Dale R. DeBoer

1
An Introduction to International Economics

• Chapter 13 Automatic Adjustments with Flexible
  and Fixed Exchange Rates
• Dominick Salvatore
• John Wiley Sons, Inc.

2
Focus of the chapter

• How is a trade deficit automatically closed by
  price and income changes?
• In this chapter private international capital
  flows are assumed to be passive responses to
  cover temporary trade imbalances.

3
Exchange rate adjustment

• Assume (1) only two nations (the U.S. and Japan)
  and (2) no capital flows.
• Under these assumptions the demand for yen will
  be driven by U.S. demand for Japanese goods and
  services, or imports.

/
D
/day
4
Exchange rate adjustment

• Assume (1) only two nations (the U.S. and Japan)
  and (2) no capital flows.
• Under these assumptions the demand for yen will
  be driven by U.S. demand for Japanese goods and
  services, or imports.
• The supply of yen will be driven by Japanese
  demand for U.S. goods and services, or exports.

/
S
D
/day
5
Exchange rate adjustment

• If the exchange rate is at level A, the U.S. will
  have a trade deficit.

/
S
A
D
/day
6
Exchange rate adjustment

• If the exchange rate is at level A, the U.S. will
  have a trade deficit.
• If exchange rates in the U.S. are flexible, over
  time the exchange rate will move to its
  equilibrium value of B.

/
S
B
A
D
/day
7
Exchange rate adjustment

• If the exchange rate is at level A, the U.S. will
  have a trade deficit.
• If exchange rates in the U.S. are flexible, over
  time the exchange rate will move to its
  equilibrium value of B.
• As the exchange rate adjusts to B, the trade
  deficit will close.

/
S
B
A
D
/day
8
Exchange rate adjustment

• If instead of the original supply and demand
  curves, supply and demand are given by S and
  D, a depreciation of the dollar will still
  occur.
• However, the depreciation will be much greater in
  this case (to level C).

/
S
S
C
B
A
D
D
/day
9
Exchange rate adjustment

• The more significant depreciation of the dollar
  (from A to C) will have more severe inflationary
  effects on the U.S. economy.
• This implication points to the importance of
  knowing the elasticity of the supply and demand
  curves.

/
S
S
C
A
D
D
/day
10
Elasticity

• Since the demand for foreign currency depends on
  the demand for imports, the elasticity depends on
  the price elasticity of the demand for imports
  (?M).
• ?M ?QM ?PM
• Similarly, the elasticity of supply depends on
  the price elasticity of supply for exports (?X).
• ?X ?QX ?PX

11
Unstable foreign exchange market

• If the supply of foreign currency is negatively
  sloped and more elastic than the demand for
  foreign currency, the foreign exchange market
  will be unstable.

/
S
D
/day
12
Unstable foreign exchange market

• If the supply of foreign currency is negatively
  sloped and more elastic than the demand for
  foreign currency, the foreign exchange market
  will be unstable.
• In this case, a trade deficit occurs at an
  exchange rate above the equilibrium value.

/
A
S
D
/day
13
Unstable foreign exchange market

• In this case, a trade deficit occurs at an
  exchange rate above the equilibrium value.
• At level A, the quantity demanded of foreign
  exchange (Z) exceeds the quantity supplied (Y).

/
A
S
D
/day
Y
Z
14
Unstable foreign exchange market

• At level A, the quantity demanded of foreign
  exchange (Z) exceeds the quantity supplied (Y).
• The excess demand puts upward pressure on the
  exchange rate and pushes the exchange market
  further from equilibrium.

/
A
S
D
/day
Y
Z
15
The Marshall-Lerner condition

• The unstable condition just depicted will be
  avoided if the Marshall-Lerner condition holds.
• The Marshall-Lerner condition is that ?M ?X gt
  1.
• Empirical evidence indicates that this condition
  does hold.

16
J-curve effect

• A currency depreciation is expected to lessen a
  countrys trade deficit.
• This improvement may take time to occur.
• Initially, the depreciation may worsen the trade
  deficit since import prices will rise more
  quickly than the improvement in exports.
• This generates a J-shaped pattern to exchange
  rate movements.

17
The gold standard

• The gold standard generates a system of fixed
  exchange rates.

18
The gold standard

• The gold standard generates a system of fixed
  exchange rates.
• The gold standard for the international monetary
  system operated from 1880 to 1914.
• This system is similar to the post-WWII Bretton
  Woods monetary system that collapsed in 1971.

19
The gold standard

• The gold standard generates a system of fixed
  exchange rates.
• The gold standard for the international monetary
  system operated from 1880 to 1914.
• Under the gold standard, each nation specified
  the gold content of its currency.
• 1 gold coin contained 113.0016 grains of gold
• 1 gold coin contained 23.22 grains of gold
• This entails an exchange rate of 113.0016 23.22
  or 4.87/.

