Exchange-Rate Adjustments and the Balance of Payments © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole

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Exchange-Rate Adjustmentsand the Balance of Payments

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password protected website for classroom use‐

PowerPoint slides prepared by:Andreea ChiritescuEastern Illinois University


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Effects of Exchange-Rate Changes on Costs and Prices

• How do exchange-rate fluctuations affect relative costs?• Extent to which a firm’s costs are denominated

in terms of the home currency or foreign currency

• No foreign sourcing - all costs are denominated in dollars• If the dollar appreciates by 100%, the U.S. firm:• Increase in franc-denominated production costs by

100% - Reduced international competitiveness


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Effects of a dollar appreciation on a U.S. steel firm’s production costs when all costs are dollar-denominated

TABLE 14.1


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• Foreign sourcing—some costs denominated in dollars and some costs denominated in francs• If the dollar appreciates by 100%, the U.S. firm:• Production costs in francs increase by 100% for the

inputs denominated in dollars• Production costs in francs stay the same for the

inputs denominated in francs • Overall, higher production costs (by less than 100%)• Reduced international competitiveness


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Effects of a dollar appreciation on a U.S. steel firm’s production costs when some costs are dollar-denominated and other costs are franc-denominated

TABLE 14.2


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• Generalization • As franc-denominated costs become a larger

portion of Nucor’s total costs• A dollar appreciation (depreciation) leads to• A smaller increase (decrease) in the franc cost of

Nucor steel • A larger decrease (increase) in the dollar cost of

Nucor steel compared to the cost changes that occur when all input costs are dollar-denominated


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• Changes in relative costs • Because of exchange-rate fluctuations • Influence relative prices • Influence the volume of goods traded among

nations


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• Dollar appreciation• Increasing relative U.S. production costs• Raise U.S. export prices in foreign-currency

terms• Decrease in the quantity of U.S. goods sold

abroad• Increase in U.S. imports


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• Dollar depreciation• Decreasing relative U.S. production costs• Lower U.S. export prices in foreign-currency

terms• Increase in the quantity of U.S. goods sold

abroad• Decrease in U.S. imports


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• Factors influencing the extent by which exchange-rate movements lead to relative price changes among nations• U.S. exporters – reduce profit margins to

maintain competitiveness• Perceptions concerning long-term trends in

exchange rates - promote price rigidity• Product substitutability• Move production offshore


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TRADE CONFLICTS

Japanese firms outsource production to limit effects of strong Yen

• Strong yen in recent years• Japanese exporters - smaller profits when

converting dollar profits back into yen• Protect profits: move production to the U.S.• Lessening the amount of money they convert

from dollars to yen • Contributes to the excess capacity of

manufacturing plants in Japan• Results in job losses for Japanese workers


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Cost-Cutting Strategies of Manufacturers in Response to Currency Appreciation

• Yen appreciation: Japanese manufacturers• 1990 - 1996, Japanese yen relative to U.S.

dollar increased by 40%• Japanese firms• Establish integrated manufacturing bases in the U.S.

and in dollar-linked Asia• Use cheaper dollar-denominated parts and materials • Purchase cheaper components from around the world

• Shifted production from commodity-type goods to high-value products


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• Yen appreciation: Japanese manufacturers• Japanese auto industry• Cut the yen prices of their autos• Falling unit-profit margins• Reduced manufacturing costs• Increasing worker productivity• Importing materials and parts• Outsourcing larger amounts of a vehicle’s production to

transplant factories


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Hitachi’s global diversification permitted it to sell TVs in the United States without raising prices as the yen appreciated against the dollar.

Coping with the yen’s appreciation: Hitachi’s geographic diversification as a manufacturer of television sets

FIGURE 14.1


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• Dollar appreciation: U.S. manufacturers• 1996-2002, dollar appreciated by 22%• Sipco Molding Technologies• Partnership with an Austrian company• Austrian company - designing and making the tools• Sipco simply resold them


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• Dollar appreciation: U.S. manufacturers• American Feed Co. - pact with a Spanish

company• Divvying up the work to keep both factories

operating (U.S. and Spain)• Benefits of having a European production base • Without having to take on the risks of building its own

factory there

• Redesigned: more efficient and less expensive to build


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Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach

• Currency depreciation• Improve a nation’s competitiveness• Reducing its costs and prices

• The elasticity approach • Relative price effects of depreciation• Depreciation works best when demand

elasticities are high


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• The absorption approach • Income effects of depreciation• A decrease in domestic expenditure relative to

income must occur for depreciation to promote trade equilibrium

• The monetary approach• Effects depreciation has on the purchasing

power of money and the resulting impact on domestic expenditure levels


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• Elasticity of demand • Responsiveness of buyers to changes in price• Percentage change in the quantity demanded

stemming from a one percent change in price• >1, elastic demand• <1, inelastic demand• =1, unitary elastic demand


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• Marshall-Lerner condition• Depreciation will improve the trade balance if• The currency-depreciating nation’s demand

elasticity for imports • Plus the foreign demand elasticity for the nation’s

exports exceeds one• Depreciation will worsen the trade balance if• The sum of the demand elasticities is less than one

• The trade balance will be neither helped nor hurt if the sum of the demand elasticities equals one


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Effect of pound depreciation on the trade balance of the United Kingdom

