Chapter 8

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# Chapter 8 - PowerPoint PPT Presentation

Chapter 8. The Balance-of-Payments Adjustment (I). Elasticity Approach (Relative Price Effects). Elasticity is the ratio between proportional change in one variable and proportional change in another.

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## Chapter 8

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### Chapter 8

Elasticity Approach (Relative Price Effects)
• Elasticity is the ratio between proportional change in one variable and proportional change in another.
• The elasticity of export (or import) demand is the responsiveness of the quantity demanded to a change in price.

EX = △QX /△PX

EM = △QM /△PM

The elasticity of export (or import) supply is the responsiveness of the quantity supplied to a change in price.

• If EX > 1, demand is elastic; the percent rise in quantity of exports is greater than the percent fall in price.
• If EX < 1, demand is inelastic; the percent rise in quantity of exports is smaller than the percent fall in price.

If EX = 1, it is unitary elastic demand. Percent change in quantity demanded matches percent change in price.

• The above are also true for supply. Supply is elastic if the change in quantity supplied exceeds the change in price.
• Supply is inelastic if the change in quantity supplied is less than the change in price.
Assumptions of the elasticity approach
• Assume the demand for and supply of foreign exchanges depends only on goods exports and imports.
• It implies there is no capital flows. A country’s BOP is determined by its goods exports and imports. So that:

BOP = CA = X + M

Assume the price of exports in terms of domestic price remains unchanged. For instance, the prices of China’s exports in terms of RMB do not change; the prices of China’s imports in terms of foreign currency do not change.

• Assume producers supply unlimited quantity of goods at a set price. Or supply is infinitely elastic.
• Elasticity approach aims to bring BOP imbalance into equilibrium.

Price effect: the quantity of foreign exchanges received decreases because of lower foreign prices. BOP gets worse.

• Volume effect: the quantity of exports increases and the quantity of imports decreases because of lower foreign prices and high domestic prices. BOP improves.
• For example. Before devaluation, S = ￥6/\$ (or \$0.1667/￥; after devaluation, S = ￥7/\$ (or \$0.1429).

Price of Chinese exports ￥6/unit.

Price of U.S. exports \$2.

Description Volume Price RMB value Dollar value

China exports 12,000 ￥6 ￥72,000 \$12,000

China imports 6,000 ￥12 ￥72,000 \$12,000

Current account 0 0

Scenario 1 Devaluation leads to a current account deficit

China exports 13,200 ￥6 ￥79,200 \$11,314

China imports 5,775 ￥14 ￥80,850 \$11,550

Current account - 1,650 -230

Scenario 2 Devaluation leaves the current account unaffected

China exports 13560 ￥6 ￥81,360 \$11,622

China imports 5811 ￥14 ￥81,354 \$11,622

Current account -6 0

Scenario 3 Devaluation leads to a current account surplus

China exports 13,800 ￥6 ￥82,800 \$11,828

China imports 5,400 ￥14 ￥75,600 \$10,800

Current account ￥7,200 \$1,028

Terms of trade effect. Terms of trade is the ratio of export price to import price. In the previous example, China’s terms of trade is 6/12 = 0.5 before devaluation. It means one unit of exports can buy ½ units of imports. The terms of trade deteriorates after the devaluation, because it is 6/14 = 0.43, smaller than before. One unit of exports can be exchanged for fewer units of imports.

• The key to the success of devaluation depends on the elasticities of export demand and import demand.

Marshall-Lerner condition postulates that if the sum of the elasticities of export demand and import exceeds unity, the devaluing country improves its BOP.

| EX | + | EM | > 1

• Empirical evidence shows Marshall-Lerner condition was satisfied for most countries. But a devaluation improves a country’s BOP only in the long run. In the short run, it may worsens BOP.
J-curve effect and time leg effect
• J-curve effect is that the BOP gets worse right after devaluation and gets better over the long run.
• Time lag in consumer responses

Consumers need time to change their

consuming habits.

They will be worried about reliability

and reputation of the new goods.

Time lag in producer responses

Producers need time to expand production of

exports.

and are usually not readily cancelled.

Some firms will not place new orders until

they use up inventories and wear out existing

machineries.

The pass-through effect
• Pass-through effect refers to the extent to which a depreciation of a currency leads to a rise in import prices.
• Complete pass-through means a 10% depreciation of a currency leads to a 10% rise in import prices in the devaluing country.
• Partial pass-through means a 10% depreciation of a currency leads to less than 10% rise in import prices, say 8% or 6%.

Producers want to keep market share.

• Exporters of the devaluing country seek to increase profit margin.
• Import-competing industries in domestic country cut the prices of imports-substitutes, limiting the amount of additional exports by the devaluing country.
• The partial pass-through effect can also explain the J-curve effect.
The Absorption Approach
• The absorption approach thinks that the domestic output and expenditure determine the country’s BOP. The theory examines the impact of devaluation on income and expenditure.
• National income (Y) equals aggregate expenditure (E).
• Y = E = C + I + G + (X – M)
• (C + I + G) = A represents absorption, (X – M) = CA.

CA = Y – A

• This equation says a country’s BOP is based on its national income and absorption.
• BOP deficit means absorption is greater than income; surplus means absorption is less than income.
• Absorption instrument is the economic policy to change a nation’s expenditure. The restrictive fiscal and monetary policies limit absorption; while the expansionary ones boost consumption and investment.

Expenditure-switching instrument is the rules and laws to alter expenditures among exports and imports.

• Tariffs and quotas are the common form to restrict imports and encourage exports.
• Dumping helps firms to sell at a lower price in world market.
• Export subsidy is used to encourage exports. It includes tax exemptions, lower borrowing interest rates for the exporting firms, etc.
The effects of devaluation on national income
• If the economy is already at full employment, it is impossible to raise total output.
• Employment effect means devaluation bring more opportunities for employment, and thus more income.
• Improvement of the BOP depends on the absorption. This is because absorption rises with the increase in income.

Marginal propensity to absorb measures units of absorption increase resulting from one unit of income increase.

• If this ratio is greater than one, absorption exceeds income, BOP will not improve.
• Devaluation reduces national income because of deteriorated terms of trade.
The effects of a devaluation on direct absorption
• Income redistribution effect refers to the income redistributed among different groups. Some people’s income increases while other people’s income decreases.
• It’s hard to say whether devaluation will raise or lower absorption.
• Real balance effect means devaluation reduces direct absorption.

The purchasing power of the money people hold goes down after devaluation so that people more likely to save and less likely to spend their incomes.

• In order to keep the real cash balances people tend to sell bonds or stocks. Interest rates rise; investment and consumption fall.
• Generally, the effects of devaluation on direct absorption are not so clear and mixed. So for a devaluation to be successful, it should be accompanied by other policy measures.