Exchange-Rate Adjustments and the Balance of Payments

Transcription

1 Exchange-Rate Adjustments and the Balance of Payments CHAPTER 14 The previous chapter demonstrated that disequilibrium in the balance of trade tends to be reversed by automatic adjustments in prices, interest rates, and incomes. However, if these adjustments are allowed to operate, reversing trade imbalances may come at the expense of domestic recession or price inflation. The cure may be perceived as worse than the disease. Instead of relying on adjustments in prices, interest rates, and incomes to counteract trade imbalances, governments permit alterations in exchange rates. By adopting a floating exchange-rate system, a nation permits its currency to depreciate or appreciate in a free market in response to shifts in either the demand for or supply of the currency. Under a fixed exchange-rate system, rates are set by the government in the short term. However, if the official exchange rate becomes overvalued over a period of time, a government may initiate policies to devalue its currency. Currency devaluation causes a depreciation of a currency s exchange value; it is initiated by government policy rather than by the free-market forces of supply and demand. When a nation s currency is undervalued, it may be revalued by the government; this policy causes the currency s exchange value to appreciate. Currency devaluation and revaluation will be discussed further in the next chapter. In this chapter, we examine the impact of exchange-rate adjustments on the balance of trade. We will learn under what conditions currency depreciation (appreciation) will improve (worsen) a nation s trade position. Effects of Exchange-Rate Changes on Costs and Prices Industries that compete with foreign producers, or that rely on imported inputs in production, can be noticeably affected by exchange-rate fluctuations. Changing exchange rates influence the international competitiveness of a nation s industries through their influence on relative costs. How do exchange-rate fluctuations affect 441

2 442 Exchange-Rate Adjustments and the Balance of Payments relative costs? The answer depends on the extent to which a firm s costs are denominated in terms of the home currency or foreign currency. Case 1 No foreign sourcing all costs are denominated in dollars. Table 14.1 illustrates the hypothetical production costs of Nucor, a U.S. steel manufacturer. Assume that in its production of steel, Nucor utilizes U.S. labor, coal, iron, and other inputs whose costs are denominated in dollars. In period 1, the exchange value of the dollar is assumed to be 50 cents per Swiss franc (2 francs per dollar). Assume that the firm s cost of producing a ton of steel is $500, which is equivalent to 1,000 francs at this exchange rate. Suppose that in period 2, because of changing market conditions, the dollar s exchange value appreciates from 50 cents per franc to 25 cents per franc, a 100 percent appreciation (the franc depreciates from 2 to 4 francs per dollar). With the dollar appreciation, Nucor s labor, iron, coal, and other input costs remain constant in dollar terms. However, in terms of the franc, these costs rise from 1,000 francs to 2,000 francs per ton, a 100 percent increase. The 100 percent dollar appreciation induces a 100 percent increase in Nucor s franc-denominated production cost. The international competitiveness of Nucor is thus reduced. This example assumes that all of a firm s inputs are acquired domestically and that their costs are denominated in the domestic currency. But, in many industries, some of a firm s inputs are purchased in foreign markets (foreign sourcing), and these input costs are denominated in a foreign currency. What impact does a change in the home-currency s exchange value have on a firm s costs in this situation? Case 2 Foreign sourcing some costs denominated in dollars and some costs denominated in francs. Table 14.2 again illustrates the hypothetical production costs of Nucor, whose costs of labor, iron, coal, and certain other inputs are assumed to be denominated in dollars. However, suppose Nucor acquires scrap iron from Swiss suppliers (foreign sourcing), and these costs are denominated in francs. Once again, assume the dollar s TABLE 14.1 EFFECTS OF A DOLLAR APPRECIATION ON A U.S. STEEL FIRM S PRODUCTION COSTS WHEN ALL COSTS ARE DOLLAR-DENOMINATED COST OF PRODUCING A TON OF STEEL PERIOD 1 $0.50 PER FRANC (2 FRANCS 5 $1) Dollar Cost Franc Equivalent PERIOD 2 $0.25 PER FRANC (4 FRANCS 5 $1) Dollar Cost Franc Equivalent Labor Materials (iron/coal) $ francs $ francs ,200 Other costs (energy) Total $500 1,000 francs $500 2,000 francs Percentage change 100%

