Price Adjustment and BoP Disequilibrium

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Price Adjustment and BoP Disequilibrium
2
Introduction

• This chapter examines how a change in the
  exchange rate
• affects prices of goods and services
• affects demand and supply of goods and services
• causes a correction of a current account imbalance

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Flexible Exchange Rate

• Normally,
• an incipient deficit in the current account leads
  to a depreciation
• we expect that a depreciation will cause foreign
  goods to become more expensive relative to home
  goods
• this leads to expenditure switching where home
  people import less and foreign country residents
  buy more of out exports
• this response leads to a reduction in the current
  account deficit

4
Assumptions underlying expenditure switching

• consumers and producers respond quickly to
  changes in the exchange rate
• the supply prices of traded goods do not change
  with the change in expenditures in either country
  (assume infinitely elastic supply)
• effects of change in exchange rate on income,
  etc ignored
• this approach therefore called the elasticities
  approach or price adjustment mechanism

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Looking at price adjustment mechanism more deeply

• recall current account demand for foreign
  exchange is caused by factors that drive demand
  for real imported goods and services
• real imports are influenced by
• price at home
• existence of tariffs or subsidies
• prices of domestic substitutes and/or complements
• tastes and preferences
• domestic income

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Demand for imported goods and services
The table below shows how the demand for imports
becomes a demand and supply for currency. Lets
fill it in.
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Equilibrium exchange rate

• If we plot the demand and supply for on one
  graph and the demand and supply for on another,
  we find the equilibrium exchange rate.
• The table shows how the demand for one currency
  is equivalent to the supply of another!

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Price adjustment

• If the demand and supply curves are well-behaved,
  then we can expect a change in one of the
  exogenous variable to lead to a new equilibrium
• For example, an increase in U.S.income will
• increase the demand for imports, and shift out
  the demand for s.
• This leads to a current account deficit.
• The deficit leads to a depreciation of the dollar

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Price adjustment

• Show the effect of an increase in prices in the US

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Price Adjustment

• an increase in US prices leads to
• a decrease in demand for US exports (shift left
  in demand for s and supply of s),
• an increase in demand for UK imports (shift right
  in demand for s and supply of ), and
• a depreciation of the .

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Market stability

• Market stability relies on the correct shape of
  the demand and supply curves,
• in particular, the supply of currency cannot be
  steeper than the demand for currency.
• Because the demand for one currency is equal to
  the supply of another, it is possible to have a
  downward sloping supply curve even if demand is
  well-behaved in the original currency

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Inelastic Demand

• Complete the table below, use the same demand for
  s as before, and draw the demand and supply for
  s.

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Elasticity of demand

• The elastictity of demand can be calculated as
• calculate the elasticity of demand for imports by
  Britain in the two examples for each change in
  the exchange rate.

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First example

• price faced by Britain changes from 13.33 to
  16
• quantity demanded changes from 100 to 80
• elasticity of demand is

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Calculate elasticities of demand

• 1. when q changes from 80 to 60 as price changes
  from 16 to 20
• Using the second example
• 2. when q changes from 100 to 85 as price
  changes from 13.33 to 16
• 3. when q changes from 85 to 80 as price changes
  from 16 to 20

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Answers

• 1. -1.2857
• 2. -0.8919
• 3. -0.27273
• NOTE Backward bending supply of foreign
  exchange occurs when the elasticity of demand is
  less than 1.

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Slope of foreign exchange supply

• The demand for s translates into a supply of s.
  
• If the demand for s is elastic, the supply of
  s is upward sloping
• If the demand for s is inelastic the supply of
  s is downward sloping

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For a straight line demand curve

• recall the demand price is e/ and the supply
  price is 1/e/
• the top part of the demand curve therefore is
  equivalent to the bottom part of the supply curve
• Because the top half of the straight line demand
  curve is elastic, the bottom of the supply curve
  is upward sloping
• Because the bottom half of the straight line
  demand curve is inelastic, the top of the supply
  of currency curve is downward sloping.

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Backward bending supply of foreign exchange
e /
e /
S
c
a

b
b
a
c
D

US faces supply of
UK demand for
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Stability conditions

• How exactly does a depreciation in the home
  currency affect the balance of payments, and how
  can we be sure that it will correct a BofP
  deficit?
• Two effects At home, there is an increase in
  price of imports, therefore the demand for
  imports unambiguously falls (Note an decrease
  in demand due to a price change is a movement
  along the curve!)
• For now assume all supply curves are perfectly
  elastic.

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Stability conditions

• Our exporters do not face a change in the price
  of their goods at home when the dollar
  depreciates
• Foreign importers face a drop in the price of
  imports and therefore increase demand
• Our exporters face an outward shift in the demand
  for exports at the original price.
• The export effect on the BofP is unambiguous, it
  brings more currency into the country
• The import effect is less so.

