E. Exchange-Rate Adjustments and the Balance of
Payments
1. Impact on costs and prices
a. No foreign sourcing
.
.
.
.
.
.
.
.
b. Some foreign sourcing
.
.
.
.
.
.
.
.
- 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
.
- 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
.
2. Strategies for dealing with appreciation
a. Geographical diversification
- Establish facilities overseas
.
.
.
.
.
.
b. Produce high-value (differentiated) vs.
commodity-type goods
- Consumers less sensitive to price changes
.
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
.
a. Marshall-Lerner condition
- Depreciation improves trade balance if sum of
elasticities > 1
.
.
- Depreciation worsens trade balance if sum of
elasticities < 1
.
.
Ex. - Trade balance improves
.
.
.
.
Ex. - Trade balance worsens
.
.
.
.
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
.
.
.
.
.
.
.
.
.
.
- Prices of imports increase, but little initial
change in quantity because of prior commitments
- Quantities adjust over time - imports down,
exports up
.
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
.
.
.
.
.
(2) Partial pass-through - prices rise
by less than full proportion of currency change
.
.
.
.
.
4. Absorption approach to exchange-rate
adjustment
.
.
.
.
.
- Unemployment and a trade deficit
- Depreciation reduces price of exports =>
domestic producers more competitive
- Domestic output increases, exports increase,
imports decrease
.
.
.
- 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
.
.
.
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
|