Economics of International FinanceEconomics of International FinanceEcon. 315Econ. 315

Chapter 5:Chapter 5:

The Price Adjustment Under The Price Adjustment Under Flexible and Fixed Exchange RatesFlexible and Fixed Exchange Rates

I. OverviewI. Overview

Objectives:Objectives: Examining how a nation’s current account is affected by price Examining how a nation’s current account is affected by price

changes under fixed and flexible exchange rates. changes under fixed and flexible exchange rates.

Assumptions:Assumptions:

We assume no We assume no autonomous international private capital flowsautonomous international private capital flows, , i.e., they take place as a response to temporary trade balances.i.e., they take place as a response to temporary trade balances.

Current account is corrected Current account is corrected only by exchange rate changesonly by exchange rate changes. .

Since this approach is based on trade flows and the speed of Since this approach is based on trade flows and the speed of adjustment depends on how responsive (adjustment depends on how responsive (elasticelastic) imports are to ) imports are to price changes (exchange rate changes), it is also called price changes (exchange rate changes), it is also called tradetrade or or elasticityelasticity approach. approach.

II. Adjustment with Exchange RatesII. Adjustment with Exchange Rates

Current account is corrected by a depreciation (Current account is corrected by a depreciation (a flexible a flexible exchange rateexchange rate) or a devaluation () or a devaluation (a fixed or pegged exchange a fixed or pegged exchange raterate). ).

Depreciation or devaluation operates on Depreciation or devaluation operates on pricesprices to bring about an to bring about an adjustment in the current accountadjustment in the current account and BOP, i.e., affects the and BOP, i.e., affects the relative prices of exports and imports. relative prices of exports and imports.

Example :Example :

Look at figure 1, where USA and EMU are assumed to be the only two Look at figure 1, where USA and EMU are assumed to be the only two economies in the world. There are economies in the world. There are nono international capital flows, such international capital flows, such that the US demand and supply for € reflects that the US demand and supply for € reflects only trade in goods and only trade in goods and servicesservices..

At R = $1/ €1, the US demand for € is 12 bn, while supply is only €8 At R = $1/ €1, the US demand for € is 12 bn, while supply is only €8 bn, i.e., a deficit € 4 bn. bn, i.e., a deficit € 4 bn.

If demand and supply for euros are D€ and S€, a 20% devaluation If demand and supply for euros are D€ and S€, a 20% devaluation would equilibrate BOP at €10 bn (point E). would equilibrate BOP at €10 bn (point E).

If demand and supply for euros are less elastic D€’ and S€’ a 20% If demand and supply for euros are less elastic D€’ and S€’ a 20% devaluation would not equilibrate BOP at €10 bn. A 20% devaluation devaluation would not equilibrate BOP at €10 bn. A 20% devaluation would reduce the deficit to €3 bn, and 100% devaluation (R = $2/ €1) would reduce the deficit to €3 bn, and 100% devaluation (R = $2/ €1) would completely eliminate the deficit (point E’). would completely eliminate the deficit (point E’). Why?Why?

The scale of depreciation depends on The scale of depreciation depends on how elastic is the demand and how elastic is the demand and supply for foreign currencysupply for foreign currency (imports and exports). (imports and exports).

Figure 1 Balance-of-Payments Adjustments with Exchange Rate Changes.

A deficit is corrected by a20% devaluation

A deficit is corrected bya 100% devaluation

The 20% devaluation would reduce the deficit but not to correct for it

III. Derivations and Term of TradeIII. Derivations and Term of Trade

- Derivation of demand curve for foreign exchange- Derivation of demand curve for foreign exchange

Look at panel A of figure 2. the demand for imports is DM at R=$1/€1 while the European supply of imports is SM. Suppose that the euro price for a unit of imports is PM = €1, and the quantity of imports = 12 bn units (this corresponds to point B’ in figure 1 (i.e., 12 bn units × €1 = €12 bn).

If the dollar depreciates by 20% pushes the DM down to to DM’, SM

remains unchanged, Why?. For the US to continue to demand 12 bn units the euro price of US imports would have to fall to PM = €0.8, i.e., by exactly the 20% depreciation of the dollar in order to leave the dollar’s price of European imports almost unchanged (point H on DM).

Figure 2 Derivation of the U.S. Demand and Supply Curves for Foreign Exchange

Panel A

A compromise price € .9 per unit

at which BOP is in eq.

If the $ depreciates by 20%, DM shifts down.