3 Chapter TABLE 14.2 EFFECTS OF A DOLLAR APPRECIATION ON A U.S. STEEL FIRM S PRODUCTION COSTS WHEN SOME COSTS ARE DOLLAR-DENOMINATED AND OTHER COSTS ARE FRANC-DENOMINATED COST OF PRODUCING A TON OF STEEL PERIOD 1 $.50 PER FRANC (2 FRANCS 5 $1) Dollar Cost Franc Equivalent PERIOD 2 $.25 PER FRANC (4 FRANCS 5 $1) Dollar Cost Franc Equivalent Labor $ francs $ francs Materials $ denominated (iron/coal) $ francs $ francs Franc denominated (scrap iron) $ francs $ francs Total $ francs $ francs Other costs (energy) $ francs $ francs Total cost $500 1,000 francs $410 1,640 francs Percentage change 18% 64% exchange value appreciates from 50 cents per franc to 25 cents per franc. As before, the cost in francs of Nucor s labor, iron, coal, and certain other inputs rise by 100 percent following the dollar appreciation; however, the franc cost of scrap iron remains constant. As can be seen in the table, Nucor s franc cost per ton of steel rises from 1,000 francs to 1,640 francs a large increase of 64 percent. Thus, the dollar appreciation worsens Nucor s international competitiveness, but not as much as in the previous example. In addition to influencing Nucor s franc-denominated cost of steel, a dollar appreciation affects a firm s dollar cost when franc-denominated inputs are involved. Because scrap-iron costs are denominated in francs, they remain at 360 francs after the dollar appreciation; however, the dollar-equivalent scrap-iron cost falls from $180 to $90. Because the costs of Nucor s other inputs are denominated in dollars and do not change following the dollar appreciation, the firm s total dollar cost falls from $500 to $410 per ton a decrease of 18 percent. This cost reduction offsets some of the cost disadvantage that Nucor incurs relative to Swiss exporters as a result of the dollar appreciation (franc depreciation). The preceding examples suggest the following generalization: As franc-denominated costs become a larger portion of Nucor s total costs, a dollar appreciation (depreciation) leads to a smaller increase (decrease) in the franc cost of Nucor steel and a larger decrease (increase) in the dollar cost of Nucor steel compared to the cost changes that occur when all input costs are dollar-denominated. As franc-denominated costs become a smaller portion of total costs, the opposite conclusions apply. These conclusions have been especially significant for the world trading system during the 1980s to 2000s as industries e.g., autos and computers have become increasingly internationalized and utilize increasing amounts of imported inputs in the production process. Changes in relative costs because of exchange-rate fluctuations also influence relative prices and the volume of goods traded among nations. By increasing relative

4 444 Exchange-Rate Adjustments and the Balance of Payments TRADE CONFLICTS JAPANESE FIRMS OUTSOURCE PRODUCTION TO LIMIT EFFECTS OF STRONG YEN Facing a strong yen in recent years, Japanese exporters have realized that a more costly yen results in smaller profits if they convert their dollar profits back into yen. How can they protect their profits? By moving production to the United States and thus lessening the amount of money they convert from dollars to yen. During the 1990s, executives at Toyota, Toshiba, and other Japanese firms were apprehensive about an appreciating yen that made their exports more expensive. By 2003, however, the harm caused by an appreciating yen was not nearly as great for these firms due to their increasing efforts to locate production in the United States and other offshore markets. Although the yen s appreciation hindered Japan s companies, it did not stop them in their tracks. For example, Toshiba exported about $6 billion more in goods than it imported in This level meant that the firm s sales could theoretically decline by 6 billion yen ($54 million) each time the yen appreciated against the dollar by one yen. Since then, Japan s largest semiconductor producer has succeeded in slashing its net dollar exposure by locating manufacturing abroad and increasing dollar-based imports of parts. In 1996, Toshiba started up a plant in Indonesia to manufacture color-tv sets; it also opened a factory in the Philippines to produce hard-disk and optical-disk drives. Other factories in Asia followed, including a personal-computer plant in China. By 2003, Toshiba produced more than 30 percent of its goods abroad, compared with 17 percent in 1995; and it exported only $1 billion of goods more than it imported. Moving production to the United States and other countries helps Japan s electronics and auto firms to escape much of the dollar/yen problem and sell their products to foreigners. However, it contributes to the excess capacity of manufacturing plants in Japan and results in job losses for Japanese workers. Simply put, a continually strong yen can promote a hollowing out of Japan s economy, as some have feared. Sources: Japanese Firms Practice Yen Damage Control, The Wall Street Journal, September 26, 2003, p. A7 and The Strong Yen and Toyota s Choice, The Wall Street Journal, December 20, 1994, p. A11. U.S. production costs, a dollar appreciation tends to raise U.S. export prices in foreigncurrency terms, which induces a decrease in the quantity of U.S. goods sold abroad; similarly, the dollar appreciation leads to an increase in U.S. imports. By decreasing relative U.S. production costs, a dollar depreciation tends to lower U.S. export prices in foreign-currency terms, which induces an increase in the quantity of U.S. goods sold abroad; similarly, the dollar depreciation leads to a decrease in U.S. imports. Several factors govern the extent by which exchange-rate movements lead to relative price changes among nations. Some U.S. exporters may be able to offset the price-increasing effects of an appreciation in the dollar s exchange value by reducing profit margins to maintain competitiveness. Perceptions concerning long-term trends in exchange rates also promote price rigidity: U.S. exporters may be less willing to raise prices if the dollar s appreciation is viewed as temporary. The extent to which industries implement pricing strategies depends significantly on the substitutability of their product: the greater the degree of product differentiation (as in quality or service), the greater control producers can exercise over prices; the pricing policies of such producers are somewhat insulated from exchange-rate movements. Is there any way in which companies can offset the impact of currency swings on their competitiveness? Suppose the exchange value of the Japanese yen appreciates against other currencies, which causes Japanese goods to become less competitive in

