Exchange-Rate Adjustments and The Balance of Payments

Exchange-Rate Adjustments
and the Balance of Payments

PowerPoint slides prepared by:
Andreea Chiritescu
Eastern Illinois University
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password‐protected website for classroom use 1
The previous chapter demonstrated the disequilibrium
in the balance of trade tends to be reversed by
automatics adjustments in prices, interest rates ,and
incomes.
However ,if these adjustments are allowed to
operate ,reversing trade imbalances may come at the
expense of domestic recession or price inflation.
In stead of relying on adjustments in prices, interest
rates ,and incomes to counteract trade imbalances ,
governments permit alterations in exchange rates.
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 2
By adopting a floating exchange-rates system, a
nation permits its currency to depreciate or appreciate in a
free market in response to shifts in either the demand for
or supply of the currency.
Under a fixed exchange-rate system , rates are set

by the government in short term. However, if the official
exchange rate becomes overvalued over a period of time, a
government may initiate polices to devalue its currency.
Currency devaluation causes a depreciation of a currency’s
exchange value; it is initiates by government policy rather
than by the free-market forces of supply and demand. When
a nation’s currency is undervalued, it may be revalued by
the government; this policy causes the currency’s exchange
value to appreciate .
In this chapter ,we examine the impact of
exchange-rate adjustments on the balance of trade.
We will learn under what conditions currency

depreciation (appreciation) will improve(worsen) a
nation’s trade position.
Effects of Exchange-Rate Changes on Costs and
Prices （汇率变动对费用和物价的影响）
Changing exchange rates influence the
international competitiveness of a nation’s
industries through their influence on relative costs.
Case1: No foreign sourcing --- all costs are denominated
in dollars.
The dollar’s exchange value appreciates from $0.5 per
Franc to $0.25 per Franc, a 100 percent appreciation (the
franc depreciates from 2 to 4 francs per dollar).
The 100% dollar appreciation induces a 100% increase in
Nucor’s franc-denominated production cost.(See Table 5.1)
TABLE 5.1 Effects of a dollar appreciation on a U.S. steel
firm’s production costs when all costs are dollar-
denominated
Case2: Foreign sourcing ----some costs
denominated in dollars and some costs
denominated in francs.
Same appreciation of USD. But, Nucor’s franc cost per ton of
steel rises from 1,000 francs to 1,640 francs ---a large increase
of 64 percent. Thus ,the dollar appreciation worsens Nucor’s
competitiveness , but not as much as in the previous example.
And, the firms total cost falls from $500 to $410 per ton---a
decrease of 18 percent. This cost reduction offsets some of the
cost disadvantage that Nucor incurs relative to Swiss exporters
as a result of the dollar appreciation (franc depreciation).
TABLE 5.2 Effects of a dollar appreciation on a U.S. steel
firm’s production costs when some costs are
dollar-denominated and other costs are franc-
denominated
The preceding examples suggest the following generalization:
As franc-denominated costs become a larger portion of
Nucor ‘s total costs, a dollar appreciation leads to a
smaller increase in the franc cost of Nucor steel and a
larger decrease in the dollar cost of Nucor steel compared
to the cost changes that occur when all inputs are dollar-
dominated.
Changes in relative cost because of exchange-rate fluctuations
also influence relative prices and the volume of goods traded
among nations.
A dollar appreciation (depreciation) tends to raise (lower) U.S
export prices in foreign-currency terms, which induces a
decrease( an increase) in the quantity of U.S goods sold
abroad ; similarly, the dollar appreciation (depreciation) leads
to an increase(a decrease) in U.S imports.
Cost-Cutting Strategies of Manufacturers in
response to Currency Appreciation
The extent to which industries implement pricing

strategies depends significantly on the substitut-
ability of their product : the greater the degree of
product differentiation, the greater control producers
can exercise over prices, the pricing policies of such
producers are somewhat insulated from exchange-
rate movements.
Japanese Manufacturers’ Countermeasures
From 1990-96, Yen appreciated 40% to U.S. dollar.
1. Japanese firms remained competitive by using the yen’s
strength to cheaply establish integrated manufacturing bases
in the United States and in dollars-linked Asia.
(1) Using cheaper dollar-denominated parts and materials to

offset higher yen-related costs.
(2) Using the strong yen to purchase cheaper components

from around the world and ship them home for assembly.
2. Japanese exporters shifted production from commodity-type

goods to high-value products that are not sensitive to price.
11
FIGURE 5.1 Coping with the yen’s appreciation: Hitachi’s
geographic diversification as a manufacturer of
television sets
Hitachi’s global diversification permitted it to sell TVs in the United States without raising prices as
the yen appreciated against the dollar.
U.S Manufacturers’ Countermeasures
From 1996-2002, U.S. dollar appreciated by 22% to the
main partners’ currencies.
1. Sharing the benefits of having a nation’s production base
without having to take on the risks of building its own
factory there, such as American Feed Company’s deal
with Spain’s manufacturing company.
2. Redesigned its machines to make them more efficient

