Intl Economics – Chapter 14: Exchange Rate Adjustments and the Balance-of-Payments

[Music] We have explored how a nation's Trade Balance enters a period of disequilibrium with correctionsautomatically instigated in the form of changes to domestic prices, interest rates, and destabilizedincome and employment levels.

Some of the system's auto-adjustments includeeconomic recession, inflation, loss of jobs, and devalued income in the domestic economy.

It works, but it also causes pain.

There might be other ways to accomplish thestabilization goal, which may be less distressing.

This chapter begins with a look at exchange-rateadjustments and the Balance of Payments.

We will cover currency depreciation, or devaluation,affecting a nation's trade position through its impact on relative prices, incomes, andpurchasing power of monetary balances.

We will look into the situation where allof a firm's inputs are acquired and denominated in the domestic currency.

As a result, an appreciation in the domesticcurrency exchange value increases that firm's costs by the same proportion, in terms offoreign currencies.

Next, we will consider the situation of manufacturersobtaining inputs from abroad whose costs are denominated in terms of a foreign currency.

As foreign-currency-denominated costs becomea larger portion of a producer's total costs, an appreciation of the domestic currency exchangevalue leads to a smaller increase in the foreign-currency cost of the firm's output and a larger decreasein the domestic cost of the firm's output, as compared to the cost changes that occurwhen all input costs are denominated in the domestic currency.

At that point, we will emphasize the elasticitiesapproach to depreciation.

According to this approach, currency depreciationleads to the greatest improvement in a country's trade position when demand elasticities arehigh.

The time path of currency depreciation canbe explained in terms of the J-curve effect and the extent to which exchange-rate changeslead to changes in import prices and export prices – explained by the pass-through effect.

Finally, we will explore the importance ofboth the absorption approach and the Monetary Approach to currency devaluation.

According to these views, currency devaluationsmay initially stimulate a nation's exports and production of import-competing goods.

But this will either promote excess domesticspending, or expand real output if domestic absorption is reduced.

These options result in a country's returnto a payments deficit.

[Music] Multi-national companies are confronted bycost management challenges, when cross-currency exchange rates rapidly fluctuate.

Companies with their entire production apparatusin their domestic economy, with sales to a foreign nation, face the greatest risk oftheir domestic currency appreciating against their product market's currency, causing thecost of their exported goods to escalate in the foreign economy.

This makes their product less affordable inthat foreign market, and generally results in a loss of sales.

It can be especially frustrating for the domesticcompany, as expenses on their domestic ledger may show no Real cost increases, but the exchangerate modification of their offshore sales price can spell disaster.

Taking a look at this hypothetical productioncost time-series, we see a steel manufacturing company based in the US, with clients in Switzerland.

All of their production costs, including labor,raw materials, facility operations, and management expenses are paid for in US Dollars.

When their product is exported offshore, theproduct is charged in Swiss francs.

In the initial period, the domestic costswere $500 per ton, with the exchange rate of 2 francs per US Dollar, netting a Switzerlandcost of 1,000 francs per ton.

Moving ahead in time, cross currency exchangerates changed to the level of an appreciating US Dollar moving from 2 francs per dollar,to 4 francs per dollar.

Although none of the US firm's costs increased,their conversion into Swiss francs doubled the cost of US steel in Switzerland, to 2,000francs per ton.

On a price competition level, the US steelis less preferable.

It may be interesting to note, this happenedbecause of an appreciation of the US Dollar against the Swiss franc, but the same resultwould be seen if the Swiss franc devalued against the US Dollar.

Either way, the international competitivenessof the US Steel manufacturer is reduced by the modified US Dollar/Swiss franc exchangerate.

Now a slightly different spin on this situation:Consider the US Steel manufacturer with headquarters in the US, but they acquire scrap metal fromSwitzerland with costs denominated in francs.

Now we step back into the appreciation ofthe US Dollar against the Swiss franc, to see that the scrap metal cost acquired inSwitzerland dropped in US Dollar terms from $180 to $90 per ton.

All other costs being equal, the appreciationof the US Dollar against the Swiss franc caused US production costs to reduce from $500 to$410 per ton.

In US Dollar terms, when the reduced costfinal steel product is exported to Switzerland and valued in their foreign currency, theexchange rate differential takes the price from the original 1,000 francs per ton to1,640 francs, instead of 2,000 francs per ton.

The exchange rate migration still resultsin a cost increase to the Swiss buyer, but foreign sourcing, also through Switzerland,moderated the increased cost effects.

