International Economics

By Robert J. Carbaugh
9th Edition

Chapter 15:
Exchange-Rate Adjustments
and the Balance of Payments

Copyright ©2004, South-Western College Publishing

Exchange rate adjustments

Exchange-rate adjustment and the BOP

 Automatic mechanisms may restore
balance-of-payments equilibrium, but at the
cost of recession or inflation
 As an alternative, governments allow
exchange rates to change
 Floating exchange rates, determined by
markets
 Devaluing or revaluing fixed exchange rates

Carbaugh, Chap. 15 2
Exchange rate adjustments

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
proportion of total costs, exchange rate changes have
less effect on the foreign 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 foreign
currency price of the product and less on domestic
price

Carbaugh, Chap. 15 3
Exchange rate adjustments

Exchange rate effects on costs & prices

 Generally, currency appreciation increases
the costs of exports in foreign currency
terms, which hurts total exports (while
depreciation encourages exports)
 Effect on prices is modified by the ability and
willingness of sellers to change their prices

Carbaugh, Chap. 15 4
Exchange rate adjustments

Requirements for successful devaluation

 When can devaluation correct a payments deficit?
 Elasticity approach
 Emphasizes price effects; devaluation works best when
demand is elastic
 Absorption approach
 Focus on income effects; domestic spending must fall,
too
 Monetary approach
 Focus on change in purchasing power of money and
effect on domestic spending

Carbaugh, Chap. 15 5
Devaluation as adjustment tool

Elasticity approach
 Impact of currency devaluation depends on
price elasticity of domestic demand for
imports and of foreign demand for exports
 The less either foreign or domestic demand
responds to price changes, the less effect a
devaluation will have on the payments
imbalance

Carbaugh, Chap. 15 6
Devaluation as adjustment tool

Elasticity approach
 Marshall-Lerner condition:
 Devaluation will improve the trade balance if
domestic demand elasticity for imports plus
foreign demand elasticity for exports is greater
than 1
 Devaluation will worsen the trade balance if the
sum of the two elasticities is less than 1
 If the sum is equal to 1, devaluation will have
no effect

Carbaugh, Chap. 15 7
Devaluation as adjustment tool

Devaluation and time horizon

 The J-curve effect: in short run, devaluation
worsens trade balance, but with time the
balance improves (3-5 years)
 Recognition lags; decision lags; delivery lags;
replacement lags; production lags
 Currency pass-through: effect of
devaluation depends on how quickly
producers pass on higher or lower costs to
their customers
Carbaugh, Chap. 15 8
Devaluation as adjustment tool

Absorption approach
 Emphasizes impact of devaluation on
spending behavior of domestic economy
 Balance of trade is the difference between
total domestic output and domestic
absorption
 Positive balance means output exceeds
domestic spending
 Negative balance means spending exceeds
total production
Carbaugh, Chap. 15 9
Devaluation as adjustment tool

Absorption approach (cont’d)

 Devaluation will only improve the trade
balance if output rises relative to domestic
absorption
 If an economy is operating below capacity, a
devaluation will shift resources into export
production and encourage spending on import
substitutes
 If an economy is operating at full employment,
production cannot rise; trade balance can only
be cut by slowing the domestic economy
Carbaugh, Chap. 15 10
Devaluation as adjustment tool

Monetary approach
 Elasticity and absorption approaches apply
only to the trade balance; monetary
approach includes capital account
 Devaluation may induce a temporary
improvement in the balance of payments
 Devaluation increases the domestic price level,
increasing demand for money and drawing
foreign capital flows (because of higher interest
rates that result)

Carbaugh, Chap. 15 11
Devaluation as adjustment tool

Monetary approach (cont’d)

 In the long run, the inflow of money
increases domestic spending, increasing
imports and returning the economy to the
starting point
 Devaluation affects real economy only
temporarily; only long run effect is to raise
the domestic price level

Carbaugh, Chap. 15 12