and less expensive to build in order to chop about 20%
off the machines’ production costs.
3. Procure machines from a nation and resold them.
Will Currency Depreciation Reduce a Trade Deficit?
The Elasticity Approach
Several aspects of currency depreciation must be

considered:
—— Elasticity Approach;
—— Absorption Approach;
—— Monetary Approach.
Elasticity of demand refers to the
responsiveness of buyers to changes in price.
Elasticity is the ratio of the percentage
Q P
Elasticity  
change in the quantity demanded to the
Q P
percentage change in price.

Q P
Elasticity  
Q P
By increasing(decreasing) relative US
production costs,a dollar
appreciation(depreciation) tends to
raise(lower) US goods sold abroad;similarly,a
dollar appreciation(depreciation) tends to
raise(lower) the amount of US imports.
Depending on the size of the demand
elasticities for Uk exports and imports,the
United Kingdom’s trade balance may improve,
worsen, or remain unchanged in response to
the pound depreciation.
The general rule that determines the actual
outcome is the so-called Marshall-Lerner
condition.
Ee + Em ≥ 1
The Marshall-Lerner condition states:
1.Depreciation will improve the trade balance if the
currency-depreciating nation’s demand elasticity
for imports plus the foreign demand elasticity for
the nation’s exports exceeds one
2.If the sum of the demand elasticities is less than

one, depreciation will worsen the trade balance
3.The trade balance will be neither helped nor hurt

if the sum of the demand elasticities equals one.
TABLE 5.3 Effect of pound depreciation on the trade
balance of the United Kingdom
TABLE 5.4 Long-term price elasticities of demand for total
imports and exports of selected countries
J-curve effect: Time Path of Depreciation
This view suggests that in the very short

term, a currency depreciation will lead to a
worsening of a nation’s trade balance.
But as time passes, the trade balance

will likely improve.
FIGURE 5.2 Depreciation flowchart
FIGURE 5.3 Time path of U.S. balance of trade (billions of dollars)
in response to dollar appreciation and depreciation
Between 1980 and 1987, the U.S. merchandise trade deficit expanded at a rapid rate. The trade deficit decreased
substantially between 1988 and 1991. The rapid increase in the trade deficit that took place during the early
1980s occurred mainly because of the appreciation of the dollar at the time, which resulted in a steady increase in
imports and a drop in U.S. exports. The depreciation of the dollar that began in 1985 led to a boom in exports in
1988 and a drop in the trade deficit through 1991.
23
Empirical evidence suggests that the trade-
balance effects of currency depreciation do
not materialize until years afterward.
Adjustment lags may be four years or more,

although the major portion of adjustment
takes place in about two years.
The Types of Lags
• Recogniation lags:――
• Decision Lags: ――
• Delivery Lags: ――
• Replacement Lags: ――
• Production Lags: ――
(refer to the materials on Page 124)

Exchange Rate Pass-Through
The J-curve analysis assumes that a given
change in the exchange rate brings about a
proportionate change in import prices.
In practice, this relation may be less than
proportionate, thus weakening the influence
of a change in the exchange rate on the
volume of trade.
The extent to which changing currency
values lead to changes in import and export
prices is known as the exchange rate pass-
through relation.
Pass-through is important because buyers have
incentives to alter their purchases of foreign goods
only to the extent that the prices of these goods
change in terms of their domestic currency following
a change in the exchange rate.
The change depends in part on the willingness

of exporters to permit the change in the exchange
rate to affect the prices they charge for their goods,
measured in terms of the buyer’s currency.
Complete pass-through
Complete pass-through exists: import prices in dollars
rise by the full proportion of the dollar depreciation.
To illustrate the calculation of complete currency pass-through, assume that
Caterpillar charges $50,000 for a tractor exported to Japan. If the exchange
rate is 150 yen per U.S. dollar, the price paid by the Japanese buyer will be
7,500,000 yen.
Assuming the dollar price of tractor remains constant, a 10% appreciation in
the dollar’s exchange value will increase the tractor’s yen price 10%, to
8,250,000 yen (165*50,000=8,250,000). Conversely, if the dollar
depreciates by 10%, the yen price of the tractor will fall by 10%, to 6,750,000
(135*50,000= 6,750,000 ） .
So long as Caterpillar keeps the dollar price if its tractor constant, changes in
the dollar’s exchange rate will be fully reflected in changes in the foreign-
currency price of exports. The ratio of changes in the foreign-currency will be
100%, implying complete currency pass-through.
Partial Exchange Rate Pass-Through
Although complete exchange rate pass-

