An Introduction to International Economics

An Introduction to International Economics Chapter 13: Automatic Adjustments with Flexible and Fixed Exchange Rates Dominick Salvatore John Wiley & Sons, Inc. Dale R. DeBoer University of Colorado, Colorado Springs

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.

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. Exchange rate adjustment $/¥ D¥ ¥/day

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. Exchange rate adjustment $/¥ S¥ D¥ ¥/day

If the exchange rate is at level A, the U.S. will have a trade deficit. Exchange rate adjustment $/¥ S¥ A D¥ ¥/day

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. Exchange rate adjustment $/¥ S¥ B A D¥ ¥/day

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. Exchange rate adjustment $/¥ S¥ B A D¥ ¥/day

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). Exchange rate adjustment $/¥ S¥* S¥ C B A D¥ D¥* ¥/day

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. Exchange rate adjustment $/¥ S¥* S¥ C A D¥ D¥* ¥/day

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 (ηM). • ηM = %ΔQM ÷ %ΔPM • Similarly, the elasticity of supply depends on the price elasticity of supply for exports (ηX). • ηX = %ΔQX ÷ %ΔPX

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. Unstable foreign exchange market $/¥ S¥ D¥ ¥/day

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. Unstable foreign exchange market $/¥ A S¥ D¥ ¥/day

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). Unstable foreign exchange market $/¥ A S¥ D¥ ¥/day Y Z

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. Unstable foreign exchange market $/¥ A S¥ D¥ ¥/day Y Z

The Marshall-Lerner condition • The unstable condition just depicted will be avoided if the Marshall-Lerner condition holds. • The Marshall-Lerner condition is that ηM + ηX> 1. • Empirical evidence indicates that this condition does hold.

J-curve effect • A currency depreciation is expected to lessen a country’s 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.

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

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.

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/£.

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.

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.

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.

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.

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.

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).

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.

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.

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.

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.

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).

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: ΔS = sΔY. • The marginal propensity to save (s) is amount of additional savings that flows from each additional dollar of income.

Income determination in a closed economy • If planned investment is autonomous but savings is determined by the marginal propensity to save (s), then: ΔS = sΔY. • Since S = I at equilibrium, this entails that: ΔI = sΔY or 1 ÷ s = ΔY ÷ ΔI.

Income determination in a closed economy • Since S = I at equilibrium, this entails that: ΔI = sΔY or 1 ÷ s = ΔY ÷ ΔI. • If k = 1 ÷ s, then ΔY = k • ΔI. • k is the multiplier. • Any change in investment will induce a multiplied change in income as given by the above formula.

Income determination in a closed economy • If k = 1 ÷ s, then ΔY = k • ΔI. • An example • s = 0.25 • ΔI = 300 • What is the value of k? • k = 1 ÷ 0.25 = 4 • What is the change in income? • ΔY = 4 • 300 = 1,200

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.

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 ΔS + ΔM = ΔI + ΔX.

Income determination in an open economy • The new equilibrium equation is: S + M = I + X or ΔS + ΔM = ΔI + ΔX. • If ΔM = mΔY, then the multiplier (k*) becomes: k* = 1 ÷ (s + m) • Where m is the marginal propensity to import.

Income determination in an open economy • The new equilibrium equation is: S + M = I + X or ΔS + ΔM = ΔI + ΔX. • If ΔM = mΔY, then the multiplier (k*) becomes: k* = 1 ÷ (s + m) • Where m is the marginal propensity to import. • This leaves ΔY = k* • ΔI or ΔY = k* • ΔX.

Income determination in an open economy • This leaves ΔY = k* • ΔI or ΔY = k* • ΔX. • An example • s = 0.25 • m = 0.25 • ΔI = 400 • What is the value of k*? • k = 1 ÷ (0.25 + 0.25) = 2 • What is the change in income? • ΔY = 2 • 200 = 800

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* • ΔI.

Foreign repercussions • Suppose Nation 1 experiences an increase in its planned autonomous investment. • The increase in Nation 1’s income will increase its imports by mΔY.

Foreign repercussions • Suppose Nation 1 experiences an increase in its planned autonomous investment. • The increase in Nation 1’s income will increase its imports by mΔY. • Assuming only two countries, Nation 1’s increased imports will increase Nation 2’s exports leading to an expansion in Nation 2’s income by k2* • ΔX2.

Foreign repercussions • The increase in Nation 1’s income will increase its imports by mΔY. • Assuming only two countries, Nation 1’s increased imports will increase Nation 2’s exports leading to an expansion in Nation 2’s income by k2* • ΔX2. • The increase in Nation 2’s income will lead to an increase in its imports, spurring a secondary expansion in Nation 1.

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.

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).

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.

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.

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.

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.

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

An Introduction to International Economics