PM should go down to € .8 (by 20%)

for US to continue buying 12 bn. units

It is obvious that DM’ should not be parallel (compare points J-G and H-B’)

With DM’ and SM the price of imports is PM = €0.9 and QM = 11 bn. the US will move to point E’ and demand of the € would be (11 bn. × 0.9 = 9.9 bn) ≈ 10 bn.

So: at R=$1/€1 the demand was € 12 bn, (point B in figure 1) and at R=$1.2/€1 the demand was 10 bn, (point E in figure 1). Therefore, D€ is derived from the demand and supply of imports. (If demand for imports is less elastic, the demand for euros would be D€* in figure 1)

The less elastic is the demand for euros, the steeper is the demand.

- Derivation of the supply curve for foreign exchange.- Derivation of the supply curve for foreign exchange.

Look at panel B of figure 2. SLook at panel B of figure 2. SXX is the supply of US exports, and D is the supply of US exports, and DXX is the is the

European demand for US exports. If the US price in euros is € 2, the quantity European demand for US exports. If the US price in euros is € 2, the quantity of exports would be 4 bn and supply of euros would be 2 of exports would be 4 bn and supply of euros would be 2 ×× 4 = € 8 bn (point 4 = € 8 bn (point A in figure 1). A in figure 1).

With A devaluation of 20% of the dollar DWith A devaluation of 20% of the dollar DXX remains unchanged but S remains unchanged but SXX would would

shift down to Sshift down to SXX’. The price of exports would be €1.6 for each unit, this will ’. The price of exports would be €1.6 for each unit, this will

encourage European to demand more and there will be a movement toward E’ encourage European to demand more and there will be a movement toward E’ on DX which is an increase in the quantity exported by US from 4 bn to 5.5 on DX which is an increase in the quantity exported by US from 4 bn to 5.5 bn. (i.e., 5.5x1.8≈ €10 bn).bn. (i.e., 5.5x1.8≈ €10 bn).

So at R = $2/ €1, the supply of euros is €8 bn (point A in figure 1), at R = So at R = $2/ €1, the supply of euros is €8 bn (point A in figure 1), at R = $2.4/ €1, The supply of euros is 10 (point E in figure 1). The supply of euros $2.4/ €1, The supply of euros is 10 (point E in figure 1). The supply of euros is driven from the supply and demand for US exports.is driven from the supply and demand for US exports.

If demand for exports is less elastic there could be a movement form point A If demand for exports is less elastic there could be a movement form point A to point C instead of E in figure 1. to point C instead of E in figure 1.

Panel B

Figure 2 Derivation of the U.S. Demand and Supply Curves for Foreign Exchange

If the $ depreciates by 20%, SX shifts

and PX should go down to € 1.6 (by 20%)

This encourages demand for US exports

that pushes the price up to 1.8 euros

the price of exports € 1.8 per unit

at which BOP is in eq.

- Effect of Exchange Rate on Domestic Prices & Terms of Trade- Effect of Exchange Rate on Domestic Prices & Terms of Trade

1.1. Depreciation or devaluation stimulates the production of import substitutes Depreciation or devaluation stimulates the production of import substitutes and exports leading to a rise in prices, i.e., depreciation is and exports leading to a rise in prices, i.e., depreciation is inflationaryinflationary. The . The greater the depreciation or devaluation, the greater is the inflationary impact, greater the depreciation or devaluation, the greater is the inflationary impact, and the and the less flexibleless flexible is the increase in exchange rates as a method of correcting is the increase in exchange rates as a method of correcting deficit in BOP. deficit in BOP.

2.2. A depreciation or devaluation is also likely to affect the nations terms of trade A depreciation or devaluation is also likely to affect the nations terms of trade TOT (the ratio between export prices and import prices), since TOT are either TOT (the ratio between export prices and import prices), since TOT are either measured in domestic prices or in foreign currency, a depreciation or measured in domestic prices or in foreign currency, a depreciation or devaluation will cause TOT to increase, fall, or remain unchanged. devaluation will cause TOT to increase, fall, or remain unchanged.

