Transcript Chapter 14 Exchange-Rate Adjustments and the balance of pay

Exchange-Rate Adjustments
and the Balance of Payments
PowerPoint slides prepared by:
Andreea Chiritescu
Eastern Illinois University
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Effects of Exchange-Rate Changes on Costs
and Prices
• How do exchange-rate fluctuations affect
relative costs?
• Extent to which a firm’s costs are denominated
in terms of the home currency or foreign
currency
• No foreign sourcing - all costs are denominated
in dollars
• If the dollar appreciates by 100%, the U.S. firm:
• Increase in franc-denominated production costs by
100% - Reduced international competitiveness
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TABLE 14.1 Effects of a dollar appreciation on a U.S. steel
firm’s production costs when all costs are dollardenominated
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Effects of Exchange-Rate Changes on Costs
and Prices
• Foreign sourcing—some costs denominated in
dollars and some costs denominated in francs
• If the dollar appreciates by 100%, the U.S. firm:
• Production costs in francs increase by 100% for the
inputs denominated in dollars
• Production costs in francs stay the same for the
inputs denominated in francs
• Overall, higher production costs (by less than
100%)
• Reduced international competitiveness
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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 francdenominated
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Effects of Exchange-Rate Changes on Costs
and Prices
• 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
• 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
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6
Effects of Exchange-Rate Changes on Costs
and Prices
• Changes in relative costs
• Because of exchange-rate fluctuations
• Influence relative prices
• Influence the volume of goods traded among
nations
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Effects of Exchange-Rate Changes on Costs
and Prices
• Dollar appreciation
• Increasing relative U.S. production costs
• Raise U.S. export prices in foreign-currency
terms
• Decrease in the quantity of U.S. goods sold
abroad
• Increase in U.S. imports
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8
Effects of Exchange-Rate Changes on Costs
and Prices
• Dollar depreciation
• Decreasing relative U.S. production costs
• Lower U.S. export prices in foreign-currency
terms
• Increase in the quantity of U.S. goods sold
abroad
• Decrease in U.S. imports
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Effects of Exchange-Rate Changes on Costs
and Prices
• Factors influencing the extent by which
exchange-rate movements lead to relative
price changes among nations
• U.S. exporters – reduce profit margins to
maintain competitiveness
• Perceptions concerning long-term trends in
exchange rates - promote price rigidity
• Product substitutability
• Move production offshore
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TRADE
CONFLICTS
Japanese firms outsource production
to limit effects of strong Yen
• Strong yen in recent years
• Japanese exporters - smaller profits when
converting dollar profits back into yen
• Protect profits: move production to the U.S.
• Lessening the amount of money they convert
from dollars to yen
• Contributes to the excess capacity of
manufacturing plants in Japan
• Results in job losses for Japanese workers
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Cost-Cutting Strategies of Manufacturers in
Response to Currency Appreciation
• Yen appreciation: Japanese manufacturers
• 1990 - 1996, Japanese yen relative to U.S.
dollar increased by 40%
• Japanese firms
• Establish integrated manufacturing bases in the
U.S. and in dollar-linked Asia
• Use cheaper dollar-denominated parts and materials
• Purchase cheaper components from around the world
• Shifted production from commodity-type goods to
high-value products
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Cost-Cutting Strategies of Manufacturers in
Response to Currency Appreciation
• Yen appreciation: Japanese manufacturers
• Japanese auto industry
• Cut the yen prices of their autos
• Falling unit-profit margins
• Reduced manufacturing costs
• Increasing worker productivity
• Importing materials and parts
• Outsourcing larger amounts of a vehicle’s production to
transplant factories
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FIGURE 14.1 Coping with the yen’s appreciation: Hitachi’s
geographic diversification as a manufacturer of
television sets
Hitachi’s global diversification permitted it to sell TVs in the United States without raising
prices as the yen appreciated against the dollar.
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Cost-Cutting Strategies of Manufacturers in
Response to Currency Appreciation
• Dollar appreciation: U.S. manufacturers
• 1996-2002, dollar appreciated by 22%
• Sipco Molding Technologies
• Partnership with an Austrian company
• Austrian company - designing and making the tools
• Sipco simply resold them
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Cost-Cutting Strategies of Manufacturers in
Response to Currency Appreciation
• Dollar appreciation: U.S. manufacturers
• American Feed Co. - pact with a Spanish
company
• Divvying up the work to keep both factories
operating (U.S. and Spain)
• Benefits of having a European production base
• Without having to take on the risks of building its own
factory there
• Redesigned: more efficient and less expensive to
build
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Will Currency Depreciation Reduce a Trade
Deficit? The Elasticity Approach
• Currency depreciation
• Improve a nation’s competitiveness
• Reducing its costs and prices
• The elasticity approach
• Relative price effects of depreciation
• Depreciation works best when demand
elasticities are high
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Will Currency Depreciation Reduce a Trade
Deficit? The Elasticity Approach
• The absorption approach
• Income effects of depreciation
• A decrease in domestic expenditure relative to
income must occur for depreciation to promote
trade equilibrium
• The monetary approach
• Effects depreciation has on the purchasing
power of money and the resulting impact on
domestic expenditure levels
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Will Currency Depreciation Reduce a Trade
Deficit? The Elasticity Approach
• Elasticity of demand
• Responsiveness of buyers to changes in price
• Percentage change in the quantity demanded
stemming from a one percent change in price
• >1, elastic demand
• <1, inelastic demand
• =1, unitary elastic demand
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Will Currency Depreciation Reduce a Trade
Deficit? The Elasticity Approach
• Marshall-Lerner condition
• 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
• Depreciation will worsen the trade balance if
• The sum of the demand elasticities is less than one
• The trade balance will be neither helped nor
hurt if the sum of the demand elasticities
equals one
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TABLE 14.3 Effect of pound depreciation on the trade
balance of the United Kingdom
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Will Currency Depreciation Reduce a Trade
Deficit? The Elasticity Approach
• Marshall-Lerner condition
• Simplifying assumptions
• A nation’s trade balance is in equilibrium when the
depreciation occurs
• No change in the sellers’ prices in their own
currency
• Illustrates the price effects of currency
depreciation on the home-country’s trade
balance
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TABLE 14.4 Long-term price elasticities of demand for total
imports and exports of selected countries
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J-Curve Effect: Time Path of Depreciation
• J-curve effect
• 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
• Because of lags between changes in relative
prices and the quantities of gods traded
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J-Curve Effect: Time Path of Depreciation
• Types of lags
• 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
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J-Curve Effect: Time Path of Depreciation
• Types of lags
• 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
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FIGURE 14.2 Depreciation flowchart
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FIGURE 14.3 Time path of U.S. balance of trade (billions of dollars)
in response to dollar appreciation and depreciation
Between 1980 and 1987, the U.S. merchandise trade deficit expanded at a rapid rate. The trade deficit decreased
substantially between 1988 and 1991. 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 1991.
