International Economics
Mordecai E. Kreinin
Part II
International Financial Relations
Copyright ©2002 South-Western/Thomson Learning.
All rights reserved.
CHAPTER 14
Effects of Exchange
Rate Adjustments on the
Current Account
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OVERVIEW
 Relative Price Effect
 Domestic Income Effect
 Domestic Price Effect
 Another View of Depreciation: The Absorption
Approach
 Summary of Policy Analysis
 Additional Insights: Fiscal and Monetary
Policies under Alternative Exchange-Rate
Regimes
 Some Unanswered Questions
C14-3
Important Concepts
 Relative price effect
 Absorption approach
 Demand elasticity
 Policy mix
 Supply elasticity
 Dutch disease
 Stability or elasticity
conditions
 Absolute and relative
PPP
 Domestic price and
income effects
 J-Curve
 Resource
redistribution effects
 Hysteresis
 Pass-through effect
 Elasticity approach
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Introduction
 Exchange rate adjustments for inconsistent
situations
 Fixed exchange rate systems, vs. floating
rate systems
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Relative Price Effect
 Depreciation and competitiveness






Elasticity coefficient

Supply elasticity

Laurie add formula, p.316
Effect on Dollar Outpayments
Effect on Dollar Inpayments
Effect on DFI
Outpayments and Inpayments Combined
The stability condition
C14-6
FIGURE 14.1
Demand Function and Supply Function
C11-7
FIGURE 14.2
Demand and Supply
C11-8
FIGURE 14.3
Effect of
Depreciation of
the Pound on
U.K. Dollar
Outpayments
C11-9
FIGURE 14.4
Effect of
Depreciation of
the Pound on
U.K. Dollar
Inpayments
C11-10
FIGURE 14.5
Number of Yen a Dollar Bought, Plotted Weekly
C11-11
Domestic Income Effect
1
Y  X  M 
MPS  MPM
 Depreciation under deficit and UE
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Domestic Price Effect
 Inflation
 Redistribution of Domestic Resources
 Resource Reallocation
 Cost of Depreciation

Elasticity approach
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Another View of Depreciation:
The Absorption Approach
The difference between the value of goods produced
in the economy (Y) and that of goods absorbed
domestically by all users (A) must equal the
difference between exports (X) and imports (M).
In other words,
A  Y  M  X or Y  A  X  M
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Additional Insights:
National income consists of four types of expenditure,
consumption, investment, government expenditures, and net
exports.
Y  C  I  G  X  M 
(1)
If we omit the import component of C, I, and G and confine
these terms to spending on domestically produced goods, we
must also delete M. We obtain
Y  Cd  I d  Gd  X
(2)
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Additional Insights:
Y  Cd  I d  Gd  X
(2)
where d denotes domestic. Equation (2) states that national
product or income consists of what is produced and absorbed
domestically (Cd + Id+ Gd) plus what is exported (X). The
goods and services produced and absorbed domestically are
called domestic absorption (Ad). That is Ad = Cd + Id + Gd.
Therefore,
Y  Ad  X
(3)
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Additional Insights:
Y  Ad  X
(3)
On the other hand, total absorption (A) consists of what is
produced (and absorbed) domestically (Ad) plus imports (M).
In our notation,
A  Ad  M
(4)
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Additional Insights:
A  Ad  M
(4)
and therefore, Ad = A – M. We may combine this with
equation (3) to obtain
Y  Ad  X  A  M  X  A  X  M
(5)
Hence,
Y  A  X  M or A  Y  M  X
(6)
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Additional Insights:
To illustrate:
The U.S. absorbs more than it produces:
A–Y=M–X
Japan produces more than it absorbs:
Y–A=X–M
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Summary of Policy Analysis
 The Need for Policy Mixes
 Effectiveness of Policy
 Foreign Retaliation
 What Governs Exchange Variations?

Productivity increase, foreign developments, domestic
policies
 Dutch disease
 Role of Fluctuating Exchange Rates
 Additional Insights: Fiscal and Monetary Polices
under Alternative Exchange Rate Regimes
C14-20
Some Unanswered Questions
 Degree of Impact
 Purchasing Power Parity

Absolute, relative
 Personal services
 PPP and GDP




Time Path
J-Curve
Incomplete Pass-through
Hysteresis
C14-21
FIGURE 14.6
Relative PPP (Solid Line) and Actual Dollar-Mark
Exchange Rate (Dashed Line), 1970 - 1999
C11-22
Summary
 Exchange rate changes’ effects on current account
 Depreciation
 Appreciation
 Resource shift
 Elasticities approach
 Absorption approach
 Domestic policies
 Dutch disease
 Freely fluctuating exchange rate
 Fixed exchange rate
 PPP
 J-curve, incomplete pass-through, hysteresis
C14-23
FIGURE A14-1.1
Stable U.K.
ForeignExchange
Market, I
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FIGURE A14-1.2
Stable U.K.
Foreign
Exchange
Market, II
C1-25
FIGURE A14-1.3
Unstable
U.K.
ForeignExchange
Market
C1-26
FIGURE A14-2.1
The DD Schedule
C1-27
FIGURE A14-2.2
The EE Schedule
C1-28
FIGURE A14-2.3
Equilibrium Output and Exchange Rate
C1-29
FIGURE A14-3.1
The Swan Diagram of Internal and External Balance1
C1-30
FIGURE A14-4.1
Fiscal Policy Under a Fixed Exchange Rate
C1-31
FIGURE A14-4.2
Monetary Policy Under a Fixed Exchange Rate
C1-32
FIGURE A14-4.3
Fiscal Policy Under a Freely Floating
Exchange Rate
C1-33
FIGURE A14-4.4
Monetary Policy Under a Freely Floating
Exchange Rate
C1-34