20
The gold standard

• The gold standard generates a system of fixed
  exchange rates.
• The gold standard for the international monetary
  system operated from 1880 to 1914.
• Under the gold standard, each nation specified
  the gold content of its currency.
• The exchange rate of 4.87/ is known as mint
  parity.

21
The gold standard

• Under the gold standard, each nation specified
  the gold content of its currency.
• The exchange rate of 4.87/ is known as mint
  parity.
• As the cost of shipping gold from New York to
  London was approximately 3 cents, the actual
  exchange rate would always lie between 4.84/
  and 4.90/.
• 4.84/ is the gold import point.
• 4.90/ is the gold export point.

22
Adjustment under the gold standard

• Adjustment to equilibrium under the gold standard
  occurs via the price-specie-flow mechanism.
• The concept of the price-specie-flow mechanism
  was initially introduced in 1752 by David Hume.

23
Adjustment under the gold standard

• Adjustment to equilibrium under the gold standard
  occurs via the price-specie-flow mechanism.
• If a trade imbalance exists, gold will flow from
  the country with a trade deficit to the country
  with a trade surplus.

24
Adjustment under the gold standard

• Adjustment to equilibrium under the gold standard
  occurs via the price-specie-flow mechanism.
• If a trade imbalance exists, gold will flow from
  the country with a trade deficit to the country
  with a trade surplus.
• The fall in gold supplies in the trade deficit
  country reduces its money supply and pushes its
  price level lower the increase in gold supplies
  in the trade surplus country increases its money
  supply and raises its price level.

25
Adjustment under the gold standard

• The fall in gold supplies in the trade deficit
  country reduces its money supply and pushes its
  price level lower the increase in gold supplies
  in the trade surplus country increases its money
  supply and raises its price level.
• The price level movement is seen via the equation
  of exchange M V P Y (where M is the money
  supply, V is the velocity of money, P is the
  price level, and Y is real output).

26
Adjustment under the gold standard

• The price level movement is seen via the equation
  of exchange M V P Y (where M is the money
  supply, V is the velocity of money, P is the
  price level, and Y is real output).
• As the price level falls in the country with a
  trade deficit, exports of its goods and services
  will be encouraged as the price level increases
  in the country with a trade surplus, exports of
  its goods and services will be discouraged.

27
Adjustment under the gold standard

• As the price level falls in the country with a
  trade deficit, exports of its goods and services
  will be encouraged as the price level increases
  in the country with a trade surplus, exports of
  its goods and services will be discouraged.
• These changes in trade will decrease both the
  trade deficit and surplus leaving a situation of
  balanced international trade.

28
Income determination in a closed economy

• In a closed economy (without international trade)
  without a government sector, equilibrium output
  is determined by
• Y C S C I
• where Y is income, C is planned consumption
  expenditures, I is planned business savings, and
  S is savings.

29
Income determination in a closed economy

• In a closed economy (without international trade)
  without a government sector, equilibrium output
  is determined by
• Y C S C I
• where Y is income, C is planned consumption
  expenditures, I is planned business savings, and
  S is savings.
• This yields an equilibrium condition of
• S I 0.

30
Income determination in a closed economy

• This yields an equilibrium condition of
• S I 0.
• In words, this entails that at equilibrium
  leakages from the economy (S) must be balanced by
  injections into the economy (I).

31
Income determination in a closed economy

• In words, this entails that at equilibrium
  leakages from the economy (S) must be balanced by
  injections into the economy (I).
• If planned investment is autonomous but savings
  is determined by the marginal propensity to save
  (s), then
• ?S s?Y.
• The marginal propensity to save (s) is amount of
  additional savings that flows from each
  additional dollar of income.

32
Income determination in a closed economy

• If planned investment is autonomous but savings
  is determined by the marginal propensity to save
  (s), then
• ?S s?Y.
• Since S I at equilibrium, this entails that
• ?I s?Y
• or
• 1 s ?Y ?I.

33
Income determination in a closed economy

• Since S I at equilibrium, this entails that
• ?I s?Y
• or
• 1 s ?Y ?I.
• If k 1 s, then ?Y k ?I.
• k is the multiplier.
• Any change in investment will induce a multiplied
  change in income as given by the above formula.

34
Income determination in a closed economy

• If k 1 s, then ?Y k ?I.
• An example
• s 0.25
• ?I 300
• What is the value of k?
• k 1 0.25 4
• What is the change in income?
• ?Y 4 300 1,200

35
Income determination in an open economy

• In an open economy, equilibrium is still
  determined by the condition that leakages must
  equal injections.
• In an open economy, imports (M) are a new
  leakage.
• In an open economy, exports (X) are a new
  injection.

36
Income determination in an open economy

• In an open economy, equilibrium is still
  determined by the condition that leakages must
  equal injections.
• The new equilibrium equation is
• S M I X
• or
• ?S ?M ?I ?X.

37
Income determination in an open economy

• The new equilibrium equation is
• S M I X
• or
• ?S ?M ?I ?X.
• If ?M m?Y, then the multiplier (k) becomes
• k 1 (s m)
• Where m is the marginal propensity to import.

38
Income determination in an open economy

• The new equilibrium equation is
• S M I X
• or
• ?S ?M ?I ?X.
• If ?M m?Y, then the multiplier (k) becomes
• k 1 (s m)
• Where m is the marginal propensity to import.
• This leaves ?Y k ?I or ?Y k ?X.

39
Income determination in an open economy

• This leaves ?Y k ?I or ?Y k ?X.
• An example
• s 0.25
• m 0.25
• ?I 400
• What is the value of k?
• k 1 (0.25 0.25) 2
• What is the change in income?
• ?Y 2 200 800

40
Foreign repercussions

• Suppose Nation 1 experiences an increase in its
  planned autonomous investment.
• Nation 1 will experience an increase in its
  domestic income of k ?I.

41
Foreign repercussions

• Suppose Nation 1 experiences an increase in its
  planned autonomous investment.
• The increase in Nation 1s income will increase
  its imports by m?Y.

42
Foreign repercussions

• Suppose Nation 1 experiences an increase in its
  planned autonomous investment.
• The increase in Nation 1s income will increase
  its imports by m?Y.
• Assuming only two countries, Nation 1s increased
  imports will increase Nation 2s exports leading
  to an expansion in Nation 2s income by k2 ?X2.

43
Foreign repercussions

• The increase in Nation 1s income will increase
  its imports by m?Y.
• Assuming only two countries, Nation 1s increased
  imports will increase Nation 2s exports leading
  to an expansion in Nation 2s income by k2
  ?X2.
• The increase in Nation 2s income will lead to an
  increase in its imports, spurring a secondary
  expansion in Nation 1.

44
Absorption approach

• The absorption approach integrates the effect of
  induced income changes in the process of
  correcting a balance of payments disequilibrium
  by a change in the exchange rate.

45
Absorption approach

• The absorption approach integrates the effect of
  induced income changes in the process of
  correcting a balance of payments disequilibrium
  by a change in the exchange rate.
• Domestic equilibrium is given by
• Y C I (X M).

46
Absorption approach

• Domestic equilibrium is given by
• Y C I (X M).
• Define A (domestic absorption) C I and B
  (foreign absorption) X M. Then
• Y A B
• or
• Y A B.

47
Absorption approach

• Define A (domestic absorption) C I and B
  (foreign absorption) X M. Then
• Y A B
• or
• Y A B.
• A depreciation of the currency is expected to
  increase B.

48
Absorption approach

• A depreciation of the currency is expected to
  increase B.
• This can only occur if A falls or Y increases.
• If the economy is at full employment, Y cannot
  increase.
• Therefore, a depreciation must result in a fall
  in A.

49
Absorption approach

• A depreciation of the currency is expected to
  increase B.
• This can only occur if A falls or Y increases.
• Forces that lead to a fall in domestic absorption
  (A).
• Income is redistributed from wages to profits.
• The depreciation increases prices and hence
  lowers domestic expenditures.
• The depreciation pushes people into higher tax
  brackets and hence lowers disposable income.

50
Synthesis

• Flexible exchange rate adjustment
• A trade deficit leads to a depreciation of the
  domestic currency.

51
Synthesis

• Flexible exchange rate adjustment
• A trade deficit leads to a depreciation of the
  domestic currency.
• The depreciation spurs an improvement in the
  balance of trade.

52
Synthesis

• Flexible exchange rate adjustment
• A trade deficit leads to a depreciation of the
  domestic currency.
• The depreciation spurs an improvement in the
  balance of trade.
• The improvement in the balance of trade spurs
  increased domestic production.

53
Synthesis

• Flexible exchange rate adjustment
• A trade deficit leads to a depreciation of the
  domestic currency.
• The depreciation spurs an improvement in the
  balance of trade.
• The improvement in the balance of trade spurs
  increased domestic production.
• The increase in production generates increased
  domestic incomes that spur greater investment
  partially offsetting the initial improvement in
  the trade balance.

54
Synthesis

• Flexible exchange rate adjustment
• The improvement in the balance of trade spurs
  increased domestic production.
• The increase in production generates increased
  domestic incomes that spur greater investment
  partially offsetting the initial improvement in
  the trade balance.
• If production cannot increase because the nation
  is already at full employment, domestic
  absorption must fall.

55
Synthesis

• Flexible exchange rate adjustment
• Fixed exchange rate adjustment
• A trade deficit spurs a decrease in the domestic
  money supply.

56
Synthesis

• Flexible exchange rate adjustment
• Fixed exchange rate adjustment
• A trade deficit spurs a decrease in the domestic
  money supply.
• The fall in the money supply pushes the domestic
  price level lower.

57
Synthesis

• Flexible exchange rate adjustment
• Fixed exchange rate adjustment
• A trade deficit spurs a decrease in the domestic
  money supply.
• The fall in the money supply pushes the domestic
  price level lower.
• As domestic prices fall, exports are encouraged
  and imports discouraged moving the economy to a
  situation of balanced trade.