1. Price Adjustments and Balance-of- Payments Disequilibrium Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin Chapter 23

2. 23-2 Learning Objectives Explain how changes in the exchange rate affect the movement of goods and services and the trade balances of countries. Discuss how price elasticity of demand relates to the stability of foreign exchange markets. Summarize how the price adjustment mechanism functions under a system of fixed or pegged exchange rates.

3. 23-3 The Price Adjustment Process and the Current Account Under A Flexible Rate System A depreciation of the home currency causes foreign goods to become more expensive, reducing consumption of imports relative to domestic alternatives. A depreciation makes the home countrys exports seem cheaper, so the trading partner switches expenditure towards home products. This process is expenditure switching.

4. 23-4 Demand for Foreign Goods and Services and the Foreign Exchange Market Demand for foreign exchange is derived from demand for goods and services. Demand for imports depends on price of foreign goods or services, tariffs or subsidies, prices of domestic substitutes and complements, domestic income, and tastes. Demand for foreign currency by home country is also supply of foreign currency to the foreign country.

5. 23-5 Demand and Supply of Foreign Exchange e $/£ e £/$ £$ 1.20.83 S$S$ D$D$ D£D£ S£S£

6. 23-6 Demand and Supply of Foreign Exchange With normally shaped supply and demand curves, the market for foreign exchange is stable. If U.S. income rises, demand for imports rises and so does demand for foreign exchange. The rightward shift of the demand for foreign exchange creates a current account deficit and an increase in the price of pounds (a depreciation of the dollar).

7. 23-7 Demand and Supply of Foreign Exchange e $/£ e £/$ £$ e eq S$S$ D$D$ D£D£ S£S£ D'£D'£ e ' eq e eq

8. 23-8 Demand and Supply of Foreign Exchange If U.S. prices increase relative to British prices: U.S. consumers demand more British products, increasing demand for pounds. British consumers demand fewer U.S. products, decreasing the supply of pounds. The overall effect is an increase in the dollar price of pounds.

9. 23-9 Demand and Supply of Foreign Exchange e $/£ E $/£ £ e eq S £ D £ D£D£ S£S£ D'£D'£ e ' eq e eq S ' £ D ' £ e ' eq £

10. 23-10 Market Stability and the Price Adjustment Mechanism This price adjustment depends on the slope of the supply and demand curves for foreign exchange. Supply curves can be backward- sloping. If supply curve is steeper than demand curve, the market is still stable. If supply curve is flatter than demand curve, the market is unstable.

11. 23-11 Demand and Supply of Foreign Exchange e $/£ e £/$ £$ S$S$ D$D$ D£D£ S£S£ In this case, if e is too high, there is an excess supply and e will fall. In this case, if e is too high, there is an excess demand and e will rise.

12. 23-12 Explaining the Backward- Sloping Supply Curve As the dollar becomes more expensive, two effects happen: More pounds are required to buy each unit of imports from the U.S. The number of units imported falls due to the increase in price in terms of pounds. Its easy to see these effects by considering the price elasticity of demand

13. 23-13 Explaining the Backward- Sloping Supply Curve Example: Suppose the depreciation of the dollar causes the U.K. price of the imported good to increase from £16 to £22, and this causes quantity demanded to fall from 120 units to 100 units. If foreign demand for home goods is inelastic, supply of foreign exchange is downward-sloping.

14. 23-14 Exchange Market Stability: The Marshall- Lerner Condition If home-country demand is elastic, a depreciation will improve the current account balance. The increased price of imports reduces total expenditures on imports and the reduced price of exports to foreigners causes an increase in their expenditures. If home-country demand is inelastic, a depreciation will have an ambiguous effect on the current account balance. The increased price of imports will increase total expenditures on imports, possibly offsetting the foreign countrys increased expenditures on exports.

15. 23-15 Exchange Market Stability: The Marshall- Lerner Condition The Marshall-Lerner Condition: The foreign exchange market will be stable as long as where X = expenditures on exports M = expenditures on imports η DX = price elasticity for home exports η DM = price elasticity for imports.

16. 23-16 Exchange Market Stability: The Marshall- Lerner Condition Some empirical studies suggest these demand elasticities may be low. However, the general consensus is that these elasticities are large enough that the foreign exchange market is stable.

17. 23-17 Price Adjustment Process: Short Run vs. Long Run When the Marshall-Lerner condition holds, changes in the exchange rate bring about appropriate switches in expenditures between domestic and foreign goods. A home currency depreciation leads to a substitution of domestic goods for imports. A home currency depreciation causes foreigners to switch to home country exports.