Look at figure 2, before depreciation, the price of exports PLook at figure 2, before depreciation, the price of exports PXX = €2 (point A’ in = €2 (point A’ in

the right panel) and Pthe right panel) and PMM = €1 (point B’ in panel A). Hence TOT (P = €1 (point B’ in panel A). Hence TOT (PXX / P / PMM =2/1 = =2/1 =

2 or 200%). After a 20% depreciation P2 or 200%). After a 20% depreciation PXX = €1.8 (point E’ in panel B) and P = €1.8 (point E’ in panel B) and PM M = =

€ 0.9 (point E’ in panel A), so TOT = 1.8/0.9 = 2 or 200%. TOT remain € 0.9 (point E’ in panel A), so TOT = 1.8/0.9 = 2 or 200%. TOT remain unchanged. But in general we expect TOT to change in case of depreciation. unchanged. But in general we expect TOT to change in case of depreciation.

The Dutch DiseaseThe Dutch DiseaseWhen an industrial nation begins to exploit a domestic When an industrial nation begins to exploit a domestic natural resource previously imported, the nation’s natural resource previously imported, the nation’s exchange rate might appreciate to cause the nation’s loss exchange rate might appreciate to cause the nation’s loss of international competitiveness in its traditional of international competitiveness in its traditional industrial sector, and even face deindustrialization. industrial sector, and even face deindustrialization.

IV. The Stability of Foreign Exchange Markets:IV. The Stability of Foreign Exchange Markets:

1.1. Stable Foreign Exchange MarketStable Foreign Exchange Market: when disturbances from the : when disturbances from the equilibrium exchange rate give rise to automatic forces that push equilibrium exchange rate give rise to automatic forces that push exchange rate back to the equilibrium level. exchange rate back to the equilibrium level.

2.2. Unstable Foreign Exchange MarketUnstable Foreign Exchange Market: when disturbances from the : when disturbances from the equilibrium exchange rate push the exchange rate further away equilibrium exchange rate push the exchange rate further away from the equilibrium level.from the equilibrium level.

Note: A foreign exchange market is stable when the supply curve of Note: A foreign exchange market is stable when the supply curve of foreign exchange is positively slopped or if it is less elastic foreign exchange is positively slopped or if it is less elastic (steeper) than the demand curve for foreign exchange.(steeper) than the demand curve for foreign exchange.

When foreign exchange market is unstable, a When foreign exchange market is unstable, a flexible exchange flexible exchange rate system increases, rather than reduces, BOP deficitrate system increases, rather than reduces, BOP deficit. The . The revaluation or appreciation not depreciation is required to revaluation or appreciation not depreciation is required to eliminate the BOP deficit, while devaluation is required to eliminate the BOP deficit, while devaluation is required to correct for BOP surplus.correct for BOP surplus.

Determining whether the foreign exchange market is Determining whether the foreign exchange market is stable is stable is importantimportant. If the foreign exchange market is stable, . If the foreign exchange market is stable, elasticityelasticity of of the demand for foreign exchange and supply of foreign exchange the demand for foreign exchange and supply of foreign exchange become become importantimportant..

The Marshall-Learner ConditionThe Marshall-Learner Condition

The condition that tells us whether the foreign exchange market The condition that tells us whether the foreign exchange market is stable or unstable is the Marshall-Learner condition (M.L.C). is stable or unstable is the Marshall-Learner condition (M.L.C). The simplified version of the M.L.C is that if supply curve of The simplified version of the M.L.C is that if supply curve of imports and exports are infinitely elastic.imports and exports are infinitely elastic.

the M.L.C indicates that a stable foreign exchange market occurs the M.L.C indicates that a stable foreign exchange market occurs if the sum of price elasticities of demand for Dx and Dm of if the sum of price elasticities of demand for Dx and Dm of foreign exchange in absolute terms is greater than one.foreign exchange in absolute terms is greater than one.

If the sum of elasticities of demand If the sum of elasticities of demand for Dx and Dm Dx and Dm of foreign of foreign exchange is exchange is less than oneless than one 1, the foreign exchange market is 1, the foreign exchange market is unstableunstable. .

If the sum of elasticities of demand If the sum of elasticities of demand for Dx and Dm Dx and Dm of foreign of foreign exchange is exchange is oneone, the , the BOP will remain unchangedBOP will remain unchanged. .

V. Elasticities in the Real World. V. Elasticities in the Real World.

A. Elasticities Estimates A. Elasticities Estimates

M.L.C postulates a stable foreign exchange market if the sum of price M.L.C postulates a stable foreign exchange market if the sum of price elasticities of Delasticities of DMM and D and DXX exceeds one in real absolute terms. However, the exceeds one in real absolute terms. However, the sum of elasticities of Dsum of elasticities of DMM and D and DXX should be should be substantially greater than onesubstantially greater than one to to make depreciation feasible as a method of correcting a deficit in BOP. make depreciation feasible as a method of correcting a deficit in BOP.