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Exchange Rate Pass-Through
• Exchange rate pass-through relation
• The extent to which changing currency values
lead to changes in import and export prices
• Buyers have incentives to alter their purchases of
foreign goods
• If the prices of foreign goods change in terms of their
domestic currency
• Exporters – willingness to change the prices they
charge for their goods
• Measured in terms of the buyer’s currency
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Exchange Rate Pass-Through
• Partial exchange rate pass-through
• Percentage change in import prices <
percentage change in the exchange rate
• Exchange rate pass-through – tend to be
partial because
• Invoicing practices
• Market-share considerations
• Distribution costs
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TABLE 14.5 Exchange rate pass-through into import prices
after one year
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Exchange Rate Pass-Through
• Invoicing practices
• Choose the currency to invoice exports
• Own home currency
• Currency of their customers
• U.S. trade – dollars
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TABLE 14.6 Use of the U.S. dollar in export and import
invoicing, 2002–2004
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Exchange Rate Pass-Through
• Market-share considerations
• Foreign producers
• Preserve market share for goods sold in the U.S.
• Accept a lower profit margin when their currency
appreciates
• To keep their dollar prices constant against American
competitors
• Relatively strong domestic competition for
imported goods in the U.S.
• Lessen the extent of exchange rate pass-through
into import prices
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Exchange Rate Pass-Through
• Distribution costs
• Costs of distributing the imported good to the
final consumer
• Transportation
• Marketing
• Wholesaling
• Retailing costs
• 40% of overall U.S. consumer prices
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TRADE
CONFLICTS
Why a dollar depreciation may not
close the U.S. trade deficit
• U.S. trade deficit - high levels
• Dollar depreciation to reduce the U.S. appetite
for foreign goods
• U.S. partial exchange rate pass-through
• The near-exclusive use of the dollar in invoicing
U.S. trade
• The market share strategies of foreign
exporters
• Sizable U.S. distribution costs added to U.S.
imports.
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36
TRADE
CONFLICTS
Why a dollar depreciation may not
close the U.S. trade deficit
• Dollar depreciation
• U.S. imports and consumer prices –
unresponsive
• Trade balance adjustment
• Through exchange-rate changes
• Not from a reduction of imports
• But from a reduction in U.S. export prices
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The Absorption Approach to Currency
Depreciation
• The absorption approach
• Impact of depreciation on the spending
behavior of the domestic economy
• Influence of domestic spending on the trade
balance
• Total spending =
• consumption (C) + investment (I) + government
expenditures (G) + net exports (X-M)
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The Absorption Approach to Currency
Depreciation
• Total domestic output (Y) = level of total
spending
• Y = C + I + G + (X-M)
• Absorption, A = C + I + G
• Balance of trade, B = (X-M)
• Total domestic output (Y) = Absorption (A)
+Net exports (B)
• B=Y–A
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The Absorption Approach to Currency
Depreciation
• Balance of trade (B) = Total domestic output (Y)
- Level of absorption (A)
• Positive trade balance: national output exceeds
domestic absorption
• Negative trade balance: an economy is
spending beyond its ability to produce
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The Absorption Approach to Currency
Depreciation
• The absorption approach
• Currency depreciation will improve an
economy’s trade balance
• Only if national output rises relative to absorption
• A country must
• Increase its total output
• Reduce its absorption
• Combine the two
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The Absorption Approach to Currency
Depreciation
• Unemployment + a trade deficit
• Currency depreciation
• Direct idle resources into the production of goods
for export
• Divert spending away from imports to domestically
produced substitutes
• Expand domestic output + improve the trade
balance
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The Absorption Approach to Currency
Depreciation
• Full employment + trade deficit
• Currency depreciation
• Cut domestic absorption
• Restrictive fiscal and monetary policies
• Sacrifice on the part of those who bear the burden
of such measures
• Complementary
• The absorption approach
• The elasticity approach
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The Monetary Approach to Currency
Depreciation
• The monetary approach
• Currency depreciation
• Temporary improvement in a nation’s balance-ofpayments position
• Initial equilibrium in the home country’s
money market + Depreciation of the home
currency
• Increase the price level
• Increase the demand for money
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The Monetary Approach to Currency
Depreciation
• Initial equilibrium in the home country’s
money market + Depreciation of the home
currency
•
•
•
•
Inflow of money from overseas
Balance-of-payments surplus
Rise in international reserves
Increase in spending (absorption) - reduces the
surplus
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