5 Chapter world markets. To insulate themselves from the squeeze on profits caused by the rising yen, Japanese companies could move production to affiliates located in countries whose currencies have depreciated against the yen. This strategy would be most likely to occur if the yen s appreciation is sizable and is regarded as being permanent. Even if the yen s appreciation is not permanent, shifting production offshore can help reduce the uncertainties associated with currency swings. Indeed, Japanese companies have resorted to offshore production to protect themselves from an appreciating yen. Cost-Cutting Strategies of Manufacturers in Response to Currency Appreciation For years, manufacturers have watched with dismay as the home currency surges to new heights, making it harder for them to wring profits out of exports. This situation tests their ingenuity to become more efficient in order to remain competitive on world markets. Let us consider how Japanese and American manufacturers responded to appreciations of their home currencies. Appreciation of the Yen: Japanese Manufacturers From 1990 to 1996, the value of the Japanese yen relative to the U.S. dollar increased by almost 40 percent. In other words, if the yen and dollar prices in the two nations had remained unchanged, Japanese products in 1996 would have been roughly 40 percent more expensive, compared with U.S. products, than they were in How then did Japanese manufacturers respond to a development that could have had disastrous consequences for their competitiveness in world markets? Japanese firms remained competitive by using the yen s strength to cheaply establish integrated manufacturing bases in the United States and in dollar-linked Asia. This strategy allowed Japanese firms to play both sides of the fluctuations in the yen/dollar exchange rate: using cheaper dollar-denominated parts and materials to offset higher yen-related costs. While they maintained their U.S. markets, many Japanese companies also used the strong yen to purchase cheaper components from around the world and ship them home for assembly. That action provided a competitive edge in Japan for these firms. Consider the Japanese electronics manufacturer Hitachi whose TV sets were a global production effort in the mid-1990s, as shown in Figure The small tubes that projected information onto Hitachi TV screens came from a subsidiary in South Carolina, while the TV chassis and circuitry were manufactured by an affiliate in Malaysia. From Japan came only computer chips and lenses, which amounted to 30 percent of the value of the parts used. By sourcing TV production in countries whose currencies had fallen against the yen, Hitachi was able to hold down the dollar price of its TV sets in spite of the rising yen. To limit their vulnerability to a rising yen, Japanese exporters also shifted production from commodity-type goods to high-value products. The demand for commodities for example, metals and textiles is quite sensitive to price changes because these goods are largely indistinguishable, except by price. Customers, therefore, could easily switch to non-japanese suppliers if an increase in the yen shoved

6 446 Exchange-Rate Adjustments and the Balance of Payments FIGURE 14.1 COPING WITH THE YEN S APPRECIATION: HITACHI S GEOGRAPHIC DIVERSIFICATION AS A MANUFACTURER OF TELEVISION SETS From Japan, Hitachi procured semiconductors and lenses. Thus, only 30 percent of the value of the parts used was yen denominated. The small tubes that project information onto the screen came from Hitachi Electric Devices U.S.A. in South Carolina. Denominated in dollars. The chassis, including circuit board, came from another Hitachi subsidiary, Consumer Products Malaysia, in Selangor, Malaysia. Denominated in dollars. Hitachi Consumer Product de Mexico assembled the TVs in Tijuana. Peso-denominated costs such as labor decreased in yen terms as the dollar depreciated against the yen and the peso depreciated against the dollar. Hitachi s global diversification permitted it to sell TVs in the United States without raising prices as the yen appreciated against the dollar. the dollar price of Japanese exports higher. In contrast, more sophisticated, high-value products for example, transportation equipment and electrical machinery are less sensitive to price increases. For these goods, factors such as embedded advanced technology and high-quality standards work to neutralize the effect on demand if prices are driven up by an appreciating yen. Shifting production from commoditytype products to high-value products from 1990 to 1996 enhanced the competitiveness of Japanese firms. Then, there s the Japanese auto industry. To offset the rising yen, Japanese automakers cut the yen prices of their autos and thus realized falling unit-profit margins. They also reduced manufacturing costs by increasing worker productivity, importing materials and parts whose prices were denominated in currencies that had depreciated against the yen, and outsourcing larger amounts of a vehicle s production to transplant factories in countries whose currencies had depreciated against the yen. In 1994, Toyota Motor Corporation announced that its competitiveness had been eroded by as much as 20 percent as a result of the yen s recent appreciation. Toyota therefore convinced its subcontractors to cut part prices by 15 percent over three years. By using common parts in various vehicles and shortening the time needed to design, test, and commercialize automobiles, Toyota was also able to cut costs. Moreover, Toyota pressured Japanese steelmakers to produce less costly galvanized sheet steel for use in its vehicles. Also, Toyota reintroduced less expensive models with fewer options in an effort to reduce costs and prices and thus recapture sales in the midsize-family-car segment of the market. Foreign-made parts, once rejected by Japanese automakers as inferior to domestically produced parts, became much less alien to them in the 1990s. Foreign parts