The generalizations shown here, and writtenabout in the textbook, give clear indication of how mixing the sources of raw materialsbetween the domestic country and the end user's country, acted as a hedge against currencyvaluation changes as they affect costs and revenues.

In this case it happened when the US Dollarappreciated against the Swiss franc.

But it could just as easily have happenedas a Swiss franc devaluation.

In both situations, a company spreading itscost and revenue factors to various currency-linked countries can assist the manufacturer whenmoderating potential losses.

A difficult consideration the manufacturermust consider, is which countries to target for its cross-currency buffering? It is not always so convenient that the foreignnation is both a raw materials supplier and also a primary final product customer.

That situation makes the cross-national currencydecision clear.

It becomes complicated when three, four, orten other nations are both categorized as raw material suppliers and final product consumers,but maybe your company needs raw materials from only one or two of the ten.

Taken into the global level, for a US company,the effect of migrating exchange rates must be taken as the relative value of the US Dollaragainst the sea of other currencies involved with trade between their countries and theUS.

When the US Dollar appreciates against othercurrencies, in general, the change will lead to a decrease in the cost of foreign country'sraw materials, while also creating a price increase in the final export product salesto the linked countries.

A final product export cost increase causesthe quantity of foreign sold items to decrease.

However, the changed value of the US Dollarmay result in an increase of imported goods to the US, which comparatively results ina lower foreign origin price.

US Dollar depreciation will initiate the oppositesituations including an increase of US exports.

I stress to you the importance of understandingthese two ideas, concerning currency Appreciation and Depreciation.

Be able to "reason out" in your mind theseexpected outcomes for the domestic currency and the currencies of your trading partners.

You will use this information a lot in thischapter, and in Economics generally.

Staying ahead of fluctuating cross-currencyvalues can be a never-ending endeavor.

Predicting future currency appreciation ordevaluation is difficult enough, but knowing if the changes are temporary or permanentfalls into the realm of crystal-ball forecasting.

{Professor Trelawney Speaking}Only then can you see.

Try Again? Now what do we have here? {Hermione speaking}Oh, do you mind me trying? Exchange Rate Appreciation, possibly? {Professor Trelawney Speaking}My dear, from the first moment you stepped foot into my class, I sensed you did not possessthe proper spirit for the noble art of divination.

No, you see there, you may be young in years,but the heart that beats beneath your bosom is as shriveled as an old maid's.

Your soul as dry as the pages of the booksto which you so desperately cleave.

Nonetheless, companies seek strategies mitigatingthe situation of being unprepared for cross-currency valuation changes.

Some companies have initiated production factoriesin other countries that have exhibited counter-reactive economies from their home economy.

It might be Japanese automakers also investingin production sites in the US, Mexico, Philippines, Brazil, Portugal, and fifty other locationsaround the world.

When profitable, they can modify materialacquisition and assembly accounting for currency valuation.

Of course, they also have to keep on top oftariffs and quotas in the profit optimization profile.

Another strategy for the multi-national company,is to tighten profit margins as currency values change.

The exporter reduces profit margins into theimporting country to counteract an increase in their currency value against the importreceiving country's cost of goods.

If the product has price driven competitivenessin the foreign market, this can serve the exporter by maintaining "market share," thattries to bridge a short term adjustment to currency values.

The company may view lower profits as an acceptablealternative to reduced sale quantities, and overall profitability, as long as they canmaintain market share.

Again, foreign companies need to beware of"Dumping" allegations, so be cautious and be prepared to celebrate partial success.

[Music] Foreign competitiveness forces businesses to seek solutions that can survive increasingraw material costs, lowering final product prices, and difficult to predict cross-currencyvaluation cycles.

Some businesses have enjoyed success in thisrealm, while others have faded away.

Most success stories share the feature oflow cost manufacturing, highly efficient product design, and low commencement-to-market latency.

When they start building a product, it doesnot take long for it to arrive on the retail store in the destination country.

As an example, we can look into the appreciationof the Japanese Yen in the 1990s, as its value rose 40% in relation to the US Dollar.

As the Yen increased in value, the cost ofJapanese products in the US climbed by an equal amount.

Instead of taking a loss in sales becauseof their higher prices, Japanese firms redirected manufacturing efforts to the US, and intoDollar-linked Asian countries, where their comparative costs were lower.

This positioning allowed Japanese firms touse less expensive Dollar-denominated parts and materials to offset higher Yen relatedcosts.

