Economics of International Finance Econ. 315

1. Economics of International FinanceEcon. 315 Chapter 4 The Price Adjustment with Flexible and Fixed Exchange Rates

2. Objectives: • Examining how a nation’s current account is affected by price changes under fixed and flexible exchange rates. Assumptions • We assume no autonomous international private capital flows, i.e., they take place as a response to temporary trade balances. • Current account is corrected only by exchange rate changes. • Since this approach is based on trade flows and the speed of adjustment depends on how responsive (elastic) imports are to price changes (exchange rate changes), it is also called trade or elasticity approach. Adjustment with Flexible Exchange Rates • Current account is corrected by a depreciation (a flexible exchange rate) or a devaluation (a fixed or pegged exchange rate). • Depreciation or devaluation operates on prices to bring about an adjustment in the current account and BOP, i.e., affects the relative prices of exports and imports.

3. BOP adjustments with exchange rate changes • Look at figure 1, where USA and EMU are assumed to be the only two economies in the world. There are no international capital flows, such that the US demand and supply for € reflects only trade in goods and services. • At R = $1/ €1, the US demand for € is 12 bn, while supply is only €8 bn, i.e., a deficit € 4 bn. • If demand and supply for euros are D€ and S€, a 20% devaluation would equilibrate BOP at €10 bn (point E). • If demand and supply for euros are less elastic D€’ and S€’ a 20% devaluation would not equilibrate BOP at €10 bn. A 20% devaluation would reduce the deficit to €3 bn, and 100% devaluation (R = $2/ €1) would completely eliminate the deficit (point E’). Why? • The scale of depreciation depends on how elastic is the demand and supply for foreign currency (imports and exports).

4. A deficit is corrected by a 100% devaluation The 20% devaluation would reduce the deficit but not to correct for it A deficit is corrected by a 20% devaluation Figure 1Balance-of-Payments Adjustments with Exchange Rate Changes.

5. Derivation of the demand curve for foreign exchange. • Look at panel A of figure 2. the demand for imports is DM at R=$1/€1 while the European supply of imports is SM. Suppose that the euro price for a unit of imports is PM = €1, and the quantity of imports = 12 bn units (this corresponds to point B’ in figure 1 (i.e., 12 bn units ×€1 = €12 bn). • If the dollar depreciates by 20% pushes the DM down to to DM’, SM remains unchanged, Why?. For the US to continue to demand 12 bn units the euro price of US imports would have to fall to PM = €0.8, i.e., by exactly the 20% depreciation of the dollar in order to leave the dollar’s price of European imports almost unchanged (point H on DM).

6. It is obvious that DM’should not be parallel (compare points J-G and H-B’) • With DM’ and SM the price of imports is PM = €0.9 and QM = 11 bn. the US will move to point E’ and demand of the € would be (11 bn.× 0.9 = 9.9 bn) ≈ 10 bn. • So: at R=$1/€1 the demand was € 12 bn, (point B in figure 1) and at R=$1.2/€1 the demand was 10 bn, (point E in figure 1). Therefore, D€ is derived from the demand and supply of imports. (If demand for imports is less elastic, the demand for euros would be D€ ‘ in figure 1) • Only in the unusual case where the demand for imports is vertical, the quantity demanded of the foreign currency remains constant after devaluation. However, the less elastic is the demand for euros, the steeper is the demand.

7. Panel A A compromise price € .9 per unit at which BOP is in eq. If the $ depreciates by 20%, DM shifts down. PM should go down to € .8 (by 20%) for US to continue buying 12 bn. units Figure 2 Derivation of the U.S. Demand and Supply Curves for Foreign Exchange

8. Derivation of the supply curve for foreign exchange. • Look at panel B of figure 2. SX is the supply of US exports, and DX is the European demand for US exports. If the US price in euros is € 2, the quantity of exports would be 4 bn and supply of euros would be 2 × 4 = € 8 bn (point A in figure 1). • With A devaluation of 20% of the dollar DX remains unchanged but SX would shift down to SX’. The price of exports would be €1.6 for each unit, this will encourage European to demand more and there will be a movement toward E’ on DX which is an increase in the quantity exported by US from 4 bn to 5.5 bn. (i.e., 5.5x1.8≈ €10 bn). • So at R = $2/ €1, the supply of euros is €8 bn (point A in figure 1), at R = $2.4/ €1, The supply of euros is 10 (point E in figure 1). The supply of euros is driven from the supply and demand for US exports. • If demand for exports is less elastic there could be a movement form point A to point C instead of E in figure 1.

