1. International Economics By Robert J. Carbaugh 9th Edition
Chapter 15:
Exchange-Rate Adjustments and the Balance of Payments

2. Exchange-rate adjustment and the BOP
Exchange rate adjustments
Exchange-rate adjustment and the BOP
Automatic mechanisms may restore balance-of-payments equilibrium, but at the cost of recession or inflation
As an alternative, governments allow exchange rates to change
Floating exchange rates, determined by markets
Devaluing or revaluing fixed exchange rates
Carbaugh, Chap. 15

3. Exchange rate effects on costs & prices
Exchange rate adjustments
Exchange rate effects on costs & prices
Impact of appreciation or depreciation on costs depends on the proportion of inputs priced in foreign vs. domestic currency
As foreign-currency denominated costs rise as a proportion of total costs, exchange rate changes have less effect on the foreign currency price and more effect on the domestic price
If foreign-currency costs are a small part of total costs, exchange rate changes have more impact on foreign currency price of the product and less on domestic price
Carbaugh, Chap. 15

4. Exchange rate effects on costs & prices
Exchange rate adjustments
Exchange rate effects on costs & prices
Generally, currency appreciation increases the costs of exports in foreign currency terms, which hurts total exports (while depreciation encourages exports)
Effect on prices is modified by the ability and willingness of sellers to change their prices
Carbaugh, Chap. 15

5. Requirements for successful devaluation
Exchange rate adjustments
Requirements for successful devaluation
When can devaluation correct a payments deficit?
Elasticity approach
Emphasizes price effects; devaluation works best when demand is elastic
Absorption approach
Focus on income effects; domestic spending must fall, too
Monetary approach
Focus on change in purchasing power of money and effect on domestic spending
Carbaugh, Chap. 15

6. Devaluation as adjustment tool
Elasticity approach
Impact of currency devaluation depends on price elasticity of domestic demand for imports and of foreign demand for exports
The less either foreign or domestic demand responds to price changes, the less effect a devaluation will have on the payments imbalance
Carbaugh, Chap. 15

7. Elasticity approach Marshall-Lerner condition:
Devaluation as adjustment tool
Elasticity approach
Marshall-Lerner condition:
Devaluation will improve the trade balance if domestic demand elasticity for imports plus foreign demand elasticity for exports is greater than 1
Devaluation will worsen the trade balance if the sum of the two elasticities is less than 1
If the sum is equal to 1, devaluation will have no effect
Carbaugh, Chap. 15

8. Devaluation and time horizon
Devaluation as adjustment tool
Devaluation and time horizon
The J-curve effect: in short run, devaluation worsens trade balance, but with time the balance improves (3-5 years)
Recognition lags; decision lags; delivery lags; replacement lags; production lags
Currency pass-through: effect of devaluation depends on how quickly producers pass on higher or lower costs to their customers
Carbaugh, Chap. 15

9. Devaluation as adjustment tool
Absorption approach
Emphasizes impact of devaluation on spending behavior of domestic economy
Balance of trade is the difference between total domestic output and domestic absorption
Positive balance means output exceeds domestic spending
Negative balance means spending exceeds total production
Carbaugh, Chap. 15

10. Absorption approach (cont’d)
Devaluation as adjustment tool
Absorption approach (cont’d)
Devaluation will only improve the trade balance if output rises relative to domestic absorption
If an economy is operating below capacity, a devaluation will shift resources into export production and encourage spending on import substitutes
If an economy is operating at full employment, production cannot rise; trade balance can only be cut by slowing the domestic economy
Carbaugh, Chap. 15

11. Devaluation as adjustment tool
Monetary approach
Elasticity and absorption approaches apply only to the trade balance; monetary approach includes capital account
Devaluation may induce a temporary improvement in the balance of payments
Devaluation increases the domestic price level, increasing demand for money and drawing foreign capital flows (because of higher interest rates that result)
Carbaugh, Chap. 15

12. Monetary approach (cont’d)
Devaluation as adjustment tool
Monetary approach (cont’d)
In the long run, the inflow of money increases domestic spending, increasing imports and returning the economy to the starting point
Devaluation affects real economy only temporarily; only long run effect is to raise the domestic price level
Carbaugh, Chap. 15