IB Economics
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May 2008 Short Answer Paper Question 5 (Higher Level)
Explain why a depreciation of a country’s exchange rate may not always lead to an
improvement in its current account of the balance of payments. [10]
This is a question that should be broken down into three key components- definitions, basic
economic theory, and evaluation/limitations of theory.
Definitions
Start by defining the terms found in the question, in this particular case precise definitions can
earn you three easy marks.
Depreciation: the fall in the value of a currency under a floating exchange rate regime.
Exchange Rate: the price of one currency in terms of another.
Current Account: one of the two major accounts that comprises the balance of payments and is
comprised by four major components: net trade in goods, net trade in services, net investment
from overseas and net transfers.
Basic Theory
With depreciation a country’s exchange rate exports become cheaper and imports more
expensive. Demand for exports may rise and demand for imports may fall.
This would improve the position of the current account.
If your answer finished at this point and you had covered the definitions and basic theory you could
expect to score 6/10. (Level 5)
However…(The evaluation)
•
There will only be an improvement in the current account of the balance of payments
following an exchange rate depreciation if the sum of price elasticities of demand for exports
and imports is greater than 1. (The Marshall-Lerner condition)
•
The improvement may not be immediate, there will be time lags involved as firms and
households take time to alter their purchasing decisions. This is known as the J-Curve.
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An answer that includes a full explanation of the J- Curve and Marshall-Lerner condition
would be rewarded with full marks [10/10].
Other factors that may limit the effectiveness of a depreciation in terms of improving the
current account position could include:
•
Non-price factors are often as important as price factors. If the quality of imported products
is high, demand may be inelastic and a depreciation in the currency may not lead to a
significant fall in demand.
•
Other currencies may depreciate at the same time, hence offsetting any benefit that the
economy may experience from a depreciation.
Link for tutor2u revision worksheet on the J-Curve and Marshall-Lerner condition:
http://www.tutor2u.net/blog/index.php/ib-diploma/comments/marshall-lerner-and-the-jcurve/
IB Economics
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