Policies to correct disequilibrium
Correcting an imbalance
- A current account deficit can be tackled two ways:
- expenditure-reducing — cut total demand (higher taxes/interest rates) → fewer imports (but slows growth),
- expenditure-switching — shift spending to home goods via a lower exchange rate (a depreciation when floating, a devaluation when fixed).
Practice
A lower exchange rate to fix a deficit is an example of:
A lower exchange rate switches spending from imports to home goods (expenditure-switching).
Marshall–Lerner and the J-curve
- A lower exchange rate only helps if buyers respond enough — the Marshall–Lerner condition:
$$PED_{\text{exports}} + PED_{\text{imports}} > 1$$
- The J-curve: just after a depreciation the current account first gets worse (imports cost more at once), then improves as trade volumes adjust.
Practice
The Marshall–Lerner condition says a depreciation improves the current account if:
PED(exports) + PED(imports) > 1 is needed for a depreciation to improve the current account.
Practice
On the J-curve, the current account first worsens after a depreciation, then improves.
Imports cost more immediately, but trade volumes adjust slowly — tracing a J shape.
You've got it
Key idea
- expenditure-reducing (cut demand) vs expenditure-switching (lower exchange rate)
- a depreciation helps only if $PED_{exports} + PED_{imports} > 1$ (Marshall–Lerner)
- the J-curve: worse first, better later