Vassil Kirtchev Åva gymnasium

1205-016 Commentary 4

Commentary number 4

The government may want to devalue1 the currency to improve the current account.2
Effectively, imports will be relatively more expensive than exports, thus satisfying
Marshall-Lerner condition if price elasticity of demand3 of exports and the PED of
imports is more than one. The Japanese economy is at point A with a ¥324 billion
deficit, and devaluing the currency makes the situation worse in the short run, moving
to point B. Elasticity increases over time, and in the short time span PED of exports is
inelastic, meaning revenue from exports decrease as price has been lowered, but
demand has not increased significantly. This is because there is time for adjustment to
new prices. The same scenario will happen for imports, in the short run PED of
imports will be inelastic, and expenditure will increase due to a higher price with
relatively less demand. PED of exports and imports will increase over time, and when
both add up to more than 1, Marshall-Lerner condition is satisfied, and export revenue
will increase, while import expenditure will decrease—economy moving to point C.

Because of the global financial climate, the above may not work. Demand for
Japanese goods (especially automobiles) has fallen, but since exports will become
relatively cheaper, this might improve the trade deficit. There is growing fear of
deflation, as the economy has contracted and in recession.4

1
Fall in exchange rate in fixed exchange rate system
2
Trade in goods/services, income flows
3
Demand responsiveness to price changes
4
Two consecutive quarters of negative economic growth
Vassil Kirtchev Åva gymnasium
1205-016 Commentary 4

The figure shows that there will be malignant deflation,5 where output decreases as
well as a price decrease (P1 to P2), causing a slump in economic growth. Because of
this deflation, unemployment6 surges, as seen by the graph, because output decreases.
The rising costs of raw materials will not have the same cost-push inflation effect
because production is decreasing anyway due to less demand (fewer workers are
needed to meet the demand). Aggregate demand has decreased due to the trade
imbalance, because expenditure on imports have been greater than export revenue, as
these are components of aggregate demand. The increase in price of raw materials as
well as the lower exchange rate of the currency, will add inflationary pressures,
outweighing deflation costs. Lower exchange rate adds to foreign debt burden, a
negative effect. Domestic consumers lose purchasing power abroad, may decreasing
utility.

In addition, the economic contraction causes several negative long-term effects. With
decreasing demand, less profit is made and having negative effect on business
confidence, causing less investment. Investment is also a component of aggregate
demand, and in worst case, firms put off investments indefinitely, causing further
layoffs and shrinkage in aggregate demand. Investment could increase due to it being
relatively cheaper to invest in Japan, but in reality will not because of risk associated
with the financial climate. Since domestic demand is so low, consumer confidence is
depressed, putting downward pressure on aggregate demand. The costs are extremely
high both economically and socially. With more unemployment, households
experience less income, and standards of living will decrease.

It is therefore a good measure to try to improve the trade balance in order to ensure
fewer falls in aggregate demand, and try to stop the deflationary spiral. To foreigners,
5
Average price level decrease over time
6
People who are willing and able to work, but don’t have jobs
Vassil Kirtchev Åva gymnasium
1205-016 Commentary 4
the Japanese goods and services have become relatively cheaper and may be
demanded more. This will boost production and therefore increase aggregate demand
and economic growth–more competitive internationally. Supply-side policies7 might
add competitiveness and increasing economic potential—message sent by decreased
demand for Japanese goods. The winner here is the Japanese industry in the long run
if correct policies are carried out. In the short run, the situation will not improve
much, with pain felt, especially if the situation continues to deteriorate. The figures
show that the Japanese government needs to prioritize long run growth that needs to
come through an increase in output/production; policies need to be adapted
accordingly. Even though some policies may be inflationary, it is better than suffering
from deflation, as business/consumer confidence decreases, with less investment and
consumption—a problem that has to be addressed.

7
Policies in an economy endeavoring to increase aggregate supply