Exchange Rate Adjustments and the Balance of Payments

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INTERNATIONAL ECONOMICS SEVENTEENTH EDITION

ROBERT J. CARBAUGH

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Chapter 13 Exchange- Rate Adjustments and the Balance of Payments

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Chapter Outline (1 of 2)

Effects of Exchange-Rate Changes on Costs and Prices

Cost-Cutting Strategies of Manufacturers in Response to Currency Appreciation

Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach

J-Curve Effect: Time Path of Depreciation

Exchange Rate Pass-Through

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Chapter Outline (2 of 2)

The Absorption Approach to Currency Depreciation

The Monetary Approach to Currency Depreciation

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Effects of Exchange-Rate Changes on Costs and Prices (1 of 10)

How do exchange-rate fluctuations affect relative costs?

Depends on whether firm’s costs are denominated in home or foreign currency

Case 1: No foreign sourcing⎯all costs denominated in dollars

If the dollar appreciates by 100%, the U.S. firm’s production costs also rise by 100%

Reduced international competitiveness

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Effects of Exchange-Rate Changes on Costs and Prices (2 of 10)

TABLE 13.1 Effects of a Dollar Appreciation on a U.S. Steel Firm’s Production Costs When All Costs Are Dollar Denominated

COST OF PRODUCING A TON OF STEEL

PERIOD 1 $0.50 PER FRANC (2 FRANCS = $1)

PERIOD 2 $0.25 PER FRANC (4 FRANCS = $1)

	Dollar Cost	Franc Equivalent	Dollar Cost	Franc Equivalent
Labor	$160	320 francs	$160	640 francs
Materials (iron/coal)	300	600	300	1,200
Other costs (energy)	40	80	40	160
Total	$500	1,000 francs	$500	2,000 francs
Percentage change	—	—	—	100%

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Effects of Exchange-Rate Changes on Costs and Prices (3 of 10)

Case 2: Foreign sourcing—some costs denominated in dollars and some in francs

If dollar appreciates by 100%, for U.S. firm:

Production costs in francs increase by 100% for inputs denominated in dollars

Production costs in francs stay the same for inputs denominated in francs

Overall, production costs are higher (by less than 100%)

International competitiveness is reduced

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Effects of Exchange-Rate Changes on Costs and Prices (4 of 10)

TABLE 13.2 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

COST OF PRODUCING A TON OF STEEL

PERIOD 1 $0.50 PER FRANC (2 FRANCS = $1)

PERIOD 2 $0.25 PER FRANC (4 FRANCS = $1)

	Dollar Cost	Franc Equivalent	Dollar Cost	Franc Equivalent
Labor	$160	320 francs	$160	640 francs
Materials
$ denominated (iron/coal)	120	240	120	480
Franc denominated (scrap iron)	180	360	90	360
Total	300	600	210	840
Other costs (energy)	40	80	40	160
Total cost	$500	1,000 francs	$410	1,640 francs
Percentage change	—	—	−18%	+64%

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Effects of Exchange-Rate Changes on Costs and Prices (5 of 10)

Generalization

As franc-denominated costs become larger portion of Nucor’s total costs, dollar appreciation (depreciation) leads to

Smaller increase (decrease) in franc cost of Nucor steel

Larger decrease (increase) in dollar cost of Nucor steel compared to cost changes that occur when all input costs are dollar denominated

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Effects of Exchange-Rate Changes on Costs and Prices (6 of 10)

Exchange-rate fluctuations cause changes in relative costs

Influencing relative prices and volume of goods traded among nations

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Effects of Exchange-Rate Changes on Costs and Prices (7 of 10)

Dollar depreciation lowers U.S. production costs

Lowers export prices in foreign currency terms

Induces increase in U.S. goods sold abroad

Dollar depreciation leads to decrease in U.S. imports

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Effects of Exchange-Rate Changes on Costs and Prices (8 of 10)

Dollar depreciation lowers U.S. production costs and thus export prices in foreign currency terms

Induces increase in U.S. goods sold abroad

Dollar depreciation leads to decrease in U.S. imports

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Effects of Exchange-Rate Changes on Costs and Prices (9 of 10)

Factors influencing extent to which exchange-rate movements lead to relative price changes

U.S. exporters can offset price-increasing effects of appreciation by reducing profit margins

Perceptions of long-term trends in exchange rates may promote price rigidity if appreciation seen as temporary

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Effects of Exchange-Rate Changes on Costs and Prices (10 of 10)

Factors influencing extent to which exchange-rate movements lead to relative price changes (cont’d)

If product not highly substitutable, producers can exercise greater control over price

Production can be moved offshore, to countries whose currencies have depreciated against home country currency

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Cost-Cutting Strategies of Manufacturers in Response to Currency Appreciation (1 of 6)

Appreciation of yen: Japanese manufacturers

1990–1996, 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

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Cost-Cutting Strategies of Manufacturers in Response to Currency Appreciation (2 of 6)

Appreciation of the yen: Japanese manufacturers

Hitachi TV Sets

Parts from SC and Malaysia

Japan supplied computer chips

Only 30% of supplies came from Japan

TV price stayed low despite rising yen

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Cost-Cutting Strategies of Manufacturers in Response to Currency Appreciation (3 of 6)

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Cost-Cutting Strategies of Manufacturers in Response to Currency Appreciation (4 of 6)

Appreciation of yen: Japanese manufacturers (cont.)

