Exchange rate and balance of payments determination

CHAPTER 8

Traditional Approaches to Exchange-Rate
and Balance-of-Payments Determination

CHAPTER OVERVIEW

Chapter 8 surveys two traditional approaches to exchange rate and balance of payments determination, namely the “elasticities” approach and the “absorption” approach. The text points out that these approaches were developed long before international capital flows become as prevalent as they are today, and that therefore these approaches are based almost exclusively on assumptions pertaining to goods market transactions alone in the absence of capital mobility.

The first model to be considered is based on the elasticities approach, and for the model the chapter shows how the demand for foreign exchange and the supply of foreign exchange can be derived. The chapter furthermore shows how the elasticity of foreign exchange demand is determined by the elasticity of export supply, and the elasticity of foreign exchange supply is determined by the elasticity of import demand. The chapter then demonstrates how these elasticities can be used to determine the effect on the current account of a change in the exchange rate. The Marshall-Lerner condition is provided as a necessary condition for exchange rate stability in this model, and the J-curve effect is explained as a consequence of the fact that import demand and export supply tend to be less elastic in the short run than in the long run. Finally, the pass-through effect is defined as the effect that changes in the exchange rate can have on the domestic prices of imported goods and services.

The second model to be considered is based on the absorption approach. Here the text makes a distinction between two types of instruments that will impact current account balances:  absorption instruments which act to change the total level of absorption, and expenditure switching instruments which act to alter the level of private expenditure on imports versus exports by affecting their relative price through the exchange rate, or by imposing direct trade restrictions.

OUTLINE

I.     Exports, Imports, and the Market for Foreign Exchange
A.    Demand for Foreign Exchange
1.     International Trade
2.     Typical Downward Sloping Demand Curve
B.    Elasticity and the Demand for Foreign Exchange
1.     Relate to Elasticity of Supply of Foreign Goods
2.     Direct Relationship Between Elasticites
C.    Supply of Foreign Exchange
1.     International Trade
2.     Typical Upward Sloping Supply Curve

        D.    Elasticity and the Demand for Foreign Exchange
1.     Relate to Elasticity of Demand for Foreign Goods
2.     Direct Relationship Between Elasticites

II.    Elasticities Approach
A.    Exchange Rate and Balance of Payments
1.     Role of Elasticity
2.     The Marshall-Lerner Condition
B.    Short- and Long-Run Elasticities and the J-Curve
1.     Distinguish Short-Run from Long-Run
2.     J-Curve
3.     Pass-Through Effects

III. The Absorption Approach
A.  Model
1.     Domestic Absorption
2.     Real Income
3.     Current Account
B.    Determination of Current Account Balance
C.    Economic Expansion and Contraction
D.    Policy Instruments
1.     Absorption Instrument
2.     Expenditure-Switching Instrument

IV.  Summary

FUNDAMENTAL ISSUES

1.     How does the supply of exports and demand for imports determine the supply of and demand for foreign exchange?

2.     What is the elasticity approach to balance-of-payments and exchange-rate determination?

3.     What is the J-curve effect?

4.     What are pass-through effects?

5.     What is the absorption approach to balance-of-payments and exchange-rate determination?

6.     How do changes in real income and absorption affect a nation’s current account balance and the foreign exchange value of its currency?

CHAPTER FEATURES

1.     Policy Notebook:  “ ‘J-Curves’, ‘S-Curves’, or No Curves?”

This exercise examines the effect of exchange rate changes on a country’s trade balance. It discusses the traditional “J-curve” which illustrates that, in the short run, a trade balance may deteriorate after a currency devaluation, only to improve after some time passes. This is attributed to factors which do not allow trade patters to adjust immediately to new foreign exchange values. An “S-curve” is also discussed, which makes reference to the J-curve effect followed by another deterioration and improvement of a country’s trade balance.

For Critical Analysis:  Trade balances of different countries may respond differently to currency devaluations depending upon the type of goods that are traded. For instance, trade in agricultural goods may be negotiated rather quickly. Thus, any currency value changes will quickly be reflected in trade patterns for agricultural goods. On the other hand, manufactured goods may be subject to longer contract periods for trade. Thus, their trade may not respond as quickly to changes in exchange rates.

