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Domestic Trade Balance after a Devaluation of Domestic Currency

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Assume the following to be true:
Export contracts are denominated in domestic currency. Import contracts are denominated in foreign currency. The foreign supply of exports or domestic imports is inelastic.

What will happen to the domestic trade balance following a devaluation of the domestic currency? Explain carefully the effects during the currency contract period and the pass through period, and be sure to explain why these effects occur.

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Solution Summary

This solution explains what will happen to the domestic trade balance following a devaluation of the domestic currency.

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The impact of exchange rate fluctuation can be evaluated in three different stages.

1. The first stage is currency contract period. The export contracts are denominated in domestic currency and import contracts are denominated in foreign currency. If the domestic currency depreciates then, in the currency contract period, the import bill for the country will increase (due to foreign currency contract) while the export bill will remain same (due to domestic currency contract). This will result in deterioration in domestic trade balance. The trade deficit will increase. The major reasons for immediate changes in quantity and price adjustments in currency contract period are contractual agreements, production and delivery lags, ...

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