9. Panel B the price of exports € 1.8 per unit at which BOP is in eq. If the $ depreciates by 20%, SX shifts and PX should go down to € 1.6 (by 20%) This encourages demand for US exports that pushes the price up to 1.8 euros Figure 2 Derivation of the U.S. Demand and Supply Curves for Foreign Exchange

10. The Effect of Exchange Rate on Domestic Prices and the Terms of Trade • Depreciation or devaluation stimulates the production of import substitutes and exports leading to a rise in prices, i.e., depreciation is inflationary. The greater the depreciation or devaluation, the greater is the inflationary impact, and the less flexible is the increase in exchange rates as a method of correcting deficit in BOP. • A depreciation or devaluation is also likely to affect the nations terms of trade TOT (the ratio between export prices and import prices), since TOT are either measured in domestic prices or in foreign currency, a depreciation or devaluation will cause TOT to increase, fall, or remain unchanged. • Look at figure 2. after depreciation, the price of exports PX = €2 (point A’ in the right panel) and PM = €1 (point B’ in panel A). Hence TOT (PX / PM =2/1 = 2 or 200%). After a 20% depreciation PX = €1.8 (point E’ in panel B) and PM = € 0.9 (point E’ in panel A), so TOT = 1.8/0.9 = 2 or 200%. TOT remain unchanged. But in general we expect TOT to change in case of depreciation.

11. The Dutch Disease When an industrial nation begins to exploit a domestic natural resource previously imported, the nation’s exchange rate might appreciate to cause the nation’s loss of international competitiveness in its traditional industrial sector, and even face deindustrialization. Does it apply to Kuwait?. Stability of Foreign Exchange Markets: • Stable Foreign Exchange Market: when disturbances from the equilibrium exchange rate give rise to automatic forces that push exchange rate back to the equilibrium level. • Unstable Foreign Exchange Market: when disturbances from the equilibrium exchange rate push the exchange rate further away from the equilibrium level. A foreign exchange market is stable when the supply curve of foreign exchange is positively slopped or if it is less elastic (steeper) than the demand curve for foreign exchange.

12. Stable Foreign Exchange Market: Look at figure 3; in panel A: R = $1.2 = €1 at equilibrium. If R fell to R $1= €1  excess demand of € (deficit in US BOP = € 4 bn). This would automatically push R back to equilibrium R ($1.2 = €1) and vice versa when R increases to $1.4 = €1. Hence the foreign exchange market is stable. In panel B, supply is negatively slopped but steeper (inelastic) than the demand. When the rate falls to R $1= €1  excess demand (deficit in BOP = € 1.5 bn) which automatically pushes R towards equilibrium R ($1.2 = €1) and vice versa when R increases to $1.4 = €1. Hence the foreign exchange market is stable. • Unstable Foreign Exchange Market: In panel C, the supply curve is negatively slopped, but is flatter (more elastic) than the demand. When R falls to R $1= €1  excess supply of € of € 1.5 bn which pushes R away from equilibrium. If R = $1.4= €1  excess demand for € which automatically pushes R up away from equilibrium. Thus the foreign exchange market is unstable.

13. Panel A Panel B Panel C FIGURE 3 Stable and Unstable Foreign Exchange Markets.

14. When foreign exchange market is unstable, a flexible exchange rate system increases, rather than reduces, BOP deficit. The revaluation or appreciation not depreciation is required to eliminate the BOP deficit, while devaluation is required to correct for BOP surplus. • Determining whether the foreign exchange market is stable is important. If the foreign exchange market is stable, elasticity of the demand for foreign exchange and supply of foreign exchange become important. The Marshall-Learner Condition • The condition that tells us whether the foreign exchange market is stable or unstable is the Marshall-Learner condition (M.L.C). The simplified version of the M.L.C is that if supply curve of imports and exports are infinitely elastic, the M.L.C indicates that a stable foreign exchange market occurs if the sum of price elasticities of demand and supply of foreign exchange in absolute terms is greater than one.

