1. Exchange-Rate Adjustments and the Balance of Payments
PowerPoint slides prepared by:
Andreea Chiritescu
Eastern Illinois University
© 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

2. 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
© 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

3. TABLE 14.1
Effects of a dollar appreciation on a U.S. steel firm’s production costs when all 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 password‐protected website for classroom use

4. Effects of Exchange-Rate Changes on Costs and Prices
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
© 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

5. TABLE 14.2
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
© 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

6. Effects of Exchange-Rate Changes on Costs and Prices
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
© 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

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 password‐protected website for classroom use

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 password‐protected website for classroom use

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 password‐protected website for classroom use

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 password‐protected website for classroom use

11. 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 password‐protected website for classroom use

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 password‐protected website for classroom use

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 vehicle’s 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 password‐protected website for classroom use

14. FIGURE 14.1
Coping with the yen’s appreciation: Hitachi’s geographic diversification as a manufacturer of television sets
Hitachi’s 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 password‐protected website for classroom use

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 password‐protected website for classroom use

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 password‐protected website for classroom use

17. Will Currency Depreciation Reduce a Trade Deficit
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
© 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

18. Will Currency Depreciation Reduce a Trade Deficit
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 password‐protected website for classroom use

19. Will Currency Depreciation Reduce a Trade Deficit
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 password‐protected website for classroom use

20. Will Currency Depreciation Reduce a Trade Deficit
Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach
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
© 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

21. TABLE 14.3
Effect of pound depreciation on the trade balance of the United Kingdom
© 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

22. Will Currency Depreciation Reduce a Trade Deficit
Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach
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
© 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

23. TABLE 14.4
Long-term price elasticities of demand for total imports and exports of selected countries
© 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

24. J-Curve Effect: Time Path of Depreciation
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
© 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

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 password‐protected website for classroom use

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 password‐protected website for classroom use

27. Depreciation flowchart
FIGURE 14.2
Depreciation flowchart
© 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

28. FIGURE 14.3
Time path of U.S. balance of trade (billions of dollars) in response to dollar appreciation and depreciation
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 1991.
© 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

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 buyer’s 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 password‐protected website for classroom use

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 password‐protected website for classroom use

31. Exchange rate pass-through into import prices after one year
TABLE 14.5
Exchange rate pass-through into import prices after one year
© 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

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 password‐protected website for classroom use

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

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 password‐protected website for classroom use

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 password‐protected website for classroom use

36. 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 password‐protected website for classroom use

37. Why a dollar depreciation may not close the U.S. trade deficit
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 password‐protected website for classroom use

38. The Absorption Approach to Currency Depreciation
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 password‐protected website for classroom use

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 password‐protected website for classroom use

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 password‐protected website for classroom use

41. The Absorption Approach to Currency Depreciation
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
© 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

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 password‐protected website for classroom use

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 password‐protected website for classroom use

44. The Monetary Approach to 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
© 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

45. 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
© 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