INTERNATIONAL FINANCE
EC 654
Foreign Exchange Market and
Trade Elasticities
Crucial Question:
Under which circumstances will a
devaluation lead to an improvement of the
trade balance
Literature: KO pp. 464f. and appendix to
ch. 16 or CFJ., 16.
Dr. Carsten Lange
Some Assumptions
• No net capital flows: FA=0, KA = 0.
• Residents in a country respond only to prices in
their domestic currency.
• Export price are fixed in domestic currency (e.g. $).
Imports prices are fixed in foreign currency.
• Supply is infinitely elastic. This means: If firms
experience a higher demand for their goods, they
will produce the extra demand without a price
increase.
How Does a Devaluation of the Domestic
Currency Effect the Trade Balance?
$/€
Demand
(Imports)
Supply
(Exports)
$/€1
$/€0
The diagram seems to suggest, that a devaluation leads always to an
improvement, but this is here only true since the Marshall-Lerner condition is
fulfilled.
€ demand and supply
Three Effects of a Devaluation of lets
say 1% (exchange rate increase of 1%)
1. Import quantity will decrease by x%.
(we don’t know the exact number for x).
C.p. the trade balance will improve by x%.
2. Export quantity will increase by y%.
(we don’t know the exact number for y)
C.p. the trade balance will improve y%.
Preliminary result:
Considering only effect 1 and 2 the trade balance would
improve by x% + y%.
Reminder on Price Elasticity of
Demand
Price Elasticity of Demand
e :=
Percentage Change in Demand Quantity
Percentage Change in Price
What is the price change, that customers for
export (import goods) are facing?
1% !!!
Therefore in our example the import and export
quantities can be expressed by the price elasticity
for import goods
em resp. export goods ex.
Three Effects of a Devaluation of lets say 1%
1. Import quantity will decrease by em %.
(we don’t know the exact number for em)
C.p. the trade balance will improve by em %
2. Export quantity will increase by ex %.
(we don’t know the exact number for ex)
C.p. the trade balance will improve ex %.
Preliminary result:
Considering only effect 1 and 2 the trade balance would improve by em
+ ex %.
The Third Effect of a Devaluation is
Always Determined
a) Given the quantity of imports the value of
imports expressed in domestic currency
will increase.
b) Given a 1% devaluation, the import value
would increase c.p. by 1% and would
hurt the trade balance by 1%.
Summarizing the Three Effects
Marshall/Lerner Condition
Only if the sum of effect #1 and #2 is stronger
than effect #3, a devaluation will lead to an
improvement of the trade balance.
In Other Words:
e
e
If and only if m + x >= 1, a devaluation will
lead to an improvement of the trade balance.
Example Marshall Learner
not fulfilled
Before:
After:
Imp. Elast.
Imports
0.2
Price
BMW (amount)
$100,000
200
$101,000
199.6
Trade Balance:
$20,100,000
Exp. Elast.
Export
Exports
0.5
Value
Price
GM (amount)
$20,000,000
$50,000
400 $20,000,000
$20,159,600
$50,000
402 $20,100,000
Import
Value
-
$20,159,600
=
-$59,600
Example Marshall Learner
exactly fulfilled
Before:
After:
Imp. Elast.
Imports
0.01
Price
BMW (amount)
$100,000
200
$101,000
199.98
Trade Balance:
$20,198,000
Exp. Elast.
Export
Exports
0.99
Value
Price
GM (amount)
$20,000,000
$50,000
400 $20,000,000
$20,197,980
$50,000
403.96 $20,198,000
Import
Value
-
$20,197,980
=
The balance of payment effect is supposed to be exactly 0. The $20
difference results from the fact that the increased price effects only 199.98
BMWs instead of 200. This fact is not considered in the Marshall/Lerner
condition.
$20
Example Marshall Learner
fulfilled (assignment: complete the table)
Before:
After:
Imp. Elast.
Imports
0.5
Price
BMW (amount)
$100,000
200
Trade Balance:
Exp. Elast.
Export
Exports
2
Value
Price
GM (amount)
$20,000,000
$50,000
400 $20,000,000
$
Import
Value
-
=
Example Marshall Learner
fulfilled (assignment answer)
Before:
After:
Imp. Elast.
Imports
0.5
Price
BMW (amount)
$100,000
200
$101,000
199
Trade Balance:
$20,400,000
Exp. Elast.
Export
Exports
2
Value
Price
GM (amount)
$20,000,000
$50,000
400 $20,000,000
$20,099,000
$50,000
408 $20,400,000
Import
Value
-
$20,099,000
=
$301,000
Short Run
em %.
c.p. the trade balance will improve by em %
2. Export quantity will increase by ex %.C.p. the trade balance
will improve ex %.
1. Import quantity will decrease by
3.
Given a 1% devaluation, the import value would
immediately (!) increase c.p. by 1% and would hurt the
trade balance by 1%.
Even if the Marshall/Lerner condition is fulfilled, in the short run the
3rd. Effect will dominate. Later the trade balance will improve which
leads to a J-Curve.
Example: Short Run Reaction of the
Balance of Payment to a depreciation of the
Domestic Currency
Before:
After:
Imp. Elast.
Imports
0
Price
BMW (amount)
$100,000
200
$101,000
200
Trade Balance:
$20,000,000
Exp. Elast.
Export
Exports
0
Value
Price
GM (amount)
$20,000,000
$50,000
400 $20,000,000
$20,200,000
$50,000
400 $20,000,000
Import
Value
-
$20,200,000
=
-$200,000