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Economics of International Finance
Econ. 315
Chapter 4
The Price Adjustment with Flexible
and Fixed Exchange Rates
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Objectives:

Examining how a nation’s current account is affected by price changes
under fixed and flexible exchange rates.
Assumptions

We assume no autonomous international private capital flows, i.e., they
take place as a response to temporary trade balances.

Current account is corrected only by exchange rate changes.

Since this approach is based on trade flows and the speed of adjustment
depends on how responsive (elastic) imports are to price changes
(exchange rate changes), it is also called trade or elasticity approach.
Adjustment with Flexible Exchange Rates


Current account is corrected by a depreciation (a flexible exchange rate)
or a devaluation (a fixed or pegged exchange rate).
Depreciation or devaluation operates on prices to bring about an
adjustment in the current account and BOP, i.e., affects the relative prices
of exports and imports.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University


BOP adjustments with exchange rate changes
Look at figure 1, where USA and EMU are assumed to be the only two
economies in the world. There are no international capital flows, such that
the US demand and supply for € reflects only trade in goods and services.

At R = $1/ €1, the US demand for € is 12 bn, while supply is only €8 bn,
i.e., a deficit € 4 bn.

If demand and supply for euros are D€ and S€, a 20% devaluation would
equilibrate BOP at €10 bn (point E).

If demand and supply for euros are less elastic D€’ and S€’ a 20%
devaluation would not equilibrate BOP at €10 bn. A 20% devaluation
would reduce the deficit to €3 bn, and 100% devaluation (R = $2/ €1)
would completely eliminate the deficit (point E’). Why?

The scale of depreciation depends on how elastic is the demand and
supply for foreign currency (imports and exports).
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
A deficit is corrected by
a 100% devaluation
The 20% devaluation would reduce
the deficit but not to correct for it
A deficit is corrected by a
20% devaluation
Figure 1 Balance-of-Payments Adjustments with Exchange Rate Changes.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Derivation of the demand curve for foreign exchange.

Look at panel A of figure 2. the demand for imports is DM at
R=$1/€1 while the European supply of imports is SM. Suppose
that the euro price for a unit of imports is PM = €1, and the
quantity of imports = 12 bn units (this corresponds to point B’ in
figure 1 (i.e., 12 bn units × €1 = €12 bn).

If the dollar depreciates by 20% pushes the DM down to to DM’,
SM remains unchanged, Why?. For the US to continue to demand
12 bn units the euro price of US imports would have to fall to PM
= €0.8, i.e., by exactly the 20% depreciation of the dollar in order
to leave the dollar’s price of European imports almost unchanged
(point H on DM).
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

It is obvious that DM’ should not be parallel (compare points J-G
and H-B’)

With DM’ and SM the price of imports is PM = €0.9 and QM = 11
bn. the US will move to point E’ and demand of the € would be
(11 bn. × 0.9 = 9.9 bn) ≈ 10 bn.

So: at R=$1/€1 the demand was € 12 bn, (point B in figure 1)
and at R=$1.2/€1 the demand was 10 bn, (point E in figure 1).
Therefore, D€ is derived from the demand and supply of imports.
(If demand for imports is less elastic, the demand for euros
would be D€ ‘ in figure 1)

Only in the unusual case where the demand for imports is
vertical, the quantity demanded of the foreign currency remains
constant after devaluation. However, the less elastic is the
demand for euros, the steeper is the demand.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Panel A
A compromise price € .9 per unit
at which BOP is in eq.
If the $ depreciates by 20%, DM shifts down.
PM should go down to € .8 (by 20%)
for US to continue buying 12 bn. units
Figure 2 Derivation of the U.S. Demand and Supply Curves for Foreign Exchange
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Derivation of the supply curve for foreign exchange.

Look at panel B of figure 2. SX is the supply of US exports, and DX is the
European demand for US exports. If the US price in euros is € 2, the quantity
of exports would be 4 bn and supply of euros would be 2 × 4 = € 8 bn (point
A in figure 1).