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Import effect on BofP from depreciation

• the decrease in the amount of imports purchased
  has the effect of reducing the BofP deficit
• the increase in the price of imports has the
  effect of increasing the BofP deficit
• the combination of the two effects determine the
  total effect of the increase in price of imports
• the overall effect on the BofP depends on both
  the import effect and the export effect

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Stability

• The market will only be unstable (a depreciation
  leading to a deterioration in the BofP) when the
  size of the export effect and the reduction of
  demand for imports are both too small to offset
  the price effect of the increase in imports
• for this to occur, both the demand for imports
  and the foreign demand for our exports must be
  inelastic (quite inelastic)

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Marshall-Lerner Condition

• The exact condition for stability is called the
  Marshall-Lerner condition
• It is
• This condition shows that the weight assigned to
  the export elasticity depends on whether there is
  an export surplus

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Inelastic supply

• If supply is less than perfectly elastic, then
  the Marshall-Lerner condition must be adjusted to
  include the effect of supply.
• In this case the supply of exports curve slopes
  up, and so, an increase in demand for exports
  leads to a smaller increase in the amount
  exported, and a smaller increase in price
• similarly, the original increase in price
  associated with a depreciation would be smaller
• NOTE an upward sloping import supply could only
  be expected for a large country

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Effect of a depreciation - imports

• importers see the price rise, and reduce quantity
  demanded as a reaction to the price change

PM
SM
p2
SM
p1
DM
Q quantity of imports
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Effect of a depreciation - imports

• importers see the price rise, and reduce quantity
  demanded as a reaction to the price change
• because imports are not perfectly elastic,
  importers reduce price, leading to a smaller
  price increase and smaller reduction in imports

PM
SM
SM
p2
p1
DM
Q quantity of imports
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Effect of a depreciation - exports

• Without changing the price at home, exporters see
  a shift in demand, since the price has fallen
  abroad

PX
Sx
p1p1
DX
DX
QX
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Does M-L condition hold?

• Jaime Marquez (1990) checked M-L condition for a
  number of countries
• using quarterly estimates, he calculated
  bilateral (two-way) trade elasticities between
  any two partners, and resulting multilateral
  trade elasticities
• found all but UK had sum of elasticities greater
  than 1, and for UK, it was -0.91
• Therefore, expect that even in UK, in the
  long-run the M-L condition is satisfied

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Price Adjustment Short vs Long Run

• short-run elasticities of demand and supply tend
  to be smaller than long-run elasticities because
• consumers
• need to alter consumption plans,
• find substitutes to higher priced goods
• need to honour contracts
• if expect further depreciation, may even increase
  imports when a small depreciation occurs
• producers
• recognition lag - decision-making lag
• production/inventory lag - delivery lag

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Exchange rate pass-through

• complete pass-through occurs when the effect of
  the exchange rate change does not affect producer
  prices, and so, if the importing countrys
  currency appreciates, the price of imports rises
  proportionally to the depreciation
• see graph, page 152
• the price/cost ratio of U.S. exporters is
  unrelated to changes in the exchange rate
• the price/cost ratio of foreign exporters to the
  US follows the exchange rate closely,
• this shows there is less than complete exchange
  rate pass-through by foreign exporters to the
  U.S., they adjust their prices to accommodate
  changes in the exchange rate
• this mutes the price signals caused by a
  (ap)depreciation

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Short-run and long run market

• In the short-run the foreign exchange rate market
  may seem unstable,
• in the short-run, a depreciation may lead to a
  worsening of a current account deficit
• this is because both consumers and producers may
  be slow to adjust their consumption and
  production patterns in reaction to the price
  change
• but over time, the exchange rate pass-through
  becomes more complete and the market is stable.
• Note in the next graph, the short-run curves
  rotate toward the long run curves, with both
  becoming more elastic

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Short run currency market

• depreciation leads to a bigger current account
  deficit

e
e
e
DGS
SGS
Foreign exchange
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Short and long run currency market

• depreciation leads to a bigger current account
  deficit

S(LR)GS
e
e
e
D(LR)GS
D(SR)GS
S(SR)GS
Foreign exchange
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J-curve

• the short-run and long-run reaction to a
  depreciation leads to a movement of the current
  account balance over time in the shape of a
  j-curve
• p. 156 shows response takes about 6 quarters to
  work through the market

X-M
Time
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Fixed exchange rates

• Price adjustment depends on the reaction of
  prices in the market to adjust to a BoP
  imbalance, rather than the price of the currency
• Requirements for price adjustment to work under a
  fixed exchange rate
• 1. no restraint on buying and selling gold
• 2. money supply is allowed to change in response
  to changes in gold holdings
• 3. prices and wages need to be flexible upward
  and downward

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Gold export point

• Since there is a cost of transportation, gold is
  moved if demand and supply differ by an amount
  that would make the equilibrium exchange rate
  differ from the pegged rate by more than the cost
  of transportation

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