1. INTERNATIONAL ECONOMICS, 15E Robert Carbaugh © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2. Exchange Rate Adjustments and the Balance of Payments Chapter 14 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3. Chapter Outline (1 of 2) Effects of Exchange Rate Changes on Costs and Prices Cost Cutting Strategies of Manufacturers in Response to Currency Appreciation Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach J-Curve Effect: Time Path of Depreciation Exchange Rate Pass-Through © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4. Chapter Outline (2 of 2) The Absorption Approach to Currency Depreciation The Monetary Approach to Currency Depreciation © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5. Effects of Exchange Rate Changes on Costs and Prices (1 of 7) How do exchange-rate fluctuations affect relative costs? ◦ It will depend if a firm’s costs are denominated in local or foreign currency Case 1: No foreign sourcing - all costs are denominated in dollars ◦ If the dollar appreciates by 100%, the U.S. firm’s production costs also rises by 100% ◦ Reduced international competitiveness © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6. Table 14.1- Effects…All Costs Dollar Denominated... © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7. Effects of Exchange Rate Changes on Costs and Prices (2 of 7) Case 2. Foreign sourcing—some costs denominated in $ and some costs in Francs ◦ If the dollar appreciates by 100%, for the U.S. firm:  Production costs in francs increase by 100% for the inputs denominated in dollars  Production costs in francs stay the same for the inputs denominated in francs  Overall, higher production costs (by less than 100%)  Reduced international competitiveness © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8. Table 14.2-Effects… Some Costs Dollar Denominated, Some Franc... © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9. Effects of Exchange Rate Changes on Costs and Prices (3 of 7) Generalization ◦ As franc-denominated costs become a larger portion of Nucor’s total costs ◦ A dollar appreciation (depreciation) leads to  A smaller increase (decrease) in the franc cost of Nucor steel  A larger decrease (increase) in the dollar cost of Nucor steel compared to the cost changes that occur when all input costs are dollar-denominated © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

10. Effects of Exchange Rate Changes on Costs and Prices (4 of 7) Changes in relative costs ◦ Because of exchange-rate fluctuations ◦ Influence relative prices ◦ Influence the volume of goods traded among nations © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11. Effects of Exchange Rate Changes on Costs and Prices (5 of 7) Dollar appreciation ◦ Increasing relative U.S. production costs ◦ Raise U.S. export prices in foreign-currency terms ◦ Decrease in the quantity of U.S. goods sold abroad ◦ Increase in U.S. imports © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12. Effects of Exchange Rate Changes on Costs and Prices (6 of 7) Dollar depreciation ◦ Decreasing relative U.S. production costs ◦ Lower U.S. export prices in foreign-currency terms ◦ Increase in the quantity of U.S. goods sold abroad ◦ Decrease in U.S. imports © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13. Effects of Exchange Rate Changes on Costs and Prices (7 of 7) Factors influencing the extent by which exchange-rate movements lead to relative price changes among nations ◦ U.S. exporters – reduce profit margins to maintain competitiveness ◦ Perceptions concerning long-term trends in exchange rates - promote price rigidity ◦ Product substitutability ◦ Move production offshore © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

14. Cost Cutting Strategies of Manufacturers in Response to Currency Appreciation (1 of 4) Appreciation of the Yen: Japanese Manufacturers ◦ 1990 - 1996, Japanese yen relative to U.S. dollar increased by 40% ◦ Japanese firms  Establish integrated manufacturing bases in the U.S. and in dollar-linked Asia  Use cheaper dollar-denominated parts and materials  Purchase cheaper components from around the world  Shifted production from commodity-type goods to high-value products © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

15. Figure 14.1 - How Hitachi Coped with the Yen’s Appreciation © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

16. Cost Cutting Strategies of Manufacturers in Response to Currency Appreciation (2 of 4) Appreciation of the Yen: Japanese Manufacturers (cont.) ◦ Japanese auto industry  Cut the yen prices of their autos  Falling unit-profit margins  Reduced manufacturing costs  Increasing worker productivity  Importing materials and parts  Outsourcing larger amounts of a vehicle’s production to transplant factories © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

17. Cost Cutting Strategies of Manufacturers in Response to Currency Appreciation (3 of 4) Appreciation of the Dollar: U.S. Manufacturers ◦ 1996-2002, dollar appreciated by 22% ◦ Sipco Molding Technologies  Partnership with an Austrian company  Austrian company - designing and making the tools  Sipco simply resold them © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

18. Cost Cutting Strategies of Manufacturers in Response to Currency Appreciation (4 of 4) Appreciation of the Dollar: U.S. Manufacturers (cont.) ◦ American Feed Co. - pact with a Spanish company  Divvying up the work to keep both factories operating (U.S. and Spain)  Benefits of having a European production base  Without having to take on the risks of building its own factory there  Redesigned: more efficient and less expensive to build © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

19. Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach (1 of 5) Currency depreciation ◦ Improve a nation’s competitiveness  Reducing its costs and prices The elasticity approach ◦ Relative price effects of depreciation ◦ Depreciation works best when demand elasticities are high © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

20. Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach (2 of 5) The absorption approach Income effects of depreciation ◦ A decrease in domestic expenditure relative to income must occur for depreciation to promote trade equilibrium The monetary approach ◦ Effects depreciation has on the purchasing power of money and the resulting impact on domestic expenditure levels © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

21. Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach (3 of 5) Elasticity of demand ◦ Responsiveness of buyers to changes in price ◦ Percentage change in the quantity demanded stemming from a one percent change in price  >1, elastic demand  <1, inelastic demand  =1, unitary elastic demand © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22. Derivation: Elasticity Approach (Marshall- Lerner Condition)

23. Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach (4 of 5) Marshall-Lerner condition ◦ Depreciation will improve the trade balance if  The currency-depreciating nation’s demand elasticity for imports  Plus the foreign demand elasticity for the nation’s exports exceeds one ◦ Depreciation will worsen the trade balance if  The sum of the demand elasticities is less than one ◦ The trade balance will be neither helped nor hurt if the sum of the demand elasticities equals one © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

24. Table 14.3 – Effect of Pound Depreciation on Trade Balance of UK © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

25. Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach (5 of 5) Marshall-Lerner condition (cont.) ◦ Simplifying assumptions  A nation’s trade balance is in equilibrium when the depreciation occurs  No change in the sellers’ prices in their own currency ◦ Illustrates the price effects of currency depreciation on the home-country’s trade balance © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

26. Table 14.4 – Long Run Price Elasticities of Demand for Total Imports & Exports… © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

27. J-Curve Effect: Time Path of Depreciation (1 of 3) J-curve effect ◦ In the very short term, a currency depreciation will lead to a worsening of a nation’s trade balance ◦ But as time passes, the trade balance will likely improve ◦ Because of lags between changes in relative prices and the quantities of gods traded © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

28. Figure 14.2 – Depreciation Flowchart © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

29. J-Curve Effect: Time Path of Depreciation (2 of 3) Types of lags ◦ Recognition lags  Of changing competitive conditions ◦ Decision lags  In forming new business connections and placing new orders ◦ Delivery lags  Between the time new orders are placed and their impact on trade and payment flows is felt © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

30. J-Curve Effect: Time Path of Depreciation (3 of 3) Types of lags (cont.) ◦ Replacement lags  In using up inventories and wearing out existing machinery before placing new orders ◦ Production lags  Involved in increasing the output of commodities for which demand has increased © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

31. Figure 14.3 – Time Path of U.S. Balance of Trade…Appreciation and Depreciation © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

32. Exchange Rate Pass-Through (1 of 5) Exchange rate pass-through relation ◦ The extent to which changing currency values lead to changes in import and export prices  Buyers have incentives to alter their purchases of foreign goods  If the prices of foreign goods change in terms of their domestic currency  Exporters – willingness to change the prices they charge for their goods  Measured in terms of the buyer’s currency © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

33. Exchange Rate Pass-Through (2 of 5) Partial Exchange Rate Pass-Through ◦ Percentage change in import prices < percentage change in the exchange rate Exchange rate pass-through – tend to be partial because ◦ Invoicing practices ◦ Market-share considerations ◦ Distribution costs © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

34. Table 14.5 – Exchange Rate Pass-Through into Import Prices after One Year © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

35. Exchange Rate Pass-Through (3 of 5) Invoicing practices ◦ Choose the currency to invoice exports  Own home currency  Currency of their customers ◦ U.S. trade – dollars © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

36. Table 14.6 – Use of U.S. Dollar in Export & Import Invoicing, 2002-2004 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

37. Exchange Rate Pass-Through (4 of 5) Market-share considerations ◦ Foreign producers  Preserve market share for goods sold in the U.S.  Accept a lower profit margin when their currency appreciates  To keep their dollar prices constant against American competitors ◦ Relatively strong domestic competition for imported goods in the U.S.  Lessen the extent of exchange rate pass-through into import prices © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

38. Exchange Rate Pass-Through (5 of 5) Distribution costs ◦ Costs of distributing the imported good to the final consumer  Transportation  Marketing  Wholesaling  Retailing costs ◦ 40% of overall U.S. consumer prices © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

39. The Absorption Approach to Currency Depreciation (1 of 6) The absorption approach ◦ Impact of depreciation on the spending behavior of the domestic economy ◦ Influence of domestic spending on the trade balance Total spending = ◦ consumption (C) + investment (I) + government expenditures (G) + net exports (X-M) © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

40. The Absorption Approach to Currency Depreciation (2 of 6) Total domestic output (Y) = level of total spending ◦ Y = C + I + G + (X-M) ◦ Absorption, A = C + I + G ◦ Balance of trade, B = (X-M) Total domestic output (Y) = Absorption (A) +Net exports (B) ◦ B = Y – A © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

41. The Absorption Approach to Currency Depreciation (3 of 6) Balance of trade (B) = Total domestic output (Y) - Level of absorption (A) ◦ Positive trade balance: national output exceeds domestic absorption ◦ Negative trade balance: an economy is spending beyond its ability to produce © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

42. The Absorption Approach to Currency Depreciation (4 of 6) The absorption approach ◦ Currency depreciation will improve an economy’s trade balance  Only if national output rises relative to absorption ◦ A country must  Increase its total output  Reduce its absorption  Combine the two © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

43. The Absorption Approach to Currency Depreciation (5 of 6) Unemployment + a trade deficit ◦ Currency depreciation  Direct idle resources into the production of goods for export  Divert spending away from imports to domestically produced substitutes  Expand domestic output + improve the trade balance © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

44. The Absorption Approach to Currency Depreciation (6 of 6) Full employment + trade deficit ◦ Currency depreciation  Cut domestic absorption  Restrictive fiscal and monetary policies  Sacrifice on the part of those who bear the burden of such measures Complementary ◦ The absorption approach ◦ The elasticity approach © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

45. The Monetary Approach to Currency Depreciation (1 of 2) The monetary approach ◦ Currency depreciation  Temporary improvement in a nation’s balance-of- payments position Initial equilibrium in the home country’s money market + Depreciation of the home currency ◦ Increase the price level ◦ Increase the demand for money © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

46. The Monetary Approach to Currency Depreciation (2 of 2) Initial equilibrium in the home country’s money market + Depreciation of the home currency ◦ Inflow of money from overseas ◦ Balance-of-payments surplus ◦ Rise in international reserves ◦ Increase in spending (absorption) - reduces the surplus © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.