Ch16 Salvatore PPP

CHAPTER S I X T E E N
16 International
Economics
Tenth Edition
The Price Adjustment Mechanism

with Flexible and Fixed Exchange
Rates
Dominick Salvatore
John Wiley & Sons, Inc.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
Learning Goals:
 Understand the effect of a change in the
exchange rate on the nation’s current account
 Understand the meaning and importance of
the “stability of the foreign exchange market”
 Understand the meaning and importance of
the exchange rate “pass-through”
 Explain how the gold standard operated
Introduction
 Assumptions
 International private capital flows take place
only as passive responses to cover temporary
trade imbalances.
 The nation wants to correct a deficit in its
current account by exchange rate changes.
Adjustment with Flexible Exchange Rates
 Price adjustment mechanism relies on depreciation

and devaluation of currency to adjust current
account and balance of payments.
 Income adjustment mechanism relies on income
changes in the nation and abroad to make the
adjustments.
 Elasticity of the demand and supply curves will
determine effectiveness of adjustment
mechanisms.
FIGURE 16-1 Balance-of-Payments Adjustments with
Exchange Rate Changes.
FIGURE 16-2 Derivation of the U.S. Demand and Supply Curves
for Foreign Exchange.
Effect of Exchange Rate Changes on Domestic
Prices and the Terms of Sale
 The greater the devaluation or depreciation of

the dollar, the greater its inflationary impact, and
the less feasible is the increase of the exchange
rate for correcting balance of payments deficits.
Effect of Exchange Rate Changes on Domestic
Prices and the Terms of Sale
 Depreciation of the currency increases prices of

both exports and imports in terms of domestic
currency.
 Terms of trade can rise, fall or remain
unchanged, depending on the relative magnitude
of the price changes.
Stability of Foreign Exchange Markets
 Unstable foreign exchange market - when a

disturbance from equilibrium pushes the
exchange rate further away from equilibrium.
 Supply curve is negatively sloped and more
elastic than the demand curve of foreign
exchange.
 Flexible exchange rate system increases (rather
than reduces) a balance of payments
disequilibrium.
 Stable foreign exchange market - when a

disturbance from equilibrium gives rise to
automatic forces that push exchange rate back
to equilibrium.
 Supply curve is positively sloped, or if
negatively sloped, is less elastic than the
demand curve of foreign exchange.
FIGURE 16-3 Stable and Unstable Foreign Exchange Markets.
 Marshall-Lerner condition - Sum of the price

elasticities of demand for imports and demand for
exports is (in absolute terms) indicates degree of
foreign exchange market stability:
 Greater than 1 = stable foreign exchange market
 Devaluation required to correct BOP deficit.
 Less than 1 = unstable foreign exchange market

 Revaluation required to correct BOP deficit.
 Equal to 1 = change in exchange rate leaves balance of

payments unchanged.
Elasticities in the Real World
 Empirical evidence suggests that the Marshall-

Lerner condition holds for the foreign exchange
market, indicating a stable market.
 Quantity response to price change must be
measured over longer time periods for accurate
elasticity measures.
FIGURE 16-4 The Identification Problem.
 Junz and Rhomberg (1973) identified five possible

lags in quantity responses to price changes in
international trade:
1. Recognition lag before price change becomes evident.
2. Decision lag to take advantage of price changes.
3. Delivery lag of new orders placed
4. Replacement lag to use up available inventories
before placing new orders.
5. Production lag to change output mix resulting from
price changes.
 J-Curve Effect
 A nation’s trade balance may actually worsen
soon after devaluation or depreciation before
improving later on.
 This occurs because import prices tend to rise
faster than export prices, with quantities initially
not changing much.
 Over time, export prices catch up with import
prices so initial deterioration in trade balance is
reversed, generating a J-shaped pattern to
exchange rate movements.
FIGURE 16-5 The J-Curve.
Currency Pass-Through
 Changes in exchange rates may not be fully

reflected in the price of imported goods.
 For example, a 10% depreciation of the currency
may lead to a less than 10% increase in import
prices.
 For the United States, it is estimated that the
pass-through from dollar depreciation is about
42%.
Currency Pass-Through, continued
 Exporters may not be willing to pass on the full

price increase due to fears of losing market share
 It is costly to build new production and
distribution facilities and to enter or leave
markets.
 This beachhead effect implies that pass-through is
likely to be incomplete, particularly in the short
run.
Adjustment Under the Gold Standard
 The gold standard operated from about 1880 to

outbreak of World War I in 1914.
 Attempt to reestablish gold standard after the
war failed in 1931 during Great Depression.
 Advantages and disadvantages of gold standard
also apply to fixed exchange system (Bretton
Woods, or gold-exchange standard) operating
from World War II until its collapse in 1971.
 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 implies a fixed exchange rate, or mint
parity, of:
R = $/£ = 113.0016 / 23.22 = $4.87/£
 The cost of shipping gold from New York to

London was approximately 3 cents.
 So, the actual exchange rate would always lie
between $4.84/£ (gold import point) and $4.90/£
(gold export point).
 The tendency of the dollar to depreciate (rise

above gold export point) was countered by gold
shipments from the United States.
 Gold outflows = size of U.S. balance of payments
deficit.
 The tendency of the dollar to appreciate (fall

below gold import point) was countered by gold
shipments to the United States.
 Gold inflows = size of U.S. balance of payments
surplus.
 The price-specie-flow mechanism is the

automatic adjustment mechanism under the gold
standard.
 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.
 The price level movement is based on the

quantity theory of money:
MV = PQ
where M = money supply

V = velocity of circulation of money
P = general price index
Q = physical 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.
 These changes in trade will decrease both the trade
deficit and surplus leaving a situation of balanced
international trade.
Case Study 16-1 Currency Depreciation and
Inflation in Developing Countries during the
1997-1998 East Asian Crisis
Case Study 16-2 Estimated Price Elasticities in
International Trade
Case Study 16-3 Other Estimated Price
Elasticities in International Trade
Case Study 16-4 Effective Exchange Rate of
the Dollar and the U.S. Current Account
Balance
FIGURE 16-6 Effective Exchange Rate of the Dollar and U.S.