They also used the stronger Yen to purchasecertain components from other countries, representing a lower net cost after inflated Yen valuewas factored in.

Because of the offshoring established by Japanesefirms in the 1980s and early 90s, the acceleration of changed production possibilities gave thema competitive edge.

Hitachi was a widely known name of TVs inthe 1990s.

As it turns out, their components combinedvideo projection units made in the USA with circuitry and chassis made in Malaysia, andfinal assembly in Japan where only about 30% of the TV set's final value was integrated.

The appreciation of the Yen against the othercurrencies during this period meant Hitachi could shelter 70% of its costs from the appreciatingcurrency.

However, in an aggressive step of more costcutting, Hitachi migrated their final assembly work to Mexico where the Peso devalued againstboth the Dollar and the Yen, resulting in competitive-cost final-products in globalmarkets, despite the rise in the value of the Yen.

Japanese automobile manufacturers in thisperiod made their first price competitive moves to reduce profit margins, and convincedtheir subcontractors to reduce their prices by 15%.

Their automotive design and assembly strategyinvolved re-styling across models to use interchangeable component-parts, and re-patterned domesticallyproduced sheet metal.

Toyota also changed their marketing focusto target lower priced models with fewer options on cars shipped to countries like the US.

You may also remember from a previous lecture,that in the 1980s, Japanese companies agreed to a voluntary export quota to the US, limitingtheir shipments of Japanese made vehicles, giving them incentive to manufacture automobilesin transplant factories in the USA.

Given the appreciation of the Yen over theUS Dollar, this relocation of manufacturing fit nicely into the Japanese cost cuttingscheme.

They took advantage of these plans in theface of the appreciating Yen, to grow their business.

Fast forwarding to the end of the last century,the US Dollar strengthened against major currencies of Asia and Europe, by about 22%.

The Dollar appreciation against the currenciesof our trading partners caused significant foreign-price increases for US products overseas.

Two example companies given in the textbook show opposing response profiles to the same situation.

In the first example, the US firm, Sipco Moldings,took a reverting position by laying off 30% of their US employees, and partnering withan Austrian company who built the products Sipco had designed, while the Austrian companyshipped the completed tools to Sipco in the US for final sales, costs were cut, but thecore business of the company evaporated.

Their production services were sent to Austriawhere they still remain.

In the other example, collaborated with aSpanish firm in a duopolistic arrangement.

American Feed and their Spanish counterpartcollaborated to streamline joint production, but divided contracts between their operationsto eliminate cross-partner competition, with each taking the contracts matching their physicallocations.

By eliminating competition between the twocompanies, and partnering on cost proposals, they were able to float through the periodof US Dollar appreciation cycle.

[Music] We have looked at currency appreciation cases that have led to a reduction of foreign salesfor domestic exporting companies.

Domestic goods become more expensive in theforeign markets, making a shift of their supply curve to the left, resulting in a higher equilibriumprice and lower quantity sold.

When taken in the reverse, the domestic currencydevalues, foreign sales quantity increases.

But, can a currency devaluation reduce a country'strade deficit? It seems reasonable, but we should look forany externalities associated with specific cases.

Trade deficits are observed when a countryimports more than it exports.

When a currency devalues compared to othercurrencies, a cost approach gives expectation for lowered imports and increased exports.

The details of the trade balance interactionsrequire a look under the hood, so to say, at the price elasticity of demand for botha nation's imports and its exports.

Elasticity of Demand expresses buyers' responsivenessto changes in the product's price.

We can recall the formula for elasticity ofdemand, and remember the terms for elastic demand, inelastic demand, and unitary demand.

Each condition holds different implicationsfor the manufactured product's quantity sold for the price offered.

Elasticity of Demand will hold different valuesin each market where products are sold; meaning that the response to price modifications canbe unequal in each market.

Let us take a close look at a currency exchangerate situation from recent memories, starting in the mid 1980s.

In blue we see the Japanese Yen scaled onthe left side axis, and in red, the Chinese Yuan renminbi scaled on the right axis.

The Yen is a free floating currency on worldmarkets exchanged under the auspices of demand and supply.

The horizontal lines of the exchange ratefor the Chinese yuan renminbi.

China does not have a floating exchange ratethat is determined by market forces, as is the case with most advanced economies suchas the Yen.

Instead it pegs its currency, the yuan renminbi, to the U.

S.

dollar.

The yuan was pegged to the US currency at8.

27 to the dollar in February 1994, then to about 8.

3 until June 2005.

Undoubtedly, the rise of the US Dollar duringthe 1980s and more so, the massive devaluation of the yuan renminbi in January 1994 from5.

8210 to 8.

7219 created a favorable exchange rate environment for exporting goods fromChina.

As a country, China made their goods lessexpensive for foreign nation companies to purchase.

China's central bank shocked markets on 11August 2015 when it devalued its currency from 6.

2096 to 6.

3908 to the US dollar, a1.

87% shift weaker against the US dollar.

A day later, the central bank sent shockwavesagain with a second devaluation, pushing down the price to 6.

4083, another 1.

62% shift againstthe US dollar.

Shock waves rippled through China to encompassglobal trading partners with a regional currency war as China's moves came on the back of thesoftening of Japan's yen and the Korean won through 2015.

By the end of 2016, the yuan renminbi wastrading for 6.

95 per dollar.

China's currency devaluation was seen largelyas a bid to boost the competitiveness of its exports but is not without implications forits ambition to internationalize their currency as a component of the global Special DrawingRights.

Perhaps the biggest dent in the trend wasthe global financial crisis of 2008-09 which put a big lid on US consumer demand.

China's rapid growth since the 1980s has beenfueled by massive exports.

A significant chunk of these exports goesto the U.

S.

, which overtook the European Union as China's largest export market in 2012.

The tremendous expansion in economic tiesbetween the U.

S.

and China – which accelerated with China'sentry into the World Trade Organization in 2001 – and is evident with China as our largestgoods trading partner with $578.

6 billion in total.

Goods exports totaled $115.

8 billion; goodsimports totaled $462.

8 billion.

The Federal Reserve Economic Data portal makeseconomic data digitally and graphically available through this online interface.

Two of the most significant datasets are theConsumer Price Index, the CPI, and the Producer Price Index, the PPI.

The PPI is a significant dataset for businessesas it measures a commercial market basket of commodities bought and sold by Americanbusinesses.

The index values represent a prism shapedlens for American producers, as it measures both prices and quantities of transactionscommonly used by American businesses.

The path of the PPI through time shows theanticipated expansionary periods following most recessions and the dropping, or slowingof the index values during recessions.

The contraction pattern in 2009 was severe,with an aggressive recovery response lasting only until mid-2011 when other forces restrictedbusiness expansions normally seen in the US economy.

The stumbling steps reflected in the PPI indexcame from a series of new government regulations, increased tax rates, and imposition of theAffordable Care Act on US companies and consumers to the point that significant American businessesmoved operations to other countries where the cost of doing business was lower.

As 2014 progressed, prices paid to US manufacturersand the volume they sold continued dropping.

The trend line shown here replicates anotherrecessionary period from June 2014 through February 2016.

This drop in PPI index values was accentuatedby the devaluation of the yuan renminbi in August 2015.

As the PPI value was 191.

9 in August 2015,fell to 189.

1 in September, and finally to 181.

3 in February 2016.

American businesses were not able to competeagainst the lower priced Chinese sourced goods.

At the time, many American buyers shiftedsource orders to lower cost Chinese goods, and some companies, such as General MotorsCorporation, established manufacturing facilities in China.

Both prices and quantities sourced from theUSA were reduced.

The Marshall-Lerner Condition is at the heartof the Elasticity Approach to the Balance of Payments.

It is named after the economists who revealedit independently: British Economist Alfred Marshall, and Economist Abraham Lerner, aRussian national who immigrated first to Britain then to the USA.

The condition seeks to answer the question:when does a real devaluation, in fixed exchange rates, or a real depreciation, in floatingexchange rates, of the currency improve the current-account balance of a country? The Marshall-Lerner Condition postulates thatan exchange rate devaluation or depreciation will only cause a balance of trade improvementif the absolute sum of the long-run export and import demand elasticity is equal to,or greater than 1.

Thinking it through, if the domestic currencydevalues, there will be a positive quantity effect on the Balance of Trade, because domesticconsumers will buy fewer imports and foreign consumers will buy more of our exports.

Working contrary to this however, is a negativecost effect on the balance of trade, since the relative cost of imports will be higher.

The net effect on the trade balance can bepositive or negative depending on the magnitude of the quantity effect versus the cost effect.

If the quantity effect is greater, then theMarshall-Lerner condition is met.

We look at example of UK Pound depreciation, relative to the currencies of its trading partners.

