1 International Economics Exchange Rate Changes and Current Account Reactions

2 Current Account Adjustments under Flexible Exchange Rates

3 Elasticities Approach F Switch focus to effects of exchange rate on flows of goods & services (Current Account). –Monetary approach focused on capital account primarily. F Examine conditions under which EXR changes from Current Account imbalances are self-correcting. F Example:Current Account Deficit F Example: Current Account Deficit may lead to: –Fall in value of domestic currency (depreciation). –Domestic goods cheaper to Row, Domestic Exports rise. –Foreign goods more expensive, Domestic imports fall. –Current Account balance improves. Expenditure Switching F Expenditure Switching effects of EXR depreciation. –Emphasis is on EXR elasticity of exports and imports. –Not true that Current Account Balance necessarily improves.

4 EXR Effects on Current Account F Current Account Balance CAB(e) = NX(e) = X(e) – eM(e) F Assuming that X’>0 and M’<0. Want to know what sign of NX’ is. –Rise in e (depreciation) raises X() and lowers M() but effect on eM() is uncertain, and so effect on NX is uncertain. F Extreme Case I: not F Extreme Case I: EXR depreciation does not affect X or M. –Rise in e then increases eM without changing X. larger –CAB deficit is actually larger than before depreciation. F Extreme Case II: large F Extreme Case II: EXR depreciation has large effect X & M. –Rise in e raises X greatly, lowers M enough, so eM falls. smaller –CAB deficit much smaller than before depreciation.

5 Marshall-Lerner Conditions F Intuition: fall –If Import demand is elastic ( |  M |  1) then rise in price (e) results in fall in total expenditure (eM), and CAB will improve regardless of what happens to X. F Current Account Balance CAB(e) = NX(e) = X(e) – eM(e) –Condition required for depreciation to improve Current Account balance is that d CAB/ d e > 0. F Take derivative of CAB wrt e. Rearrange to yield: Marshall-Lerner condition[X/M] |  X | + |  M | > 1 Marshall-Lerner condition [X/M] |  X | + |  M | > 1 –Where  X and  M are the elasticity of demand of exports and imports with respect to the exchange rate respectively. –Have assumed supply curves for both exports and imports are horizontal.

6 Marshall-Lerner Conditions and FX Market Adjustment

7 Marshall-Lerner & the FX Market F Marshall-Lerner conditions determine the “look” & stability of the FX market as well as CAB reactions. F Supply of FX F Supply of FX to the FX market depends on: –$ amount of US goods foreigners wish to purchase. –The level of e, which determines how much FX must be exchanged to get the required amount of $’s. F Assume that demand for US goods is linear in the exchange rate measured appropriately. –Elasticity of demand for US goods varies over the curve. –Elasticity of demand, however, determines how the amount of FX needed varies with the exchange rate. F Illustrate consequences for supply of FX on next slide.

8 Elasticities of FX Demand & Supply D$D$ £/$ e (£/$) U.K. Demand for US Goods & Services Elastic |  | > 1 Elastic Inelastic |  | < 1 Inelastic S£S£ $/£ e ($/£) U.K. Supply of Pounds to FX Market £ $

9 Market Stability P Q D Q Stable Equilibrium Q P D P D Market Stability P0P0 P0P0 P0P0 Unstable Equilibrium ED ES S 1. Standard Market equilibrium is stable. ED so P up - Excess Demand leads to Price rise. ES so P down - Excess Supply leads to Price drop. S 2. Even unusual market here is stable S 3. This market is not stable ED - ED forces P up which worsens ED. ES - ES brings P down, makes ES worse.

10 Current Account Adjustment to Exchange Rate Changes

11 Current Account Adjustments F Goods markets tend to adjust slowly to changes. F SR & LR responses of CAB to EXR moves may differ. –Short Run: –Short Run: Demand for Exports and Imports may not respond to changes in e due to decision-making lags or contracts. –Long Run: –Long Run: Both demands should adjust to new exchange rate level. F Simple Model of Lagged CAB Adjustment X t =.25X(e t-1 )+.25X(e t-2 )+.25X(e t-3 )+.25X(e t-4 ) e t M t = e t [.25M(e t-1 )+.25M(e t-2 )+.25M(e t-3 )+.25M(e t-4 )] F Immediate effect of EXR depreciation is to lower CAB (increase CAB deficit) as X and M fixed by past exchange rates. J-Curve F Over time CAB will rise as larger % of both X and M reflect the exchange rate depreciation. This result is known as the J-Curve.

12 J-Curve for EXR Depreciation Time e CAB (+) (-) Exchange Rate Path CAB Path EXR Depreciation CAB 0 e0e0