An Introduction to
International Economics
Chapter 13: Automatic Adjustments
with Flexible and Fixed Exchange
Rates
Dominick Salvatore
John Wiley & Sons, Inc.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 1
Focus of the chapter
• How is a trade deficit automatically closed by
price and income changes?
– In this chapter private international capital flows
are assumed to be passive responses to cover
temporary trade imbalances.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 2
• Assume (1) only two
nations (the U.S. and
Japan) and (2) no
capital flows.
– Under these
assumptions the demand
for yen will be driven by
U.S. demand for
Japanese goods and
services, or imports.
$/¥
Exchange rate adjustment
D¥
¥/day
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 3
• Assume (1) only two
nations (the U.S. and
Japan) and (2) no capital
flows.
– Under these assumptions
the demand for yen will be
driven by U.S. demand for
Japanese goods and
services, or imports.
– The supply of yen will be
driven by Japanese
demand for U.S. goods
and services, or exports.
Dale R. DeBoer
University of Colorado, Colorado Springs
$/¥
Exchange rate adjustment
S¥
D¥
¥/day
13 - 4
• If the exchange rate is
at level A, the U.S. will
have a trade deficit.
$/¥
Exchange rate adjustment
S¥
A
D¥
¥/day
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 5
• If the exchange rate is at
level A, the U.S. will have
a trade deficit.
• If exchange rates in the
U.S. are flexible, over
time the exchange rate
will move to its
equilibrium value of B.
$/¥
Exchange rate adjustment
S¥
B
A
D¥
¥/day
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 6
• If the exchange rate is at
level A, the U.S. will have
a trade deficit.
• If exchange rates in the
U.S. are flexible, over
time the exchange rate
will move to its equilibrium
value of B.
• As the exchange rate
adjusts to B, the trade
deficit will close.
Dale R. DeBoer
University of Colorado, Colorado Springs
$/¥
Exchange rate adjustment
S¥
B
A
D¥
¥/day
13 - 7
• If instead of the original
supply and demand
curves, supply and
demand are given by S¥*
and D¥*, a depreciation
of the dollar will still
occur.
• However, the
depreciation will be
much greater in this
case (to level C).
Dale R. DeBoer
University of Colorado, Colorado Springs
$/¥
Exchange rate adjustment
S¥*
S¥
C
B
A
D¥*
D¥
¥/day
13 - 8
• The more significant
depreciation of the
dollar (from A to C) will
have more severe
inflationary effects on
the U.S. economy.
• This implication points
to the importance of
knowing the elasticity of
the supply and demand
curves.
Dale R. DeBoer
University of Colorado, Colorado Springs
$/¥
Exchange rate adjustment
S¥*
S¥
C
A
D¥*
D¥
¥/day
13 - 9
Elasticity
• Since the demand for foreign currency
depends on the demand for imports, the
elasticity depends on the price elasticity of the
demand for imports (ηM).
• ηM = %ΔQM ÷ %ΔPM
• Similarly, the elasticity of supply depends on
the price elasticity of supply for exports (ηX).
• ηX = %ΔQX ÷ %ΔPX
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 10
• If the supply of foreign
currency is negatively
sloped and more elastic
than the demand for
foreign currency, the
foreign exchange
market will be unstable.
$/¥
Unstable foreign exchange market
S¥
D¥
¥/day
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 11
• If the supply of foreign
currency is negatively
sloped and more elastic
than the demand for
foreign currency, the
foreign exchange market
will be unstable.
• In this case, a trade
deficit occurs at an
exchange rate above
the equilibrium value.
Dale R. DeBoer
University of Colorado, Colorado Springs
$/¥
Unstable foreign exchange market
A
S¥
D¥
¥/day
13 - 12
• In this case, a trade deficit
occurs at an exchange
rate above the equilibrium
value.
• At level A, the quantity
demanded of foreign
exchange (Z) exceeds
the quantity supplied
(Y).
$/¥
Unstable foreign exchange market
A
S¥
D¥
Y Z
Dale R. DeBoer
University of Colorado, Colorado Springs
¥/day
13 - 13
• At level A, the quantity
demanded of foreign
exchange (Z) exceeds the
quantity supplied (Y).
