Transcript Price Adjustments and Balance-of

Chapter 23
Price Adjustments
and Balance-ofPayments
Disequilibrium
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
23-1
Learning Objectives
• Explain how changes in the exchange
rate affect the movement of goods
and services and the trade balances
of countries.
• Discuss how price elasticity of
demand relates to the stability of
foreign exchange markets.
• Summarize how the price adjustment
mechanism functions under a system
of fixed or pegged exchange rates.
23-2
The Price Adjustment Process and
the Current Account Under A
Flexible Rate System
 A depreciation of the home currency
causes foreign goods to become more
expensive, reducing consumption of
imports relative to domestic
alternatives.
 A depreciation makes the home
country’s exports seem cheaper, so
the trading partner switches
expenditure towards home products.
 This process is expenditure switching.
23-3
Demand for Foreign Goods and
Services and the Foreign
Exchange Market
 Demand for foreign exchange is derived from
demand for goods and services.
 Demand for imports depends on price of
foreign goods or services, tariffs or
subsidies, prices of domestic substitutes
and complements, domestic income, and
tastes.
 Demand for foreign currency by home
country is also supply of foreign currency to
the foreign country.
23-4
Demand and Supply of Foreign
Exchange
e$/£
S£
e£/$
1.2
S$
0.83
D$
D£
£
$
23-5
Demand and Supply of Foreign
Exchange
 With normally shaped supply and
demand curves, the market for foreign
exchange is stable.
 If U.S. income rises, demand for
imports rises and so does demand for
foreign exchange.
 The rightward shift of the demand for
foreign exchange creates a current
account deficit and an increase in the
price of pounds (a depreciation of the
dollar).
23-6
Demand and Supply of Foreign
Exchange
e$/£
S£
e£/$
e'eq
eeq
S$
eeq
D$
D£
D '£
£
$
23-7
Demand and Supply of Foreign
Exchange
 If U.S. prices increase relative to
British prices:
 U.S. consumers demand more British
products, increasing demand for pounds.
 British consumers demand fewer U.S.
products, decreasing the supply of
pounds.
 The overall effect is an increase in the
dollar price of pounds.
23-8
Demand and Supply of Foreign
Exchange
S' £
e$/£
S£
E$/£
S£
e'eq
e'eq
eeq
eeq
D£
D' £
D£
D '£
£
£
23-9
Market Stability and the Price
Adjustment Mechanism
 This price adjustment depends on the
slope of the supply and demand
curves for foreign exchange.
 Supply curves can be backwardsloping.
 If supply curve is steeper than demand
curve, the market is still stable.
 If supply curve is flatter than demand
curve, the market is unstable.
23-10
Demand and Supply of
Foreign Exchange
e$/£
S£
e£/$
S$
D£
£
In this case, if e is too high,
there is an excess supply and e
will fall.
D$
$
In this case, if e is too high,
there is an excess demand and e
will rise.
23-11
Explaining the BackwardSloping Supply Curve
 As the dollar becomes more
expensive, two effects happen:
 More pounds are required to buy each unit
of imports from the U.S.
 The number of units imported falls due to
the increase in price in terms of pounds.
 It’s easy to see these effects by
considering the price elasticity of
demand
 arc
Q /Q1  Q2  / 2

P /P1  P2  / 2
23-12
Explaining the BackwardSloping Supply Curve
 Example:
 Suppose the depreciation of the dollar
causes the U.K. price of the imported
good to increase from £16 to £22, and
this causes quantity demanded to fall
from 120 units to 100 units.
 arc
Q /Q1  Q2  / 2 20 / 120  100  / 2


