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Exchange-Rate Adjustments and the Balance of Payments Chapter 14 Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved.

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Presentation on theme: "Exchange-Rate Adjustments and the Balance of Payments Chapter 14 Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved."— Presentation transcript:

1 Exchange-Rate Adjustments and the Balance of Payments Chapter 14 Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved.

2 Exchange Rate Effect on Costs o assume: all costs denominated in dollars o assume: appreciation of dollar o costs increase significantly putting the U.S. firm at a competitive disadvantage

3 Exchange Rate Effect on Costs (cont.) o assume: some costs denominated in francs o assume: appreciation of dollar o costs increase but not as much as if all costs were denominated in dollars

4 Implications o greater percentage of costs foreign denominated appreciation => smaller increase in costs depreciation => smaller decrease in costs general results: o appreciation raises prices of U.S. exports in foreign currency terms decreasing exports and increasing imports o depreciation lowers prices of U.S. exports in foreign currency terms increasing exports and decreasing imports

5 Appreciation of Yen: Japanese Firms o yen appreciated 40% in relation to U.S. dollar o assuming constant price levels Japanese products would become more expensive o Japanese firms used strong yen to establish manufacturing bases in the U.S. and dollar linked nations in Asia o using dollar denominated parts and materials partially offset higher costs resulting from appreciation of yen

6 Appreciation of Dollar: U.S. Firms o dollar appreciated 22% against currencies of major U.S. trading partners o with constant price levels U.S. products would become more expensive and less competitive o U.S. firms established joint operations in other nations to avoid increased costs associated with stronger dollar o U.S. firms shifted production to other locations where possible to reduce such costs

7 Will Currency Depreciation Reduce a Trade Deficit? o elasticity approach: emphasizes relative price effects of depreciation suggesting impact is greatest when elasticities are high o absorption approach: decrease in domestic expenditure relative to income must occur for depreciation to promote trade equilibrium o monetary approach: emphasizes effect depreciation has on purchasing power of money and resulting impact on domestic spending

8 Elasticity Approach o elasticity of demand – responsiveness of buyers to changes in price elasticity = ÷ o ratio > 1 implies elastic demand o ratio < 1 implies inelastic demand o ratio = 1 implies unitary elastic demand (each in terms of absolute value) ΔQ ΔP Q P

9 Elasticity Approach (cont.) Marshall-Lerner Condition o depreciation will improve trade balance if nations demand elasticity for imports plus foreign demand elasticity for that nations exports is greater than 1 o depreciation will worsen trade balance if the sum of these elasticities is less than 1 o depreciation will have no impact on trade balance if the sum of these elasticities equals 1

10 J-Curve o J-curve effect – depreciation will cause decline in trade balance initially but lead to improvement in the long run o advocates cite U.S. balance of trade in 1980s and 1990s as evidence

11 Types of Time Lags o recognition lag - time needed to realize change in competitiveness exists o decision lag - time needed to place new orders o delivery lags - time between orders and their impact on trade balance o replacement lags - time needed to use up existing inventories o production lags - time needed to increase output of goods for which demand has increased

12 Exchange Rate Pass Through o complete pass through – import prices change by full proportion of change in exchange rates o partial pass through – percentage change in import prices is less than percentage change in exchange rate

13 Reasons for Partial Pass Through 1)Invoice Practices: If firms conducting international trade invoice exports in a foreign currency, changes in the exchange rate will not cause prices to change immediately. 2)Market Share Considerations: Firms may elect to change prices by a lesser proportion in order to maintain market share. 3)Distribution Costs: After an import reaches the border there are additional transportation, marketing, wholesaling, and retailing costs which are denominated in the home currency.

14 Absorption Approach o impact of depreciation on domestic spending Y= C + I + G + (X - M) o absorption written as A = C + I + G o net exports written as B = X - M Y= A + B B= Y – A o currency depreciation will improve trade balance only if national output rises relative to absorption o economy at full employment unlikely to see substantial change in trade balance

15 Monetary Approach o elasticities and absorption approaches neglect implications of capital movements o monetary approach suggests depreciation will lead to temporary improvement in balance of payments o changes in exchange rates alter the demand for money which will lead to capital inflows or outflows o over time currency depreciation only changes the domestic price level


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