Current Account Balance, 1980-2005.
Case Study 16-5 Dollar Depreciation and the
U.S. Current Account Balance
Case Study 16-6 Exchange Rates and Current
Account Balances during the European
Financial Crisis of the Early 1990s
Case Study 16-7 Exchange Rate Pass-Through
to Import Prices in Industrial Countries
Appendix to Chapter 16
 Effect of Exchange Rate Change on Domestic

Prices
 Currency depreciation or devaluation decreases
the supply for home-country imports (in terms of
the domestic currency ) and increases the demand
for home-country exports (in terms of the
domestic currency.
 Thus import and export prices rise, in domestic-
currency terms.
 This price change is necessary to induce changes
in production or consumption, but reduces the
export price advantage from the depreciation.
FIGURE 16-7 Effect of a Depreciation or Devaluation on
Domestic Prices.
FIGURE 16-8 An Unstable Foreign Exchange Market Becomes
Stable for Large Exchange Rate Changes.
 Derivation of the Marshall-Lerner Condition

 The trade balance is
B = 𝑄𝑋 𝑃𝑋 − 𝑃𝑀 𝑄𝑀
 For a small devaluation, the change in the trade
balance is
dB = 𝑃𝑋 𝑑𝑄𝑋 + 𝑄𝑋 𝑑𝑃𝑋 − (𝑃𝑀 𝑑𝑄𝑀 + 𝑄𝑀 𝑑𝑃𝑀 )
 Using rules of differentiation to simplify,
rearranging, and rewriting in terms of elasticities
dB = k(𝑃𝑋 𝑑𝑄𝑋 (𝜂𝑋 −1) + 𝜂𝑀 𝑃𝑀 𝑑𝑄𝑀 )
where k = 𝑑𝑃𝑀 /𝑃𝑀
 Derivation of the Marshall-Lerner Condition

 The initial level of the trade balance is significant
for the relative importance of the elasticities.
 If the elasticity of foreign supply of domestic
imports and domestic supply of exports are not
infinite, then the Marshall-Lerner condition
becomes
𝑒𝑀 𝑒𝑋 (𝜂𝑀 + 𝜂𝑋 − 1) + 𝜂𝑀 𝜂𝑋 (𝑒𝑀 + 𝑒𝑋 + 1)
(𝑒𝑋 + 𝜂𝑋 )(𝑒𝑀 + 𝜂𝑀 )
Appendix: Derivation of Gold Points
FIGURE 16-8 Gold Points and Gold Flows.
 Copyright 2013 John Wiley & Sons, Inc.
 All rights reserved. Reproduction or translation of this work beyond

that permitted in section 117 of the 1976 United States Copyright Act
without express permission of the copyright owner is unlawful.
Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser may
make back-up copies for his/her own use only and not for distribution
or resale. The Publisher assumes no responsibility for errors, omissions,
or damages caused by the use of these programs or from the use of the
information herein.

Ch16 Salvatore PPP

Uploaded by

Copyright:

Available Formats

Ch16 Salvatore PPP

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Ch16 Salvatore PPP

Uploaded by

Copyright:

Available Formats

How do flexible exchange rates help adjust a nation's current account?

How do flexible exchange rates help adjust a nation's current account?

What factors determine the effectiveness of adjustment mechanisms with flexible exchange rates?

What factors determine the effectiveness of adjustment mechanisms with flexible exchange rates?

CHAPTER S I X T E E N

The Price Adjustment Mechanism

 Price adjustment mechanism relies on depreciation

 The greater the devaluation or depreciation of

 Depreciation of the currency increases prices of

 Unstable foreign exchange market - when a

 Stable foreign exchange market - when a

 Marshall-Lerner condition - Sum of the price

 Less than 1 = unstable foreign exchange market

 Equal to 1 = change in exchange rate leaves balance of

 Empirical evidence suggests that the Marshall-

 Junz and Rhomberg (1973) identified five possible

 Changes in exchange rates may not be fully

 Exporters may not be willing to pass on the full

 The gold standard operated from about 1880 to

 Under the gold standard, each nation

R = $/£ = 113.0016 / 23.22 = $4.87/£

 The cost of shipping gold from New York to

 The tendency of the dollar to depreciate (rise

 The tendency of the dollar to appreciate (fall

 The price-specie-flow mechanism is the

 The price level movement is based on the

where M = money supply

 As the price level falls in the country with a trade

FIGURE 16-6 Effective Exchange Rate of the Dollar and U.S.

 Effect of Exchange Rate Change on Domestic

 Derivation of the Marshall-Lerner Condition

 Derivation of the Marshall-Lerner Condition

FIGURE 16-8 Gold Points and Gold Flows.

 All rights reserved. Reproduction or translation of this work beyond

You might also like