Transcript Chapter 6

Chapter 8
The Balance-of-Payments
Adjustment (I)
Elasticity Approach (Relative Price Effects)

Elasticity is the ratio between proportional
change in one variable and proportional
change in another.

The elasticity of export (or import) demand
is the responsiveness of the quantity
demanded to a change in price.
EX = △QX /△PX
EM = △QM /△PM



The elasticity of export (or import) supply
is the responsiveness of the quantity
supplied to a change in price.
If EX > 1, demand is elastic; the percent rise
in quantity of exports is greater than the
percent fall in price.
If EX < 1, demand is inelastic; the percent
rise in quantity of exports is smaller than
the percent fall in price.

If EX = 1, it is unitary elastic demand.
Percent change in quantity demanded
matches percent change in price.

The above are also true for supply. Supply is
elastic if the change in quantity supplied
exceeds the change in price.

Supply is inelastic if the change in quantity
supplied is less than the change in price.
Assumptions of the elasticity
approach

Assume the demand for and supply of foreign
exchanges depends only on goods exports and
imports.

It implies there is no capital flows. A
country’s BOP is determined by its goods
exports and imports. So that:
BOP = CA = X + M

Assume the price of exports in terms of
domestic price remains unchanged. For
instance, the prices of China’s exports in
terms of RMB do not change; the prices of
China’s imports in terms of foreign currency
do not change.

Assume producers supply unlimited quantity
of goods at a set price. Or supply is
infinitely elastic.

Elasticity approach aims to bring BOP
imbalance into equilibrium.

Price effect: the quantity of foreign
exchanges received decreases because of
lower foreign prices. BOP gets worse.

Volume effect: the quantity of exports
increases and the quantity of imports
decreases because of lower foreign prices
and high domestic prices. BOP improves.

For example. Before devaluation, S = ￥6/$ (or
$0.1667/￥; after devaluation, S = ￥7/$ (or
$0.1429).
Price of Chinese exports ￥6/unit.
Price of U.S. exports $2.
Description
China exports
China imports
Current account
China exports
China imports
Current account
China exports
China imports
Current account
China exports
China imports
Current account
Before devaluation China’s BOP (current account) is in balance
Volume
Price
RMB value
Dollar value
12,000
6,000
￥6
￥12
￥72,000
￥72,000
0
$12,000
$12,000
0
Scenario 1
13,200
5,775
Devaluation leads to a current account deficit
￥6
￥79,200
$11,314
￥14
￥80,850
$11,550
- 1,650
-230
Scenario 2
13560
5811
Devaluation leaves the current account unaffected
￥6
￥81,360
$11,622
￥14
￥81,354
$11,622
-6
0
Scenario 3
13,800
5,400
Devaluation leads to a current account surplus
￥6
￥82,800
$11,828
￥14
￥75,600
$10,800
￥7,200
$1,028

Terms of trade effect. Terms of trade is the
ratio of export price to import price. In the
previous example, China’s terms of trade is
6/12 = 0.5 before devaluation. It means one
unit of exports can buy ½ units of imports.
The terms of trade deteriorates after the
devaluation, because it is 6/14 = 0.43, smaller
than before. One unit of exports can be
exchanged for fewer units of imports.

The key to the success of devaluation
depends on the elasticities of export demand
and import demand.

Marshall-Lerner condition postulates that
if the sum of the elasticities of export
demand and import exceeds unity, the
devaluing country improves its BOP.
| EX | + | EM | > 1

Empirical evidence shows Marshall-Lerner
condition was satisfied for most countries.
But a devaluation improves a country’s BOP
only in the long run. In the short run, it may
worsens BOP.
The elasticity of demand for exports and imports
of 15 industrial countries
The elasticity of demand for exports and imports
for 9 developing countries (Con’t)
J-curve effect and time leg effect

J-curve effect is that the BOP gets worse
right after devaluation and gets better over
the long run.

Time lag in consumer responses
Consumers need time to change their
consuming habits.
They will be worried about reliability
and reputation of the new goods.
J-curve effect
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Time lag in producer responses
Producers need time to expand production of
exports.
Orders for imports are made well in advance
and are usually not readily cancelled.
Some firms will not place new orders until
they use up inventories and wear out existing
machineries.
The pass-through effect

Pass-through effect refers to the extent to
which a depreciation of a currency leads to a
rise in import prices.

Complete pass-through means a 10%
depreciation of a currency leads to a 10%
rise in import prices in the devaluing
country.

Partial pass-through means a 10%
depreciation of a currency leads to less than
10% rise in import prices, say 8% or 6%.

Producers want to keep market share.

Exporters of the devaluing country seek to
increase profit margin.

Import-competing industries in domestic
country cut the prices of importssubstitutes, limiting the amount of
additional exports by the devaluing country.

The partial pass-through effect can also
explain the J-curve effect.
The Absorption Approach

The absorption approach thinks that the
domestic output and expenditure determine
the country’s BOP. The theory examines the
impact of devaluation on income and
expenditure.

National income (Y) equals aggregate
expenditure (E).

Y = E = C + I + G + (X – M)

(C + I + G) = A represents absorption, (X – M) =
CA.

CA = Y – A
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This equation says a country’s BOP is based
on its national income and absorption.

BOP deficit means absorption is greater than
income; surplus means absorption is less
than income.

Absorption instrument is the economic
policy to change a nation’s expenditure. The
restrictive fiscal and monetary policies
limit absorption; while the expansionary
ones boost consumption and investment.

Expenditure-switching instrument is the
rules and laws to alter expenditures among
exports and imports.

Tariffs and quotas are the common form to
restrict imports and encourage exports.

Dumping helps firms to sell at a lower price
in world market.

Export subsidy is used to encourage exports.
It includes tax exemptions, lower borrowing
interest rates for the exporting firms, etc.
The effects of devaluation on national
income

If the economy is already at full employment,
it is impossible to raise total output.

Employment effect means devaluation bring
more opportunities for employment, and thus
more income.

Improvement of the BOP depends on the
absorption. This is because absorption rises
with the increase in income.

Marginal propensity to absorb measures
units of absorption increase resulting from
one unit of income increase.

If this ratio is greater than one, absorption
exceeds income, BOP will not improve.

Devaluation reduces national income because
of deteriorated terms of trade.
The effects of a devaluation on direct
absorption

Income redistribution effect refers to the
income redistributed among different groups.
Some people’s income increases while other
people’s income decreases.

It’s hard to say whether devaluation will
raise or lower absorption.
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Real balance effect means devaluation
reduces direct absorption.

The purchasing power of the money people
hold goes down after devaluation so that
people more likely to save and less likely to
spend their incomes.

In order to keep the real cash balances
people tend to sell bonds or stocks. Interest
rates rise; investment and consumption fall.

Generally, the effects of devaluation on
direct absorption are not so clear and mixed.
So for a devaluation to be successful, it
should be accompanied by other policy
measures.