E.  Exchange-Rate Adjustments and the Balance of Payments

1.  Impact on costs and prices

a.  No foreign sourcing

• Costs increase if currency appreciates => reduced international competitiveness

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b.  Some foreign sourcing

• Costs increase partially => reduced international competitiveness

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• As foreign currency denominated costs become a larger share of total costs,

- domestic currency appreciation leads to a smaller increase in the foreign currency cost of the product and a larger decrease in the domestic currency cost of the product

- domestic currency depreciation leads to a smaller decrease in the foreign currency cost of the product and a larger increase in the domestic currency cost of the product

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• Relative prices and trade affected

- Appreciation - increasing relative domestic production costs, export prices higher in foreign currency terms, decrease in exports, increase in imports

- Depreciation - decreasing relative domestic production costs, export prices lower in foreign currency terms, increase in exports, decrease in imports

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2.  Strategies for dealing with appreciation

a.  Geographical diversification

• Establish facilities overseas

• Buy foreign inputs

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b.  Produce high-value (differentiated) vs. commodity-type goods

• Consumers less sensitive to price changes

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3.  Elasticity approach to exchange-rate adjustment

• Depreciation of currency improves a country's competitive position

- Price of imports increases, price of exports decreases

- Quantity of imports decreases, quantity of exports increases

- What will happen to balance of payments?

- Depends on domestic elasticity of demand for imports, foreign elasticity of demand for exports

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a.  Marshall-Lerner condition

• Depreciation improves trade balance if sum of elasticities > 1

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• Depreciation worsens trade balance if sum of elasticities < 1

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Ex. - Trade balance improves

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Ex. - Trade balance worsens

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b. J-curve effect

• Time lag between change in exchange rate and ultimate impact on trade balance

• Depreciation could cause trade balance to worsen before it improves

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• Prices of imports increase, but little initial change in quantity because of prior commitments

• Quantities adjust over time - imports down, exports up

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c.  Exchange-rate pass-through

• To what extent do prices change in response to exchange rate changes?

(1) Complete pass-through - prices rise by full proportion of currency change

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(2) Partial pass-through - prices rise by less than full proportion of currency change

• Due to competition

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4.  Absorption approach to exchange-rate adjustment

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• Unemployment and a trade deficit

- Depreciation reduces price of exports => domestic producers more competitive

- Domestic output increases, exports increase, imports decrease

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• Full employment and a trade deficit

- Output can't be expanded

- Need to cut absorption to improve trade balance

- Slow economy with monetary and fiscal policy

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5.  Monetary approach to exchange-rate adjustment

• Currency depreciation may induce a temporary improvement in balance-of-payments balance

- Depreciation increases price level

- Demand for money increases

- Money flows in from overseas to meet demand

- Balance-of-payments surplus results

• Surplus eventually disappears

- Increase in spending (absorption) eliminates surplus