2.     Management Notebook:  “ Do Exporters Pass Through Exchange Rate Fluctuations?”

This notebook considers the degree to which exporters pass on exchange rate changes to foreign consumers through price changes. Various studies are cited that consider different importing countries and the degree to which exchange rate changes are passed along to consumers. 

For Critical Analysis:  Smaller countries may experience a larger degree of exchange rate pass-through if consumers in smaller countries do not have as many alternatives for certain goods as consumers in larger countries. If there are fewer alternatives, their price-sensitivity will be lessened. Consequently, firms can pass through more of an exchange rate change. This is related to the previous policy notebook on the J-curves, etc. in so far as firms are concerned with the effect of price change on purchasing patterns. In these cases, price changes come from exchange rate changes.

ANSWERS TO END OF CHAPTER QUESTIONS

1.     Using the formula provided in the question, the elasticity of foreign exchange demand is, in absolute value, 3, and the elasticity of foreign exchange supply is 1.286.

2.     A 1 percent depreciation of the Canadian dollar results in a 3 percent decline in imports demanded and a rise of 1.3 percent in exports supplied.

3.     If the Canadian dollar depreciates relative to the U.S. dollar, then the quantity of hockey pucks demanded declines. The amount of depreciation (given by the percentage change formula) in Figure 9-3 is 20 percent. Hence, the price of hockey pucks would have to decline by 20 percent for the quantity demanded to remain unchanged.

4.     Net exports, x – im, equals –$500. Therefore, there is a trade deficit of $500.

5.     With the change in exports and imports, net exports becomes –$400. The trade balance has improved by $100.

6.     The advertising campaign would induce consumers to increase expenditures on domestic output and decrease expenditures on foreign output. Domestic absorption will rise and, if expenditures on imports decrease, the trade balance improves.

MULTIPLE CHOICE EXAM QUESTIONS

1.     The assumptions of the traditional approaches to exchange rate and balance of payments determination reflect the fact that  

A.  they were developed during the time of the gold standard and the early Bretton Woods systems.
B.    economists had not yet recognized the importance of monetary factors at the time they were developed.
C.    there were sizable capital flows between industrialized countries at the time they were developed.
D.  the Keynesian school of thought had not permeated international theory at the time they were developed.

        Answer:  A

2.     The size of trade flows relative to capital flows is

A.  considerably larger.
B.    roughly equal due to trade balances effects.
C.    exactly equal due to double entry accounting.
D.  quite minuscule.

        Answer:  D

3.     The traditional approaches to exchange rate and balance of payments determination assume that capital flows occur

A.  at the time of transactions.
B.    only as a means of financing current account transactions.
C.    largely between countries of equal size and wealth.
D.  in relatively unpredictable waves determined by the animal spirits of investors.

        Answer:  B

4.     The elasticity of the export supply in turn determines the elasticity of the

A.  demand for foreign exchange.
B.    supply of foreign exchange.
C.    demand for domestic currency.
D.  supply of domestic currency.

        Answer:  A

5.     The more elastic is the export supply curve, the

A.  less elastic is the demand for domestic currency.
B.    more elastic is the supply of domestic currency.
C.    less elastic is the supply of foreign exchange.
D.  more elastic is the demand for foreign exchange.

        Answer:  D

6.     The import demand curve determines the ________ in the same way that the export supply curve determines the ________.

A.  supply of domestic currency; demand for domestic currency
B.    demand for domestic currency; supply of domestic currency
C.    supply of foreign exchange; demand for foreign exchange
D.  demand for foreign exchange; supply of foreign exchange

        Answer:  C

7.     The more elastic is the import demand curve, the

A.  more elastic is the foreign exchange demand curve.
B.    less elastic is the foreign exchange demand curve.
C.    more elastic is the foreign exchange supply curve.
D.    less elastic is the foreign exchange supply curve.

        Answer:  C

8.     The elasticities approach emphasizes the effects of changes in ________ in determining the balance of payments and the exchange rate.

A.  the quantities of goods
B.    the relative supply of money
C.    the prices of goods
D.  real income

        Answer:  C

9.     According to the elasticities approach, the elasticities of the import demand and export supply curves determine how much the quantity of imports demanded and the quantity of exports supplied will change in response to

A.  a shift in consumer tastes.
B.    a change in the exchange rate.
C.    trade restrictions placed on imports and exports.
D.  the business cycle.

