Question

If the sum of price elasticities of imports and exports of a country exceeds unity, then a depreciation of domestic currency will ultimately result in:

• A. contraction in trade deficit of the country
• B. widening of trade deficit of the country
• C. an uncertain net effect on the trade balance
• D. a huge outflow of foreign portfolio capital from that country

Hint:

If the sum of price elasticities of imports and exports is greater than 1, a depreciation of the domestic currency can lead to a worsening of the trade deficit as the rise in import values outpaces the increase in exports.

Answer 1

The Correct Option is A

The relationship between a country's trade balance and currency depreciation is fundamentally shaped by the price elasticities of imports and exports. When a country’s currency depreciates, it makes imports more expensive and exports cheaper. However, the overall impact on the trade balance depends on the price elasticities of demand for imports and exports, which reflect how sensitive the quantity demanded for these goods is to changes in price. Step 1: Analyzing the Price Elasticities of Imports and Exports
- The price elasticity of demand for imports reflects how the quantity of imports changes in response to price changes. A higher elasticity implies that the demand for imports is more responsive to price changes.
- The price elasticity of demand for exports reflects how the quantity of exports changes in response to price changes. A higher elasticity implies that the demand for exports is more responsive to price changes.
Step 2: Impact of Currency Depreciation
When a country’s currency depreciates:
- Imports become more expensive for the country’s consumers, leading to a decrease in the quantity of imports. This would theoretically help improve the trade balance by reducing imports.
- Exports, on the other hand, become cheaper for foreign consumers, leading to an increase in the quantity of exports.
However, if the sum of the price elasticities of imports and exports exceeds unity, the demand for both imports and exports is quite elastic. In this case:
- The increased cost of imports (due to depreciation) is likely to outweigh the benefit of increased exports. This is because the responsiveness of imports to price increases (elastic demand) could cause the value of imports to rise faster than the increase in export volume, worsening the trade deficit.
Step 3: Conclusion
In this scenario, the trade balance is more likely to worsen, resulting in a widening trade deficit. The correct answer is (B), as the higher elasticities lead to a situation where the depreciation does not sufficiently boost exports to offset the increase in the cost of imports. Therefore, the widening of the trade deficit is the most probable outcome.
Final Answer: \boxed{(B) \text{widening of trade deficit of the country}}