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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.

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Presentation on theme: "Exchange-Rate Adjustments and the Balance of Payments © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole."— Presentation transcript:

1 Exchange-Rate Adjustments and 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 passwordprotected website for classroom use 1 PowerPoint slides prepared by: Andreea Chiritescu Eastern Illinois University

2 Effects of Exchange-Rate Changes on Costs and Prices How do exchange-rate fluctuations affect relative costs? Extent to which a firms 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 © 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 passwordprotected website for classroom use 2

3 3 Effects of a dollar appreciation on a U.S. steel firms production costs when all costs are dollar- denominated TABLE 14.1

4 Effects of Exchange-Rate Changes on Costs and Prices Foreign sourcingsome 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 © 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 passwordprotected website for classroom use 4

5 5 Effects of a dollar appreciation on a U.S. steel firms production costs when some costs are dollar-denominated and other costs are franc- denominated TABLE 14.2

6 Effects of Exchange-Rate Changes on Costs and Prices Generalization As franc-denominated costs become a larger portion of Nucors 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 © 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 passwordprotected website for classroom use 6

7 Effects of Exchange-Rate Changes on Costs and Prices Changes in relative costs Because of exchange-rate fluctuations Influence relative prices Influence the volume of goods traded among nations © 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 passwordprotected website for classroom use 7

8 Effects of Exchange-Rate Changes on Costs and Prices 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 © 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 passwordprotected website for classroom use 8

9 Effects of Exchange-Rate Changes on Costs and Prices 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 © 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 passwordprotected website for classroom use 9

10 Effects of Exchange-Rate Changes on Costs and Prices 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 © 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 passwordprotected website for classroom use 10

11 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 © 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 passwordprotected website for classroom use 11

12 Cost-Cutting Strategies of Manufacturers in Response to Currency Appreciation Yen appreciation: Japanese manufacturers , 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 © 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 passwordprotected website for classroom use 12

13 Cost-Cutting Strategies of Manufacturers in Response to Currency Appreciation 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 vehicles production to transplant factories © 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 passwordprotected website for classroom use 13

14 Hitachis global diversification permitted it to sell TVs in the United States without raising prices as the yen appreciated against the dollar. © 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 passwordprotected website for classroom use 14 Coping with the yens appreciation: Hitachis geographic diversification as a manufacturer of television sets FIGURE 14.1

15 Cost-Cutting Strategies of Manufacturers in Response to Currency Appreciation Dollar appreciation: U.S. manufacturers , dollar appreciated by 22% Sipco Molding Technologies Partnership with an Austrian company Austrian company - designing and making the tools Sipco simply resold them © 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 passwordprotected website for classroom use 15

16 Cost-Cutting Strategies of Manufacturers in Response to Currency Appreciation 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 © 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 passwordprotected website for classroom use 16

17 Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach Currency depreciation Improve a nations competitiveness Reducing its costs and prices The elasticity approach Relative price effects of depreciation Depreciation works best when demand elasticities are high © 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 passwordprotected website for classroom use 17

18 Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach 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 © 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 passwordprotected website for classroom use 18

19 Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach 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 © 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 passwordprotected website for classroom use 19

20 Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach Marshall-Lerner condition Depreciation will improve the trade balance if The currency-depreciating nations demand elasticity for imports Plus the foreign demand elasticity for the nations 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 © 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 passwordprotected website for classroom use 20

21 © 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 passwordprotected website for classroom use 21 Effect of pound depreciation on the trade balance of the United Kingdom TABLE 14.3

22 Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach Marshall-Lerner condition Simplifying assumptions A nations 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-countrys trade balance © 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 passwordprotected website for classroom use 22

23 © 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 passwordprotected website for classroom use 23 Long-term price elasticities of demand for total imports and exports of selected countries TABLE 14.4

24 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 nations 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 © 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 passwordprotected website for classroom use 24

25 J-Curve Effect: Time Path of Depreciation 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 © 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 passwordprotected website for classroom use 25

26 J-Curve Effect: Time Path of Depreciation 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 © 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 passwordprotected website for classroom use 26

27 © 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 passwordprotected website for classroom use 27 Depreciation flowchart FIGURE 14.2

28 Between 1980 and 1987, the U.S. merchandise trade deficit expanded at a rapid rate. The trade deficit decreased substantially between 1988 and 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 © 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 passwordprotected website for classroom use 28 Time path of U.S. balance of trade (billions of dollars) in response to dollar appreciation and depreciation FIGURE 14.3

29 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 buyers currency © 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 passwordprotected website for classroom use 29

30 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 © 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 passwordprotected website for classroom use 30

31 © 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 passwordprotected website for classroom use 31 Exchange rate pass-through into import prices after one year TABLE 14.5

32 Exchange Rate Pass-Through Invoicing practices Choose the currency to invoice exports Own home currency Currency of their customers U.S. trade – dollars © 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 passwordprotected website for classroom use 32

33 © 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 passwordprotected website for classroom use 33 Use of the U.S. dollar in export and import invoicing, 2002–2004 TABLE 14.6

34 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 © 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 passwordprotected website for classroom use 34

35 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 © 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 passwordprotected website for classroom use 35

36 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. © 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 passwordprotected website for classroom use 36

37 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 © 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 passwordprotected website for classroom use 37

38 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) © 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 passwordprotected website for classroom use 38

39 The Absorption Approach to Currency Depreciation 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 © 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 passwordprotected website for classroom use 39

40 The Absorption Approach to Currency Depreciation 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 © 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 passwordprotected website for classroom use 40

41 The Absorption Approach to Currency Depreciation The absorption approach Currency depreciation will improve an economys trade balance Only if national output rises relative to absorption A country must Increase its total output Reduce its absorption Combine the two © 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 passwordprotected website for classroom use 41

42 The Absorption Approach to Currency Depreciation 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 © 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 passwordprotected website for classroom use 42

43 The Absorption Approach to Currency Depreciation 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 © 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 passwordprotected website for classroom use 43

44 The Monetary Approach to Currency Depreciation The monetary approach Currency depreciation Temporary improvement in a nations balance-of- payments position Initial equilibrium in the home countrys money market + Depreciation of the home currency Increase the price level Increase the demand for money © 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 passwordprotected website for classroom use 44

45 The Monetary Approach to Currency Depreciation Initial equilibrium in the home countrys 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 © 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 passwordprotected website for classroom use 45


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