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.
The Balance-of-Payments Adjustment (I)
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, it is unitary elastic demand. Percent change in quantity demanded matches percent change in price.
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.
Price effect: the quantity of foreign exchanges received decreases because of lower foreign prices. BOP gets worse.
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.
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
Consumers need time to change their
They will be worried about reliability
and reputation of the new goods.
Producers need time to expand production of
Orders for imports are made well in advance
and are usually not readily cancelled.
Some firms will not place new orders until
they use up inventories and wear out existing
Expenditure-switching instrument is the rules and laws to alter expenditures among exports and imports.
Marginal propensity to absorb measures units of absorption increase resulting from one unit of income increase.
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.