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

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Cost-Cutting Strategies of Manufacturers in Response to Currency Appreciation (5 of 6)

Appreciation of dollar: U.S. manufacturers

1996–2002, dollar appreciated by 22%

American Feed Co.

Napoleon, Ohio

Made machinery used in auto plants

when orders come in, two companies meet to decide which plant should make which parts

American Feed can share in the benefits of having a European production base without having to take on risks of building its own factory there

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Cost-Cutting Strategies of Manufacturers in Response to Currency Appreciation (6 of 6)

Appreciation of dollar: U.S. manufacturers

Sipco Molding Technologies

Partnership with an Austrian company

Austrian company designed and made the tools

Sipco simply resold them

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Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach (1 of 7)

Currency depreciation

Improves nation’s competitiveness by reducing its costs and prices

Elasticity approach

Emphasizes relative price effects of depreciation

Depreciation works best when demand elasticities are high

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Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach (2 of 7)

Absorption approach

Focuses on income effects of depreciation

Decrease in domestic expenditure relative to income must occur for depreciation to promote trade equilibrium

Monetary approach

Stresses effects of depreciation on purchasing power of money and resulting impact on domestic expenditure

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Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach (3 of 7)

Elasticity of demand

Responsiveness of buyers to changes in price

Percentage change in quantity demanded stemming from 1% change in price

>1, elastic demand

<1, inelastic demand

=1, unitary elastic demand

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Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach (4 of 7)

Marshall-Lerner condition

Depreciation will improve trade balance if

Currency-depreciating nation’s demand elasticity for imports plus foreign demand elasticity for the nation’s exports exceeds one

Depreciation will worsen trade balance if

Sum of demand elasticities is less than one

Trade balance will neither improve nor worsen if sum of demand elasticities equals one

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Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach (5 of 7)

TABLE 13.3 Effect of Pound Depreciation on the Trade Balance of the United Kingdom

(a) IMPROVED TRADE BALANCE

Sector	Pound Price (%)	Quantity Demanded (%)	Net Effect (in pounds)
Import	+10	−25	−15% out payments
Export	0	+15	+15% in payments

Assumptions:

U.K. demand elasticity for imports = 2.5

Demand elasticity for U.K. exports = 1.5 Sum = 4.0

Pound depreciation = 10%

(b) WORSENED TRADE BALANCE

Sector	Change in Pound Price (%)	Change in Quantity Demanded (%)	Net Effect (in pounds)
Import	+10	−2	+8% out payments
Export	0	+1	+1% in payments

Assumptions:

U.K. demand elasticity for imports = 0.2

U.S. demand elasticity for U.K. exports = 0.1 Sum = 0.3

Pound depreciation = 10%

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Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach (6 of 7)

Marshall-Lerner condition (cont.)

Simplifying assumptions

A nation’s trade balance is in equilibrium when 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

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Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach (7 of 7)

TABLE 13.4 Price Elasticities of Demand for Total Imports and Exports of Selected Countries

Country	Import Price Elasticity	Export Price Elasticity	Sum of Import and Export Elasticities
Canada	0.9	0.9	1.8
France	0.4	0.2	0.6
Germany	0.1	0.3	0.4
Italy	0.4	0.9	1.3
Japan	0.3	0.1	0.4
United Kingdom	0.6	1.6	2.2
United States	0.3	1.5	1.8

Source: From Peter Hooper, Karen Johnson, and Jaime Marquez, “Trade Elasticities for the G-7 Countries,” Princeton Studies in International Economics, No. 87, August 2000, p. 9.

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J-Curve Effect: Time Path of Depreciation (1 of 5)

J-curve effect

Currency depreciation leads to worsening of nation’s trade balance in short run

Trade balance likely improves because of lags between changes in relative prices and quantities of goods traded as time passes

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J-Curve Effect: Time Path of Depreciation (2 of 5)

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J-Curve Effect: Time Path of Depreciation (3 of 5)

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J-Curve Effect: Time Path of Depreciation (4 of 5)

Types of lags

Recognition lags

Changing competitive conditions

Decision lags

Forming new business connections and placing new orders

Delivery lags

Between time new orders are placed and their impact on trade and payment flows is felt

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J-Curve Effect: Time Path of Depreciation (5 of 5)

Types of lags (cont.)

Replacement lags

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

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Exchange Rate Pass-Through (1 of 8)

Exchange rate pass-through

Extent to which changing currency values lead to changes in import and export prices

Buyers have incentive to alter purchases of foreign goods only to extent that prices of foreign goods change in terms of buyers’ domestic currency

This change depends in part on exporters’ willingness to change prices they charge for goods measured in buyers’ currency

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Exchange Rate Pass-Through (2 of 8)

Partial exchange rate pass-Through

Percentage change in import prices < percentage change in exchange rate

Exchange rate pass-through – tends to be partial because of

Invoicing practices

Market-share considerations

Distribution costs

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Exchange Rate Pass-Through (3 of 8)

TABLE 13.5 Exchange Rate Pass-Through into Import Prices after One Year

Country	Pass-Through Rate (For every 1 percent a currency depreciates/ appreciates the price of imports for the country increases/decreases by)*
OECD** average	0.64%
United States	0.42
Euro area	0.81
Japan	0.57–1.0
Other advanced countries	0.60

*Estimates are based on data from 1973 to 2003.