• The excess demand
puts upward pressure
on the exchange rate
and pushes the
exchange market
further from
equilibrium.
Dale R. DeBoer
University of Colorado, Colorado Springs
$/¥
Unstable foreign exchange market
A
S¥
D¥
Y Z
¥/day
13 - 14
The Marshall-Lerner condition
• The unstable condition just depicted will be
avoided if the Marshall-Lerner condition holds.
• The Marshall-Lerner condition is that ηM + ηX >
1.
• Empirical evidence indicates that this
condition does hold.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 15
J-curve effect
• A currency depreciation is expected to lessen
a country’s trade deficit.
• This improvement may take time to occur.
• Initially, the depreciation may worsen the trade
deficit since import prices will rise more
quickly than the improvement in exports.
• This generates a J-shaped pattern to
exchange rate movements.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 16
The gold standard
• The gold standard generates a system of fixed
exchange rates.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 17
The gold standard
• The gold standard generates a system of fixed
exchange rates.
• The gold standard for the international
monetary system operated from 1880 to 1914.
– This system is similar to the post-WWII Bretton
Woods monetary system that collapsed in 1971.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 18
The gold standard
• The gold standard generates a system of fixed
exchange rates.
• The gold standard for the international monetary
system operated from 1880 to 1914.
• Under the gold standard, each nation
specified the gold content of its currency.
– £1 gold coin contained 113.0016 grains of gold
– $1 gold coin contained 23.22 grains of gold
– This entails an exchange rate of 113.0016 ÷ 23.22
or $4.87/£.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 19
The gold standard
• The gold standard generates a system of fixed
exchange rates.
• The gold standard for the international monetary
system operated from 1880 to 1914.
• Under the gold standard, each nation specified
the gold content of its currency.
• The exchange rate of $4.87/£ is known as mint
parity.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 20
The gold standard
• Under the gold standard, each nation specified
the gold content of its currency.
• The exchange rate of $4.87/£ is known as mint
parity.
• As the cost of shipping gold from New York to
London was approximately 3 cents, the actual
exchange rate would always lie between
$4.84/£ and $4.90/£.
– $4.84/£ is the gold import point.
– $4.90/£ is the gold export point.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 21
Adjustment under the gold standard
• Adjustment to equilibrium under the gold
standard occurs via the price-specie-flow
mechanism.
– The concept of the price-specie-flow mechanism
was initially introduced in 1752 by David Hume.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 22
Adjustment under the gold standard
• Adjustment to equilibrium under the gold standard
occurs via the price-specie-flow mechanism.
• If a trade imbalance exists, gold will flow from
the country with a trade deficit to the country
with a trade surplus.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 23
Adjustment under the gold standard
• Adjustment to equilibrium under the gold standard
occurs via the price-specie-flow mechanism.
• If a trade imbalance exists, gold will flow from the
country with a trade deficit to the country with a
trade surplus.
• The fall in gold supplies in the trade deficit
country reduces its money supply and pushes
its price level lower; the increase in gold
supplies in the trade surplus country
increases its money supply and raises its
price level.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 24
Adjustment under the gold standard
• The fall in gold supplies in the trade deficit country
reduces its money supply and pushes its price
level lower; the increase in gold supplies in the
trade surplus country increases its money supply
and raises its price level.
• The price level movement is seen via the
equation of exchange: M • V = P • Y (where M
is the money supply, V is the velocity of
money, P is the price level, and Y is real
output).
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 25
Adjustment under the gold standard
• The price level movement is seen via the
equation of exchange: M • V = P • Y (where M is
the money supply, V is the velocity of money, P is
the price level, and Y is real output).
• As the price level falls in the country with a
trade deficit, exports of its goods and services
will be encouraged; as the price level
increases in the country with a trade surplus,
exports of its goods and services will be
discouraged.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 26
Adjustment under the gold standard
• As the price level falls in the country with a trade
deficit, exports of its goods and services will be
encouraged; as the price level increases in the
country with a trade surplus, exports of its goods
and services will be discouraged.
