Question

Assume the following to be true in Turkey

Exports contracts are denominated in foreign currency.

Imports contracts are denominated in foreign currency.

What will happen to the domestic trade balance following a devaluation of domestic currency? Explain carefully the effects during the currency contract period.

thank you :) (:

Answer 1

Both exports and imports are denominated in foreign currency. To understand the effect of domestic currency devaluation, lets consider that initially 1 Turkish Iira (TRY) = 1 Foreign Currency (FC). Now the amount of export and import is fixed by contract. Lets say 100 units are going to be exported by Turkey at the price of 1TRY each which equals 1FC each for the foreign importer. Now when currency is devalued then the new exchange rate becomes (say) 1 TRY = 1.20FC. Now as the export is denominated in FC, then the Turkish exporter receives the 100 units for 100FC which equals 120TRY for the Turkish exporter. The price received in TRY has increased and exporter receives 20% gain while it is unchanged in FC.

Similarly lets understand the impact on import. Lets a contract of importing 100 units be fixed by contract which cost 1TRY (=1FC) each. After devaluation of currency to 1TRY = 1.20 FC, the same 100 units cost 120TRY instead of 100TRY to the Turkinsh importer meaning the he incurrs losses due to devaluation of domestic currency. In terms of FC the import value is still 100 FC.

Based on this we can see that when Trade Balance(X-M) is measured in FC, there is no change in trade balance. However in terms of dollars, the trade balance can go up, down or stay constant depending on whether initial trade balance was surplus, deficit or balanced. If initially trade balance was in surplus then due to the increased export value in home currency, trade will be in surplus. If trade balance was in deficit then due to losses from imports in home currency will cause deficit. While if trade was balanced, then the profits in exports value (in home currency) and losses in imports value (in home currency) will nullify each other and trade will remain balanced.