7 Chapter steadily made their way into Japanese autos, helped by both the strong yen and Japanese automakers urgency to slash costs. Moreover, Japanese auto-parts makers set up manufacturing operations in Southeast Asia and South America to cut costs; these parts were then exported to Japan for assembly into autos. Appreciation of the Dollar: U.S. Manufacturers From 1996 to 2002, U.S. manufacturers were alarmed as the dollar appreciated by 22 percent on average against the currencies of major U.S. trading partners. This appreciation resulted in U.S. manufacturers seeking ways to tap overseas markets and defend their home turf. Take American Feed Co., a Napoleon, Ohio company that makes machinery used in auto plants. In 2001, the firm reached a deal with a similar manufacturing company in Spain. Both companies produce machines that car factories use to unroll giant coils of steel and feed them through presses to make parts. According to the pact, when orders come in, management of the two companies meet to decide which plant should make which parts, in essence divvying up the work to keep both factories operating. As a result, American Feed can share in the benefits of having a European production base without having to take on the risks of building its own factory there. Also, the company redesigned its machines to make them more efficient and less expensive to build. These efforts chopped about 20 percent off the machines production costs. Then, there s Sipco Molding Technologies, a Meadville, Pennsylvania tool-and-die maker that also had to cut costs to survive the dollar s appreciation. For years, Sipco had a partnership with an Austrian company, which designed a special line of tools that Sipco once built in the United States. However, because of the strong dollar, the Austrian company assumed the responsibility of designing and making the tools, while Sipco simply resold them. Although these efforts helped the firm cut costs, it resulted in a loss of jobs for 30 percent of its employees. Will Currency Depreciation Reduce a Trade Deficit? The Elasticity Approach We have seen that currency depreciation tends to improve a nation s competitiveness by reducing its costs and prices, while currency appreciation implies the opposite. Under what circumstances will currency depreciation reduce a trade deficit? Several aspects of currency depreciation must be considered, and each of them will be dealt with in a separate section. The elasticity approach emphasizes the relative price effects of depreciation and suggests that depreciation works best when demand elasticities are high. The absorption approach deals with the income effects of depreciation; the implication is that a decrease in domestic expenditure relative to income must occur for depreciation to promote trade equilibrium. The monetary approach stresses the effects depreciation has on the purchasing power of money and the resulting impact on domestic expenditure levels. Let us begin by considering the elasticity approach. Currency depreciation affects a country s balance of trade through changes in the relative prices of goods and services internationally. A trade-deficit nation may be able to reverse its imbalance by lowering its relative prices, so that exports

8 448 Exchange-Rate Adjustments and the Balance of Payments increase and imports decrease. The nation can lower its relative prices by permitting its exchange rate to depreciate in a free market or by formally devaluing its currency under a system of fixed exchange rates. The ultimate outcome of currency depreciation depends on the price elasticity of demand for a nation s imports and the price elasticity of demand for its exports. Recall that elasticity of demand refers to the responsiveness of buyers to changes in price. It indicates the percentage change in the quantity demanded stemming from a one percent change in price. Mathematically, elasticity is the ratio of the percentage change in the quantity demanded to the percentage change in price. This ratio can be symbolized as follows: Elasticity The elasticity coefficient is stated numerically, without regard to the algebraic sign. If the preceding ratio exceeds one, a given percentage change in price results in a larger percentage change in quantity demanded; this is referred to as relatively elastic demand. If the ratio is less than one, demand is said to be relatively inelastic, because the percentage change in quantity demanded is less than the percentage change in price. A ratio precisely equal to one denotes unitary elastic demand, meaning that the percentage change in quantity demanded just matches the percentage change in price. Next, we investigate the effects of a currency depreciation on a nation s balance of trade that is, the value of its exports minus imports. Suppose the UK pound depreciates by ten percent against the dollar. Whether the UK trade balance will be improved depends on what happens to the dollar inpayments for the United Kingdom s exports as opposed to the dollar outpayments for its imports. This balance, in turn, depends on whether the U.S. demand for UK exports is elastic or inelastic and whether the UK demand for imports is elastic or inelastic. Depending on the size of the demand elasticities for UK exports and imports, the United Kingdom s trade balance may improve, worsen, or remain unchanged in response to the pound depreciation. The general rule that determines the actual outcome is the so-called Marshall-Lerner condition. The Marshall-Lerner condition states: (1) Depreciation will improve the trade balance if the currency-depreciating nation s demand elasticity for imports plus the foreign demand elasticity for the nation s exports exceeds one. (2) If the sum of the demand elasticities is less than one, depreciation will worsen the trade balance. (3) The trade balance will be neither helped nor hurt if the sum of the demand elasticities equals one. The Marshall- Lerner condition may be stated in terms of the currency of either the nation undergoing a depreciation or its trading partner. Our discussion is confined to the currency of the currency-depreciating country, the United Kingdom. Case 1 Improved trade balance. Table 14.3 illustrates the effect of a depreciation of the pound on the UK trade balance. Referring to Table 14.3(a), assume that the UK demand elasticity for imports equals 2.5 and the U.S. demand elasticity for UK exports equals 1.5; the sum of the elasticities is 4.0. Suppose the pound depreciates by ten percent against the dollar. An assessment of the overall impact of the depreciation on the United Kingdom s payments position requires identification of the depreciation s impact on import expenditures and export receipts. ΔQ Q ΔP P