• These changes in trade will decrease both the
trade deficit and surplus leaving a situation of
balanced international trade.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 27
Income determination in a closed
economy
• In a closed economy (without international
trade) without a government sector,
equilibrium output is determined by:
Y=C+S=C+I
where Y is income, C is planned consumption
expenditures, I is planned business savings,
and S is savings.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 28
Income determination in a closed
economy
• In a closed economy (without international trade)
without a government sector, equilibrium output is
determined by:
Y=C+S=C+I
where Y is income, C is planned consumption
expenditures, I is planned business savings, and
S is savings.
• This yields an equilibrium condition of:
S – I = 0.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 29
Income determination in a closed
economy
• This yields an equilibrium condition of:
S – I = 0.
• In words, this entails that at equilibrium
leakages from the economy (S) must be
balanced by injections into the economy (I).
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 30
Income determination in a closed
economy
• In words, this entails that at equilibrium leakages
from the economy (S) must be balanced by
injections into the economy (I).
• If planned investment is autonomous but
savings is determined by the marginal
propensity to save (s), then:
ΔS = sΔY.
– The marginal propensity to save (s) is amount of
additional savings that flows from each additional
dollar of income.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 31
Income determination in a closed
economy
• If planned investment is autonomous but savings
is determined by the marginal propensity to save
(s), then:
ΔS = sΔY.
• Since S = I at equilibrium, this entails that:
ΔI = sΔY
or
1 ÷ s = ΔY ÷ ΔI.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 32
Income determination in a closed
economy
• Since S = I at equilibrium, this entails that:
ΔI = sΔY
or
1 ÷ s = ΔY ÷ ΔI.
• If k = 1 ÷ s, then ΔY = k • ΔI.
– k is the multiplier.
– Any change in investment will induce a multiplied
change in income as given by the above formula.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 33
Income determination in a closed
economy
• If k = 1 ÷ s, then ΔY = k • ΔI.
• An example
– s = 0.25
– ΔI = 300
– What is the value of k?
• k = 1 ÷ 0.25 = 4
– What is the change in income?
• ΔY = 4 • 300 = 1,200
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 34
Income determination in an open
economy
• In an open economy, equilibrium is still
determined by the condition that leakages
must equal injections.
– In an open economy, imports (M) are a new
leakage.
– In an open economy, exports (X) are a new
injection.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 35
Income determination in an open
economy
• In an open economy, equilibrium is still
determined by the condition that leakages must
equal injections.
• The new equilibrium equation is:
S+M=I+X
or
ΔS + ΔM = ΔI + ΔX.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 36
Income determination in an open
economy
• The new equilibrium equation is:
S+M=I+X
or
ΔS + ΔM = ΔI + ΔX.
• If ΔM = mΔY, then the multiplier (k*) becomes:
k* = 1 ÷ (s + m)
– Where m is the marginal propensity to import.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 37
Income determination in an open
economy
• The new equilibrium equation is:
S+M=I+X
or
ΔS + ΔM = ΔI + ΔX.
• If ΔM = mΔY, then the multiplier (k*) becomes:
k* = 1 ÷ (s + m)
– Where m is the marginal propensity to import.
• This leaves ΔY = k* • ΔI or ΔY = k* • ΔX.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 38
Income determination in an open
economy
• This leaves ΔY = k* • ΔI or ΔY = k* • ΔX.
• An example
–
–
–
–
s = 0.25
m = 0.25
ΔI = 400
What is the value of k*?
• k = 1 ÷ (0.25 + 0.25) = 2
– What is the change in income?
• ΔY = 2 • 200 = 800
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 39
Foreign repercussions
• Suppose Nation 1 experiences an increase in
its planned autonomous investment.
– Nation 1 will experience an increase in its
domestic income of k* • ΔI.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 40
Foreign repercussions
• Suppose Nation 1 experiences an increase in its
planned autonomous investment.
• The increase in Nation 1’s income will
increase its imports by mΔY.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 41
Foreign repercussions
• Suppose Nation 1 experiences an increase in its
planned autonomous investment.