With A devaluation of 20% of the dollar DX remains unchanged but SX would
shift down to SX’. The price of exports would be €1.6 for each unit, this will
encourage European to demand more and there will be a movement toward E’
on DX which is an increase in the quantity exported by US from 4 bn to 5.5
bn. (i.e., 5.5x1.8≈ €10 bn).

So at R = $2/ €1, the supply of euros is €8 bn (point A in figure 1), at R =
$2.4/ €1, The supply of euros is 10 (point E in figure 1). The supply of euros
is driven from the supply and demand for US exports.

If demand for exports is less elastic there could be a movement form point A
to point C instead of E in figure 1.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Panel B
the price of exports € 1.8 per unit
at which BOP is in eq.
If the $ depreciates by 20%, SX shifts
and PX should go down to € 1.6 (by 20%)
This encourages demand for US exports
that pushes the price up to 1.8 euros
Figure 2 Derivation of the U.S. Demand and Supply Curves for Foreign Exchange
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
The Effect of Exchange Rate on Domestic Prices and the Terms of Trade
1.
Depreciation or devaluation stimulates the production of import
substitutes and exports leading to a rise in prices, i.e., depreciation is
inflationary. The greater the depreciation or devaluation, the greater is
the inflationary impact, and the less flexible is the increase in exchange
rates as a method of correcting deficit in BOP.
2.
A depreciation or devaluation is also likely to affect the nations terms of
trade TOT (the ratio between export prices and import prices), since
TOT are either measured in domestic prices or in foreign currency, a
depreciation or devaluation will cause TOT to increase, fall, or remain
unchanged.

Look at figure 2. after depreciation, the price of exports PX = €2 (point A’
in the right panel) and PM = €1 (point B’ in panel A). Hence TOT (PX / PM
=2/1 = 2 or 200%). After a 20% depreciation PX = €1.8 (point E’ in panel
B) and PM = € 0.9 (point E’ in panel A), so TOT = 1.8/0.9 = 2 or 200%.
TOT remain unchanged. But in general we expect TOT to change in case
of depreciation.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

The Dutch Disease
When an industrial nation begins to exploit a domestic natural resource
previously imported, the nation’s exchange rate might appreciate to cause
the nation’s loss of international competitiveness in its traditional
industrial sector, and even face deindustrialization. Does it apply to
Kuwait?.
Stability of Foreign Exchange Markets:
1.
Stable Foreign Exchange Market: when disturbances from the
equilibrium exchange rate give rise to automatic forces that push
exchange rate back to the equilibrium level.
2.
Unstable Foreign Exchange Market: when disturbances from the
equilibrium exchange rate push the exchange rate further away from the
equilibrium level.
A foreign exchange market is stable when the supply curve of foreign
exchange is positively slopped or if it is less elastic (steeper) than the
demand curve for foreign exchange.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Stable Foreign Exchange Market:
Look at figure 3; in panel A: R = $1.2 = €1 at equilibrium. If R fell to R
$1= €1  excess demand of € (deficit in US BOP = € 4 bn). This would
automatically push R back to equilibrium R ($1.2 = €1) and vice versa
when R increases to $1.4 = €1. Hence the foreign exchange market is
stable.
In panel B, supply is negatively slopped but steeper (inelastic) than the
demand. When the rate falls to R $1= €1  excess demand (deficit in
BOP = € 1.5 bn) which automatically pushes R towards equilibrium R
($1.2 = €1) and vice versa when R increases to $1.4 = €1. Hence the
foreign exchange market is stable.

Unstable Foreign Exchange Market:
In panel C, the supply curve is negatively slopped, but is flatter (more
elastic) than the demand. When R falls to R $1= €1  excess supply of €
of € 1.5 bn which pushes R away from equilibrium. If R = $1.4= €1 
excess demand for € which automatically pushes R up away from
equilibrium. Thus the foreign exchange market is unstable.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Panel A
Panel B
Panel C
FIGURE 3 Stable and Unstable Foreign Exchange Markets.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

When foreign exchange market is unstable, a flexible exchange
rate system increases, rather than reduces, BOP deficit. The
revaluation or appreciation not depreciation is required to
eliminate the BOP deficit, while devaluation is required to correct
for BOP surplus.