TABLE 14.3


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• Marshall-Lerner condition• Simplifying assumptions• A nation’s trade balance is in equilibrium when the

depreciation occurs• No change in the sellers’ prices in their own

currency• Illustrates the price effects of currency

depreciation on the home-country’s trade balance


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Long-term price elasticities of demand for total imports and exports of selected countries

TABLE 14.4


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J-Curve Effect: Time Path of Depreciation

• J-curve effect• In the very short term, a currency depreciation

will lead to a worsening of a nation’s trade balance• But as time passes, the trade balance will likely

improve• Because of lags between changes in relative

prices and the quantities of gods traded


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• Types of lags• Recognition lags• Of changing competitive conditions

• Decision lags • In forming new business connections and placing

new orders• Delivery lags • Between the time new orders are placed and their

impact on trade and payment flows is felt


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• Types of lags• Replacement lags • In using up inventories and wearing out existing

machinery before placing new orders• Production lags • Involved in increasing the output of commodities

for which demand has increased


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Depreciation flowchartFIGURE 14.2


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Between 1980 and 1987, the U.S. merchandise trade deficit expanded at a rapid rate. The trade deficit decreased substantially between 1988 and 1991. The rapid increase in the trade deficit that took place during the early 1980s occurred mainly because of the appreciation of the dollar at the time, which resulted in a steady increase in imports and a drop in U.S. exports. The depreciation of the dollar that began in 1985 led to a boom in exports in 1988 and a drop in the trade deficit through 1991.

Time path of U.S. balance of trade (billions of dollars) in response to dollar appreciation and depreciation

FIGURE 14.3


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Exchange Rate Pass-Through• Exchange rate pass-through relation • The extent to which changing currency values

lead to changes in import and export prices• Buyers have incentives to alter their purchases of

foreign goods • If the prices of foreign goods change in terms of their

domestic currency

• Exporters – willingness to change the prices they charge for their goods• Measured in terms of the buyer’s currency


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Exchange Rate Pass-Through• Partial exchange rate pass-through• Percentage change in import prices <

percentage change in the exchange rate• Exchange rate pass-through – tend to be

partial because• Invoicing practices• Market-share considerations• Distribution costs


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Exchange rate pass-through into import prices after one year

TABLE 14.5


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Exchange Rate Pass-Through• Invoicing practices• Choose the currency to invoice exports• Own home currency• Currency of their customers

• U.S. trade – dollars


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Use of the U.S. dollar in export and import invoicing, 2002–2004

TABLE 14.6


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Exchange Rate Pass-Through• Market-share considerations • Foreign producers• Preserve market share for goods sold in the U.S.• Accept a lower profit margin when their currency

appreciates • To keep their dollar prices constant against American

competitors

• Relatively strong domestic competition for imported goods in the U.S.• Lessen the extent of exchange rate pass-through

into import prices


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Exchange Rate Pass-Through• Distribution costs• Costs of distributing the imported good to the

final consumer• Transportation• Marketing• Wholesaling• Retailing costs

• 40% of overall U.S. consumer prices


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TRADE CONFLICTS

Why a dollar depreciation may not close the U.S. trade deficit

• U.S. trade deficit - high levels • Dollar depreciation to reduce the U.S. appetite

for foreign goods • U.S. partial exchange rate pass-through• The near-exclusive use of the dollar in invoicing

U.S. trade• The market share strategies of foreign

exporters• Sizable U.S. distribution costs added to U.S.

imports.


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TRADE CONFLICTS

Why a dollar depreciation may not close the U.S. trade deficit

• Dollar depreciation• U.S. imports and consumer prices –

unresponsive• Trade balance adjustment • Through exchange-rate changes• Not from a reduction of imports• But from a reduction in U.S. export prices


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The Absorption Approach to Currency Depreciation

• The absorption approach • Impact of depreciation on the spending

behavior of the domestic economy • Influence of domestic spending on the trade

balance• Total spending = • consumption (C) + investment (I) + government

expenditures (G) + net exports (X-M)


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• Total domestic output (Y) = level of total spending• Y = C + I + G + (X-M)• Absorption, A = C + I + G• Balance of trade, B = (X-M)

• Total domestic output (Y) = Absorption (A) +Net exports (B)• B = Y – A


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• Balance of trade (B) = Total domestic output (Y) - Level of absorption (A)• Positive trade balance: national output exceeds

domestic absorption• Negative trade balance: an economy is

spending beyond its ability to produce


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• The absorption approach • Currency depreciation will improve an

economy’s trade balance • Only if national output rises relative to absorption

• A country must• Increase its total output• Reduce its absorption• Combine the two


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• Unemployment + a trade deficit• Currency depreciation• Direct idle resources into the production of goods

for export• Divert spending away from imports to domestically

produced substitutes• Expand domestic output + improve the trade

balance


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• Full employment + trade deficit• Currency depreciation • Cut domestic absorption• Restrictive fiscal and monetary policies• Sacrifice on the part of those who bear the burden

of such measures

• Complementary• The absorption approach• The elasticity approach


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The Monetary Approach to Currency Depreciation

• The monetary approach• Currency depreciation• Temporary improvement in a nation’s balance-of-

payments position

• Initial equilibrium in the home country’s money market + Depreciation of the home currency• Increase the price level• Increase the demand for money


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The Monetary Approach to Currency Depreciation

• Initial equilibrium in the home country’s money market + Depreciation of the home currency• Inflow of money from overseas• Balance-of-payments surplus• Rise in international reserves• Increase in spending (absorption) - reduces the

surplus

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Exchange-Rate Adjustments and the Balance of Payments © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole