1

International Economics

Exchange Rate Changes and

Current Account Reactions

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Current Account Adjustments under Flexible Exchange Rates

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Elasticities Approach Switch focus to effects of exchange rate on flows of goods &

services (Current Account).– Monetary approach focused on capital account primarily.

Examine conditions under which EXR changes from Current Account imbalances are self-correcting.

Example:Example: Current Account DeficitCurrent Account Deficit may lead to:– Fall in value of domestic currency (depreciation).– Domestic goods cheaper to Row, Domestic Exports rise.– Foreign goods more expensive, Domestic imports fall.– Current Account balance improves.

Expenditure SwitchingExpenditure Switching effects of EXR depreciation.– Emphasis is on EXR elasticity of exports and imports.– Not true that Current Account Balance necessarily improves.

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EXR Effects on Current Account Current Account BalanceCurrent Account Balance

CAB(e) = NX(e) = X(e) – eM(e)CAB(e) = NX(e) = X(e) – eM(e)

Assuming that X’>0 and M’<0. Want to know what sign of NX’ is.– Rise in e (depreciation) raises X() and lowers M() but effect

on eM() is uncertain, and so effect on NX is uncertain.

Extreme Case I:Extreme Case I: EXR depreciation does not not affect X or M.– Rise in e then increases eM without changing X.– CAB deficit is actually largerlarger than before depreciation.

Extreme Case II:Extreme Case II: EXR depreciation has largelarge effect X & M.– Rise in e raises X greatly, lowers M enough, so eM falls.– CAB deficit much smallersmaller than before depreciation.

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Marshall-Lerner Conditions Intuition:Intuition:

– If Import demand is elastic ( |M | 1) then rise in price (e) results in fallfall in total expenditure (eM), and CAB will improve regardless of what happens to X.

Current Account BalanceCurrent Account Balance

CAB(e) = NX(e) = X(e) – eM(e)CAB(e) = NX(e) = X(e) – eM(e)

– Condition required for depreciation to improve Current Account balance is that CAB/e > 0.

Take derivative of CAB wrt e. Rearrange to yield:

Marshall-Lerner conditionMarshall-Lerner condition [X/M] | [X/M] | XX | + | | + |MM | > 1 | > 1

– Where X and M are the elasticity of demand of exports and imports with respect to the exchange rate respectively.

– Have assumed supply curves for both exports and imports are horizontal.

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Marshall-Lerner Conditions and FX Market Adjustment

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Marshall-Lerner & the FX Market

Marshall-Lerner conditions determine the “look” & stability of the FX market as well as CAB reactions.

Supply of FXSupply of FX to the FX market depends on:– $ amount of US goods foreigners wish to purchase.– The level of e, which determines how much FX must be

exchanged to get the required amount of $’s. Assume that demand for US goods is linear in the

exchange rate measured appropriately.– Elasticity of demand for US goods varies over the curve.– Elasticity of demand, however, determines how the amount

of FX needed varies with the exchange rate. Illustrate consequences for supply of FX on next slide.

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Elasticities of FX Demand & Supply

D$

e (££/$/$)U.K. Demand for U.K. Demand for

US Goods & ServicesUS Goods & Services

|| > 1 ElasticElastic

|| < 1 InelasticInelastic

S£

e ($/$/££)U.K. Supply of U.K. Supply of

Pounds to FX MarketPounds to FX Market

££$$

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Market StabilityP

Q

D

Q

Stable EquilibriumStable Equilibrium Stable EquilibriumStable Equilibrium

Q

P

D

P

D

Market StabilityMarket Stability

P0P0

P0

Unstable EquilibriumUnstable Equilibrium

ED

ES

S

1. Standard Market equilibrium is stable.

ED so P up

- Excess Demand leads to Price rise.

ES so P down

- Excess Supply leads to Price drop.

S

2. Even unusual market here is stableS

3. This market is not stable

ED

- ED forces P up which worsens ED.ES

- ES brings P down, makes ES worse.

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Current Account Adjustment to Exchange Rate Changes

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Current Account Adjustments Goods markets tend to adjust slowly to changes. SR & LR responses of CAB to EXR moves may differ.

– Short RunShort Run: : Demand for Exports and Imports may not respond to changes in e due to decision-making lags or contracts.

– Long Run:Long Run: Both demands should adjust to new exchange rate level.

Simple Model of Lagged CAB AdjustmentSimple Model of Lagged CAB Adjustment

Xt = .25X(et-1)+.25X(et-2)+.25X(et-3)+.25X(et-4)

et Mt = et[.25M(et-1)+.25M(et-2)+.25M(et-3)+.25M(et-4)]

Immediate effect of EXR depreciation is to lower CAB (increase CAB deficit) as X and M fixed by past exchange rates.

Over time CAB will rise as larger % of both X and M reflect the exchange rate depreciation. This result is known as the J-CurveJ-Curve.

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J-Curve for EXR Depreciation

Time

e

Time

CAB(+)

(-)

Exchange Rate Path

CAB Path

EXRDepreciation

CAB0

e0