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Session 7B Professor Augustine H H Tan MBA Global Economy 1

Exchange-rate Adjustmentandthe Balance of Payments

MBA Global EconomySession 7B

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Session 7B Professor Augustine H H Tan MBA Global Economy 2

Exchange-rate adjustment and the BOP Automatic mechanisms may restore balance-of-

payments equilibrium, but at the cost of recession orinflation

As an alternative, governments allow exchange ratesto change

Floating exchange rates, determined by markets

Devaluing or revaluing fixed exchange rates

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Session 7B Professor Augustine H H Tan MBA Global Economy 3

Exchange Rate Adjustments Impact of exchange-rate adjustments on the balance

of payments Conditions under which currency depreciation and

appreciation will improve/worsen a nationspayments position

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Session 7B Professor Augustine H H Tan MBA Global Economy 4

Effects of Exchange-Rate Changes on Costs and Prices Changing exchange rates: Influence on relative costs

Case 1: No foreign sourcing all costs denominated indollars

Hypothetical production costs (Table 14.1)

International competitiveness reduced because of

dollar appreciation Case 2: Foreign sourcing some costs denominated in

dollars and some costs denominated in francs

Hypothetical production costs (Table 14.2)

Dollar appreciation worsens internationalcompetitiveness, but not as much as in Case 1

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Session 7B Professor Augustine H H Tan MBA Global Economy 5

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Session 7B Professor Augustine H H Tan MBA Global Economy 6

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Session 7B Professor Augustine H H Tan MBA Global Economy 7

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 proportionof total costs, exchange rate changes have less effect on theforeign 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 foreigncurrency price of the product and less on domestic price

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Session 7B Professor Augustine H H Tan MBA Global Economy 8

Exchange rate effects on costs & prices Generally, currency appreciation increases the costs

of exports in foreign currency terms, which hurts totalexports (while depreciation encourages exports)

Effect on prices is modified by the ability andwillingness of sellers to change their prices

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Session 7B Professor Augustine H H Tan MBA Global Economy 9

Effects of Exchange-Rate Changes on Costs and Prices Factors governing the extent by which rate

movements lead to relative price changes Reduction in profit margins

Perceptions concerning long-term trends inexchange rates

Substitutability of products

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Session 7B Professor Augustine H H Tan MBA Global Economy 10

Cost-Cutting Strategies of Manufacturers Appreciation of the Yen

Japanese manufacturers used yens strength Cheaply established integrated manufacturing

bases in the U.S. and in dollar-linked Asia

Example of Hitachi: (Figure 14.1) Japanese auto industry

Cut the yen prices of their autos

Reduced manufacturing costs

Dollar appreciation: U.S. manufacturers

Cost reduction strategies

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Session 7B Professor Augustine H H Tan MBA Global Economy 11

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Session 7B Professor Augustine H H Tan MBA Global Economy 12

Requirements for a Successful Depreciation Approaches to currency depreciation:

Elasticity approach Absorption approach

Monetary approach

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Session 7B Professor Augustine H H Tan MBA Global Economy 13

Elasticity Approach to Exchange-Rate Adjustment Emphasizes the relative price effects of depreciation

Suggests that depreciation works best whendemand elasticities are high

Elasticity is the ratio of the percentage change inthe quantity demanded to the percentage change inprice

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Session 7B Professor Augustine H H Tan MBA Global Economy 14

Elasticity Approach to Exchange-Rate Adjustment Marshall-Lerner condition

Depreciation will improve the trade balance if thecurrency-depreciating nations demand elasticityfor imports plus the foreign demand elasticity forthe nations exports exceeds 1

If the sum of the demand elasticities is less than 1,depreciation will worsen the trade balance

The trade balance will be neither helped nor hurt if

the sum of the demand elasticities equals 1

Continued

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Session 7B Professor Augustine H H Tan MBA Global Economy 15

Elasticity Approach to Exchange-Rate Adjustment Effect of depreciation of the pound on the British

trade balance Cases for discussion:

Case 1: Improved trade balance (Table 14.3(a))

Case 2: Worsened trade balance (Table 14.3(b))

Continued

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Session 7B Professor Augustine H H Tan MBA Global Economy 16

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Session 7B Professor Augustine H H Tan MBA Global Economy 17

Empirical Measurement: Import/Export DemandElasticities

Elasticity pessimists (1940s and 1950s)

Low demand elasticities Currency depreciations and appreciations largely

ineffectual in promoting changes in trade balance

Elasticity optimists (by 1960s)

Estimated rather high demand elasticities for mostnations

Estimated price elasticities (Table 14.4)

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Session 7B Professor Augustine H H Tan MBA Global Economy 18

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Session 7B Professor Augustine H H Tan MBA Global Economy 19

J-Curve Effect: Time Path of Depreciation Currency depreciation affects trade balance

Net impact on export receipts and importexpenditures (Figure 14.2)

J-curve effect

Initial effect is an increase in import expenditures

Home-currency price of imports has risen, butthe volume is unchanged owing to priorcommitments

As time passes, the quantity adjustment effectbecomes relevant

U.S. balance of trade (1980s and 1990s) (Figure 14.3)

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Session 7B Professor Augustine H H Tan MBA Global Economy 20

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Session 7B Professor Augustine H H Tan MBA Global Economy 21

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Session 7B Professor Augustine H H Tan MBA Global Economy 22

J-Curve Effect: Time Path of Depreciation Adjustment lags

May be four years or more

Major portion takes place in about two years

Types of lags

Recognition lags Decision lags

Delivery lags

Replacement lags Production lags

Continued

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Session 7B Professor Augustine H H Tan MBA Global Economy 23

Exchange-Rate Pass-Through Extent to which changing currency values lead to

changes in prices Incentives to alter purchases of foreign goods

Willingness of exporters to permit the change inthe exchange rate to affect the prices

Complete pass-through

Partial pass-through

Average pass-through rate for the U.S. (Table 14.5)

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Session 7B Professor Augustine H H Tan MBA Global Economy 24

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Session 7B Professor Augustine H H Tan MBA Global Economy 25

Exchange-Rate Pass-Through and the DollarDepreciation

2002-2004

Steady depreciation of the U.S. dollar

Expected to reduce imports and increase exports

Restrictions on dollars effect on prices

Excess capacity world-wide

Sharp competition Asian currency intervention

Low overall pass-through rate as Americans importedmore consumer goods

Toleration of reduced margins to maintain U.S. marketshare

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Session 7B Professor Augustine H H Tan MBA Global Economy 26

The Absorption Approach to Exchange-RateAdjustment

Deals with the income effects of depreciation

Balance of trade (B) equals the difference betweentotal domestic output (Y) and level of absorption(A)

Currency depreciation will improve trade balanceonly if national output rises relative to absorption

A country must increase its total output, reduce

its absorption, or do some combination of thetwo

At full employment, only A can be reduced

Expression: B = Y- A

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Session 7B Professor Augustine H H Tan MBA Global Economy 27

The Monetary Approach to Exchange-Rate Adjustment Effects depreciation has on the purchasing power of

money Resulting impact on domestic expenditure levels

Effects of depreciation:

Temporary improvement in balance-of-paymentsposition

Raises the domestic price level in the long-run

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Session 7B Professor Augustine H H Tan MBA Global Economy 28

Requirements for successful devaluation When can devaluation correct a payments deficit?

Elasticity approach

Emphasizes price effects; devaluation works best whendemand is elastic

Absorption approach

Focus on income effects; domestic spending must fall, too

Monetary approach

Focus on change in purchasing power of money and effecton domestic spending