1. Foreign Exchange Market and Trade Elasticities
IMQF course in International Finance
Caves, Frankel and Jones (2007) World Trade and Payments, 10e, Pearson

2. Outline Basic definitions
Foreing exchange (FX) market (supply and demand) under different FX regimes
Impact of imports and exports on FX market supply and demand
Impact of devalution on trade balance (theoretical framework and empirical evidence)

3. Basic definitions Exchange rate Effective exchange rate
Price of foreign currency in terms of domestic currency (except in Britain)
Depreciation (increase in the exchange rate) vs. appreciation (decrease in the exchange rate)
Effective exchange rate
Weighted average of the exchange rates against each of the individual countries
Weigths? Countries’ share in trade

4. Supply and Demand for Foreign Exchange
Supply of foreign exchange (FX)
Exports proceeds
Other credit items in the BoP
Demand for FX
Import spending
Other debit items in the BoP

5. Increase in Demand for Foreign Currency
Floating FX regime:
Rise in demand triggers increase in FX rate and in the quantity of FX
FX rate is determined so as to equilibrate demand and supply
Fixed („pegged“) FX regime:
Rise in demand triggers increase in the quantity of FX
There is no price adjustment at the market, but rather the Central bank stands ready to buy or sell FX, in order to equilibrate demand and supply for the given FX rate
If demand rises, Central bank must sell foreign currency in order to meet excess demand
By interventions at the FX market, the Central bank makes impact on the FX rate
How long and how much can the Central bank intervene at the FX market?
Is there an (policy) alternative to Central bank intervention?
What happens when the Central bank runs out of the FX reserves?
Devaluation (setting the new FX rate)
Shift to floating FX regime (depreciation)

6. Increase in Demand for Foreign Currency

7. Deriving Supply and Demand for FX from Exports and Imports
Assumption 1: there are no net capital flows (KA=0)
Supply and demand for FX entirely determined by the trade account (exports –imports)
Instead of KA=0, the same would hold if the KA=const.
Assumption 2: domestic residents look only at prices expressed in domestic currency, while foreign residents look only at prices in foreign currency
Demand for imported goods depends on the price of imported goods in domestic currency, while supply of exports depends only on the price of exported goods in domestic currency
Effect of changes in income on demand is ignored

8. Deriving Supply and Demand for FX from Exports and Imports
Assumption 3: supply is infinitely elastic (firm sets the price of the product and than meets any forthcoming demand)
P is the price (in domestic currency) at which domestic firms supply exportables with infinite elasticity
P* is the price (in foreign currency) at which foreign firms supply importables
E is exchange rate (price of foreign currency stated in domestic currency)
Output levels are determined by demand, i.e. demand for imports is decreaseing function of the import’s price expressed in domestic currency (fixed price in foreign currency times FX (E))
Demand for export is decreasing function of their price expressed in foreign currency (fixed price in domestic currency divided by FX)
Devaluation (increase in E) lowers price of exports, triggering increase in exports, and rises the price of imports reducing demand for imports

9. Effect of a Devaluation on Trade

10. Effect of a Devaluation on Trade
FX market
Demand for FX depends on imports, while supply of FX depends on exports
Net supply of FX:
Net supply of FX equals the trade balance (TB), i.e. the difference between the exports revenue and the imports revenue

11. Does Devaluation Improve Trade Balance? - The Marshall-Lerner Condition
Effects of devaluation on trade balance:
a) Reduction in the quantity of imports
b) Increase in the quantity of exports
c) Decrease in the FX inflow, as the prices are set in domestic currency (hurting trade balance)
Net effect of devaluation on exports revenue depends on the elasticity of exports demand
if it is small, e.g. less than 1, devaluation can trigger decline in exports revenue - (c) outweights (b)
…but decline in exports revenue can be outweigthed by a reduction in imports, so the trade balance is improved (or TB can get worsen if import elasticity is low)
Assumption 4: Economy is initially in a position of balanced trade (TB=0)
For a devaluation to improve the trade balance (and to have the stable FX market), Marshall-Lerner condition should be met:
e.g. exports elasticity is 1, (b) and (c) cancel each other, so if imports elasticity is positive, TB gets improved
Homework: Write down the proof of Marshall-Lerner condition

12. Does Devaluation Improve Trade Balance? - The Marshall-Lerner Condition
Model generalization– relaxing assumption 4
Country devalues if it has a trade deficit (TB<0)
If trade is measured in domestic currency, the necessary condition for a devaluation to improve the trade balance is: the elasticities must be higher than given by Marshall-Lerner condition
As TB<0, initial quantity of import is large, so small devaluation triggers large absolute increase in imports (denominated in domestic currency), which means that exports response should be very strong to outweight the import effect

13. Empirical Effects of Devaluation on Trade Balance
Effects of devaluation on TB depend on exports and imports elasticities
Elasticity pessimism
Volatility of FX in 1930s;
Many countries with fixed FX regime saw their TB worsenning after devaluation (e.g. oil importers if price elasticity of demand in short run is low);
Early econometric estimates of elasticities were low (below 0.5)…but when time lag is taken into account, elasticities in long run are higher

14. Empirical Effects of Devaluation on Trade Balance
The J curve
It takes time for import demand to adjust to devaluation
Only 50% of the total quantity of import adjustment takes place in the first three years (90% - in 5 years)
Why demand elasticities rise over time?
Time lag in dissemination of information, during which importers recognize that relative prices have changed
Time lag in deciding to place a new import order (devaluation does not affect current inventories) and time lag in changing consumer habits (e.g. replacing fuel with electricity)
Time lag between placement of import order and delivery of goods
It takes time for producers to relocate their factories to the countries where costs are lower becase of FX advantage
E.g. The case of Yen appreciation from 1985 to 1995
Production relocation hysteresis
Plants realocation costs are high, so investors need to make sure that favorable FX in the host country is not transitory. When the plants are moved to the host country it might stay there even if the FX gets worsen
The J curve phenomenon – elasticities tend to rise over time, so the trade balance reaction to devaluation is J-curved
At the moment of devaluation, nominal import rises, while nominal exports declines, as there is no quantity adjustment
As the time passes, prices change, quantity of import declines, while the quantity of export rises
Marshall-Lerner condition kicks-in
However, it may be hard to meet all the demand for export (due to capacities limitation)
Rise in prices, rise in wages?

15. The J-Curve