• The increase in Nation 1’s income will increase its
imports by mΔY.
• Assuming only two countries, Nation 1’s
increased imports will increase Nation 2’s
exports leading to an expansion in Nation 2’s
income by k2* • ΔX2.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 42
Foreign repercussions
• The increase in Nation 1’s income will increase its
imports by mΔY.
• Assuming only two countries, Nation 1’s
increased imports will increase Nation 2’s exports
leading to an expansion in Nation 2’s income by
k2* • ΔX2.
• The increase in Nation 2’s income will lead to
an increase in its imports, spurring a
secondary expansion in Nation 1.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 43
Absorption approach
• The absorption approach integrates the effect
of induced income changes in the process of
correcting a balance of payments
disequilibrium by a change in the exchange
rate.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 44
Absorption approach
• The absorption approach integrates the effect of
induced income changes in the process of
correcting a balance of payments disequilibrium
by a change in the exchange rate.
• Domestic equilibrium is given by:
Y = C + I + (X – M).
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 45
Absorption approach
• Domestic equilibrium is given by:
Y = C + I + (X – M).
• Define A (domestic absorption) = C + I and B
(foreign absorption) = X – M. Then:
Y=A+B
or
Y – A = B.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 46
Absorption approach
• Define A (domestic absorption) = C + I and B
(foreign absorption) = X – M. Then:
Y=A+B
or
Y – A = B.
• A depreciation of the currency is expected to
increase B.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 47
Absorption approach
• A depreciation of the currency is expected to
increase B.
• This can only occur if A falls or Y increases.
– If the economy is at full employment, Y cannot
increase.
– Therefore, a depreciation must result in a fall in A.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 48
Absorption approach
• A depreciation of the currency is expected to
increase B.
• This can only occur if A falls or Y increases.
• Forces that lead to a fall in domestic
absorption (A).
– Income is redistributed from wages to profits.
– The depreciation increases prices and hence
lowers domestic expenditures.
– The depreciation pushes people into higher tax
brackets and hence lowers disposable income.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 49
Synthesis
• Flexible exchange rate adjustment
– A trade deficit leads to a depreciation of the
domestic currency.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 50
Synthesis
• Flexible exchange rate adjustment
– A trade deficit leads to a depreciation of the domestic
currency.
– The depreciation spurs an improvement in the
balance of trade.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 51
Synthesis
• Flexible exchange rate adjustment
– A trade deficit leads to a depreciation of the domestic
currency.
– The depreciation spurs an improvement in the
balance of trade.
– The improvement in the balance of trade spurs
increased domestic production.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 52
Synthesis
• Flexible exchange rate adjustment
– A trade deficit leads to a depreciation of the domestic
currency.
– The depreciation spurs an improvement in the
balance of trade.
– The improvement in the balance of trade spurs
increased domestic production.
– The increase in production generates increased
domestic incomes that spur greater investment –
partially offsetting the initial improvement in the
trade balance.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 53
Synthesis
• Flexible exchange rate adjustment
– The improvement in the balance of trade spurs
increased domestic production.
– The increase in production generates increased
domestic incomes that spur greater investment –
partially offsetting the initial improvement in the trade
balance.
– If production cannot increase because the nation
is already at full employment, domestic
absorption must fall.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 54
Synthesis
• Flexible exchange rate adjustment
• Fixed exchange rate adjustment
– A trade deficit spurs a decrease in the domestic
money supply.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 55
Synthesis
• Flexible exchange rate adjustment
• Fixed exchange rate adjustment
– A trade deficit spurs a decrease in the domestic
money supply.
– The fall in the money supply pushes the domestic
price level lower.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 56
Synthesis
• Flexible exchange rate adjustment
• Fixed exchange rate adjustment
– A trade deficit spurs a decrease in the domestic
money supply.
– The fall in the money supply pushes the domestic
price level lower.
– As domestic prices fall, exports are encouraged
and imports discouraged moving the economy to
a situation of balanced trade.
Dale R. DeBoer
University of Colorado, Colorado Springs
13 - 57