Basic Theories of the Balance of Payments Chapter 17 Basic Theories of the Balance of Payments

Topics to be Covered Elasticities Approach to the Balance of Trade Price Elasticity of Demand J Curve Effect Currency Contract Period Pass-through Analysis Evidence from Devaluations Absorption Approach to the Balance of Trade Monetary Approach to the Balance of Payments

Basic Theories Theories of the Balance of Trade (No Capital Flows) Elasticities Approach Absorption Approach Monetary Approach to the Balance of Payments

The Elasticities Approach The elasticities approach examines how changing relative prices of domestic goods and foreign goods resulting from a change in the exchange rate will affect the balance of trade of a country. For example, the relative price effect of a Japanese yen devaluation should increase U.S. demand for Japanese goods (as the $ price of Japanese goods fall) and decrease Japanese demand for U.S. goods (as the yen price of U.S. goods rise). How much quantity demanded changes in response to the relative price change is determined by the elasticity of demand.

Price Elasticity of Demand The price elasticity of demand measures the responsiveness of quantity demanded to a change in the product’s price. The coefficient of elasticity of demand is equal to the percentage change in quantity demanded divided by the percentage change in price, that is: Similarly, we can compute a price elasticity of supply.

Elasticity of Demand (cont.) If the % change in quantity demanded exceeds (is less than) the % change in price, then demand is said to be elastic (inelastic). With an elastic (inelastic) demand, total revenue (or price times quantity) will move in the opposite (same) direction as the price change.

Supply and Demand for British Pounds Refer to Figure 17.1 Downward-sloping demand curve for pounds Upward-sloping supply curve of pounds Given that the market is in equilibrium, suppose there is an increase in the demand for pounds (i.e., demand curve shifts to the right).

FIGURE 17.1 Supply and Demand in the Foreign-Exchange Market

Possible Responses to an Increase in Demand for Pounds With flexible or freely floating exchange rates, the pound will appreciate. A central bank can fix or peg the exchange rate at the original level by supplying more pounds from its foreign reserves. Foreign exchange controls or quotas can be used to restrict the demand and supply of pounds. Quotas or tariffs can be imposed on trade to maintain the original demand and supply curves.

The J Curve The J curve refers to the time pattern of the trade balance following an official central bank devaluation. The pattern traces out a path similar to the letter J, that is, after the devaluation, the balance of trade deteriorates for a while before improving. Refer to Figure 17.2

FIGURE 17.2 The J Curve

Causes of the J Curve Effect The Currency Contract Period The Pass-Through Effect

Currency Contract Period Currency Contract Period—refers to the time period immediately following a devaluation when contracts signed prior to the devaluation are settled. FIGURE 17.3 The Currency-Contract Period

Currency Contract Period and Trade Balance Effects The effects of fixed contracts on the balance of trade depend on the currency in which the contract is denominated. Refer to Table 17.1 for possible cases Based on Table 17.1, foreign currency-denominated imports is a necessary condition for the U.S. trade balance to exhibit the J curve effect.

TABLE 17.1 U.S. Trade Balance Effects during the Currency-Contract Period Following a Devaluation

Pass-through Analysis Pass-through analysis—examines the ability of goods prices to adjust in the short run. After devaluation, it is expected that import prices rise in the devaluing country and that prices of its exports fall. Refer to Table 17.2 for possible effects following a U.S. devaluation (quantities held constant due to inelastic demands or supplies). Also, discuss Global Insights 17.1 regarding differences in effects across industries.

TABLE 17.2 U.S. Trade Balance Effects during the Pass-Through Period Following a Devaluation

Evidence from Devaluations Effects of devaluation differ across countries and time. One reason is that producers in different countries (e.g., Japan and Germany) adjust their profit margins on exports to offset the effect of exchange rate changes. This behavior is called pricing to market (see Item 17.1).

Evidence (cont.) Studies show that in countries where the capital-labor ratio is low, devaluations tend to result in export expansion and economic growth. Evidence from studies also indicate that the adjustment of goods prices to changes in exchange rates takes a long time (as much as three years).

Reasons for Declining Pass-through Effect to Import Prices in the U.S. The share of imports accounted for by products with prices sensitive to exchange rate changes has been falling. Foreign exporters have been practicing “pricing-to-market” behavior. Although China’s market share has increased, the limited flexibility of China’s exchange rate relative to the dollar has reduced pass-through.

The Absorption Approach The absorption approach is a theory of the balance of trade in goods and services that emphasizes how domestic spending changes relative to domestic production. The balance of trade is the difference between what the economy produces and what it consumes or absorbs.

Absorption Approach (cont.) Given the national output (Y) identity, where C is consumption, I investment, G government spending, EX exports, and IM imports, define absorption A as: A = C + I + G

Absorption Approach (cont.) Thus, If total output exceeds absorption, then the country will export its surplus and the current account will be in surplus.

Absorption Approach (cont.) Suppose the country devalues its currency, then there are two possibilities: With unemployed resources, devaluation will increase exports and output without inflation. With full employment, devaluation will raise exports and lead to inflation as domestic prices are bid up.

Monetary Approach to the Balance of Payments (MABP) Unlike the elasticities and absorption approaches, the MABP incorporates both the current account (trade in goods and services) and financial account (trade in financial assets). The basic premise is that any balance of payments disequilibrium is based on monetary disequilibrium, or the difference between the amount of money people want to hold and the amount supplied by monetary authorities.

MABP vs. MAER The monetary approach to the balance of payments (MABP) applies to countries with fixed exchange rates. The monetary approach to the exchange rate (MAER) applies to countries with flexible or freely floating exchange rates. The adjustment mechanism, or the process by which disequilibrium is eliminated, depends on the exchange rate system. With fixed exchange rates, adjustment is through international money flows, while with floating rates, adjustment is via changes in the exchange rate.

Simple Model of the MABP Basic concepts and assumptions: Base Money is currency plus commercial bank reserves held against deposits. Domestic Credit (D) is the domestic component of base money. International Reserves (R) is the foreign part of base money consisting primarily of foreign exchange. Assume a small, open economy.

Model of MABP (cont.) The model contains equations for: Demand for money: Supply of Money: Law of One Price: Money Market Equilibrium:

MABP Model (cont.) Substituting and evaluating in terms of percentage changes, we get: R – E = PF + Y – D With fixed exchange rates, E = 0, and we have the MABP equation. A percentage increase in domestic credit, holding foreign prices and income constant, will lead to a percentage decrease in international reserves.

MABP Model (cont.) A percentage increase in either domestic income or foreign prices, other things constant, will lead to an increase in international reserves.

Policy Implications of MABP Balance of payments disequilibria are monetary phenomena. Balance of payments disequilibria are transitory. Balance of payments disequilibria can be handled with domestic monetary policies rather than with exchange rate adjustments. Domestic balance of payments will be improved by an increase in domestic income via an increase in money demand, if not offset by an increase in domestic credit.