In the UK, the demand elasticity for importsis 2.

5 while for exports it is 1.

5.

Variable elasticities of demand are common.

When the UK Pound depreciates by 10% againstthe US Dollar, import prices increase due to the devaluation of domestic currency, ittakes 10% more UK Pounds to purchase the goods in US Dollars, leading to a decrease in domesticpurchases of U.

K.

goods.

The import demand elasticity of 2.

5 resultsin a 25% quantity decrease and a matching 10% price increase in pounds.

The net effects of these events lead to anet out-payment decrease for the import sector, and a 15% increase for the export sector.

On the export side of the equation, the UKPound price decrease makes the cost of UK goods exported to the US less expensive, resultingin an increased quantity of offshore sales.

With an export demand elasticity of 1.

5, and10% currency devaluation, net foreign sales are stimulated by 15%.

This intermix of increased exports and reducedimports, reduces the UK trade deficit.

In this case, the sum of elasticities of demandis 4.

0 meeting the Marshall-Lerner Condition of the sum of elasticities greater than one.

The Marshall-Lerner Condition states thatif the domestic currency devalues, there will be a positive quantity effect on the balanceof trade, because domestic consumers will buy fewer imports and foreign consumers willbuy more exports, but only if their elasticities of demand offset by a sufficient amount.

As an Economist for a company, as a Consultant,or as a Government policy analyst, how would you use the Marshall-Lerner Condition to yourbenefit? The first response cycle to consider is whenyour domestic economy is in a trade deficit and enters a currency devaluation cycle.

You need to consider the expected semi-automaticresponses in the economy and how they will influence the trade deficit situation.

Taken to the next level, when you identifythe expected response pattern, and it is favorable, you want to make sure that response patternis not prevented through poor business decisions, or nonsensical political maneuvers – be ready! Consider what happened in August 2015 as Chinadevalued the exchange rate for the yuan renminbi.

A weak currency cheapens the price of a country'sexports, making them more attractive to international buyers by undercutting competitors.

From China's perspective, their goal is tocontract-manufacture and export consumer and commercial goods to trading partners, suchas Europe, North America, and through the Asian market areas.

China is less dependent on foreign importsof consumer goods to China, than other countries are dependent on China exports to their markets,such as the USA.

By devaluing their currency, China made Chinesesourced goods more affordable by companies in other nations.

China is focused on their Export price elasticity.

But, since the yuan renminbi is not valuedas a free-floating exchange rate, determination of price elasticities is problematic and relieson heuristic estimates of key variables.

Researchers Feenstra and Wei, in China's GrowingRole in World Trade estimated elasticities of the real exchange rate on China's overalltrade flows to be relatively small, in comparison to other nations.

China is able to maintain a substantial exporttrade component when the yuan renminbi is devalued.

Export quantities sold increase by a greateramount than the currency exchange rate is decreased.

This is by definition, a low export priceelasticity: total revenue increases with the exchange rate reaction to the currency devaluation.

Of more significance to China's trade balanceis the vitality of markets in other countries, in particular the United States, China's largesttrading partner.

Slow growth in China's trading partner countriesdelivers significantly more impact on the trade deficit of China then does its exportprice elasticity rate.

[Music] Studies show that international trade tends to be inelastic in the short term, as it takestime to change patterns of consumption and pre-existing trade contracts to expire.

Thus, the Marshall-Lerner Condition of elasticitiessumming to greater-than-one is not met, and currency devaluation is likely to worsen thetrade balance initially.

There is predictably a lag-time between theinitial response and the ultimate adjustment.

In the long-run, consumers tend to adjustto the new prices, and the nation's trade balance improves.

This time-path of trade flows is called theJ-Curve Effect.

For example, assume a country, like the US,is a net importer of oil and a net producer of jetliners.

Initially, a currency's devaluation immediatelyincreases the price of oil, and as consumption patterns remain the same in the short term,an increased amount of money is domestically spent on imported oil, worsening the deficiton the import side.

Meanwhile, it takes some time for Boeing'ssales department to exploit the lower price advantage offshore and secure new contracts.

On this diagram, the US has a current accountdeficit at point X.

The US Dollar exchange rate devalues, becauseof existing procurement contracts and imperfect knowledge, in the short term, the deficitgets deeper to Y.

In the long-term, if the Marshall-Lerner Conditionis fulfilled, export revenue will increase, and import expenditures will fall.

The current account deficit will get smaller,moving in the direction of Z.

The Marshall-Lerner Condition, extended intothe J-Curve Effect, puts definition to import and export changes of a nation's internationaltrade value.

However, the effects in markets will be seenonly after delays have worked through the system.

The lags reflect businesses commerce realities.

Sometimes time offsets involve offers thathave been made and accepted before the currency re-valuation happened; the agreements aresigned and therefore binding.

Companies can use currency forward contracts,or currency futures, to keep commerce operating through economic cycles like currency devaluations,but the preparedness efforts do not prevent lag-time effects.

In other real terms, individual businessesare not necessarily opening and closing new agreements on a daily basis.

There is a lag time between the expirationof an existing agreement and the opening of a new one, under new terms.

These events transpire within the new economicrealities, contributing to the delayed effects in the currency devaluation impacts.

These lag times were seen in the US from 1980through 1993 as the domestic economy went through an appreciation cycle in 1980 followedby a devaluation in 1985.

The appreciation event's delayed effects overlappedthe devaluation event's initial response.

[Music] President Trump's objective on this trip to Beijing was in part to persuade Chinato do more to rein in the nuclear program and the missile program of itsclient state North Korea but how well did the self-proclaimed master of theart of the deal do on his other main objective here namely persuading Chinato do more to close its trade gap with America here's chief Washingtoncorrespondent James Rosen among the 250 billion in new trade agreementsannounced during President Trump's visit to Beijing are a deal for the Chinaenergy Investment Corporation to pour 84 billion into West Virginia powerprojects and a 20% reduction in the value added tax China places on importsof American distillers dried grains among those unimpressed Secretary ofState Rex Tillerson by frankly in the grand scheme of a three to five hundredbillion dollar trade deficit the things that have been achieved thus far arepretty small candidate Trump vowed often to redress that deficit there we turn itaround folks we have the cards we have a lot of power with China in Beijingpresident Trump proved only marginally more conciliatory saying he doesn'tblame China but rather his predecessors in the Oval Office who allowed thedeficit to grow after all who can blame a country for being able to takeadvantage of another country for the benefit of its citizens I give Chinagreat credit last year the world's two largest economies traded an estimated579 billion in goods but last month the imbalance grew by twelve point twopercent over the year before rituals of American presidents visits to Chinainclude an exchange of toasts between visitors and hosts and promises by thelatter to expand market access for US businesses and investors the investmentand management environment for foreign enterprises including those of the USwill be more open more transparent and more standardized but veteran Chinahands expressed skepticism that Beijing would do much to address the multiplefactors that contribute to the imbalance I question whether the bilateral tradedeficit is the biggest problem in the relationship I'm far more worried aboutthese other practices like compulsory technology transfer lack of protectionfor intellectual property rights subsidies to state-owned enterprisescandidate Trump also called China the greatest ever currency manipulator andpromised repeatedly to designate Beijing as such but within his first 90 days inoffice President Trump rescinded that threat telling The Wall Street JournalChina had stopped the practice Brett James Rosen in Washington James thanks Exchange rate pass-through is conditional on the business relationships between buyersand sellers.

It happens when a seller, for instance fromthe USA, experiences a currency appreciation cycle against the currency of a long-termclient, say from India.

Assume the US Manufacturer and the Indianbuyer denominated contract costs in US Dollars.

Now assume the US Dollar appreciates againstthe Indian Rupee by 20%.

In a full pass-through arrangement, the USgoods would be supplied to India at a cost increase of 20% when paid in Rupee.

In reality, the actual pass-through arrangementsrely on business relationships and long-term operations of both parties, and frequentlyresult in partial pass-through of currency appreciation or devaluation events.

The US company may be concerned that an immediateincrease of their product costs to the buyer would make an opening for a competitor, usinga different currency, to capture market share against the US company.

To head off this unfortunate event, the USmanufacturer may negotiate payment adjustments with the buyer to share the burden of exchangerate changes.

Exchange Rate Pass-Through in the US and afew associated countries from 1973 through 2003 shows that on average, there was abouta 0.

50% pass-through from manufacturer to buyer as a result of each 1% of currency revaluations.

This table shows us that for every 1% theUS Dollar value changed, the price of imports into the US changed by 0.

42%.

Currency selection for international transactionsis part of business negotiations.

The US Dollar is the default currency formost of the world, although regional selections are found in Europe, for instance using theEuro, and in Australia, using their Dollar.

When the transaction currency is named aspart of negotiations, the appreciation or devaluation of the currency remains linkedto the currency of choice.

