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Price adjustment and
BOP disequilibrium
ECO422 : Chapter 6
Class 20
Till now..
• Exchange rate means price of foreign
currency
• Devaluation of dollars,
• i.e., rise in exchange rate dollars
• Reduces import surplus, import expenditure
• And process of such price adjustment can
bring BOP disequilibrium into equilibrium
condition.
• However, devaluation may have other
effects in the foreign exchange market.
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Till now..
• 1. Commodity flow
• 2. depressed foreign currency
• 3. Inflationary effect on domestic currency
• 4. Fall in Quantity of Foreign Exchange
Demanded
• 5. Increase in Quantity of Foreign Exchange
Supplied if elasticity of demand for import is
greater than one.
Summary of the Effects of
Devaluation
• 6 The Effect on America's Terms of Trade
• let see the effect of commodity flow figure
and effect on foreign price figure for this.
• Calculate the TOT
• the devaluation of the dollar causes
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(a) radio Price (dollars)
(b) clock
Price (dollars)
Britain’s
£60 supply of America’s supply of
export export schedule
schedule
£45
£ 30
REPEAT SLIDE
G
Britain’s demand for
America’s £ 27 import schedule
G
demand for
imports
schedule
5600 6000 12000 1800
(a) radio Price (dollars)
(b) clock
Price (dollars)
Britain’s
£60 supply of America’s supply of
export export schedule
Summary of the Effects of
schedule
£45
£ 30 £36
Devaluation
G Britain’s demand for
£ 25 America’s £ 27 import schedule
G
demand for
imports
schedule
5600 6000 12000 1800 3000
• Effect on foreign prices.
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Summary of the Effects of
Devaluation
• The terms of trade (TOT):
• the relative price of A-exportables falls from
• 45/30 to 36/25.
• However: The effect of devaluation on America's
terms of trade still depends on
• the various import-demand elasticities and export-
supply elasticities.
• it is not possible to predict directly without such
information.
Summary of the Effects of
Devaluation
• 7 The Effect on the Balance of Trade (BOT)
• Does devaluation improve the balance of trade?
• It depends on domestic export revenue.
• If revenue increases , then the devaluation will improve the
BOT.
• depending on foreign demand for import elasticities.
• Therefore: only in one condition the BOT and hence the
BOP will be improved after devaluation
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Summary of the Effects of
Devaluation
• As we saw earlier, an increase in the rate of exchange (that
is, devaluation of the dollar) decreases America's
expenditure on imports expressed in pounds (quantity of
pounds demanded), which works in the direction of
reducing America's deficit.
• However, before we can say whether America's balance of
trade improves, we must also know what happens to
America's export revenue (quantity of foreign exchange
supplied). If the export revenue increases, we must
unequivocally conclude that the deficit falls.
Summary of the Effects of
Devaluation
• If the reduction in export revenue is larger than the fall in
expenditures on imports, America's deficit actually
becomes larger.
• Economists have shown that the balance-of-trade effect of
devaluation depends on the import-demand and export-
supply elasticities.
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the Marshall-Lerner condition:
• whose satisfaction guarantees that devaluation actually
improves the balance of trade, that is, reduces the deficit.
• If a country's currency is devalued, and demand for both
exports and imports is elastic, then:
• 1. The cheaper A-exportable will lead to a significant
increase in the quantity demanded by foreign buyers,
boosting export revenue.
• 2. The more expensive imports will lead to a significant
decrease in the quantity demanded by domestic
consumers, reducing import expenditure.
the Marshall-Lerner condition:
• If the combined effect of these two leads to a net
increase in export revenue compared to import
expenditure, the trade balance improves.
• However, if the combined price elasticity of
demand is less than 1 (inelastic),
• the quantity changes won't be large enough to
offset the price changes, and
• the trade balance might worsen after devaluation.
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the Marshall-Lerner condition:
• The Marshall-Lerner condition states that
• a real depreciation of a currency will improve the current
account balance (BOT) if
• the sum of the absolute values of the export and import
demand elasticities is greater than one.
• a country's trade balance will improve after a currency
devaluation if the demand for its exports and imports is
sufficiently price-elastic.
Summary of the Effects of
Devaluation
• 8 The Effect on Domestic Consumption and Production
• Devaluation has some predictable effects on domestic
production and consumption of both countries.
• In general, we must expect the consumption of both A-
exportables and B-exportables to fall in America (where
they become more expensive) and rise in Britain (where
they become cheaper).
• We must also expect the production of both A-exportables
and B-exportables to rise in America and fall in Britain.
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J-curve effect
• Consider time effect
• Following a devaluation (or depreciation) of the domestic
currency, the balance of trade typically worsens for
several months before it eventually improves.
• This phenomenon is known as the J curve,
• because the trade balance traces a J-shaped curve
through time.
• Empirical studies show that the time lag involved in the
balance-of-trade improvement of devaluation varies
considerably from country to country.
What causes the J-curve
phenomenon?
• The price elasticities of demand for imports and exports
that are long-run elasticities; describe well the effects of a
devaluation after enough time (at least two years)
• Empirical studies suggest that the long-run elasticities are
roughly twice as high as the corresponding short-run
elasticities, and
• that about 50 percent of the final relative price adjustment
takes place within one year.
• Thus the short-run elasticities do not always satisfy the
Marshall-Lerner condition; hence cause the J-curve effect.
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What causes the J-curve
phenomenon?
• There are several reasons why the short-run
elasticities are lower than the long-run elasticities.
• 1. For example, immediately following a
devaluation,
• the course of export revenue and expenditure on
imports is determined by contracts (usually
denominated in the currency of the exporter)
signed before the devaluation.
What causes the J-curve
phenomenon?
• 2. Further, consumers react slowly to price
changes because it takes time for habits to adjust.
• 3. Finally, switching suppliers also takes time-
traders are likely to wait until they are reasonably
convinced that the benefits will last long enough to
make the switch worthwhile.
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FIGURE 5 The J curve
J-curve
balance
Trade
0
t0 t1
Time
• Devaluation occurs at time t0 but has no immediate effect
on the volumes of exports and imports.
• Because exports are invoiced in the exporter's currency,
FIGURE 5 The J curve
J-curve
balance
Trade
0
t0 t1
Tim
e
• the export revenue (in foreign exchange) falls, while the expenditure
on imports (in foreign exchange) remains the same.
• Thus the balance of trade deteriorates.
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FIGURE 5 The J curve
J-curve
Trade balance
0
t0 t1
Time
• By time t1, the initial balance-of-trade deterioration is
totally reversed.
• The positive effects of devaluation occur after t1.
Practice question
• Derive the price adjusted equilibrium in the commodity market
using partial equilibrium model.
• How does a depreciation of domestic currency disturbs the
initial commodity market equilibria? Graphically explain with a
set of hypothetical example.
• Graphically explain the effects of devaluation on commodity
flow, domestic price, and foreign price.
• What is Marshall-Lerner condition? Explain the effect of
devaluation on the Balance of trade in line with the Marshall-
Lerner condition.
• What is J-curve effect? What cause the J-curve phenomenon?
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