Determining whether the foreign exchange market is stable is
important. If the foreign exchange market is stable, elasticity of
the demand for foreign exchange and supply of foreign exchange
become important.
The Marshall-Learner Condition

The condition that tells us whether the foreign exchange market is
stable or unstable is the Marshall-Learner condition (M.L.C). The
simplified version of the M.L.C is that if supply curve of imports
and exports are infinitely elastic, the M.L.C indicates that a stable
foreign exchange market occurs if the sum of price elasticities of
demand and supply of foreign exchange in absolute terms is
greater than one.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

If the sum of elasticities of demand and supply of foreign
exchange is less than one 1, the foreign exchange market is
unstable.

If the sum of elasticities of demand and supply of foreign
exchange is one, the BOP will remain unchanged.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Elasticities in the Real World.


Elasticities Estimates
M.L.C postulates a stable foreign exchange market if the sum of price
elasticities of DM and DX exceeds one in real absolute terms. However, the
sum of elasticities of DM and DX should be substantially greater than one
to make depreciation feasible as a method of correcting a deficit in BOP.

Before world war II Marshall argued that price elasticities in
international trade are high (stable foreign exchange markets). This was
not based on empirical support (prewar optimism).

Econometric estimates, after the WWII however, show that the sum of
price elasticities of DM and DX is either less than 1 or barely exceed 1.
prewar optimism was replaced by post war pessimism.
Are foreign exchange markets unstable? finding an explanation.
1. The identification problem

Orcutt in 1950 argued that regression techniques led to gross
underestimation of the price elasticities of DM and DX and that Marshall
was correct. He argued that estimates of elasticities suffer from
identification problem.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Look at figure 4. points E and E’ are equilibrium points observed before
and after depreciation of the $, with non of the curves being observed.
The downward shift from SX to SX* depreciation does not affect the
foreign demand for US exports. If such a change occurs, the estimated
foreign demand for exports is DX. But E and E* are also consistent with
DX’ and DX’’ which are elastic. The identification problem results from
using DX even if the actual demand is DX’ which is elastic. This
underestimates the price elasticities in international trade.
2. The Effect of Lags

Junz and Rhomberg (1973) have identified possible lags in quantity
response to price changes in international trade: These lags explain the
low value of elasticities in the short run:





1. Recognition lag: before the change in price is evident
2. Decision lag: lag to take advantage of the price rise
3. Delivery lag: lag of new orders to be placed
4. replacement lag: to use up available inventories before new orders are
placed
5. Production lag: to change the output mix as a result of price changes.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
FIGURE 4 The Identification Problem.
Estimates used the inelastic demand
Instead of using
The elastic demand curves
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

By not taking these lags and only takes the quantities in the years of a
price change led to a underestimation of price elasticities. Hence short
run elasticities are likely to be much smaller than long run elasticities.
3. The J curve and revised elasticity estimates.

The BOP may worsen soon after the depreciation before improving later
on. This is due to the tendency of the domestic currency price of imports
to rise faster than export prices with quantities initially not changing very
much.

Over time QX rises and QM falls so that the initial deterioration of the
BOP is halted and then reversed. This is known as the J curve effect
because the response of the trade balance to a depreciation looks like the
curve of a J.

Empirical studies confirmed the existence of the J curve effect and came
up with high long term elasticities, i.e., real world elasticities are high
enough to ensure stability of the foreign exchange market in the short run
and a fairly elastic demand for and supply of foreign exchange in the long
run.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
FIGURE 5 The J-Curve.
BOP improves
Immediate deterioration of BOP
BOP deterioration halts
Deterioration lowers over time
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
4. Currency pass through

The increase in the domestic price of imported commodity may be
smaller than the amount of depreciation even after lags, i.e., the pass
through from depreciation to the domestic prices may be less than
complete, e.g., a 10% depreciation may result in a less than 10% increase
in domestic currency prices of the imported commodity. Why?

