1. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 1 An Introduction to International Economics Chapter 13: Automatic Adjustments with Flexible and Fixed Exchange Rates Dominick Salvatore John Wiley & Sons, Inc.

2. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 2 Focus of the chapter How is a trade deficit automatically closed by price and income changes? –In this chapter private international capital flows are assumed to be passive responses to cover temporary trade imbalances.

3. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 3 Exchange rate adjustment Assume (1) only two nations (the U.S. and Japan) and (2) no capital flows. –Under these assumptions the demand for yen will be driven by U.S. demand for Japanese goods and services, or imports. ¥/day $/¥ D¥D¥

4. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 4 Exchange rate adjustment Assume (1) only two nations (the U.S. and Japan) and (2) no capital flows. –Under these assumptions the demand for yen will be driven by U.S. demand for Japanese goods and services, or imports. –The supply of yen will be driven by Japanese demand for U.S. goods and services, or exports. ¥/day $/¥ D¥D¥ S¥S¥

5. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 5 Exchange rate adjustment If the exchange rate is at level A, the U.S. will have a trade deficit. ¥/day $/¥ D¥D¥ S¥S¥ A

6. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 6 Exchange rate adjustment If the exchange rate is at level A, the U.S. will have a trade deficit. If exchange rates in the U.S. are flexible, over time the exchange rate will move to its equilibrium value of B. ¥/day $/¥ D¥D¥ S¥S¥ A B

7. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 7 Exchange rate adjustment If the exchange rate is at level A, the U.S. will have a trade deficit. If exchange rates in the U.S. are flexible, over time the exchange rate will move to its equilibrium value of B. As the exchange rate adjusts to B, the trade deficit will close. ¥/day $/¥ D¥D¥ S¥S¥ A B

8. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 8 Exchange rate adjustment If instead of the original supply and demand curves, supply and demand are given by S ¥ * and D ¥ *, a depreciation of the dollar will still occur. However, the depreciation will be much greater in this case (to level C). ¥/day $/¥ D¥D¥ S¥S¥ A B C S¥*S¥* D¥*D¥*

9. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 9 Exchange rate adjustment The more significant depreciation of the dollar (from A to C) will have more severe inflationary effects on the U.S. economy. This implication points to the importance of knowing the elasticity of the supply and demand curves. ¥/day $/¥ D¥D¥ S¥S¥ A C S¥*S¥* D¥*D¥*

10. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 10 Elasticity Since the demand for foreign currency depends on the demand for imports, the elasticity depends on the price elasticity of the demand for imports (η M ). η M = %ΔQ M ÷ %ΔP M Similarly, the elasticity of supply depends on the price elasticity of supply for exports (η X ). η X = %ΔQ X ÷ %ΔP X

11. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 11 Unstable foreign exchange market If the supply of foreign currency is negatively sloped and more elastic than the demand for foreign currency, the foreign exchange market will be unstable. ¥/day $/¥ D¥D¥ S¥S¥

12. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 12 Unstable foreign exchange market If the supply of foreign currency is negatively sloped and more elastic than the demand for foreign currency, the foreign exchange market will be unstable. In this case, a trade deficit occurs at an exchange rate above the equilibrium value. ¥/day $/¥ D¥D¥ S¥S¥ A

13. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 13 Unstable foreign exchange market In this case, a trade deficit occurs at an exchange rate above the equilibrium value. At level A, the quantity demanded of foreign exchange (Z) exceeds the quantity supplied (Y). ¥/day $/¥ D¥D¥ S¥S¥ A YZ

14. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 14 Unstable foreign exchange market At level A, the quantity demanded of foreign exchange (Z) exceeds the quantity supplied (Y). The excess demand puts upward pressure on the exchange rate and pushes the exchange market further from equilibrium. ¥/day $/¥ D¥D¥ S¥S¥ A YZ

15. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 15 The Marshall-Lerner condition The unstable condition just depicted will be avoided if the Marshall-Lerner condition holds. The Marshall-Lerner condition is that η M + η X > 1. Empirical evidence indicates that this condition does hold.

16. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 16 J-curve effect A currency depreciation is expected to lessen a country’s trade deficit. This improvement may take time to occur. Initially, the depreciation may worsen the trade deficit since import prices will rise more quickly than the improvement in exports. This generates a J-shaped pattern to exchange rate movements.

17. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 17 The gold standard The gold standard generates a system of fixed exchange rates.

18. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 18 The gold standard The gold standard generates a system of fixed exchange rates. The gold standard for the international monetary system operated from 1880 to 1914. –This system is similar to the post-WWII Bretton Woods monetary system that collapsed in 1971.

19. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 19 The gold standard The gold standard generates a system of fixed exchange rates. The gold standard for the international monetary system operated from 1880 to 1914. Under the gold standard, each nation specified the gold content of its currency. –£1 gold coin contained 113.0016 grains of gold –$1 gold coin contained 23.22 grains of gold –This entails an exchange rate of 113.0016 ÷ 23.22 or $4.87/£.

20. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 20 The gold standard The gold standard generates a system of fixed exchange rates. The gold standard for the international monetary system operated from 1880 to 1914. Under the gold standard, each nation specified the gold content of its currency. The exchange rate of $4.87/£ is known as mint parity.

21. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 21 The gold standard Under the gold standard, each nation specified the gold content of its currency. The exchange rate of $4.87/£ is known as mint parity. As the cost of shipping gold from New York to London was approximately 3 cents, the actual exchange rate would always lie between $4.84/£ and $4.90/£. –$4.84/£ is the gold import point. –$4.90/£ is the gold export point.

22. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 22 Adjustment under the gold standard Adjustment to equilibrium under the gold standard occurs via the price-specie-flow mechanism. –The concept of the price-specie-flow mechanism was initially introduced in 1752 by David Hume.

23. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 23 Adjustment under the gold standard Adjustment to equilibrium under the gold standard occurs via the price-specie-flow mechanism. If a trade imbalance exists, gold will flow from the country with a trade deficit to the country with a trade surplus.

24. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 24 Adjustment under the gold standard Adjustment to equilibrium under the gold standard occurs via the price-specie-flow mechanism. If a trade imbalance exists, gold will flow from the country with a trade deficit to the country with a trade surplus. The fall in gold supplies in the trade deficit country reduces its money supply and pushes its price level lower; the increase in gold supplies in the trade surplus country increases its money supply and raises its price level.

25. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 25 Adjustment under the gold standard The fall in gold supplies in the trade deficit country reduces its money supply and pushes its price level lower; the increase in gold supplies in the trade surplus country increases its money supply and raises its price level. The price level movement is seen via the equation of exchange: M V = P Y (where M is the money supply, V is the velocity of money, P is the price level, and Y is real output).

26. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 26 Adjustment under the gold standard The price level movement is seen via the equation of exchange: M V = P Y (where M is the money supply, V is the velocity of money, P is the price level, and Y is real output). As the price level falls in the country with a trade deficit, exports of its goods and services will be encouraged; as the price level increases in the country with a trade surplus, exports of its goods and services will be discouraged.

27. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 27 Adjustment under the gold standard As the price level falls in the country with a trade deficit, exports of its goods and services will be encouraged; as the price level increases in the country with a trade surplus, exports of its goods and services will be discouraged. These changes in trade will decrease both the trade deficit and surplus leaving a situation of balanced international trade.

28. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 28 Income determination in a closed economy In a closed economy (without international trade) without a government sector, equilibrium output is determined by: Y = C + S = C + I where Y is income, C is planned consumption expenditures, I is planned business savings, and S is savings.

29. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 29 Income determination in a closed economy In a closed economy (without international trade) without a government sector, equilibrium output is determined by: Y = C + S = C + I where Y is income, C is planned consumption expenditures, I is planned business savings, and S is savings. This yields an equilibrium condition of: S – I = 0.

30. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 30 Income determination in a closed economy This yields an equilibrium condition of: S – I = 0. In words, this entails that at equilibrium leakages from the economy (S) must be balanced by injections into the economy (I).

31. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 31 Income determination in a closed economy In words, this entails that at equilibrium leakages from the economy (S) must be balanced by injections into the economy (I). If planned investment is autonomous but savings is determined by the marginal propensity to save (s), then: ΔS = sΔY. –The marginal propensity to save (s) is amount of additional savings that flows from each additional dollar of income.

32. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 32 Income determination in a closed economy If planned investment is autonomous but savings is determined by the marginal propensity to save (s), then: ΔS = sΔY. Since S = I at equilibrium, this entails that: ΔI = sΔY or 1 ÷ s = ΔY ÷ ΔI.

33. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 33 Income determination in a closed economy Since S = I at equilibrium, this entails that: ΔI = sΔY or 1 ÷ s = ΔY ÷ ΔI. If k = 1 ÷ s, then ΔY = k ΔI. –k is the multiplier. –Any change in investment will induce a multiplied change in income as given by the above formula.

34. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 34 Income determination in a closed economy If k = 1 ÷ s, then ΔY = k ΔI. An example –s = 0.25 –ΔI = 300 –What is the value of k? k = 1 ÷ 0.25 = 4 –What is the change in income? ΔY = 4 300 = 1,200

35. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 35 Income determination in an open economy In an open economy, equilibrium is still determined by the condition that leakages must equal injections. –In an open economy, imports (M) are a new leakage. –In an open economy, exports (X) are a new injection.

36. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 36 Income determination in an open economy In an open economy, equilibrium is still determined by the condition that leakages must equal injections. The new equilibrium equation is: S + M = I + X or ΔS + ΔM = ΔI + ΔX.

37. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 37 Income determination in an open economy The new equilibrium equation is: S + M = I + X or ΔS + ΔM = ΔI + ΔX. If ΔM = mΔY, then the multiplier (k * ) becomes: k * = 1 ÷ (s + m) –Where m is the marginal propensity to import.

38. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 38 Income determination in an open economy The new equilibrium equation is: S + M = I + X or ΔS + ΔM = ΔI + ΔX. If ΔM = mΔY, then the multiplier (k * ) becomes: k * = 1 ÷ (s + m) –Where m is the marginal propensity to import. This leaves ΔY = k * ΔI or ΔY = k * ΔX.

39. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 39 Income determination in an open economy This leaves ΔY = k * ΔI or ΔY = k * ΔX. An example –s = 0.25 –m = 0.25 –ΔI = 400 –What is the value of k * ? k = 1 ÷ (0.25 + 0.25) = 2 –What is the change in income? ΔY = 2 200 = 800

40. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 40 Foreign repercussions Suppose Nation 1 experiences an increase in its planned autonomous investment. –Nation 1 will experience an increase in its domestic income of k* ΔI.

41. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 41 Foreign repercussions Suppose Nation 1 experiences an increase in its planned autonomous investment. The increase in Nation 1’s income will increase its imports by mΔY.

42. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 42 Foreign repercussions Suppose Nation 1 experiences an increase in its planned autonomous investment. The increase in Nation 1’s income will increase its imports by mΔY. Assuming only two countries, Nation 1’s increased imports will increase Nation 2’s exports leading to an expansion in Nation 2’s income by k 2 * ΔX 2.

43. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 43 Foreign repercussions The increase in Nation 1’s income will increase its imports by mΔY. Assuming only two countries, Nation 1’s increased imports will increase Nation 2’s exports leading to an expansion in Nation 2’s income by k 2 * ΔX 2. The increase in Nation 2’s income will lead to an increase in its imports, spurring a secondary expansion in Nation 1.

44. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 44 Absorption approach The absorption approach integrates the effect of induced income changes in the process of correcting a balance of payments disequilibrium by a change in the exchange rate.

45. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 45 Absorption approach The absorption approach integrates the effect of induced income changes in the process of correcting a balance of payments disequilibrium by a change in the exchange rate. Domestic equilibrium is given by: Y = C + I + (X – M).

46. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 46 Absorption approach Domestic equilibrium is given by: Y = C + I + (X – M). Define A (domestic absorption) = C + I and B (foreign absorption) = X – M. Then: Y = A + B or Y – A = B.

47. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 47 Absorption approach Define A (domestic absorption) = C + I and B (foreign absorption) = X – M. Then: Y = A + B or Y – A = B. A depreciation of the currency is expected to increase B.

48. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 48 Absorption approach A depreciation of the currency is expected to increase B. This can only occur if A falls or Y increases. –If the economy is at full employment, Y cannot increase. –Therefore, a depreciation must result in a fall in A.

49. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 49 Absorption approach A depreciation of the currency is expected to increase B. This can only occur if A falls or Y increases. Forces that lead to a fall in domestic absorption (A). –Income is redistributed from wages to profits. –The depreciation increases prices and hence lowers domestic expenditures. –The depreciation pushes people into higher tax brackets and hence lowers disposable income.

50. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 50 Synthesis Flexible exchange rate adjustment –A trade deficit leads to a depreciation of the domestic currency.

51. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 51 Synthesis Flexible exchange rate adjustment –A trade deficit leads to a depreciation of the domestic currency. –The depreciation spurs an improvement in the balance of trade.

52. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 52 Synthesis Flexible exchange rate adjustment –A trade deficit leads to a depreciation of the domestic currency. –The depreciation spurs an improvement in the balance of trade. –The improvement in the balance of trade spurs increased domestic production.

53. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 53 Synthesis Flexible exchange rate adjustment –A trade deficit leads to a depreciation of the domestic currency. –The depreciation spurs an improvement in the balance of trade. –The improvement in the balance of trade spurs increased domestic production. –The increase in production generates increased domestic incomes that spur greater investment – partially offsetting the initial improvement in the trade balance.

54. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 54 Synthesis Flexible exchange rate adjustment –The improvement in the balance of trade spurs increased domestic production. –The increase in production generates increased domestic incomes that spur greater investment – partially offsetting the initial improvement in the trade balance. –If production cannot increase because the nation is already at full employment, domestic absorption must fall.

55. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 55 Synthesis Flexible exchange rate adjustment Fixed exchange rate adjustment –A trade deficit spurs a decrease in the domestic money supply.

56. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 56 Synthesis Flexible exchange rate adjustment Fixed exchange rate adjustment –A trade deficit spurs a decrease in the domestic money supply. –The fall in the money supply pushes the domestic price level lower.

57. Dale R. DeBoer University of Colorado, Colorado Springs 13 - 57 Synthesis Flexible exchange rate adjustment Fixed exchange rate adjustment –A trade deficit spurs a decrease in the domestic money supply. –The fall in the money supply pushes the domestic price level lower. –As domestic prices fall, exports are encouraged and imports discouraged moving the economy to a situation of balanced trade.