15. If the sum of elasticities of demand and supply of foreign exchange is less than one 1, the foreign exchange market is unstable. • If the sum of elasticities of demand and supply of foreign exchange is one, the BOP will remain unchanged. • If in panel A in figure 2 DM is vertical and SM is horizontal, depreciation of the $ would leave the DX unchanged and thus the US BOP unchanged. • If in panel B in figure 2, SX is horizontal, that shifts down by the same percentage of devaluation, whether the quantity of euros supplied to US rise, remain unchanged, or falls depends on whether DX is price elastic, unitary elastic or relatively inelastic respectively (the sum of elasticities of DX and SX equals the elasticity of DX as we assume that elasticity of DX = zero).

16. The US BOP improves if the elasticity of DX is greater than one. If DM is negatively sloped, depreciation of the exchange rate of the euro leads to reduce the US demand for euros and thus improving the US BOP. The reduction in the quantity of euros demanded by US is greater, the larger is the price elasticity of DM. Now even if price elasticity of DX is less than 1, so that the quantity of euros supplied falls as a result of depreciation of the $, the US BOP will still improve as long as the reduction in the exchange rate of euros demanded by US is greater than the reduction in euros supplied to US. For this to be the case, the sum of the two elasticities must be greater than 1. • The greater that the sum of elasticities of DM and SX exceeds 1, the greater the improvements in the BOP due to a given depreciation of the domestic currency.

17. Elasticities in the Real World. • Elasticities Estimates • M.L.C postulates a stable foreign exchange market if the sum of price elasticities of DM and DX exceeds one in real absolute terms. However, the sum of elasticities of DM and DX should be substantially greater than one to make depreciation feasible as a method of correcting a deficit in BOP. • Before world war II Marshall argued that price elasticities in international trade are high (stable foreign exchange markets). This was not based on empirical support (prewar optimism). • Econometric estimates, after the WWII however, show that the sum of price elasticities of DM and DX is either less than 1or barely exceed 1. prewar optimism was replaced by post war pessimism. Are foreign exchange markets unstable? finding an explanation. 1. The identification problem • Orcutt in 1950 argued that regression techniques led to gross underestimation of the price elasticities of DM and DX and that Marshall was correct. He argued that estimates of elasticities suffer from identification problem.

18. Look at figure 4. points E and E’ are equilibrium points observed before and after depreciation of the $, with non of the curves being observed. The downward shift from SX to SX* depreciation does not affect the foreign demand for US exports. If such a change occurs, the estimated foreign demand for exports is DX. But E and E* are also consistent with DX’ and DX’’ which are elastic. The identification problem results from using DX even if the actual demand is DX’ which is elastic. This underestimates the price elasticities in international trade. 2. The Effect of Lags • Junz and Rhomberg (1973) have identified possible lags in quantity response to price changes in international trade: These lags explain the low value of elasticities in the short run: • 1. Recognition lag: before the change in price is evident • 2. Decision lag: lag to take advantage of the price rise • 3. Delivery lag: lag of new orders to be placed • 4. replacement lag: to use up available inventories before new orders are placed • 5. Production lag: to change the output mix as a result of price changes.

19. FIGURE 4 The Identification Problem. Estimates used the inelastic demand Instead of using The elastic demand curves

20. By not taking these lags and only takes the quantities in the years of a price change led to a underestimation of price elasticities. Hence short run elasticities are likely to be much smaller than long run elasticities. 3. The J curve and revised elasticity estimates. • The BOP may worsen soon after the depreciation before improving later on. This is due to the tendency of the domestic currency price of imports to rise faster than export prices with quantities initially not changing very much. • Over time QX rises and QM falls so that the initial deterioration of the BOP is halted and then reversed. This is known as the J curve effect because the response of the trade balance to a depreciation looks like the curve of a J. • Empirical studies confirmed the existence of the J curve effect and came up with high long term elasticities, i.e., real world elasticities are high enough to ensure stability of the foreign exchange market in the short run and a fairly elastic demand for and supply of foreign exchange in the long run.

