Discuss Whether You Consider A Fall In Exchange Rate To Be The Most Effective Way To Achieve Full Employment.

Written by azhar.

Spot an error? Inform us!
(I am practising my essay skills. You can read and help correct some points if you wish.)

[Updated on 18/7/08]

A fall in exchange rate can help raise the level of employment in a particular country. When the country devalues its currency, the price of exports of the country will be cheaper in terms of the foreign currency. This will mean that the country’s exports will be more competitive and attractive in the global market. At the same time, when the currency is devalued, the price of the country’s imports will be more expensive in terms of its currency. This is assuming that the Marshall-Lerner condition holds, which states that for a currency devaluation to have a positive impact in trade balance, the sum of price elasticity of exports and imports (in absolute value) must be greater than 1. Assuming that both exports and imports are price elastic, a devaluation of the exchange rate means a reduction on price of exports, demand for these will increase more than proportionately. At the same time, price of imports will rise and their demand diminished more than proportionately. Thus, the net exports will increase.

An increase in exports means that the aggregate demand (AD) will also increase. This can be seen in the rightward shift from AD(1) to AD(2). This also causes an increase in the real national income from Y(1) to Y(2) and the rise in the general price level from P(1) to P(2). When this happens, the firms will step up its production of goods to meet the rising demand and enjoy more profits. And in order to do so, the producer will need to hire more workers to produce more goods.

However, there may be adverse effects due to the currency devaluation. Firstly, it would be loss in investors’ confidence. Investors will view the currency devaluation as the beginning of a series of devaluation. They will lose confidence and will pull out their funds from the country, also known as capital flight. Referring to the formula AD=C+I+G+(X-M), a fall in investments (I) will lead to a fall in AD. Therefore, firms will have to cut down on the number of workers to cut costs. Hence, unemployment rises.

Next, the currency devaluation can only bring a positive result if the Marshall-Lerner condition is met. In the short run, the demand tends to be price inelastic. This is because tastes and preferences do not change quickly and time is needed to source for substitutes. Therefore, the price increase will only result in a less than proportionate decrease in the quantity demanded for imports as they still prefer the imported goods and there are no close substitutes available. At the same time, the demand for exports will also increase less than proportionately with respect to fall in price. This can result in a worsening of the Balance Of Trade (BOT) as expenditure from imports exceeds revenue from exports. Investments will decrease in the short run as it is less profitable as both the quantity demand (brought about by a change in price) and price is low. This in turn causes a lot of workers to be jobless, resulting in a rise in the unemployment rate. However, the BOT and unemployment will improve in the long run when demand becomes elastic.
[J-curve effect-- states that the BOT deficit would worsen in the short-run and improve in the long-run due to elasticity. Learn more HERE.]

Besides that, currency devaluation may also cause inflation and make the cost of living rise. When the country devalues its currency, the price of imports will be more expensive. This means that the price of imported inputs and the cost of production will increase. Producers will transfer the rise in cost of production to the consumers in terms of higher prices. Hence, inflation will set in. This will cancel out the advantage that a falling exchange rate might have on export prices. Furthermore, it will also push up the cost of living as prices of imported goods and services are more expensive.

The fall in exchange rate is only one way to achieve full employment. There are other ways such as Demand management policies. Currency evaluation is more effective in countries with open economies and less effective in countries where the domestic demand dominates. For such instances, expansionary fiscal and monetary policies are often employed. For example, expansionary fiscal policy means an increase in government expenditure and a reduction in taxes. An increase in development expenditure such as spending on ports and schools will immediately raise aggregate demand and so reduce unemployment. This is because when the government spends on such projects, more people will be able to obtain the jobs and income. From there, since more people now earn their own income, they will be able to demand for the domestically produced goods, hence increasing AD. Firms will hire more workers to step up their production. Thus, employment rate will improve.

As for the reduction in taxes, when the government cut corporate taxes, more foreign companies will find it more attractive and profitable to invest and set up factories in the country. Since investments are a component of AD (AD=C+I+G+(X-M)), AD will also increase. Hence there will be more factories set up, which will employ more workers, increasing the employment rate of the country. Furthermore, when the government reduced the personal income tax rate, the workers will have more disposable income. They will be able to demand more domestically produced goods. With a rising AD, firms will also start to increase their number of workers to meet the rising demand. Hence, employment will increase.

If unemployment is structural in nature, falling exchange rate will be useless to address the mismatch of skills. Supply-side policies will more useful for structural unemployment. The government can provide subsidies for firms to train their workers and upgrade their skills. This can also increase productivity, which will attract investments, as it is a lower cost per unit output. Employment will rise. Moreover, the government can also nurture the service sector such as the health care and tourism industry as it is both labour-intensive and caters to workers with little formal education. Hence, there will be more job opportunities for the less-skilled workers. Employment will increase.

In conclusion, fall in exchange rate is usually seen as a short run solution to the problem of unemployment because of the various problems it creates. The government needs to investigate the root cause of unemployment before deciding on the most appropriate solution. If the unemployment is the result of the loss of competitiveness, long-term solutions should be focused on restoring the competitiveness through productivity improvements and economic restructuring.

If the unemployment is the result of slow down in worldwide economic growth, the country might have to seek an alternative engine of growth in the meanwhile to cushion the effect of a fall in external demand. Even in a country like Singapore with a small multiplier size, off-budget measures are still introduced in periods of falling AD to minimize the impact and hardships as we wait for the world economy to pick up again.


Anonymous said...

The idea that demand of imports and exports are inelastic in the short-run but elastic in the long-run is reflected in the J-curve effect. You can mention it in that particular paragraph.

J-curve effect-- states that the BOT deficit would worsen in the short-run and improve in the long-run due to elasticity.

azhar said...

Updated on 18/7/08.
Thank you.

Find It