1. Exchange-Rate Adjustments and the Balance of Payments
Chapter 14
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2. Exchange Rate Effect on Costs
assume: all costs denominated in dollars
assume: appreciation of dollar
costs increase significantly putting the U.S. firm at a competitive disadvantage

3. Exchange Rate Effect on Costs (cont.)
assume: some costs denominated in francs
assume: appreciation of dollar
costs increase but not as much as if all costs were denominated in dollars

4. Implications greater percentage of costs foreign denominated
appreciation => smaller increase in costs
depreciation => smaller decrease in costs
general results:
appreciation raises prices of U.S. exports in foreign currency terms decreasing exports and increasing imports
depreciation lowers prices of U.S. exports in foreign currency terms increasing exports and decreasing imports

5. Appreciation of Yen: Japanese Firms
yen appreciated 40% in relation to U.S. dollar
assuming constant price levels Japanese products would become more expensive
Japanese firms used strong yen to establish manufacturing bases in the U.S. and dollar linked nations in Asia
using dollar denominated parts and materials partially offset higher costs resulting from appreciation of yen

6. Appreciation of Dollar: U.S. Firms
dollar appreciated 22% against currencies of major U.S. trading partners
with constant price levels U.S. products would become more expensive and less competitive
U.S. firms established joint operations in other nations to avoid increased costs associated with stronger dollar
U.S. firms shifted production to other locations where possible to reduce such costs

7. Will Currency Depreciation Reduce a Trade Deficit?
elasticity approach: emphasizes relative price effects of depreciation suggesting impact is greatest when elasticities are high
absorption approach: decrease in domestic expenditure relative to income must occur for depreciation to promote trade equilibrium
monetary approach: emphasizes effect depreciation has on purchasing power of money and resulting impact on domestic spending

8. Elasticity Approach
elasticity of demand – responsiveness of buyers to changes in price
elasticity = ÷
ratio > 1 implies elastic demand
ratio < 1 implies inelastic demand
ratio = 1 implies unitary elastic demand
(each in terms of absolute value)
ΔQ ΔP
Q P

9. Elasticity Approach (cont.)
Marshall-Lerner Condition
depreciation will improve trade balance if nation’s demand elasticity for imports plus foreign demand elasticity for that nation’s exports is greater than 1
depreciation will worsen trade balance if the sum of these elasticities is less than 1
depreciation will have no impact on trade balance if the sum of these elasticities equals 1

10. J-Curve
J-curve effect – depreciation will cause decline in trade balance initially but lead to improvement
in the long run
advocates cite U.S. balance of trade in s and 1990s as evidence

11. Types of Time Lags
recognition lag - time needed to realize change in competitiveness exists
decision lag - time needed to place new orders
delivery lags - time between orders and their impact on trade balance
replacement lags - time needed to use up existing inventories
production lags - time needed to increase output of goods for which demand has increased

12. Exchange Rate Pass Through
complete pass through – import prices change by full proportion of change in exchange rates
partial pass through – percentage change in
import prices is less than percentage change in exchange rate

13. Reasons for Partial Pass Through
Invoice Practices: If firms conducting international trade invoice exports in a foreign currency, changes in the exchange rate will not cause prices to change immediately.
Market Share Considerations: Firms may elect to change prices by a lesser proportion in order to maintain market share.
Distribution Costs: After an import reaches the border there are additional transportation, marketing, wholesaling, and retailing costs which are denominated in the home currency.

14. Absorption Approach impact of depreciation on domestic spending
Y = C + I + G + (X - M)
absorption written as A = C + I + G
net exports written as B = X - M
Y = A + B
B = Y – A
currency depreciation will improve trade balance only if national output rises relative to absorption
economy at full employment unlikely to see substantial change in trade balance

15. Monetary Approach
elasticities and absorption approaches neglect implications of capital movements
monetary approach suggests depreciation will lead to temporary improvement in balance of payments
changes in exchange rates alter the demand for money which will lead to capital inflows or outflows
over time currency depreciation only changes the domestic price level