Transcript chapter14

International Economics
By Robert J. Carbaugh
9th Edition
Chapter 14:
Exchange-Rate Adjustments
and the Balance of Payments
Copyright ©2004, South-Western College Publishing
Exchange rate adjustments
Exchange-rate adjustment and the BOP
 Automatic mechanisms may restore
balance-of-payments equilibrium, but at the
cost of recession or inflation
 As an alternative, governments allow
exchange rates to change
 Floating exchange rates, determined by
markets
 Devaluing or revaluing fixed exchange rates
Carbaugh, Chap. 15
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Exchange rate adjustments
Exchange rate effects on costs & prices
 Impact of appreciation or depreciation on costs
depends on the proportion of inputs priced in
foreign vs. domestic currency
 As foreign-currency denominated costs rise as a
proportion of total costs, exchange rate changes have
less effect on the foreign currency price and more
effect on the domestic price
 If foreign-currency costs are a small part of total costs,
exchange rate changes have more impact on foreign
currency price of the product and less on domestic
price
Carbaugh, Chap. 15
3
Exchange rate adjustments
Exchange rate effects on costs & prices
 Generally, currency appreciation increases
the costs of exports in foreign currency
terms, which hurts total exports (while
depreciation encourages exports)
 Effect on prices is modified by the ability and
willingness of sellers to change their prices
Carbaugh, Chap. 15
4
Exchange rate adjustments
Requirements for successful devaluation
 When can devaluation correct a payments deficit?
 Elasticity approach
 Emphasizes price effects; devaluation works best when
demand is elastic
 Absorption approach
 Focus on income effects; domestic spending must fall,
too
 Monetary approach
 Focus on change in purchasing power of money and
effect on domestic spending
Carbaugh, Chap. 15
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Devaluation as adjustment tool
Elasticity approach
 Impact of currency devaluation depends on
price elasticity of domestic demand for
imports and of foreign demand for exports
 The less either foreign or domestic demand
responds to price changes, the less effect a
devaluation will have on the payments
imbalance
Carbaugh, Chap. 15
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Devaluation as adjustment tool
Elasticity approach
 Marshall-Lerner condition:
 Devaluation will improve the trade balance if
domestic demand elasticity for imports plus
foreign demand elasticity for exports is greater
than 1
 Devaluation will worsen the trade balance if the
sum of the two elasticities is less than 1
 If the sum is equal to 1, devaluation will have
no effect
Carbaugh, Chap. 15
7
Devaluation as adjustment tool
Devaluation and time horizon
 The J-curve effect: in short run, devaluation
worsens trade balance, but with time the
balance improves (3-5 years)
 Recognition lags; decision lags; delivery lags;
replacement lags; production lags
 Currency pass-through: effect of
devaluation depends on how quickly
producers pass on higher or lower costs to
their customers
Carbaugh, Chap. 15
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Devaluation as adjustment tool
Absorption approach
 Emphasizes impact of devaluation on
spending behavior of domestic economy
 Balance of trade is the difference between
total domestic output and domestic
absorption
 Positive balance means output exceeds
domestic spending
 Negative balance means spending exceeds
total production
Carbaugh, Chap. 15
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Devaluation as adjustment tool
Absorption approach (cont’d)
 Devaluation will only improve the trade
balance if output rises relative to domestic
absorption
 If an economy is operating below capacity, a
devaluation will shift resources into export
production and encourage spending on import
substitutes
 If an economy is operating at full employment,
production cannot rise; trade balance can only
be cut by slowing the domestic economy
Carbaugh, Chap. 15
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Devaluation as adjustment tool
Monetary approach
 Elasticity and absorption approaches apply
only to the trade balance; monetary
approach includes capital account
 Devaluation may induce a temporary
improvement in the balance of payments
 Devaluation increases the domestic price level,
increasing demand for money and drawing
foreign capital flows (because of higher interest
rates that result)
Carbaugh, Chap. 15
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Devaluation as adjustment tool
Monetary approach (cont’d)
 In the long run, the inflow of money
increases domestic spending, increasing
imports and returning the economy to the
starting point
 Devaluation affects real economy only
temporarily; only long run effect is to raise
the domestic price level
Carbaugh, Chap. 15
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