Before world war II Before world war II MarshallMarshall argued that price elasticities in international argued that price elasticities in international trade are high (stable foreign exchange markets). This was trade are high (stable foreign exchange markets). This was not basednot based on on empirical support (empirical support (prewar optimismprewar optimism).).

Econometric estimates, after the WWII however, show that the sum of price Econometric estimates, after the WWII however, show that the sum of price elasticities of Delasticities of DMM and D and DXX is is either less than 1either less than 1 or barely exceed 1or barely exceed 1. prewar . prewar optimism was replaced by optimism was replaced by post war pessimismpost war pessimism..

B. The J curve and revised elasticity estimatesB. The J curve and revised elasticity estimates

The BOP may worsen soon after the depreciation before improving later on. The BOP may worsen soon after the depreciation before improving later on. This is due to the tendency of the domestic currency price of imports to rise This is due to the tendency of the domestic currency price of imports to rise faster than export prices with quantities initially not changing very much. faster than export prices with quantities initially not changing very much.

Over time QOver time QXX rises and Q rises and QMM falls so that the initial deterioration of the BOP is falls so that the initial deterioration of the BOP is halted and then reversed. This is known as the J curve effect because the halted and then reversed. This is known as the J curve effect because the response of the trade balance to a depreciation looks like the curve of a J.response of the trade balance to a depreciation looks like the curve of a J.

Empirical studies confirmed the existence of the J curve effect and came up Empirical studies confirmed the existence of the J curve effect and came up with high long term elasticities, i.e., real world elasticities are high enough to with high long term elasticities, i.e., real world elasticities are high enough to ensure stability of the foreign exchange market in the short run and a fairly ensure stability of the foreign exchange market in the short run and a fairly elastic demand for and supply of foreign exchange in the long run. elastic demand for and supply of foreign exchange in the long run.

FIGURE 4 The J-Curve.

Immediate deterioration of BOP

BOP improves

BOP deterioration halts

Deterioration lowers over time

C. Currency pass throughC. Currency pass through

The increase in the domestic price of imported commodity may be smaller The increase in the domestic price of imported commodity may be smaller than the amount of depreciation even after lags, i.e., the pass through from than the amount of depreciation even after lags, i.e., the pass through from depreciation to the domestic prices may be less than complete, e.g., a 10% depreciation to the domestic prices may be less than complete, e.g., a 10% depreciation may result in a depreciation may result in a less thanless than 10% increase in domestic currency 10% increase in domestic currency prices of the imported commodity. prices of the imported commodity. WhyWhy??

Exporters often having established a large share in domestic market may be Exporters often having established a large share in domestic market may be willing to absorb at least some of the price increase they could charge out of willing to absorb at least some of the price increase they could charge out of their profits. A foreign company may increase the price of exports by 6% and their profits. A foreign company may increase the price of exports by 6% and accept a 4% reduction in the price of its exports when the nation’s currency accept a 4% reduction in the price of its exports when the nation’s currency depreciates by 10% to avoid the risk of losing foreign markets by large depreciates by 10% to avoid the risk of losing foreign markets by large increases in the price of their exports. This is known as the beachhead effect. increases in the price of their exports. This is known as the beachhead effect.

VI. Adjustment under the gold standardVI. Adjustment under the gold standard

A. The Gold standardA. The Gold standard

Operated from about 1880 to the outbreak of the WW I. After the war, there Operated from about 1880 to the outbreak of the WW I. After the war, there was an attempt to reestablish the gold standard but this failed in 1931. It is was an attempt to reestablish the gold standard but this failed in 1931. It is also unlikely that it will be reestablished in the future. But it is important to also unlikely that it will be reestablished in the future. But it is important to understand its advantages and disadvantages.understand its advantages and disadvantages.

Under the gold standard each country defines the gold content of its currency Under the gold standard each country defines the gold content of its currency and stands ready to and stands ready to buybuy or or sellsell any amount of gold at that price. Based on that any amount of gold at that price. Based on that exchange rates are determined. exchange rates are determined.

For example, the £ contains 113 grains of gold while the $ contains 23.2 For example, the £ contains 113 grains of gold while the $ contains 23.2 grains. The dollar price of the £ is 113/23.2 = 4.87. this is called the grains. The dollar price of the £ is 113/23.2 = 4.87. this is called the mint mint parityparity. .

