Chapter 16 THE FOREIGN EXCHANGE MARKET AND TRADE ELASTICITIES

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1 Chapter 16 THE FOREIGN EXCHANGE MARKET AND TRADE ELASTICITIES The model presented in Chapter 16 considers trade in goods and money. Money can be thought of as a particular type of asset that earns no nominal interest, and is legal tender in the country of issuance. Each of two nations has a national currency and each acquires foreign currency in order to purchase goods from abroad. The exchange rate is the price of foreign currency in units of domestic currency. If this price is flexible, it takes on the equilibrium value where demand for foreign currency equals supply of foreign currency. If it is fixed, excess demand or supply for foreign currency must be met by foreign reserve transactions by the central banks instead. It is a matter of considerable controversy, both among economic theorists and practitioners, whether a world of fixed exchange rates is better than a world of flexible exchange rates. Wide fluctuations in prices are considered unattractive if agents are risk averse; on the other hand, reserves may not be sufficient to sustain a regime of fixed rates. As a matter of exposition, both types of regimes will be considered in most of the models presented. In the simple model in this chapter, the flexible exchange rate version can be solved for the value that balances demand and supply for foreign exchange, which is also the value that brings trade in goods into balance. Under fixed exchange rates goods trade need not balanced. In this case exchange rate policy can be used to affect the trade balance. It has been common for countries to devalue their currencies to try to reduce, if not eliminate, politically unacceptable trade deficits. As the J-curve reveals, a country may be in for a surprise, however, as the trade balance may worsen in the short run if quantities are slow in responding to the change in relative prices. SHORT-ANSWER QUESTIONS 1. "If the elasticity of export demand is less than 1, then a devaluation will result in a decrease in revenues from exports." Do you agree? Why or why not? 2. True or false: If the demand for imports is a decreasing function of the import price expressed in domestic currency, then a devaluation will always result in a downward shift of the import demand curve. 3. True or false:

2 Fixing the exchange rate prevents short-run fluctuations in foreign exchange markets due to speculative attacks. 4. "One of the assumptions in deriving the Marshall-Lerner condition is that the economy is in a position of balanced trade. Since a country will only devalue if it is running a deficit, the elasticity approach for examining the effects of devaluation is of no use." Do you agree? Why or why not? 5. What is the J-curve? 6. True or false: Hysteresis may be one of the reasons we observe a J-curve in the balance of trade. PROBLEMS 1. Fixed versus Flexible Exchange Rates: The diagram below shows the equilibrium in the dollar-deutschemark (DM) market. The horizontal axis measures the quantity of dollars available including both the private sectors' supply and demand and the governments' supply and demand. The vertical axis measures the price of the dollar relative to the deutschemark. Suppose the Federal Reserve increases the supply of U.S. dollars. Does this result in a depreciation or an appreciation of the dollar?

3 Suppose the United States and Germany have agreed to keep the exchange rate fixed at E. Given its actions in part, what must the Federal Reserve now do to keep the exchange rate at E? (Assume that the Federal Reserve can't destroy its holdings of dollars.) What happens to the Federal Reserve's holding of DM reserves? 2. The United States is a net chocolate importer from Switzerland and the Swiss are net beefsteak importers from the United States. The diagram on the left shows the demand by American consumers for Swiss chocolate. The diagram on the right shows the demand by Swiss consumers for American exports of beefsteak. The price of chocolates in terms of Swiss francs and the price of beefsteak in terms of dollars are assumed given. (c) (d) (e) (f) Explain why the graph of chocolate import demand slopes downward even though the foreign currency price is fixed. Shade in the parts of the graph that represent the demand and supply of Swiss francs. (Assume that the initial trade balance is zero.) Suppose the dollar appreciates. What happens to the quantity of chocolate demanded? To the exports of beefsteak? What happens to the American trade balance? What parts of the graphs are you comparing when you use the Marshall-Lerner condition? Suppose that Swiss demand for American exports is less elastic than the demand curve shown above. What effect does this have on the trade balance? Suppose that American demand for chocolate is highly elastic. Does this make it more likely or less likely that the trade balance will deteriorate in response to a change in the exchange rate?

4 3. Revaluation and the Trade Balance: Curves A and B show two possible paths for the trade balance following an appreciation of the exchange rate at date T. Which curve do you think describes the trade balance following an appreciation of the currency if (i) changes in export and import prices are quickly passed on to consumers? (ii) import demand is initially very inelastic? (iii) demand for this country's exports is highly elastic? (iv) suppliers of this country's export good respond inelastically to the change in price? In addition to estimating demand elasticities, does this throw any light on how to test for the J-curve? 4. The Marshall-Lerner Condition and the Demand for Foreign Exchange: (c) "When there are no capital flows, the condition for an increase in the exchange rate to reduce the net demand for foreign exchange is equivalent to the condition for the increase in the exchange rate to improve the trade balance." Explain. How is the Marshall-Lerner condition modified when the country is currently running a trade balance deficit? The textbook assumes that supplies are infinitely elastic with respect to changes in price. Suppose supply of the export goods is relatively inelastic. How does this affect the Marshall-Lerner condition? (Hint: To simplify the problem, assume that trade account is balanced when the exchange rate change takes place. Then look at the appendix of Chapter 4 to see how trade elasticities affect the shapes of the offer curves.)

5 5. Suppose that the supply of exported french wine is infinitely elastic at 20 francs (Ff) per bottle. The U.S. demand for french wine in U.S. is the following: Q = *P, where P is dollars per bottle. If the exchange rate ($/Ff) is.25, what is the demand for francs? Draw the demand schedule of the franc.