International Economics Exchange Rate Changes and Current Account Reactions
Elasticities Approach • Switch focus to effects of exchange rate on flows of goods & services (Current Account). • Monetary approach focused on capital account primarily. • Examine conditions under which EXR changes from Current Account imbalances are self-correcting. • Example:Current Account Deficit may lead to: • Fall in value of domestic currency (depreciation). • Domestic goods cheaper to Row, Domestic Exports rise. • Foreign goods more expensive, Domestic imports fall. • Current Account balance improves. • Expenditure Switching effects of EXR depreciation. • Emphasis is on EXR elasticity of exports and imports. • Not true that Current Account Balance necessarily improves.
EXR Effects on Current Account • Current Account Balance CAB(e) = NX(e) = X(e) – eM(e) • Assuming that X’>0 and M’<0. Want to know what sign of NX’ is. • Rise in e (depreciation) raises X() and lowers M() but effect on eM() is uncertain, and so effect on NX is uncertain. • Extreme Case I:EXR depreciation does not affect X or M. • Rise in e then increases eM without changing X. • CAB deficit is actually larger than before depreciation. • Extreme Case II:EXR depreciation has large effect X & M. • Rise in e raises X greatly, lowers M enough, so eM falls. • CAB deficit much smaller than before depreciation.
Marshall-Lerner Conditions • Intuition: • If Import demand is elastic ( |M | 1) then rise in price (e) results in fallin total expenditure (eM), and CAB will improve regardless of what happens to X. • Current Account Balance CAB(e) = NX(e) = X(e) – eM(e) • Condition required for depreciation to improve Current Account balance is that dCAB/de > 0. • Take derivative of CAB wrt e. Rearrange to yield: Marshall-Lerner condition[X/M] | X | + |M | > 1 • Where X and M are the elasticity of demand of exports and imports with respect to the exchange rate respectively. • Have assumed supply curves for both exports and imports are horizontal.
Marshall-Lerner & the FX Market • Marshall-Lerner conditions determine the “look” & stability of the FX market as well as CAB reactions. • Supply of FX to the FX market depends on: • $ amount of US goods foreigners wish to purchase. • The level of e, which determines how much FX must be exchanged to get the required amount of $’s. • Assume that demand for US goods is linear in the exchange rate measured appropriately. • Elasticity of demand for US goods varies over the curve. • Elasticity of demand, however, determines how the amount of FX needed varies with the exchange rate. • Illustrate consequences for supply of FX on next slide.
U.K. Supply of Pounds to FX Market e ($/£) S£ || > 1 Elastic || < 1 Inelastic D$ £ Elasticities of FX Demand & Supply U.K. Demand for US Goods & Services e (£/$) $
ES ES so P down S ED so P up S ED 1. Standard Market equilibrium is stable. ED - Excess Demand leads to Price rise. - Excess Supply leads to Price drop. S 2. Even unusual market here is stable 3. This market is not stable ES - ED forces P up which worsens ED. - ES brings P down, makes ES worse. Market Stability P Stable Equilibrium P Stable Equilibrium P0 P0 D D Q Q Market Stability P Unstable Equilibrium P0 D Q
Current Account Adjustments • Goods markets tend to adjust slowly to changes. • SR & LR responses of CAB to EXR moves may differ. • Short Run: Demand for Exports and Imports may not respond to changes in e due to decision-making lags or contracts. • Long Run:Both demands should adjust to new exchange rate level. • Simple Model of Lagged CAB Adjustment Xt = .25X(et-1)+.25X(et-2)+.25X(et-3)+.25X(et-4) et Mt = et[.25M(et-1)+.25M(et-2)+.25M(et-3)+.25M(et-4)] • Immediate effect of EXR depreciation is to lower CAB (increase CAB deficit) as X and M fixed by past exchange rates. • Over time CAB will rise as larger % of both X and M reflect the exchange rate depreciation. This result is known as the J-Curve.
Exchange Rate Path e0 EXR Depreciation CAB Path CAB0 J-Curve for EXR Depreciation e Time CAB (+) Time (-)