Exchange-Rate Adjustments and the Balance of Payments Chapter 14 Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved.

Exchange Rate Effect on Costs assume: all costs denominated in dollars assume: appreciation of dollar costs increase significantly putting the U.S. firm at a competitive disadvantage

Exchange Rate Effect on Costs (cont.) assume: some costs denominated in francs assume: appreciation of dollar costs increase but not as much as if all costs were denominated in dollars

Implications greater percentage of costs foreign denominated appreciation => smaller increase in costs depreciation => smaller decrease in costs general results: appreciation raises prices of U.S. exports in foreign currency terms decreasing exports and increasing imports depreciation lowers prices of U.S. exports in foreign currency terms increasing exports and decreasing imports

Appreciation of Yen: Japanese Firms 1990-1996 yen appreciated 40% in relation to U.S. dollar assuming constant price levels Japanese products would become more expensive Japanese firms used strong yen to establish manufacturing bases in the U.S. and dollar linked nations in Asia using dollar denominated parts and materials partially offset higher costs resulting from appreciation of yen

Appreciation of Dollar: U.S. Firms 1996-2002 dollar appreciated 22% against currencies of major U.S. trading partners with constant price levels U.S. products would become more expensive and less competitive U.S. firms established joint operations in other nations to avoid increased costs associated with stronger dollar U.S. firms shifted production to other locations where possible to reduce such costs

Will Currency Depreciation Reduce a Trade Deficit? elasticity approach: emphasizes relative price effects of depreciation suggesting impact is greatest when elasticities are high absorption approach: decrease in domestic expenditure relative to income must occur for depreciation to promote trade equilibrium monetary approach: emphasizes effect depreciation has on purchasing power of money and resulting impact on domestic spending

Elasticity Approach elasticity of demand – responsiveness of buyers to changes in price elasticity = ÷ ratio > 1 implies elastic demand ratio < 1 implies inelastic demand ratio = 1 implies unitary elastic demand (each in terms of absolute value) ΔQ ΔP Q P

Elasticity Approach (cont.) Marshall-Lerner Condition depreciation will improve trade balance if nation’s demand elasticity for imports plus foreign demand elasticity for that nation’s exports is greater than 1 depreciation will worsen trade balance if the sum of these elasticities is less than 1 depreciation will have no impact on trade balance if the sum of these elasticities equals 1

J-Curve J-curve effect – depreciation will cause decline in trade balance initially but lead to improvement in the long run advocates cite U.S. balance of trade in 1980s and 1990s as evidence

Types of Time Lags recognition lag - time needed to realize change in competitiveness exists decision lag - time needed to place new orders delivery lags - time between orders and their impact on trade balance replacement lags - time needed to use up existing inventories production lags - time needed to increase output of goods for which demand has increased

Exchange Rate Pass Through complete pass through – import prices change by full proportion of change in exchange rates partial pass through – percentage change in import prices is less than percentage change in exchange rate

Reasons for Partial Pass Through Invoice Practices: If firms conducting international trade invoice exports in a foreign currency, changes in the exchange rate will not cause prices to change immediately. Market Share Considerations: Firms may elect to change prices by a lesser proportion in order to maintain market share. Distribution Costs: After an import reaches the border there are additional transportation, marketing, wholesaling, and retailing costs which are denominated in the home currency.

Absorption Approach impact of depreciation on domestic spending Y = C + I + G + (X - M) absorption written as A = C + I + G net exports written as B = X - M Y = A + B B = Y – A currency depreciation will improve trade balance only if national output rises relative to absorption economy at full employment unlikely to see substantial change in trade balance

Monetary Approach elasticities and absorption approaches neglect implications of capital movements monetary approach suggests depreciation will lead to temporary improvement in balance of payments changes in exchange rates alter the demand for money which will lead to capital inflows or outflows over time currency depreciation only changes the domestic price level