Copyright ©2004, South-Western College Publishing International Economics By Robert J. Carbaugh 9th Edition Chapter 14: Exchange-Rate Adjustments and the Balance of Payments

Carbaugh, Chap Exchange rate adjustments Exchange-rate adjustment and the BOP  Automatic mechanisms may restore balance-of-payments equilibrium, but at the cost of recession or inflation  As an alternative, governments allow exchange rates to change  Floating exchange rates, determined by markets  Devaluing or revaluing fixed exchange rates

Carbaugh, Chap Exchange rate adjustments Exchange rate effects on costs & prices  Impact of appreciation or depreciation on costs depends on the proportion of inputs priced in foreign vs. domestic currency  As foreign-currency denominated costs rise as a proportion of total costs, exchange rate changes have less effect on the foreign currency price and more effect on the domestic price  If foreign-currency costs are a small part of total costs, exchange rate changes have more impact on foreign currency price of the product and less on domestic price

Carbaugh, Chap Exchange rate adjustments Exchange rate effects on costs & prices  Generally, currency appreciation increases the costs of exports in foreign currency terms, which hurts total exports (while depreciation encourages exports)  Effect on prices is modified by the ability and willingness of sellers to change their prices

Carbaugh, Chap Exchange rate adjustments Requirements for successful devaluation  When can devaluation correct a payments deficit?  Elasticity approach  Emphasizes price effects; devaluation works best when demand is elastic  Absorption approach  Focus on income effects; domestic spending must fall, too  Monetary approach  Focus on change in purchasing power of money and effect on domestic spending

Carbaugh, Chap Devaluation as adjustment tool Elasticity approach  Impact of currency devaluation depends on price elasticity of domestic demand for imports and of foreign demand for exports  The less either foreign or domestic demand responds to price changes, the less effect a devaluation will have on the payments imbalance

Carbaugh, Chap Devaluation as adjustment tool Elasticity approach  Marshall-Lerner condition:  Devaluation will improve the trade balance if domestic demand elasticity for imports plus foreign demand elasticity for exports is greater than 1  Devaluation will worsen the trade balance if the sum of the two elasticities is less than 1  If the sum is equal to 1, devaluation will have no effect

Carbaugh, Chap Devaluation as adjustment tool Devaluation and time horizon  The J-curve effect: in short run, devaluation worsens trade balance, but with time the balance improves (3-5 years)  Recognition lags; decision lags; delivery lags; replacement lags; production lags  Currency pass-through: effect of devaluation depends on how quickly producers pass on higher or lower costs to their customers

Carbaugh, Chap Devaluation as adjustment tool Absorption approach  Emphasizes impact of devaluation on spending behavior of domestic economy  Balance of trade is the difference between total domestic output and domestic absorption  Positive balance means output exceeds domestic spending  Negative balance means spending exceeds total production

Carbaugh, Chap Devaluation as adjustment tool Absorption approach (cont’d)  Devaluation will only improve the trade balance if output rises relative to domestic absorption  If an economy is operating below capacity, a devaluation will shift resources into export production and encourage spending on import substitutes  If an economy is operating at full employment, production cannot rise; trade balance can only be cut by slowing the domestic economy

Carbaugh, Chap Devaluation as adjustment tool Monetary approach  Elasticity and absorption approaches apply only to the trade balance; monetary approach includes capital account  Devaluation may induce a temporary improvement in the balance of payments  Devaluation increases the domestic price level, increasing demand for money and drawing foreign capital flows (because of higher interest rates that result)

Carbaugh, Chap Devaluation as adjustment tool Monetary approach (cont’d)  In the long run, the inflow of money increases domestic spending, increasing imports and returning the economy to the starting point  Devaluation affects real economy only temporarily; only long run effect is to raise the domestic price level