through is a possibility, in practice the
relation tends to be partial. （ See table
5.5 ）
The table presents estimates of average

exchange rate pass-through rates for the
United States and other advanced countries
over the 1975-2003 period.
For example, the exchange rate pass-through for the United
States over this period was 0.42. This rate means that a 1%
change in the dollar’s exchange rate produced a 0.42%
change in U.S. import prices.
Because the percentage change in import prices was less

than the percentage change in the exchange rate,
exchange rate pass-through was “partial” for the United
States. Similar conclusion apply to other countries.
When exchange rate pass-through is partial at home and

abroad, the effect of changes in the exchange in the
exchange rate on trade volume is lessened as it forestalls
movement in relative trade prices.
TABLE 5.5 Exchange rate pass-through into import prices
after one year
TABLE 5.6 Use of the U.S. dollar in export and import
invoicing, 2002–2004
Why does exchange rate pass-through
tend to be partial?
The answer appears to lie in invoicing practices,
market-share considerations, and distribution
costs.
1. Invoice Practices
Businesses involved in international trade can select the

currency they want to use to express the price of their
exports. They can invoice their exports in their own home
currency or in the currency of their customers.
(see table 5.6) The dollar is the dominant currency of

invoicing across non-European countries. For example
93% of U.S. imports and 99% of U.S. exports were priced
in dollars during the first decade of the 2000s.
The dominant use of dollars invoicing U.S. trade helps explain
the partial pass-through of changes in the dollar’s exchange rate
to the U.S. import prices. When foreign producers invoice their
exports to the United States in dollars, the price of these goods
remains fixed in terms of the dollar if the dollar depreciates
against other currencies.
The exchange rate movements affect only the foreign

producers’ profits and will not increase the dollar price paid by
U.S. imports. After a time, of course, foreign producers may
choose to adjust their prices in response to the exchange rate.
2. Market Share Considerations
In practice, many goods and services are produced in imperfectly
competitive markets. In terms of prices for these goods, firms are able to
make a profit margin over costs. Firms may choose not to pass on the full
change in costs bought about by changing exchange rats and instead choose
to change their profit margins, thus reducing the sensitivity of consumer
prices to the exchange rate. Therefore, exports to the United States may
accept a lower profit margin when their currency appreciates in order to keep
their dollar prices constant against American competitors. This is especially for
the United States that has a very large market and where imports command a
lower share of consumption than do in smaller markets. Because American
consumers can generally substitute domestic goods for imports, foreign
exports are reluctant to pass all of the exchange rate movement into prices
because of fear of losing market share.
Simply put, relatively strong domestic competition for

imported goods in the United States tends to lessen the
extent of exchange rate pass-through into import prices.
For example, Kellwood Co., a major U.S. marketer of
garments such as Calvin Klein, noted that some of its
Asian suppliers, such as sewing factories and fabric
mills, inquired about increasing their prices as the
dollar depreciated against their currencies in the first
of the 2000s. But these suppliers knew that if they
increased their prices, Kellwood could purchase
inputs from other competing suppliers. To maintain
Kellwood as a customer, these suppliers cut their
profit margins and thus refrained from raising their
prices, which allowed Kellwood’s prices on Calvin
Klein garments to remain unchanged.
3. Distribution Costs
Thus far we have considered the transmission of exchange rates into the
prices of imports arriving at a country’s borders. However, other costs
occur between the time a good arrives at the border and the time it
is sold to the consumer. These are the costs of distributing the
imported good to the final consumer, which include transportation,
wholesaling and retailing costs.
For example, in 1996, a Barbie doll shipped from China to the United
States cost about $2, where it sold about $10. The manufacturer, Mattel,
earned about $1 of profit on this doll. The remaining $7 represented
payments for transportation in the United States and other marketing
and distribution costs. For the United States, distribution costs average
about 40% of overall consumer prices. Because domestic distribution
services are not traded internationally, their costs are not affected by
fluctuations in the dollar’s exchange rate.
Therefore, as distribution costs become a large
percentage of the consumer price, the sensitivity of the
consumer price to exchange-rate fluctuations is
© 2011reduced.
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
The Absorption Approach To Currency
Depreciation
According to the elasticity approach, currency
depreciation offers a price incentive to reduce imports
and increase exports. But even if elasticity conditions
are favorable, whether the home country’s trade
balance will actually improve may depend on how the
economy reacts to the depreciation.
The adsorption approach provides insights into
this question by considering the impact of
depreciation on the spending behavior of the
domestic economy and the influence of domestic
spending on the trade balance.
The Absorption Approach to Currency Depreciation
The absorption approach starts with the idea
that the value of total domestic output
（ Y ） equals the level of total spending.
Total spending consists of consumption (C),
investment （ I ） , government (G), and the
net exports （ X—M ） .
This relation can be written as follows:
Y=C+I+G+(X—M)
The absorption approach then consolidates
C+I+G into a single term A, which is
referred to as absorption, and designates net
exports （ X—M ） as B. Total domestic
output thus the sum of absorption plus net
exports: Y=A+B
This can be written as follows: B=Y—A
This expression suggests that the balance of trade
（ B ） equals the difference between total
domestic output (Y) and the level of absorption
(A). If national output exceeds domestic
absorption, the economy’s is spending beyond its
ability to produce.
The absorption approach predicts that a currency