Exporters often having established a large share in domestic market may
be willing to absorb at least some of the price increase they could charge
out of their profits. A foreign company may increase the price of exports
by 6% and accept a 4% reduction in the price of its exports when the
nation’s currency depreciates by 10% to avoid the risk of losing foreign
markets by large increases in the price of their exports. This is known as
the beachhead effect.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Adjustment under the gold standard

The Gold standard

Operated from about 1880 to the outbreak of the WW I. After the war,
there was an attempt to reestablish the gold standard but this failed in
1931. It is also unlikely that it will be reestablished in the future. But it is
important to understand its advantages and disadvantages.

Under the gold standard each country defines the gold content of its
currency and stands ready to buy or sell any amount of gold at that price.
Based on that exchange rates are determined.

For example, the £ contains 113 grains of gold while the $ contains 23.2
grains. The dollar price of the £ is 113/23.2 = 4.87. this is called the mint
parity.

Since shipping currencies between New York and London cost gold
(about 3 cents), the exchange rate between the $ and £ could never
fluctuate by more than 3 cents above or below the mint parity.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
FIGURE 6 Gold Points and Gold Flows.
Gold sold in US, exported to London
to buy £ at $ 4.90 Instead of buying
£ in US at $ 4.94
An increase in the
demand for imports
 deficit and a
depreciation of $
sell gold abroad
An increase in the
demand for exports
 Appreciation of $
Gold is imported from London
buy gold from abroad
due to selling the surplus of
£ there at 4.84 instead of 4.80 in US
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

None would pay more than $ 4.90 for £1 since he/she could
purchase $ 4.87 of gold in the US, ship it to London at 3 cents and
exchange it for £1 at the bank of England (central bank). Thus the
US supply of £ becomes infinitely elastic at the rate of $ 4.90 for £1.
This was the gold export point of the US

On the other hand, the $/£ rate can’t fall below $ 4.84 because no
one would accept less than 4.84 for the £. He could always
purchase £ worth of gold in London and ship it to New York at a
cost of 3 cents and exchange it for $ 4.87 (i.e. 4.84 net) as a result
the demand curve becomes infinitely elastic (horizontal) at the rate
of $ 4.84 / £1. This is the gold import point of the US. Exchange
rate is prevented from moving outside the gold points by US gold
sales or purchases.
The price-specie-flow mechanism

The automatic adjustment mechanism under the gold standard.
The price-specie-flow mechanism is working as follows
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University



Under the gold standard money supply would fall in the deficit nation
and rise in the surplus nation causing prices to fall in the deficit and rise
in the surplus nation. Exports of the deficit nation would be encouraged
and imports would be discouraged until deficit is eliminated. This is
based on the quantity theory of money:
M.V=P.Q
As the deficit nation lost gold, M falls. A reduced M by 10% encourages
exports and discourages imports. The opposite would take place in the
surplus nation (due to gold inflow) internal prices increases and
discourage exports, and encourage imports until deficit and surplus are
eliminated.
Note that while adjustment under the flexible exchange rate system relies
on high price elasticities of exports and imports, in the deficit surplus
nation, adjustment under the gold standard relies on changing internal
prices of each nation. The adjustment under the gold standard relies also
on high price elasticities of exports and imports in the deficit and surplus
nation, so that the volume of exports and imports respond readily and
significantly to price changes.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
The price-specie-flow mechanism
M.V = P.Q
Deficit nation  M↓ P
↓  imports ↓
and exports ↑  bop equilibrium
Surplus nation  M ↑ P
↑  imports ↑
and exports ↓  bop equilibrium
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Key Terms
•Devaluation
Gold standard
•Dutch disease
Mint parity
•Stable foreign exchange market
Gold export point
•Unstable foreign exchange market
Gold import point
•Marshall-Lerner condition
Price-specie flow mechanism
•Elasticity pessimism
Quantity theory of money
•Identification problem
Rules of the game of the gold standard
•J-curve effect
Pass-through effect
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University