Government of Tanzania has decided to implement the depreciation policy to promote it's exports and assume further that Tanzania exports agricultural products to the rest of the world. Explain the impact of currency devaluation to the output to the balance of trade if:
(I) farmers in Tanzania rely largely on domestic inputs
(II) A significant components of Tanzania's agricultural inputs are imported
(I) If farmers in Tanzania rely largely on domestic inputs, the impact of currency devaluation on the output of the balance of trade will depend on the price elasticity of demand for Tanzanian agricultural products.
If the price elasticity of demand is relatively elastic, meaning that a decrease in price will lead to a relatively larger increase in quantity demanded, then currency devaluation can potentially lead to an increase in exports. This is because the devaluation would make Tanzanian agricultural products relatively cheaper for international buyers, stimulating demand and increasing export volume. As a result, the balance of trade, which is the difference between exports and imports, may improve.
However, if the price elasticity of demand is relatively inelastic, meaning that a decrease in price will lead to a relatively smaller increase in quantity demanded, then the impact of currency devaluation on the output of the balance of trade may be limited. In this case, while Tanzanian agricultural products may become relatively cheaper for international buyers, the increase in quantity demanded may not be significant enough to offset the decrease in price. As a result, the balance of trade may not see a significant improvement.
(II) If a significant component of Tanzania's agricultural inputs are imported, currency devaluation can have a mixed impact on the output of the balance of trade.
On one hand, currency devaluation can increase the cost of imported inputs, potentially reducing the profitability of agricultural production. This can lead to a decrease in agricultural output and potentially decrease exports, negatively impacting the balance of trade.
On the other hand, currency devaluation can also make Tanzanian agricultural products relatively cheaper for international buyers. This can stimulate demand and potentially lead to an increase in exports, positively impacting the balance of trade.
The overall impact will depend on the combined effect of these factors. If the increase in demand resulting from cheaper exports outweighs the decrease in profitability due to increased input costs, then the balance of trade may improve. Conversely, if the decrease in profitability outweighs the increase in demand, then the balance of trade may worsen.
I. If farmers in Tanzania rely largely on domestic inputs:
Currency devaluation would have the following impacts on the output and balance of trade:
1. Increased competitiveness: A devalued currency makes the country's exports cheaper in international markets. This increased competitiveness can lead to an increase in the demand for Tanzanian agricultural products, resulting in higher output and increased export revenue.
2. Decreased imports: With a devalued currency, imported goods become relatively more expensive. This may discourage the importation of agricultural inputs, encouraging farmers to use more domestically produced inputs. As a result, the reliance on domestic inputs may increase, leading to a boost in domestic production and potentially increasing output.
3. Improved balance of trade: A combination of increased export revenue and decreased imports can improve the balance of trade. If the increase in export earnings outweighs the decrease in import expenses, the trade balance of Tanzania will improve.
II. If a significant component of Tanzania's agricultural inputs are imported:
Currency devaluation would have the following impacts on the output and balance of trade:
1. Increased costs of imported inputs: A devalued currency makes imported inputs more expensive in domestic currency terms. This can increase the production costs for Tanzanian farmers, as they would need to spend more to acquire the necessary agricultural inputs.
2. Reduced output: Higher input costs can discourage production, leading to a decrease in output. Farmers may face challenges in accessing and affording necessary imported inputs, which can hinder productivity and lower the overall agricultural output.
3. Decreased competitiveness: With the increased costs of imported inputs, the competitiveness of Tanzanian agricultural products may decrease in international markets. This could result in lower demand and reduced export revenue.
4. Deterioration in the balance of trade: In this scenario, if the decrease in export revenue outweighs the decrease in import expenses, the balance of trade may deteriorate. Higher import costs and potentially lower export revenue could contribute to a larger trade deficit or a smaller trade surplus.