Assess the economic effects of a depreciation on a countries currency

Depreciation involves reducing the value of the nations currency against others. Under a managed float this could be achieved by a central bank selling its own currency in exchange for foreign currency. This would lead to an outward shift in the supply of pounds resulting in a depreciation. Devaluation will lead to an improvement in the balance of payments on the current account. This is because a fall in the value of the pound will mean a foreigner can purchase more pounds with any given quantity of their money. As such exports will become relatively cheaper and more price competitive so if demand is elastic the fall in price of UK exports will result in a proportionally greater increase in demand increasing the value of UK exports. A UK firm or individual will be able to purchase fewer of any foreign currency with a given amount of pounds. As a result imports to the UK will become relatively more expensive and so if demand is elastic the total value of imports will fall. As such the value of net exports will increase and therefore reduce the deficit on the current account of the Balance of Payments.However it depends on the elasticity of demand for exports and imports as stated by the Marshall Learner condition. If PED x + PED m > 1 then a devaluation will improve the current account, although if the combined elasticity of demand for exports and imports is less then one than a devaluation will increase the deficit. Moreover due to the J curve effect, in the short term demand the deficit will increase as imports and exports tends to be inelastic. This is because in the UK importers may be stuck with import contracts which they signed before the devaluation or there may be no alternative domestic suppliers and so importing firms may still have to import at higher prices. Similarly exports may not increase as it will take time for firms in foreign countries to react so the volume of UK exports may not change. So after a devaluation the value of imports tends to rise and the value of exports falls causing the deficit tends to worsen before it improves over time as both exports and imports become more price elastic as firms adjust. A depreciation would also lead to higher economic growth which would in turn lead to higher rates of inflation. Part of aggregate demand is net exports (X-M), therefore assuming that PED x + PED m > 1, the depreciation will increase the value of X-M resulting in an increase in aggregate demand as shown by AD shifting out from AD1 to AD2. This will result in an increase in economic growth from RNO1 to RNO2. However it will also lead to demand pull inflation as the price level rises from P1 to P2. Inflation is also likely to be exacerbated due to cost push inflation as well. The depreciation means that imports are more expensive to UK firms, if UK firms can’t switch to domestic substitutes their average costs will rise. Some of these increases in average cost will be passed onto the consumer in the form of higher prices. Finally with exports becoming cheaper and more internationally competitive manufacturers may have less incentive to cut costs and become more efficient, so X-inefficiency could lead to costs and prices increasing over time. The effect on inflation will depend on several factors. Whether demand pull inflation is likely to occur depends on the state of the economy. If the economy is in a recession then the increase in AD will cause hardly if not any increase in the price level due to the high levels of spare capacity in the economy. Moreover cost push inflation depends on the level of competition first place. In a highly competitive market firms may simply reduce profit margins and absorb the increase in cost and not increase prices as doing so would result in a fall in market share and a fall in revenue and profit and so prices throughout the economy may not rise.