depreciation will improve an economy’s trade balance
only if national output rises relative to absorption. This
relation means that a country must increase its total
output, reduce its absorption, or do some combination
of the two.
Assume that the economy faces unemployment
as well as a trade deficit. With the economy
operating below maximum capacity, the price
incentives of depreciation would tend to direct
idle resources into expand domestic output as
well as to improve the trade balance.
It is no wonder that policymakers tend to view

currency depreciation as an effective tool when
an economy faces unemployment with a trade
deficit.
However, in the case of an economy operating
at full employment, no unutilized resources are
available for additional production. National
output is at a fixed level. The only way in which
currency depreciation can improve the trade
balance is for the economy to somehow cut
domestic absorption, freeing resources needed
to produce additional export goods and import
substitutes.
For example, domestic policy-makers could
decrease absorption by adopting restrictive
fiscal and monetary policies in the face of
higher prices resulting from the deprecation.
But this decrease would result in sacrifice on
the part of those who bear the burden of such
measures. Currency depreciation may thus
be considered inappropriate when an
economy is operating at maximum capacity.
The absorption approach goes beyond the
elasticity approach, which views the
economy’s trade balance as distinct from the
rest of the economy. Instead, currency
depreciation is viewed in relation to the
economy’s utilization of its resources and
level of production. The two approach are
therefore complementary.
The Monetary Approach to Currency depreciation
A survey of the traditional approaches to

currency depreciation reveals a major
shortcoming. According to the elasticity and
absorption approaches, monetary
consequences are not associated with
balance-of-payments adjustment; or to the
extent that such consequences exist, they can be
neutralized by domestic monetary authorities.
The elasticity and absorption approaches
apply only to the trade account of the balance
of payments, neglecting the implications of
capital movements. The monetary approach
to depreciation addresses this shortcoming.
According to the monetary approach,

currency depreciation may induce a
temporary improvement in a nation’s
balance-of-payments position.
For example, assume that equilibrium initially
exists in the home country’s money market. A
depreciation of the home currency would increase
the price level; that is, the domestic-currency prices
of potential imports and exports. This increase
would increase the demand for money, because
larger amounts of money are needed for
transactions. If that increase demand is not
fulfilled from domestic sources, an inflow of money
from overseas occur. This inflow results in a
balance-of-payments surplus and a rise in
international reserves.
49
• But the surplus does not last forever. By adding to
the international component of the home-
country money supply, the currency depreciation
leads to an increase in spending
（ absorption ） , which reduces the surplus. The
surplus eventually disappears when equilibrium is
restored in the home country’s money market.
• The effects of depreciation on real economic

variables are thus temporary. Over the long
time, currency depreciation merely raises the
domestic price level.

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Exchange-Rate Adjustments

and the Balance of Payments

Under a fixed exchange-rate system , rates are set

We will learn under what conditions currency

The extent to which industries implement pricing

(1) Using cheaper dollar-denominated parts and materials to

(2) Using the strong yen to purchase cheaper components

2. Japanese exporters shifted production from commodity-type

2. Redesigned its machines to make them more efficient

3. Procure machines from a nation and resold them.

Several aspects of currency depreciation must be

percentage change in price.

2.If the sum of the demand elasticities is less than

3.The trade balance will be neither helped nor hurt

This view suggests that in the very short

But as time passes, the trade balance

Adjustment lags may be four years or more,

(refer to the materials on Page 124)

The change depends in part on the willingness

Although complete exchange rate pass-

The table presents estimates of average

Because the percentage change in import prices was less

When exchange rate pass-through is partial at home and

Businesses involved in international trade can select the

(see table 5.6) The dollar is the dominant currency of

The exchange rate movements affect only the foreign

Simply put, relatively strong domestic competition for

The absorption approach predicts that a currency

It is no wonder that policymakers tend to view

A survey of the traditional approaches to

According to the monetary approach,

• The effects of depreciation on real economic

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