Since shipping currencies between New York and London cost gold (about 3 Since shipping currencies between New York and London cost gold (about 3 cents), the exchange rate between the $ and £ could never fluctuate by more cents), the exchange rate between the $ and £ could never fluctuate by more than than 3 cents above or below the mint parity3 cents above or below the mint parity. .

FIGURE 5 Gold Points and Gold Flows.

An increase in the demand for imports deficit and a depreciation of $sell gold abroad

An increase in the

demand for exports

Appreciation of $

buy gold from abroad

Gold sold in US, exported to London to buy £ at $ 4.90 Instead of buying£ in US at $ 4.94

Gold is imported from London

due to selling the surplus of

£ there at 4.84 instead of 4.80 in US

None would pay more than $ 4.90 for £1 since he/she could purchase $ None would pay more than $ 4.90 for £1 since he/she could purchase $ 4.87 of gold in the US, ship it to London at 3 cents and exchange it for 4.87 of gold in the US, ship it to London at 3 cents and exchange it for £1 at the bank of England (central bank). Thus the US supply of £ £1 at the bank of England (central bank). Thus the US supply of £ becomes infinitely elastic at the rate of $ 4.90 for £1. This was the becomes infinitely elastic at the rate of $ 4.90 for £1. This was the gold gold export pointexport point of the US of the US

On the other hand, the $/£ rate can’t fall below $ 4.84 because no one On the other hand, the $/£ rate can’t fall below $ 4.84 because no one would accept less than 4.84 for the £. He could always purchase £ would accept less than 4.84 for the £. He could always purchase £ worth of gold in London and ship it to New York at a cost of 3 cents worth of gold in London and ship it to New York at a cost of 3 cents and exchange it for $ 4.87 (i.e. 4.84 net) as a result the demand curve and exchange it for $ 4.87 (i.e. 4.84 net) as a result the demand curve becomes infinitely elastic (horizontal) at the rate of $ 4.84 / £1. This is becomes infinitely elastic (horizontal) at the rate of $ 4.84 / £1. This is the gold import point of the US. Exchange rate is prevented from the gold import point of the US. Exchange rate is prevented from moving outside the gold points by US gold sales or purchases. moving outside the gold points by US gold sales or purchases.

B. The price-specie-flow mechanismB. The price-specie-flow mechanism

The automatic adjustment mechanism under the gold standard. The price-specie-The automatic adjustment mechanism under the gold standard. The price-specie-flow mechanism is working as followsflow mechanism is working as follows

Under the gold standard money supply would fall in the deficit nation and rise in Under the gold standard money supply would fall in the deficit nation and rise in the surplus nation causing prices to fall in the deficit and rise in the surplus the surplus nation causing prices to fall in the deficit and rise in the surplus nation. Exports of the deficit nation would be encouraged and imports would be nation. Exports of the deficit nation would be encouraged and imports would be discouraged until deficit is eliminated. This is based on the quantity theory of discouraged until deficit is eliminated. This is based on the quantity theory of money:money:

M . V = P . QM . V = P . Q As the deficit nation lost gold, M falls. A reduced M by 10% encourages exports As the deficit nation lost gold, M falls. A reduced M by 10% encourages exports

and discourages imports. The opposite would take place in the surplus nation and discourages imports. The opposite would take place in the surplus nation (due to gold inflow) internal prices increases and discourage exports, and (due to gold inflow) internal prices increases and discourage exports, and encourage imports until deficit and surplus are eliminated. encourage imports until deficit and surplus are eliminated.

Note that while adjustment under the flexible exchange rate system relies on Note that while adjustment under the flexible exchange rate system relies on high price elasticities of exports and imports, in the deficit surplus nation, high price elasticities of exports and imports, in the deficit surplus nation, adjustment under the gold standard relies on changing internal prices of each adjustment under the gold standard relies on changing internal prices of each nation. The adjustment under the gold standard relies also on high price nation. The adjustment under the gold standard relies also on high price elasticities of exports and imports in the deficit and surplus nation, so that the elasticities of exports and imports in the deficit and surplus nation, so that the volume of exports and imports respond readily and significantly to price volume of exports and imports respond readily and significantly to price changes. changes.

M.V = P.Q

Deficit nation M↓ P ↓ imports ↓

and exports ↑ bop equilibrium

Surplus nation M ↑ P ↑ imports ↑

and exports ↓ bop equilibrium

The price-specie-flow mechanismThe price-specie-flow mechanism