9 Chapter TABLE 14.3 EFFECT OF POUND DEPRECIATION ON THE TRADE BALANCE OF THE UNITED KINGDOM (A) IMPROVED TRADE BALANCE Sector Change in Pound Price (%) Change in Quantity Demanded (%) Net Effect (in pounds) Import % outpayments Export % inpayments Assumptions: UK demand elasticity for imports 2.5 Demand elasticity for UK exports 1.5 Sum 4.0 Pound depreciation 10% (B) WORSENED TRADE-BALANCE Change in Quantity Demanded (%) Sector Change in Pound Price (%) Net Effect (in pounds) Import % outpayments Export 0 1 1% inpayments Assumptions: UK demand elasticity for imports 0.2 U.S. demand elasticity for UK exports 0.1 Sum 0.3 Pound depreciation 10% If prices of imports remain constant in terms of foreign currency, then a depreciation increases the home-currency price of goods imported. Because of the depreciation, the pound price of UK imports rises ten percent. British consumers would thus be expected to reduce their purchases from abroad. Given an import demand elasticity of 2.5, the depreciation triggers a 25 percent decline in the quantity of imports demanded. The ten percent price increase in conjunction with a 25 percent quantity reduction results in approximately a 15 percent decrease in UK outpayments in pounds. This cutback in import purchases actually reduces import expenditures, which reduces the UK deficit. How about UK export receipts? The pound price of the exports remains constant, but after depreciation of the pound, consumers in the United States find UK exports costing ten percent less in terms of dollars. Given a U.S. demand elasticity of 1.5 for UK exports, the ten percent UK depreciation will stimulate foreign sales by 15 percent, so that export receipts in pounds will increase by approximately 15 percent. This increase strengthens the UK payments position. The 15 percent reduction in import expenditures coupled with a 15 percent rise in export receipts means that the pound depreciation will reduce the UK payments deficit. With the sum of the elasticities exceeding one, the depreciation strengthens the United Kingdom s trade position. Case 2 Worsened trade balance. In Table 14.3(b), the UK demand elasticity for imports is 0.2 and the U.S. demand elasticity for UK exports is 0.1; the sum of the elasticities is 0.3. The ten percent

10 450 Exchange-Rate Adjustments and the Balance of Payments pound depreciation raises the pound price of imports by ten percent, inducing a two percent reduction in the quantity of imports demanded. In contrast to the previous case, under relatively inelastic conditions the depreciation contributes to an increase, rather than a decrease, in import expenditures of some eight percent. As before, the pound price of UK exports is unaffected by the depreciation, whereas the dollar price of exports falls ten percent. American purchases from abroad increase by one percent, resulting in an increase in pound receipts of about one percent. With expenditures on imports rising eight percent while export receipts increase only one percent, the UK deficit will tend to worsen. As stated in the Marshall-Lerner condition, if the sum of the elasticities is less than one, currency depreciation will cause a deterioration in a nation s trade position. The reader is left to verify that a nation s trade balance remains unaffected by depreciation if the sum of the demand elasticities equals one. Although the Marshall-Lerner condition provides a general rule as to when a currency depreciation will be successful in restoring payments equilibrium, it depends on some simplifying assumptions. For one, it is assumed that a nation s trade balance is in equilibrium when the depreciation occurs. If there is initially a very large trade deficit, with imports exceeding exports, then a depreciation might cause import expenditures to change more than export receipts, even though the sum of the demand elasticities exceeds one. The analysis also assumes no change in the sellers prices in their own currency. But this may not always be true. To protect their competitive position, foreign sellers may lower their prices in response to a depreciation of the home country s currency; domestic sellers may raise home-currency prices so that the depreciation s effects are not fully transmitted into lower foreign-exchange prices for their goods. However, neither of these assumptions invalidates the Marshall-Lerner condition s spirit, which suggests that currency depreciations work best when demand elasticities are high. Simply put, the Marshall-Lerner condition illustrates the price effects of currency depreciation on the home-country s trade balance. The extent to which price changes affect the volume of goods traded depends on the elasticity of demand for imports and exports. If the elasticities were known in advance, it would be possible to determine the proper exchange-rate policy to restore payments equilibrium. Table 14.4 shows estimated price elasticities of demand for total imports and exports by country. TABLE 14.4 LONG-TERM PRICE ELASTICITIES OF DEMAND FOR TOTAL IMPORTS AND EXPORTS OF SELECTED COUNTRIES Country Import Price Elasticity Export Price Elasticity Sum of Import and Export Elasticities Canada France Germany Italy Japan United Kingdom United States Source: From Peter Hooper, Karen Johnson, and Jaime Marquez, Trade Elasticities for the G-7 Countries, Princeton Studies in International Economics, No. 87, August 2000, p. 9.

