Crucial Question: Under which circumstances will a devaluation lead to an improvement of the trade balance Literature: KO pp. 464f. and appendix to ch. 16 or CFJ., 16. EC 654 INTERNATIONAL FINANCE Dr. Carsten Lange Foreign Exchange Market and Trade Elasticities

Some Assumptions No net capital flows: FA=0, KA = 0. Residents in a country respond only to prices in their domestic currency. Export price are fixed in domestic currency (e.g. $). Imports prices are fixed in foreign currency. Supply is infinitely elastic. This means: If firms experience a higher demand for their goods, they will produce the extra demand without a price increase.

How Does a Devaluation of the Domestic Currency Effect the Trade Balance? $/€ € demand and supply Supply (Exports) Demand (Imports) $/€ 1 0 The diagram seems to suggest, that a devaluation leads always to an improvement, but this is here only true since the Marshall-Lerner condition is fulfilled.

Three Effects of a Devaluation of lets say 1% (exchange rate increase of 1%) 1.Import quantity will decrease by x%. (we don’t know the exact number for x). C.p. the trade balance will improve by x%. 2. Export quantity will increase by y%. (we don’t know the exact number for y) C.p. the trade balance will improve y%. Preliminary result: Considering only effect 1 and 2 the trade balance would improve by x% + y%.

Reminder on Price Elasticity of Demand Price Elasticity of Demand   Percentage Change in Demand Quantity Percentage Change in Price What is the price change, that customers for export (import goods) are facing? 1% !!! Therefore in our example the import and export quantities can be expressed by the price elasticity for import goods  m resp. export goods  x.

Three Effects of a Devaluation of lets say 1% 1.Import quantity will decrease by  m %. (we don’t know the exact number for  m ) C.p. the trade balance will improve by  m % 2. Export quantity will increase by  x %. (we don’t know the exact number for  x ) C.p. the trade balance will improve  x %. Preliminary result: Considering only effect 1 and 2 the trade balance would improve by  m +  x %.

The Third Effect of a Devaluation is Always Determined a)Given the quantity of imports the value of imports expressed in domestic currency will increase. b)Given a 1% devaluation, the import value would increase c.p. by 1% and would hurt the trade balance by 1%.

Summarizing the Three Effects Marshall/Lerner Condition Only if the sum of effect #1 and #2 is stronger than effect #3, a devaluation will lead to an improvement of the trade balance. In Other Words: If and only if  m +  x >= 1, a devaluation will lead to an improvement of the trade balance.

Example Marshall Learner not fulfilled

Example Marshall Learner exactly fulfilled The balance of payment effect is supposed to be exactly 0. The $20 difference results from the fact that the increased price effects only BMWs instead of 200. This fact is not considered in the Marshall/Lerner condition.

Example Marshall Learner fulfilled (assignment: complete the table) Imp. Elast. Import Exp. Elast. Export Imports0.5ValueExports2Value PriceBMW (amount)PriceGM (amount) Before:$100,000200$20,000,000$50,000400$20,000,000 After:$ Trade Balance:-=

Example Marshall Learner fulfilled (assignment answer)

Short Run 1. Import quantity will decrease by  m %. c.p. the trade balance will improve by  m % 2. Export quantity will increase by  x %.C.p. the trade balance will improve  x %. 3. Given a 1% devaluation, the import value would immediately (!) increase c.p. by 1% and would hurt the trade balance by 1%. Even if the Marshall/Lerner condition is fulfilled, in the short run the 3rd. Effect will dominate. Later the trade balance will improve which leads to a J-Curve.

Example: Short Run Reaction of the Balance of Payment to a depreciation of the Domestic Currency