        Answer:  B

10. The Marshall-Lerner condition specifies

A.  a necessary condition for exchange rate stability.
B.    a sufficient condition for exchange rate instability.
C.    when a central bank should intervene in foreign exchange markets.
D.  the guidelines set forth in GATT.

        Answer:  A

11. The Marshall-Lerner condition holds when the

A.  sum of the elasticities of import demand and export supply exceed one.
B.    difference in the elasticites of import demand and export supply exceed one.
C.    difference in the absolute values of the elasticites of import demand and export supply exceed one.
D.  sum of the absolute values of the elasticities of import demand and exports supply exceed one.

        Answer:  D

12. The reason one expects supply and demand to be more price elastic over longer time periods is because

A.  goods with longer shelf life have higher elasticities.
B.    there are feedback affects which alter the initial response.
C.    time is needed for households and businesses to adjust to price changes.
D.  the elasticity of supply always exceeds that of demand.

Answer:  C

13. A phenomenon in which a depreciation of the domestic currency causes a nation’s balance of payments to worsen before it improves is called

A.  the J-curve effect.
B.    the S-curve effect.
C.    devaluation.
D.    the boomerang effect.

        Answer:  A

14. The basic assumption underlying the J-curve effect is that

A.  people are myopic in their views of how the exchange rate will evolve over time.
B.    initially, supply will exceed demand but in equilibrium the two will be equated.
C.    supply and demand are less elastic in the short run than in the long run.
D.  an overshooting effect occurs as people change their investment horizons.

        Answer:  C

15. The idea that a country’s trade balance may first deteriorate after a currency devaluation and only later improve is known as the

A.    relative price effect.
B.    elasticity effect.
C.    pass through affect.
D.    J-Curve.

        Answer:  D

16.  The effect of a currency depreciation that results in higher domestic prices of imported goods and services is known as

A.  the pass-out effect.
B.    the pass-through effect.
C.    cost-push inflation.
D.  demand-pull inflation.

        Answer:  B

17. One explanation for why a full pass-through to domestic prices is not always observed is that

A.  the exchange rate is fixed.
B.    the exchange rate is floated yet managed.
C.    domestic firms respond with temporary price increases in order to maintain market shares.
D.  foreign firms view the change in the exchange rate as temporary and alter their prices accordingly.

        Answer:  D

18.  The absorption approach to exchange rate and balance of payments determination is based on

A.  the relative prevalence of traded goods in an economy.
B.    demographic trends which alter the demand for imports.
C.    how much of GDP is consumed by government.
D.  the difference between real income and absorption levels.

        Answer:  D

19. Which of the following is not included in a nation’s expenditures?

A.  consumption
B.    investment
C.    government spending
D.  exports

        Answer:  D

20. Domestic absorption includes expenditures on final goods and services in which four basic categories?

A.  consumption, investment, government, and exports
B.    consumption, investment, exports, and imports
C.    consumption, investment, government, and imports
D.  investment, government, exports, and imports

        Answer:  C

21. The current account is defined as the

A.  sum of exports and imports.
B.    product of exports and imports.
C.    ratio of imports to exports
D.  difference between exports and imports.

        Answer:  D

22. A nation is running a current account deficit if

A.  imports are less than exports and real income is less than absorption.
B.    imports are less than exports and absorption is less than real income.
C.    exports are less than imports and real income is less than absorption.
D.  exports are less than imports and absorption is less than real income.

        Answer:  C

23. The difference between real income and absorption is equal to the

A.  current account.
B.    public budget deficit.
C.    exchange-rate.
D.  net national product.

        Answer:  A

24. Devaluation of the domestic currency will induce

A.  expenditure switching.
B.    a flow of capital out of the country.
C.    a revaluation once the trade balance has stabilized.
D.  accompanying trade restrictions.

        Answer:  A

25. The portfolio approach is believed to have been developed initially by

A.  Stanley Fischer.
B.    Sidney Alexander.
C.    Milton Friedman.
D.  Robert Lucas.

        Answer:  B

26. In the absorption approach, under adjustable-pegged exchange rates, policymakers have access to which two policy instruments?

A.  Taxes and government spending.
B.    Federal funds rate and the discount rate.
C.    Trade restrictions and foreign exchange intervention.
D.  Absorption and expenditures-switching.

        Answer:  D