11 Chapter J-Curve Effect: Time Path of Depreciation FIGURE 14.2 DEPRECIATION FLOWCHART Empirical estimates of price elasticities in international trade suggest that, according to the Marshall-Lerner condition, currency depreciation will often improve a nation s trade balance. However, a problem in measuring world price elasticities is that there tends to be a time lag between changes in exchange rates and their ultimate effect on real trade. One popular description of the time path of trade flows is the so-called J-curve effect. This view suggests that in the very short term, a currency depreciation will lead to a worsening of a nation s trade balance. But as time passes, the trade balance will likely improve. This is because it takes time for new information about the price effects of depreciation to be disseminated throughout the economy and for economic units to adjust their behavior accordingly. A currency depreciation affects a nation s trade balance through its net impact on export receipts and import expenditures. Export receipts and import expenditures are calculated by multiplying the commodity s per-unit price times the quantity being demanded. Figure 14.2 illustrates the process by which depreciation influences export receipts and import expenditures. The immediate effect of depreciation is a change in relative prices. If a nation s currency depreciates ten percent, it means that import prices initially increase ten percent in terms of the home currency. The quantity of imports demanded will then fall according to home demand elasticities. At the same time, exporters will initially receive ten percent more in home currency for each unit of foreign currency they earn. This means they can become more competitive and lower their export prices measured in terms of foreign currencies. Export sales will then rise in accordance with foreign demand elasticities. The problem with this process is that for depreciation to take effect, time is required for the pricing mechanism to induce changes in the volume of exports and imports. The time path of the response of trade flows to a currency s depreciation can be described in terms of the J-curve effect, so called because the trade balance continues to get worse for awhile after depreciation (sliding down the hook of the J) and then gets better (moving up the stem of the J). This effect occurs because the initial effect of depreciation is an increase in import expenditures: the home-currency price of imports has risen, but the volume is unchanged owing to prior commitments. As time passes, the quantity adjustment effect becomes relevant: import volume is depressed, Import Prices whereas exports become more attractive to foreign buyers. Advocates of the J-curve effect cite the experience of the U.S. balance of trade during the 1980s and 1990s. Imports Demanded As seen in Figure 14.3, between 1980 and 1987 the U.S. trade deficit expanded at a very rapid rate. The deficit decreased substantially between 1988 and The Import Expenditures rapid increase in the trade deficit that took place during the early 1980s occurred mainly because of the appreciation of the dollar at the time, which resulted in a Currency Depreciation Export Prices Exports Demanded Export Receipts Demand Elasticities

12 452 Exchange-Rate Adjustments and the Balance of Payments FIGURE 14.3 TIME PATH OF U.S. BALANCE OF TRADE (IN BILLIONS OF DOLLARS) IN RESPONSE TO DOLLAR APPRECIATION AND DEPRECIATION U.S. Balance of Trade (Billions of Dollars) +600 Exchange Rate (Right Scale) Trade-Weighted Value of the U.S. Dollar (1973 = 100) Appreciation Index Trade Deficit 0 Depreciation Year 40 Between 1980 and 1987, the U.S. merchandise trade deficit expanded at a rapid rate. The trade deficit decreased substantially between 1988 and The rapid increase in the trade deficit that took place during the early 1980s occurred mainly because of the appreciation of the dollar at the time, which resulted in a steady increase in imports and a drop in U.S. exports. The depreciation of the dollar that began in 1985 led to a boom in exports in 1988 and a drop in the trade deficit through steady increase in imports and a drop in U.S. exports. The depreciation of the dollar that began in 1985 led to a boom in exports in 1988 and a drop in the trade deficit through What factors might explain the time lags in a currency depreciation s adjustment process? The types of lags that may occur between changes in relative prices and the quantities of goods traded include the following: Recognition lags of changing competitive conditions Decision lags in forming new business connections and placing new orders Delivery lags between the time new orders are placed and their impact on trade and payment flows is felt Replacement lags in using up inventories and wearing out existing machinery before placing new orders Production lags involved in increasing the output of commodities for which demand has increased

13 Chapter Empirical evidence suggests that the trade-balance effects of currency depreciation do not materialize until years afterward. Adjustment lags may be four years or more, although the major portion of adjustment takes place in about two years. 1 Exchange Rate Pass-Through The J-curve analysis assumes that a given change in the exchange rate brings about a proportionate change in import prices. In practice, this relation may be less than proportionate, thus weakening the influence of a change in the exchange rate on the volume of trade. The extent to which changing currency values lead to changes in import and export prices is known as the exchange rate pass-through relation. Pass-through is important because buyers have incentives to alter their purchases of foreign goods only to the extent that the prices of these goods change in terms of their domestic currency following a change in the exchange rate. This change depends in part on the willingness of exporters to permit the change in the exchange rate to affect the prices they charge for their goods, measured in terms of the buyer s currency. Assume that Toyota of Japan exports autos to the United States and that the prices of Toyota are fixed in terms of the yen. Suppose the dollar s value depreciates ten percent relative to the yen. Assuming no offsetting actions by Toyota, U.S. import prices will rise ten percent. This is because ten percent more dollars are needed to purchase the yen than are used to pay for the import purchases. Complete pass-through thus exists: import prices in dollars rise by the full proportion of the dollar depreciation. To illustrate the calculation of complete currency pass-through, assume that Caterpillar charges $50,000 for a tractor exported to Japan. If the exchange rate is 150 yen per U.S. dollar, the price paid by the Japanese buyer will be 7,500,000 yen. Assuming the dollar price of the tractor remains constant, a ten percent appreciation in the dollar s exchange value will increase the tractor s yen price ten percent, to 8,250,000 yen ( ,000 8,250,000). Conversely, if the dollar depreciates by ten percent, the yen price of the tractor will fall by ten percent, to 6,750,000. So long as Caterpillar keeps the dollar price of its tractor constant, changes in the dollar s exchange rate will be fully reflected in changes in the foreign-currency price of exports. The ratio of changes in the foreign-currency price to changes in the exchange rate will be 100 percent, implying complete currency pass-through. Partial Exchange Rate Pass-Through Although complete exchange rate pass-through is a possibility, in practice the relation tends to be partial. Table 14.5 presents estimates of average exchange rate passthrough rates for the United States and other advanced countries over the period. For example, the exchange rate pass-through for the United States over this period was This rate means that a one percent change in the dollar s exchange rate produced a 0.42 percent change in U.S. import prices. Because the percentage change in import prices was less than the percentage change in the exchange rate, 1 Helen Junz and Rudolf R. Rhomberg, Price Competitiveness in Export Trade among Industrial Countries, American Economic Review, May 1973, pp

