What is the Effect of Devaluation on the Terms of Trade?

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Devaluation implies the lowering of the exchange rate of a country’s currency. It may cause either an improvement or a deterioration in the terms of trade of the devaluing country.

This depends upon the elasticities of demand for and supply of imports and exports of the country. Devaluation will tend to improve the terms of trade if the product of the demand elasticities for the country’s imports and exports is greater than the product of the supply elasticities of imports and exports. In algebraic terms: when Dm. Dx > Sm. Sx, the terms of trade will improve with devaluation (here D stands for demand elasticity and S for supply elasticity, m for import and x for export).

It is assumed that, the demand of the devaluing country for imports is elastic (Dm >1) and the demand for its exports is also elastic (Dx > 1), while the supply of imports to the devaluing country is assumed to be inelastic (Sm < 1) and the supply of its export is elastic (Sx > 1).

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Before devaluation, the prices (expressed in domestic currency) of imports are OPm and those of exports are OPx. After devaluation, the supply curve of imports will shift upwards to S’m, and the demand curve for exports will shift upwards to D ‘x. Then, the new equilibrium prices of imports and exports are OP’m and OP ‘x. The price of imports has increased by a lesser extent than I

Similarly, devaluation will deteriorate the terms of trade if the product of elasticities for supply of imports and exports is greater than the product of the demand elasticities. That is, if Sm. Sx>Dm. Dx, the terms of trade will worsen by devaluation.

It may be thus, contended that, the terms of trade of the devaluing underdeveloped countries would generally deteriorate as most of these countries specialise in the export of a few primary products, the foreign demand for which is relatively inelastic (Dx <1), while these countries import a large number of manufactured products from develop countries, the supply of which is relatively elastic (Sm >1).

To many economists, unfavourable movement in the terms of trade on account of devaluation is however, more probable due to imperfect competition in the foreign market and institutional factor” than the relative elasticities of demand for and supply of exports and imports. For, the situation of imperfect competition calls for a considerable reduction in export prices (in terms of home currencies) if exports are to be boosted up considerably.

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Its exporters would be able to cut prices from their devaluation profits. But the prices of its imports will not be reduced as foreign exporters have no such devaluation profits to enjoy nor any incentive for giving price concessions to the devaluing country or even otherwise in view of the strict trade restriction practices and exchange control policy followed by almost all the countries of the world.

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