Because of the prevalence of the default useof the US Dollar, currency swings tend to affect prices of foreign businesses more thanUS businesses.

Risk is borne by the businesses located innon-US currency countries, when using the US Dollar for import and export pricing.

Market-share positioning, as mentioned earlier,can be a significant issue involved in partial pass-through pricing.

When considering US Imports, a foreign supplierinvolved in imperfectly competitive markets may cut into their profit margin to absorba portion of an increased currency exchange cost, in order to preserve their market share,in the lucrative US marketplace.

Transportation costs of products importedinto the US, are all encumbered domestically, and are not foreign commodity affected bycurrency valuations.

However, when considering imports to the US,the costs of moving them from the arrival port to the final retail sale destinationcan account for substantial fees when expressed as a percent of total cost.

In the US, these distribution costs amountto about 40% of the retail sales price of all goods.

As importing companies manage pressures ofcost reduction efforts associated with currency revaluations, they have tried to keep distributioncosts in-line with retail sales prices, often cost trimming when possible.

[Music] We talked about the Elasticity Approach, the Marshall-Lerner Condition, and the J-CurveEffect.

The Absorption and Monetary Approaches dovetailinto this chain of reasoning by considering domestic spending during an economic depreciationor appreciation.

To begin, we will look at the Absorption Approachas a measure of how resources are consumed in the home nation, in terms of Consumption,Investments, and Government Expenditures.

According to the Elasticities Approach, currencydevaluation offers a price incentive to reduce imports and increase exports.

However, a country's trade balance is heavilyaffected by the performance of domestic consumers to purchase foreign versus domestically producedgoods.

The Absorption Approach considers the impactof currency depreciation on the spending behavior within the domestic economy and its influenceon the nation's trade balance.

We start with a relationship we identifiedearlier, for Total Spending, also called Domestic Output, as being the sum of Consumption, Investments,Government Spending, and Net Exports.

Net Exports being the difference between totalexports and total imports.

The Absorption Approach rearranges these variablesto sum Consumption, Investment, and Government Expenditures into a variable called Absorption,and to isolate Net Exports into a Balance of Trade variable.

Rearranged, Y equals A plus B, or DomesticOutput equals Absorption plus net exports, therefore, Net Exports equals Domestic Outputminus Absorption.

This relates back to the nation's Trade Balance.

If the national output exceeds domestic Absorption,the trade balance will be positive.

A negative trade balance suggests that theeconomy is spending beyond its ability to produce.

The Absorption Approach predicts that currencydepreciation will improve an economy's trade balance only if national output rises relativeto absorption.

It works in the country's favor during a currencydepreciation case, only if the country can sell more goods to other nations, than itconsumes domestically.

This means that a country must increase totaloutput and reduce absorption.

Now consider the US in the second half of2015.

The country has 25 million unemployed peopleand a $14 trillion trade deficit.

Our economy was operating below its productivecapacity.

Price incentives initiated by US Dollar Depreciationwould normally engage idle resources into the production of goods for export, whilediverting spending away from imports to domestically produced goods.

Currency devaluation in this case, could spurdomestic output as well as improve the trade balance.

The Absorption Approach goes beyond the ElasticityApproach, by combining the economy's trade balance with the other aspects of the nationaleconomy.

It engages the economy's utilization of nationalendowments and productivity, with prudent frugality, emphasizing the reality of thenation living within its means.

[Music] Balance of Payments deficits are faced by countries, large and small, and strategiesare sought to minimize the negative effects on the domestic economy.

Both the Elasticity Approach and the AbsorptionApproach, we have just discussed, are considered viable options, and they are often used forthe intended benefits.

The Monetary Approach has also been engagedto correct Balance of Payment deficits, but from a different angle.

The Monetary Approach takes the position thatgovernments, by purposefully devaluing the domestic currency, against other currencies- especially against the currencies of trading partners, will quickly cause an increase inthe domestic economy's export potential as domestic export prices become more competitiveinternationally.

Some countries, mostly in Latin America andAsia, have actively followed a policy of Exchange Rate Devaluation in an effort to maintainor promote a balance-of-payments equilibrium.

The pursuit of these policies contributesto the International Monetary Fund's view that devaluation is a valid policy in resolvingBalance of Payments problems.

Several analyses of this approach have beenmade, with conclusions published in 1988 by Parviz Asheghian of St.

Lawrence University,and William Foote of Syracuse University, both in New York.

