Trade Balance and Exchange Rates

One of the most remarkable facts about the development of international economics in the past 50 years has been the persistence of the belief that a country can improve its balance of trade by devaluing its currency. More generally, it is believed that just as a profit-maximizing monopolistic firm producing under constant costs can improve its sales and thereby its profitability by lowering its costs and thus its selling price provided the elasticity of demand for its product is greater than unity, a country can be become more “competitive” and improve its balance of trade by cutting the prices of its export goods provided the sum of its elasticity of demand for imports and the foreign elasticity of demand for its exports exceeds unity. (For brevity, the terms “balance of trade” and “trade balance” are used rather improperly throughout this paper to stand for the balance of payments on goods and services. The term “foreign balance” has an equivalent meaning.)