Chapter 17 · Further topics on exchange rates and the balance of payments (HL only)
Current-account correction through AD
Show how depreciation may improve net exports and shift aggregate demand. Explain why the outcome depends on elasticities and available capacity.
The economic idea
The balance of payments records economic transactions between residents of a country and the rest of the world. Its current account contains trade in goods and services, primary income and secondary income transfers. A current-account deficit means current-account outflows exceed inflows during the period.
Currency depreciation is a market-driven fall in value under a floating system; devaluation is an official reduction under a fixed system. Either lowers the foreign-currency price of exports and raises the domestic-currency price of imports if firms pass the exchange-rate change through.
The Marshall–Lerner condition states that depreciation improves the trade balance in the long run when the sum of the absolute price elasticities of demand for exports and imports exceeds one. It is a condition about quantity responsiveness, not a guarantee that all current-account components improve.
The J-curve describes timing: the trade balance may deteriorate immediately after depreciation because contract quantities change little while import prices rise, then improve as export and import volumes become more responsive.
When net exports rise, aggregate demand increases because AD equals consumption plus investment plus government expenditure plus net exports. The real-GDP and price-level effects depend on the shape of short-run aggregate supply and the economy’s spare capacity.
Reading the movement from E₁ to E₂
“Real GDP” is measured horizontally and “Price level” vertically.
“AD₁” is the initial aggregate-demand schedule, “AD₂” the schedule after the net-export response, and “SRAS” short-run aggregate supply.
“E₁” and “E₂” identify the initial and current macroeconomic equilibria.
Initial macroeconomic equilibrium: E₁
“AD₁” intersects “SRAS” at “E₁”, establishing “Y₁” and “PL₁” before the net-export change.
The external-balance condition comes first
The sum of the absolute export- and import-demand elasticities is greater than one. The long-run quantity response is therefore strong enough for depreciation to improve the trade balance, ceteris paribus.
The aggregate-demand result: E₂
“AD₂” lies to the right of “AD₁”. Stronger net exports move equilibrium from “E₁” to “E₂”: real GDP rises from “Y₁” to “Y₂” and the price level rises from “PL₁” to “PL₂” along “SRAS”.
Do not turn a trade improvement into a guaranteed growth claim
Net exports are export revenue minus import expenditure, not export volumes alone. A rise in exports is not enough to establish higher AD if import expenditure rises by more.
A movement between equilibria on “SRAS” shows a change in actual real GDP and the price level. It does not show a rise in productive capacity, and a higher price level does not tell us the future inflation rate. Imported-input costs or a policy response could change the result outside this diagram.
How to build a connected IB explanation
Begin with depreciation or devaluation and state how export and import prices change in the currencies relevant to buyers.
Apply the Marshall–Lerner condition to decide whether trade volumes eventually raise or lower net exports.
If net exports rise, shift aggregate demand from “AD₁” to “AD₂”; if they do not, do not claim an expansionary shift.
Use “SRAS” to trace the new equilibrium “E₂” and distinguish the real-output effect from the price-level effect.
Common mistakes to avoid
- Depreciation does not automatically improve the current account; apply the elasticity condition and allow for time.
- The J-curve is a time path of the external balance, not the shape of a demand curve.
- Use absolute elasticity magnitudes in the Marshall–Lerner sum.
- A current-account deficit is not identical to a trade-in-goods deficit and is not automatically harmful.
- A rightward AD shift requires an actual increase in net exports, not merely a lower nominal exchange rate.
How to draw this diagram
- Title the diagram “Current-account correction through AD”. Label the horizontal axis “Real GDP” and the vertical axis “Price level”.
- Draw AD₁ first and label it clearly.
- Draw AD₂ next and label it clearly.
- Draw SRAS next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The elasticity condition is partial equilibrium and holds other influences on exports, imports and income constant.
- The simple elasticity-sum threshold assumes initially balanced trade, full exchange-rate pass-through and sufficiently responsive supply; an initial imbalance or different pricing assumptions changes the more general test.
- Export supply may be capacity constrained even when foreign demand is price elastic.
- Imported intermediate inputs can raise exporters’ costs after depreciation and weaken the competitiveness gain.
- Foreign-currency debt service, inflation expectations and capital flows can dominate the trade channel.
- The current account includes income and transfers as well as trade, while the diagram focuses mainly on exports and imports.