First, in the short-run, devaluation of thecurrency successfully improves the Balance of Payments only for Developing Countries,without similar positive effects in Developed Countries.

On the other hand, increasing economic growtharound the date of the currency devaluation deteriorates the Balance of Payments for DevelopedCountries in the short-run, but has no effect on Developing Countries' Balance of Payment.

This result implies that the income elasticityof money demand is negative in Developed Countries during currency devaluations, and zero forDeveloping Countries; a result counter to the usual predictions of money demand theory.

It may be that in the case of Developed Countries,increases in income during currency devaluation lead to lower demand for money since the domesticcurrency is worth less by government fiat.

Holding money may cause disutility to domesticconsumers resulting in a switch from holding officially reported money stocks to holdingother assets or resorting to counter trade activity.

Second, in the short-run, domestic creditexpansion deteriorates the Balance of Payments of both Developing Countries and DevelopedCountries.

In the long-run, this variable worsens theBalance of Payments deficit of Developing Countries and has no significant effect onthe Balance of Payments of Developed Countries.

Third, economic growth does not affect Balanceof Payments during devaluation episodes either in the short or long-run for Developing Countries.

Conversely, Developed Countries in the short-run,do experience favorable effects in this situation, but they expire as stretched into the long-run.

This provides further evidence that the growthrate of income is unrelated to mandated currency devaluation.

Finally, the data cannot corroborate existenceof any structural differences between the relative responsiveness of Developed and DevelopingCountries to devaluation in the short-run.

The only structural difference detected wasfor Balance of Payments improvement in the long-run.

Parviz Asheghian and William Foote gave thistopic a good review, to illustrate the Monetary Approach's marginal usefulness for developednations, and only partial success for developing nations' economies.

A take home message from this summary is tobe skeptical of what you hear and read, to the level that you will look for points ofview and begin to understand for yourself how to generate reasonable results.

The findings shared in this lecture are consistentwith my view of economics and expected results.

They illustrate critical thinking as appliedto economics and business operations.

Look for, and develop, solutions that explainto you personally how events respond to economic conditions.

You can find answers, or use logic to explainthem to yourself and others.

As I have urged before, and I support foryour adoption of critical thinking: Think like an Economist! In this chapter, we considered exchange-rateadjustments and the Balance of Payments.

We noted that currency depreciation, or devaluation,can affect a nation's trade position through its impact on relative prices, incomes, andpurchasing power of money balances.

We considered the situation where all of afirm's inputs are acquired domestically and their costs are denominated in the domesticcurrency.

As a result, an appreciation in the domesticcurrency's exchange value increases a firm's costs by the same proportion, in terms ofthe foreign currency.

Next, we considered the situation where manufacturersobtain inputs from abroad whose costs are denominated in terms of a foreign currency.

As foreign-currency-denominated costs becomea larger portion of a producer's total costs, an appreciation of the domestic currency'sexchange value leads to a smaller increase in the foreign-currency cost of the firm'soutput and a larger decrease in the domestic cost of the firm's output, as compared tothe cost changes that occur when all input costs are denominated in the domestic currency.

We emphasized the elasticities approach todepreciation, when currency depreciation leads to the greatest improvement in a country'strade position if demand elasticities are high.

The time path of currency depreciation canbe explained in terms of the J-curve effect and the extent to which exchange-rate changeslead to changes in import prices and export prices is explained by the pass-through effect.

Finally, we concluded with a summary of theAbsorption Approach and Monetary Approach to Currency Devaluation events.

Theoretically sound, but practically limited,a devaluation may initially stimulate a nation's exports and production of import-competinggoods.

But this often promotes excess domestic spendingunless real output can be expanded or domestic absorption reduced.

The result becomes a return to a paymentsdeficit.

[Music].

Source: Youtube

Intl Economics - Chapter 14: Exchange Rate Adjustments and the Balance-of-Payments

We have explored how a nation’s Trade Balance enters a period of disequilibrium with corrections automatically instigated in the form of changes to domestic prices, interest rates, and destabilized income and employment levels. Some of the system’s auto-adjustments include economic recession, inflation, loss of jobs, and devalued income in the domestic economy. It works, but it also causes pain. There might be other ways to accomplish the stabilization goal, which may be less distressing.
This chapter begins with a look at exchange-rate adjustments and the Balance of Payments. We will cover currency depreciation, or devaluation, affecting a nation’s trade position through its impact on relative prices, incomes, and purchasing power of monetary balances.