Depreciation and the Trade Balance

Question 1

Draw a diagram showing a depreciation and the impacts on the trade balance

Answer 1

Real exchange rate rises from Q to Q’ (depreciation), and net exports rise by Δ(X-M).
This could be caused by a positive supply shock, shifting the ERU curve outwards.

There is now a gap between equilibrium output and the balanced trade equilibrium. This could be filled by a rise in imports, causing an appreciation of the home currency

Question 2

What is the change in the equilibrium output?

Answer 2

Rise in exports x Open economy multiplier.

Δ(X-M) x (1/1-c1(1-t)+m)

Question 3

Why is a trade surplus inevitable after a depreciation?

Answer 3

Δybt > Δy since 1/m > 1/1-c1(1-t)+m

Question 4

Long run trade balance

Answer 4

In the long run, trade imbalances with be eliminated.
The economy will be at the intersection of the BT, AD and ERU curves. It won’t be above or below bc this signifies a trade imbalance.