 0.58
P /P1  P2  / 2
6 /16  22  / 2
 If foreign demand for home goods is
inelastic, supply of foreign exchange
is downward-sloping.
23-13
Exchange Market Stability:
The Marshall-Lerner
Condition
 If home-country demand is elastic, a
depreciation will improve the current
account balance.
 The increased price of imports reduces total
expenditures on imports and the reduced price of
exports to foreigners causes an increase in their
expenditures.
 If home-country demand is inelastic, a
depreciation will have an ambiguous effect
on the current account balance.
 The increased price of imports will increase total
expenditures on imports, possibly offsetting the
foreign country’s increased expenditures on
exports.
23-14
Exchange Market Stability:
The Marshall-Lerner
Condition
 The Marshall-Lerner Condition: The
foreign exchange market will be
stable as long as
X
 DX   DM  1
M
where
X = expenditures on exports
M = expenditures on imports
ηDX = price elasticity for home exports
ηDM = price elasticity for imports.
23-15
Exchange Market Stability:
The Marshall-Lerner
Condition
 Some empirical studies suggest these
demand elasticities may be low.
 However, the general consensus is
that these elasticities are large
enough that the foreign exchange
market is stable.
23-16
Price Adjustment Process:
Short Run vs. Long Run
 When the Marshall-Lerner condition
holds, changes in the exchange rate
bring about appropriate switches in
expenditures between domestic and
foreign goods.
 A home currency depreciation leads
to a substitution of domestic goods
for imports.
 A home currency depreciation causes
foreigners to switch to home country
exports.
23-17
Price Adjustment Process:
Short Run vs. Long Run
 Short-run elasticities of supply and
demand tend to be smaller in absolute
value than long-run elasticities.
 Consumers don’t adjust immediately to
relative price changes; it’s not unusual for
the quantity demanded of imports and the
amount of foreign exchange needed to not
respond to changes in the exchange rate.
 The supply of exports may not adjust
immediately in response to changes in
exchange rates due to lags in recognition,
decision-making, production, and delivery.
23-18
Price Adjustment Process:
The J-Curve
 If the short-run elasticities are low,
the market for foreign exchange may
be unstable.
 A depreciation may initially lead to a
further depreciation, since demand for
the foreign currency outstrips supply.
 Therefore the current account deficit
worsens.
 Eventually, the current account deficit
shrinks and a new equilibrium is
attained.
23-19
The J-Curve
X-M
point of
depreciation
(X-M) = f(e,time)
time
23-20
Price Adjustment Mechanism
in a Fixed Exchange Rate
System
 Rather than allowing the foreign
exchange market to determine the
value of foreign exchange, countries
sometimes fix or “peg” the value of
their currencies.
23-21
Price Adjustment
Mechanism with the Gold
Standard
 From 1880 to 1914, countries pegged
their currencies to gold.
 This fixes countries’ exchange rates
with each other.
 For example, if the dollar is fixed at
$100 per ounce and the pound is fixed
at £50 per ounce, the “mint par”
exchange rate is $2/£.
 Governments must be prepared to
maintain the gold price by buying and
selling gold at the set price.
23-22
Price Adjustment
Mechanism with the Gold
Standard
 Since the exchange rate is fixed,
some other mechanism must be in
force to balance demand for and
supply of foreign exchange.
 These “rules of the game” are
assumed to hold:
 no restraints on buying/selling gold within
countries; gold can move freely between
countries,
 money supply is allowed to change if a
country’s gold holdings change, and
 prices/wages are flexible.
23-23
Price Adjustment
Mechanism with the Gold
Standard
 Suppose an increase in U.S. income causes
an increased demand for pounds.
 There will be upward pressure on the
exchange rate to eliminate the excess
demand for pounds.
 Buyers/sellers know that governments stand
ready to buy/sell pounds at mint par, using
gold as medium of exchange.
 Since it is costly to ship gold, the exchange
rate can vary slightly from mint par.
23-24
Foreign Exchange Market
Under a Gold Standard
e$/£
S£
e$/£
S£
$2.04
$2.00
$1.96
$2.00
D£
D '£
Mint par
D£
£
£
Assuming transactions costs represent 2% of par value, the
exchange rate can vary between $1.96 and $2.04.
23-25
Price Adjustment
Mechanism with the Gold
Standard
 Americans never need to pay more
than $2.04/£, since an unlimited
supply of pounds can be obtained at
this price.
 This price is called the gold export point.
 The British never need to receive
fewer than $1.96/£, since at that point
gold will begin to move to the U.S. to
be exchanged for dollars.
 This price is called the gold import point.
23-26
Price Adjustment
Mechanism with the Gold
Standard
 The exchange rate can vary in
between these narrow bands.
 Prices cannot adjust through
exchange rate changes.
 Instead, prices adjust through
changes in the money supply.
23-27
Price Adjustment
Mechanism with the Gold
Standard
 Assuming the quantity theory holds,
Ms = kPY.
 If gold leaves the country, Ms falls and
prices must fall in response.
 Assuming demand for tradeable goods
is elastic, this should reduce spending
on imports and increase receipts from
exports.
23-28
Price Adjustment
Mechanism with the Gold
Standard
 The price adjustment mechanism under the
gold standard is triggered by changes in the
money supply related to flows of gold.
 This adjustment depends on flexible wages
and prices – any rigidities will hinder
adjustment.
 Other adjustment may occur due the effects
of changes in the money supply on interest
rates and income.
 The gold standard works to keep inflation in
check.
23-29
Price Adjustment
Mechanism with a Pegged
Rate System
 A country can also fix its exchange
rate without reference to the value of
gold.
 The central bank must be ready to buy
foreign currency when the domestic
currency is strong, and sell foreign
currency when the domestic currency
is weak.
 Central banks must hold a sufficient
supply of foreign currencies.
23-30
Price Adjustment
Mechanism with a Pegged
Rate System
 The adjustment effects of such a
system are similar to a gold standard.
 Upward pressure on the exchange
rate caused by an increase in demand
for foreign exchange will cause the
central bank to sell foreign exchange.
 This reduces the money supply,
thereby triggering adjustments to
interest rates, income, and prices.
23-31
Price Adjustment
Mechanism with a Pegged
Rate System
 Similarly, downward pressure on the
exchange rate caused by an increase
in the supply of foreign exchange will
cause the central bank to buy foreign
exchange.
 This increases the money supply,
thereby triggering adjustments to
interest rates, income, and prices.
23-32
Price Adjustment
Mechanism with a Pegged
Rate System
 For these adjustments to occur, the
central bank must allow the actions
taken in the foreign exchange markets
to affect the domestic money supply.
 Bottom line: when a country adopts a
fixed exchange rate system, its
central bank loses effective control
over the money supply as a policy
tool.
23-33