21. FIGURE 5 The J-Curve. BOP improves Immediate deterioration of BOP BOP deterioration halts Deterioration lowers over time

22. 4. Currency pass through • The increase in the domestic price of imported commodity may be smaller than the amount of depreciation even after lags, i.e., the pass through from depreciation to the domestic prices may be less than complete, e.g., a 10% depreciation may result in a less than 10% increase in domestic currency prices of the imported commodity. Why? • Exporters often having established a large share in domestic market may be willing to absorb at least some of the price increase they could charge out of their profits. A foreign company may increase the price of exports by 6% and accept a 4% reduction in the price of its exports when the nation’s currency depreciates by 10% to avoid the risk of losing foreign markets by large increases in the price of their exports. This is known as the beachhead effect.

23. Adjustment under the gold standard • The Gold standard • Operated from about 1880 to the outbreak of the WW I. After the war, there was an attempt to reestablish the gold standard but this failed in 1931. It is also unlikely that it will be reestablished in the future. But it is important to understand its advantages and disadvantages. • Under the gold standard each country defines the gold content of its currency and stands ready to buy or sell any amount of gold at that price. Based on that exchange rates are determined. • For example, the £ contains 113 grains of gold while the $ contains 23.2 grains. The dollar price of the £ is 113/23.2 = 4.87. this is called the mint parity. • Since shipping currencies between New York and London cost gold (about 3 cents), the exchange rate between the $ and £ could never fluctuate by more than 3 cents above or below the mint parity.

24. FIGURE 6 Gold Points and Gold Flows. Gold sold in US, exported to London to buy £ at $ 4.90 Instead of buying £ in US at $ 4.94 An increase in the demand for imports  deficit and a depreciation of $ sell gold abroad An increase in the demand for exports  Appreciation of $ buy gold from abroad Gold is imported from London due to selling the surplus of £ there at 4.84 instead of 4.80 in US

25. None would pay more than $ 4.90 for £1 since he/she could purchase $ 4.87 of gold in the US, ship it to London at 3 cents and exchange it for £1 at the bank of England (central bank). Thus the US supply of £ becomes infinitely elastic at the rate of $ 4.90 for £1. This was the gold export point of the US • On the other hand, the $/£ rate can’t fall below $ 4.84 because no one would accept less than 4.84 for the £. He could always purchase £ worth of gold in London and ship it to New York at a cost of 3 cents and exchange it for $ 4.87 (i.e. 4.84 net) as a result the demand curve becomes infinitely elastic (horizontal) at the rate of $ 4.84 / £1. This is the gold import point of the US. Exchange rate is prevented from moving outside the gold points by US gold sales or purchases. The price-specie-flow mechanism • The automatic adjustment mechanism under the gold standard. The price-specie-flow mechanism is working as follows

26. Under the gold standard money supply would fall in the deficit nation and rise in the surplus nation causing prices to fall in the deficit and rise in the surplus nation. Exports of the deficit nation would be encouraged and imports would be discouraged until deficit is eliminated. This is based on the quantity theory of money: M . V = P . Q • As the deficit nation lost gold, M falls. A reduced M by 10% encourages exports and discourages imports. The opposite would take place in the surplus nation (due to gold inflow) internal prices increases and discourage exports, and encourage imports until deficit and surplus are eliminated. • Note that while adjustment under the flexible exchange rate system relies on high price elasticities of exports and imports, in the deficit surplus nation, adjustment under the gold standard relies on changing internal prices of each nation. The adjustment under the gold standard relies also on high price elasticities of exports and imports in the deficit and surplus nation, so that the volume of exports and imports respond readily and significantly to price changes.

27. The price-specie-flow mechanism M.V = P.Q Deficit nation  M↓P ↓  imports ↓ and exports ↑  bop equilibrium Surplus nation  M ↑ P ↑  imports ↑ and exports ↓  bop equilibrium

28. Key Terms • Devaluation Gold standard • Dutch disease Mint parity • Stable foreign exchange market Gold export point • Unstable foreign exchange market Gold import point • Marshall-Lerner condition Price-specie flow mechanism • Elasticity pessimism Quantity theory of money • Identification problem Rules of the game of the gold standard • J-curve effect Pass-through effect