Chapter 6
Price Adjustments And Balance-Of-Payments Disequilibrium

Chapter Objectives:

How a change in the exchange rate affect the balance of payment

Short run and long run adjustments to exchange rate change
A home country current account deficit can be eliminated by a depreciating domestic currency.
The elasticity approach to the BOP emphasizes how expenditure switching , induced by an exchange rate change can eliminate a current deficit/surplus.
The mechanics of the foreign exchange market resulting from trade in goods and services
Figures 1 and 2.
The importance of a stable market (figure 3).
Example of how a “normal” market for goods and services can give rise to a potentially unstable foreign exchange market (Table 2, and figure 4).
Unstable foreign exchange market is the net result of

A domestic currency appreciation requires more foreign currency to purchase the same one unit of domestic currency

At the same time, foreign demand for domestic goods and services is decreasing
The nature of this relationship is described by the (arc) elasticity of demand (supply):
 arc


Q / [( Q

Q
1 2

P / [( P
1

P
2
) / ]
 
1
= elastic demand (supply)

 
1
= unitary elastic
 
1
= elastic demand (supply)
If foreign demand for domestic good is inelastic, supply curve of foreign currency is backward-sloping.
If foreign demand for domestic good is elastic, supply curve of foreign currency is upward-sloping.
The Marshall-Lerner condition

It takes different forms depending on the assumptions on the elasticity of supply of imports and exports.
 If it is satisfied, a depreciation of home currency is expected to lead to an improvement in home country’s current account.

Adjustment In the Short-Run and the Long-Run
In the short run, following a home country depreciation, the home country’s current account does not improve immediately.
In the short run, domestic demand for foreign imports may be inelastic. This results in a vertical demand for foreign currency.
Also, foreign demand for domestic exports may also be inelastic. Thus the supply of foreign currency is backward-sloping. (Figure 8)
Result: In the short run, domestic country’s current account may actually deteriorate following a currency depreciation. But should not confuse with a unstable market for goods and services (imports and exports).
Over time, when there is sufficient time for adjustment, the current account gradually improves. This is the so-call J-Curve (figure 9).
Elasticity of Exchange Rate Pass-Through
Computed as:
%

%

(
min
)
Complete pass through of an exchange rate change into import prices: the elasticity will be 1.
Example: when domestic currency depreciates, domestic exporters increase their prices so that the import prices remain the same as before the depreciates and vice versa when there is a domestic currency appreciation.
No exchange rate pass-through: the elasticity will be 0.
Partial exchange rate pass-through: the elasticity will be between 0 and 1.