14 454 Exchange-Rate Adjustments and the Balance of Payments TABLE 14.5 EXCHANGE RATE PASS-THROUGH INTO IMPORT PRICES AFTER ONE YEAR Country Pass Through Rate (For every one percent a currency depreciates/appreciates, the price of imports for the country increases/decreases by)* OECD** average 0.64% United States 0.42 Euro area 0.81 Japan Other advanced countries 0.60 *Estimates are based on data from 1973 to **The organization for Economic Cooperation and Development consists of Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Republic of Korea, Japan, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, Spain, Sweden, Switzerland, Turkey, the UK, and the United States. Sources: Jose Campa and Linda Goldberg, Exchange Rate Pass-Through Into Import Prices, Review of Economics and Statistics, November 2005, pp and Hamid Faruquee, Exchange Rate Pass-Through in the Euro Area, IMF Staff Papers, April 2006, pp exchange rate pass-through was partial for the United States. Similar conclusions apply to other countries included in the table. When exchange rate passthrough is partial at home and abroad, the effect of changes in the exchange rate on trade volume is lessened, as it forestalls movement in relative trade prices. Why does exchange rate pass-through tend to be partial? The answer appears to lie in invoicing practices, market-share considerations, and distribution costs. 2 Invoice Practices Businesses involved in international trade can select the currency they want to use to express the price of their exports. They can invoice their exports in their own home currency or in the currency of their customers. Evidence on import and export invoicing in recent years reveals that the dollar is the dominant currency of invoicing across non-european countries, as seen in Table For example, 93 percent of U.S. imports and 99 percent of U.S. exports were priced in dollars during the first decade of the 2000s. The dominant use of dollars in invoicing U.S. trade helps explain the partial pass-through of changes in the dollar s exchange rate to U.S. import prices. When foreign producers invoice their exports to the United States in dollars, the price of these goods remains fixed in terms of the dollar if the dollar depreciates against other currencies. The exchange rate movements affect only the foreign producers profits and will not increase the dollar price paid by U.S. importers. After a time, of course, foreign producers may choose to adjust their prices in response to the exchange rate. Market Share Considerations Another factor that contributes to partial exchange rate pass-through for a period following a dollar depreciation is the desire of foreign producers to preserve market share for goods sold in the United States. In practice, many goods and services are produced in imperfectly competitive markets. In terms of prices for these goods, firms are able to make a profit margin over costs. Firms may choose not to pass on the full change in costs brought about by changing exchange rates and instead choose to change their profit margins, thus reducing the sensitivity of consumer prices to the exchange rate. Therefore, exporters to the United States may accept a lower profit margin when their currency appreciates in order to keep their dollar prices constant against American competitors. This is especially pertinent for the 2 This section is drawn from Linda Goldberg and Elanor Wiske Dillon, Why a Dollar Depreciation May Not Close the U.S. Trade Deficit, Current Issues in Economics and Finance, Federal Reserve Bank of New York, June 2007.

15 Chapter TABLE 14.6 USE OF THE U.S. DOLLAR IN EXPORT AND IMPORT INVOICING, Country Dollar Share in Export Financing Dollar Share in Import Financing U.S. Share in Exports United States 99.8% 92.8% Japan % South Korea Malaysia Thailand Australia United Kingdom Euro area EU Accession countries* *Bulgaria, Czech Republic, Estonia, Hungary, and Poland. Sources: Linda Goldberg and Cedric Tille, The International Role of the Dollar and Trade Balance Adjustment. The Group of Thirty Occasional Paper No. 71, 2006 and Annette Kamps, The Determinants of Currency Invoicing in International Trade, European Central Bank Working Paper No. 665, August United States that has a very large market and where imports command a lower share of consumption than they do in smaller markets. Because American consumers can generally substitute domestic goods for imports, foreign exporters are reluctant to pass all of the exchange rate movement into prices because of fear of losing market share. Simply put, relatively strong domestic competition for imported goods in the United States tends to lessen the extent of exchange rate pass-through into import prices. For example, Kellwood Co., a major U.S. marketer of garments such as Calvin Klein, noted that some of its Asian suppliers, such as sewing factories and fabric mills, inquired about increasing their prices as the dollar depreciated against their currencies in the first decade of the 2000s. But these suppliers knew that if they increased their prices, Kellwood could purchase inputs from other competing suppliers. To maintain Kellwood as a customer, these suppliers cut their profit margins and thus refrained from raising their prices, which allowed Kellwood s prices on Calvin Klein garments to remain unchanged. Distribution Costs Thus far we have considered the transmission of exchange rates into the prices of imports arriving at a country s borders. However, other costs occur between the time a good arrives at the border and the time it is sold to the consumer. These are the costs of distributing the imported good to the final consumer, which include transportation, marketing, wholesaling, and retailing costs. For example, in 1996, a Barbie doll shipped from China to the United States cost about $2, where it sold for about $10. The manufacturer, Mattel, earned about $1 of profit on this doll. The remaining $7 represented payments for transportation in the United States and other marketing and distribution costs. For the United States, distribution costs