18. 23-18 Price Adjustment Process: Short Run vs. Long Run Short-run elasticities of supply and demand tend to be smaller in absolute value than long-run elasticities. Consumers dont adjust immediately to relative price changes; its not unusual for the quantity demanded of imports and the amount of foreign exchange needed to not respond to changes in the exchange rate. The supply of exports may not adjust immediately in response to changes in exchange rates due to lags in recognition, decision-making, production, and delivery.

19. 23-19 Price Adjustment Process: The J-Curve If the short-run elasticities are low, the market for foreign exchange may be unstable. A depreciation may initially lead to a further depreciation, since demand for the foreign currency outstrips supply. Therefore the current account deficit worsens. Eventually, the current account deficit shrinks and a new equilibrium is attained.

20. 23-20 The J-Curve X-M time point of depreciation (X-M) = f(e,time)

21. 23-21 Price Adjustment Mechanism in a Fixed Exchange Rate System Rather than allowing the foreign exchange market to determine the value of foreign exchange, countries sometimes fix or peg the value of their currencies.

22. 23-22 Price Adjustment Mechanism with the Gold Standard From 1880 to 1914, countries pegged their currencies to gold. This fixes countries exchange rates with each other. For example, if the dollar is fixed at $100 per ounce and the pound is fixed at £50 per ounce, the mint par exchange rate is $2/£. Governments must be prepared to maintain the gold price by buying and selling gold at the set price.

23. 23-23 Price Adjustment Mechanism with the Gold Standard Since the exchange rate is fixed, some other mechanism must be in force to balance demand for and supply of foreign exchange. These rules of the game are assumed to hold: no restraints on buying/selling gold within countries; gold can move freely between countries, money supply is allowed to change if a countrys gold holdings change, and prices/wages are flexible.

24. 23-24 Price Adjustment Mechanism with the Gold Standard Suppose an increase in U.S. income causes an increased demand for pounds. There will be upward pressure on the exchange rate to eliminate the excess demand for pounds. Buyers/sellers know that governments stand ready to buy/sell pounds at mint par, using gold as medium of exchange. Since it is costly to ship gold, the exchange rate can vary slightly from mint par.

25. 23-25 Foreign Exchange Market Under a Gold Standard e $/£ ££ $2.00 D£D£ S£S£ D'£D'£ $1.96 $2.00 D£D£ S£S£ $2.04 Mint par Assuming transactions costs represent 2% of par value, the exchange rate can vary between $1.96 and $2.04.

26. 23-26 Price Adjustment Mechanism with the Gold Standard Americans never need to pay more than $2.04/£, since an unlimited supply of pounds can be obtained at this price. This price is called the gold export point. The British never need to receive fewer than $1.96/£, since at that point gold will begin to move to the U.S. to be exchanged for dollars. This price is called the gold import point.

27. 23-27 Price Adjustment Mechanism with the Gold Standard The exchange rate can vary in between these narrow bands. Prices cannot adjust through exchange rate changes. Instead, prices adjust through changes in the money supply.

28. 23-28 Price Adjustment Mechanism with the Gold Standard Assuming the quantity theory holds, M s = kPY. If gold leaves the country, M s falls and prices must fall in response. Assuming demand for tradeable goods is elastic, this should reduce spending on imports and increase receipts from exports.

29. 23-29 Price Adjustment Mechanism with the Gold Standard The price adjustment mechanism under the gold standard is triggered by changes in the money supply related to flows of gold. This adjustment depends on flexible wages and prices – any rigidities will hinder adjustment. Other adjustment may occur due the effects of changes in the money supply on interest rates and income. The gold standard works to keep inflation in check.

30. 23-30 Price Adjustment Mechanism with a Pegged Rate System A country can also fix its exchange rate without reference to the value of gold. The central bank must be ready to buy foreign currency when the domestic currency is strong, and sell foreign currency when the domestic currency is weak. Central banks must hold a sufficient supply of foreign currencies.

31. 23-31 Price Adjustment Mechanism with a Pegged Rate System The adjustment effects of such a system are similar to a gold standard. Upward pressure on the exchange rate caused by an increase in demand for foreign exchange will cause the central bank to sell foreign exchange. This reduces the money supply, thereby triggering adjustments to interest rates, income, and prices.

32. 23-32 Price Adjustment Mechanism with a Pegged Rate System Similarly, downward pressure on the exchange rate caused by an increase in the supply of foreign exchange will cause the central bank to buy foreign exchange. This increases the money supply, thereby triggering adjustments to interest rates, income, and prices.

33. 23-33 Price Adjustment Mechanism with a Pegged Rate System For these adjustments to occur, the central bank must allow the actions taken in the foreign exchange markets to affect the domestic money supply. Bottom line: when a country adopts a fixed exchange rate system, its central bank loses effective control over the money supply as a policy tool.