in exports. Hence, FTM is dependent upon two factors, a) MPS and b) MPM. Smaller the propensities, larger will be the value of multiplier and vice versa. Box 1 The foreign trade multiplier also known as the export multiplier operates like the investment multiplier of Keynes. It may be defined as the amount by which the national income of a nation will be raised by a unit increase in domestic investment Devaluation and its Theories Institute of Life Long Learning, University of Delhi 1) MPS: It refers to increase in savings due to increase in national income. With the increase in exports, there is an increase in income. Hence, savings will increase because of increase in income, which will create negative impact. Because, savings is considering as a leakage in national income with the increase in income, if consumption increases (i.e. MPC increases), this creates the multiplier effect, hence there is a negative relation between increase in MPS and export multiplier. 2) MPM: As savings, imports are also leakage from the economy. With an increase in imports, there is a decrease in domestic wealth and hence national income; therefore, there is a negative relation between MPM and export multiplier. According to investment and saving approach, equilibrium level of national income is given by change in injections= changes in leakages In four sector model, ?I +?X= ?S + ?M. ?S= MPS. ?Y. ?I + ?X= MPS (?Y) + (MPM). ?Y ?I + ?X= (MPS+MPM) ?Y. ?Y= 1 ???????????? + ???????????? (?I + ?X) Hence k’= ?Y ?I+ ?X = 1 ???????????? + ???????????? Where k’ is FTM. Devaluation and its Theories Institute of Life Long Learning, University of Delhi Hence, FTM shows that there is a negative relation between multiplier, MPM and MPS, i.e., the value of multiplier decreases with an increase in MPS and MPM, on the other hand, the value of multiplier increases with an increase in export and investment. Foreign Repercussions In this section, assumption that the nation is small is relaxed and foreign trade multiplier is extended with foreign repercussion. Foreign trade is done by two countries; one by the domestic country and the other by trading partner. An increase in exports of domestic country arises from and is equal to the increase in imports of foreign country. If this increase in the imports of foreign country replaces domestic production then the income of domestic nation decreases. As the income falls, which will decrease in the imports of the foreign country, this represents a foreign repercussion domestic country that neutralizes part of an original increase in its exports. This will further decrease the value of foreign trade multiplier of domestic country (i.e. exporting country), hence, foreign trade multiplier without repercussions is greater than foreign trade multiplier with repercussion. Hence, the trade balance of exporting country will not improve much. Formula of computation for the value of FTM with foreign repercussions for an increase in exports is given as: ???? ' ???? = 1 ???????????? 1 + ???????????? 1 + ???????????? 2 ( ???????????? 1 ???????????? 2 ? ) Where the subscripts 1 and 2 refers to domestic country and foreign country respectively. For example, if MPS 1 = 0.25, and MPM 1 =0.15 for domestic country and MPS 2 = 0.2 and MPM 2 = 0.1 for foreign country then:Read More
FAQs on Lecture 6 - Devaluation and its Theories - International Economics- In Depth Basics and Analysis
| 1. What is devaluation in economics? |  |
Devaluation in economics refers to the deliberate decrease in the value of a country's currency relative to other currencies. It is usually done by a government or central bank to enhance the competitiveness of domestic industries in international markets and to address trade imbalances. Devaluation makes exports cheaper and imports more expensive, leading to an increase in exports and a decrease in imports.
| 2. What are the theories behind devaluation in economics? | |
There are several theories that explain the impact and causes of devaluation in economics. Some of the prominent theories include:
- The Elasticity Theory: This theory states that devaluation can improve a country's trade balance if the demand for its exports and imports is price sensitive. When a country devalues its currency, its exports become cheaper and more attractive to foreign buyers, leading to an increase in demand and an improvement in the trade balance.
- The Monetary Theory: According to this theory, devaluation helps to correct trade imbalances by adjusting the relative prices of goods and services. When a country devalues its currency, it increases the price of imports, making them less attractive, and decreases the price of exports, making them more competitive in international markets.
- The Balance of Payments Theory: This theory suggests that devaluation can improve a country's balance of payments by reducing the value of its imports and increasing the value of its exports. By making imports more expensive and exports cheaper, devaluation helps to reduce the trade deficit and improve the overall balance of payments.
| 3. What are the potential benefits of devaluation? | |
Devaluation can bring several potential benefits to an economy, including:
- Increased Exports: Devaluation makes a country's exports cheaper in international markets, making them more competitive. This can lead to an increase in export volumes, boosting economic growth and creating employment opportunities.
- Trade Balance Improvement: Devaluation can help correct trade imbalances by reducing imports and increasing exports. By making imports more expensive, it encourages domestic consumption of locally produced goods, which can reduce trade deficits and improve the overall balance of payments.
- Tourism and Foreign Investment: Devaluation can make a country more attractive to tourists and foreign investors. With a weaker currency, the cost of visiting or investing in the country becomes relatively cheaper, stimulating tourism and foreign investment inflows.
- Domestic Demand Boost: Devaluation can also stimulate domestic demand by making imports more expensive, thereby encouraging consumers to purchase domestically produced goods. This can further support domestic industries and employment.
| 4. What are the potential drawbacks of devaluation? | |
Despite the potential benefits, devaluation can also have some drawbacks, including:
- Inflationary Pressure: Devaluation can lead to inflation as it increases the price of imported goods and raw materials. This can erode the purchasing power of consumers and reduce their standards of living.
- Increased Debt Burden: If a country has a significant amount of debt denominated in foreign currencies, devaluation can increase the burden of debt repayment. As the domestic currency weakens, the amount of local currency required to repay the debt increases, making it more challenging for the country to manage its debt obligations.
- Capital Flight: Devaluation can lead to capital flight as investors may lose confidence in the country's economy. When a currency depreciates, investors may choose to withdraw their investments, causing a decline in foreign direct investment and capital outflows.
- Political and Social Unrest: Devaluation can also lead to political and social unrest. The increase in prices of imported goods and the potential decline in living standards can result in public dissatisfaction and protests.
| 5. How does devaluation impact the exchange rate? | |
Devaluation directly impacts the exchange rate by reducing the value of a country's currency relative to other currencies. When a country devalues its currency, it becomes cheaper compared to other currencies. This means that if previously 1 unit of the domestic currency was equal to 1 unit of a foreign currency, after devaluation, it may require more units of the domestic currency to be equal to 1 unit of the foreign currency.
For example, if the exchange rate was 1 USD = 100 units of the domestic currency before devaluation, and after devaluation, it becomes 1 USD = 120 units of the domestic currency, it means the domestic currency has depreciated by 20%. This impact on the exchange rate affects the cost of imports and exports and can influence trade balances and economic competitiveness.
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