**The Organization for Economic Cooperation and Development consists of Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Republic of Korea, Japan,

Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States.

Sources: Jose Campa and Linda Goldberg, “Exchange Rate Pass-Through into Import Prices,” Review of Economics and Statistics, November 2005, pp. 984–985; and Hamid Faruqee, “Exchange Rate Pass-Through in the Euro Area,” IMF Staff Papers, April 2006, pp. 63–88.

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Exchange Rate Pass-Through (4 of 8)

Invoicing practices

Businesses choose currency in which to invoice exports

Dominance of dollar in invoicing across non-European countries helps explain partial pass-through of changes in dollar’s exchange rate to U.S. import prices

When foreign producers invoice exports to U.S. in dollars, exchange-rate movements will not immediately affect prices paid by importers, just foreign producers’ profits

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Exchange Rate Pass-Through (5 of 8)

TABLE 13.6 Use of the U.S. Dollar in Export and Import Invoicing, 2002–2004

Country	Dollar Share in Export Financing	Dollar Share in Import Financing	U.S. Share in Exports
United States	99.8%	92.8%	—
Japan	48.0	68.7	24.8
South Korea	83.2	79.6	17.0
Malaysia	90.0	90.0	20.5
Thailand	84.4	76.0	17.0
Australia	69.6	50.5	8.1
United Kingdom	26.0	37.0	15.5
Euro area	30.4	38.0	14.2
EU Accession countries*	17.5	23.9	3.2

*Bulgaria, Czech Republic, Estonia, Hungary, and Poland.

Sources: Linda Goldberg and Cedric Tille, “The International Role of the Dollar and Trade Balance Adjustment.” The Group of Thirty Occasional Paper No. 71, 2006; and Annette Kamps, “The Determinants of Currency Invoicing in International Trade,” European Central Bank Working Paper No. 665, August 2006.

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Exchange Rate Pass-Through (6 of 8)

Market-share considerations

Foreign producers may seek to preserve market share for goods sold in U.S. by keeping dollar prices constant

Forces them to accept lower profit margin when their currency appreciates

Relatively strong domestic competition for imported goods in U.S. lessens extent of exchange rate pass-through into import prices

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Exchange Rate Pass-Through (7 of 8)

Distribution costs

Costs of distributing imported good to final consumer

Transportation

Marketing

Wholesaling

Retailing costs

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Exchange Rate Pass-Through (8 of 8)

Distribution costs (cont’d)

40% of overall U.S. consumer prices

As distribution costs become large percentage of consumer price, sensitivity of consumer price to exchange rate fluctuations declines

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The Absorption Approach to Currency Depreciation (1 of 6)

The absorption approach

Impact of depreciation on spending behavior in domestic economy

Influence of domestic spending on trade balance

Total spending = Consumption (C) + Investment (I) + Government expenditures (G) + Net exports (X − M)

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The Absorption Approach to Currency Depreciation (2 of 6)

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

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The Absorption Approach to Currency Depreciation (3 of 6)

Balance of trade (B) = Total domestic output (Y) − Level of absorption (A)

Positive trade balance: national output exceeds domestic absorption

Negative trade balance: economy spending beyond its ability to produce

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The Absorption Approach to Currency Depreciation (4 of 6)

The absorption approach

Currency depreciation will improve an economy’s trade balance only if national output rises relative to absorption

Implies that a country must

Increase its total output

Reduce its absorption; or

Achieve some combination of the two

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The Absorption Approach to Currency Depreciation (5 of 6)

Given unemployment + trade deficit

Currency depreciation

Directs idle resources into production of goods for export

Diverts spending away from imports to domestically produced substitutes

Expands domestic output + improves trade balance

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The Absorption Approach to Currency Depreciation (6 of 6)

Given full employment + trade deficit

Currency depreciation improves trade balance only if domestic absorption is cut

Could be achieved through restrictive fiscal and monetary policies

Sacrifice on the part of those who bear the burden of such measures

Absorption approach and elasticity approach are complementary

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The Monetary Approach to Currency Depreciation (1 of 3)

Traditional approaches to currency depreciation are insufficient

Monetary consequences are not associated with balance-of-payments adjustment

To the extent that consequences exist, they can be neutralized by domestic monetary authorities

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The Monetary Approach to Currency Depreciation (2 of 3)

The monetary approach

Currency depreciation may induce temporary improvement in nation’s balance-of-payments position

Initial equilibrium in home country’s money market + Depreciation of home currency

Increase price level

Increase demand for money

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The Monetary Approach to Currency Depreciation (3 of 3)

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 surplus

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Elasticity

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