Consider a country that has experienced near full employment but, due to the openness of its economy, is unable to deal with its persistent and large CA deficit in its balance of payments. Due to unexpected political events, the country unexpectedly witnesses a depreciation of its currency which analysts believe will help to improve its CA balance. Explain and illustrate how an unexpected depreciation of the country’s currency is likely to impact its CA balance.

The United Kingdom’s (UK) current account (CA) balance has steadily declined since the mid 1950’s. In fact, according to the Office for National Statistics (2017), the UK reached record deficit levels of 5.4% of GDP in 2015. Resolution of the CA deficit has proven difficult for various reasons including reduced earnings on overseas investments and the country’s high marginal propensity to import (Schomberg and Heneghan, 2016). The latter is helped by the UK’s near full employment as demonstrated by record eleven year lows in the jobless rate of 4.8% in early 2017 (BBC News, 2017). Analysts have purported for some time that depreciation in the British pound (GBP) is necessary for current account improvement. The recent BREXIT events have so far resulted in a 17% depreciation in the pound vs the US dollar year over year (as of March 17th 2017; ycharts) and if maintained will soon reveal the true impact on the CA balance.

To explain and illustrate the potential impact of depreciation on the CA, two approaches will be considered – the Marshall-Lerner (ML) elasticities approach and the absorption approach. Both approaches generally do not clearly indicate whether depreciation will improve or worsen the current account (Pilbeam, 2013: p.70). However, they each contain useful messages for policy makers trying to steer depreciation toward strengthening of the CA (Pilbeam, 2013: p.70). In the case of the absorption approach, CA deficit reduction may be achieved if this approach is accompanied by other economic policy measures (IMF, 2000: p.6).