16 456 Exchange-Rate Adjustments and the Balance of Payments TRADE CONFLICTS WHY A DOLLAR DEPRECIATION MAY NOT CLOSE THE U.S. TRADE DEFICIT Partial exchange rate pass-through has implications for the trade deficit of the United States. With the U.S. trade deficit at high levels during the first decade of the 2000s, many looked to a dollar depreciation to reduce the U.S. appetite for foreign goods by pushing up the cost of imports and reducing the price of U.S. exports for consumers overseas. However, others argued that three factors carry particular force for the United States (as explained in this chapter): the near-exclusive use of the dollar in invoicing U.S. trade, the market share strategies of foreign exporters, and sizable U.S. distribution costs added to U.S. imports. These factors reduce the pass-through of the currency depreciation to U.S. import prices and consumer prices, resulting in partial exchange rate passthrough. With import prices and consumer prices rising only modestly from their pre-depreciation levels, U.S. consumers would have little incentive to significantly decrease their demand for imports or to seek out comparable domestic goods. The unresponsiveness of U.S. import and consumer prices to a dollar depreciation suggests that any substantial trade balance adjustment achieved through exchange-rate changes must come instead from a reduction in U.S. export prices. However, this would be asking a lot of the export sector. For example, in 2006, the U.S. trade deficit stood at $759 billion. If imports remained constant, exports would have to grow 52 percent to single-handedly close this gap. This growth appeared to be more than the U.S. export sector could deliver. Thus, other developments would have to be included to reduce the U.S. trade deficit. One development might be an increase in U.S. public or private saving, with related reductions in U.S. consumption of all goods. Another development might be an increase in the global demand for U.S. exports driven by economic growth abroad or increased market access for U.S. exporters. Simply put, it appeared unlikely that a weaker dollar by itself could close the U.S. trade deficit. Source: Linda Goldberg and Eleanor Wiske Dillon, Why a Dollar Depreciation May Not Close the U.S. Trade Deficit, Current Issues in Economics and Finance, Federal Reserve Bank of New York, June average about 40 percent of overall U.S. consumer prices. 3 Because domestic distribution services are not traded internationally, their costs are not affected by fluctuations in the dollar s exchange rate. Therefore, as distribution costs become a large percentage of the consumer price, the sensitivity of the consumer price to exchange-rate fluctuations is reduced. The effects of exchange rate pass-through are more fully discussed in Exploring Further 14.1 which can be found at The Absorption Approach to Currency Depreciation According to the elasticities approach, currency depreciation offers a price incentive to reduce imports and increase exports. But even if elasticity conditions are favorable, whether the home country s trade balance will actually improve may depend on how the economy reacts to the depreciation. The absorption approach provides insights into this question by considering the impact of depreciation on the spending 3 Sidney S. Alexander, Effects of a Devaluation on a Trade Balance, IMF Staff Papers, April 1952, pp

17 Chapter behavior of the domestic economy and the influence of domestic spending on the trade balance. 4 The absorption approach starts with the idea that the value of total domestic output (Y) equals the level of total spending. Total spending consists of consumption (C), investment (I), government expenditures (G), and net exports (X M). This relation can be written as follows: Y C I G X M The absorption approach then consolidates C I G into a single term A, which is referred to as absorption, and designates net exports (X M) asb. Total domestic output thus equals the sum of absorption plus net exports: This can be rewritten as follows: Y A B B Y A This expression suggests that the balance of trade (B) equals the difference between total domestic output (Y) and the level of absorption (A). If national output exceeds domestic absorption, the economy s trade balance will be positive. Conversely, a negative trade balance suggests that an economy is spending beyond its ability to produce. The absorption approach predicts that a currency depreciation will improve an economy s trade balance only if national output rises relative to absorption. This relation means that a country must increase its total output, reduce its absorption, or do some combination of the two. The following examples illustrate these possibilities. Assume that an economy faces unemployment as well as a trade deficit. With the economy operating below maximum capacity, the price incentives of depreciation would tend to direct idle resources into the production of goods for export, in addition to diverting spending away from imports to domestically produced substitutes. The impact of the depreciation is thus to expand domestic output as well as to improve the trade balance. It is no wonder that policymakers tend to view currency depreciation as an effective tool when an economy faces unemployment with a trade deficit. However, in the case of an economy operating at full employment, no unutilized resources are available for additional production. National output is at a fixed level. The only way in which currency depreciation can improve the trade balance is for the economy to somehow cut domestic absorption, freeing resources needed to produce additional export goods and import substitutes. For example, domestic policy-makers could decrease absorption by adopting restrictive fiscal and monetary policies in the face of higher prices resulting from the depreciation. But this decrease would result in sacrifice on the part of those who bear the burden of such measures. Currency depreciation may thus be considered inappropriate when an economy is operating at maximum capacity. The absorption approach goes beyond the elasticity approach, which views the economy s trade balance as distinct from the rest of the economy. Instead, currency 4 See Donald S. Kemp, A Monetary View of the Balance of Payments, Review, Federal Reserve Bank of St. Louis, April 1975, pp ; and Thomas M. Humphrey, The Monetary Approach to Exchange Rates: Its Historical Evolution and Role in Policy Debates, Economic Review, Federal Reserve Bank of Richmond, July-August 1978, pp. 2 9.