Download Price Adjustment Mechanism with the Gold Standard

Chapter 5
Price Adjustments and
Balance-of-Payments
Disequilibrium
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Learning Objectives
Explain how changes in the exchange
rate affect the movement of goods
and services and the trade balances
of countries.
Discuss how price elasticity of
demand relates to the stability of
foreign exchange markets.
Summarize how the price adjustment
mechanism functions under a system
of fixed or pegged exchange rates.
The Price Adjustment Process
and the Current Account Under
A Flexible Rate System
 A depreciation of the home currency
causes foreign goods to become more
expensive, reducing consumption of
imports relative to domestic
alternatives.
 A depreciation makes the home
country’s exports seem cheaper, so
the trading partner switches
expenditure towards home products.
 This process is expenditure switching.
Demand for Foreign Goods
and Services and the Foreign
Exchange Market
 Demand for foreign exchange is derived from
demand for goods and services.
 Demand for imports depends on price of
foreign goods or services, tariffs or
subsidies, prices of domestic substitutes
and complements, domestic income, and
tastes.
 Demand for foreign currency by home
country is also supply of foreign currency to
the foreign country.
Demand and Supply of
Foreign Exchange
e$/£
S£
e£/$
1.2
S$
0.83
D$
D£
£
$
Demand and Supply of
Foreign Exchange
 With normally shaped supply and
demand curves, the market for foreign
exchange is stable.
 If U.S. income rises, demand for
imports rises and so does demand for
foreign exchange.
 The rightward shift of the demand for
foreign exchange creates a current
account deficit and an increase in the
price of pounds (a depreciation of the
dollar).
Demand and Supply of
Foreign Exchange
e$/£
S£
e£/$
e'eq
eeq
S$
eeq
D$
D£
D '£
£
$
If U.S. prices increase relative to
British prices:
U.S. consumers
British
demand more
consumers
British products,
demand fewer
increasing
U.S. products,
demand for
decreasing the
pounds.
supply of pounds.
 The overall effect is an increase in the
dollar price of pounds.
Demand and Supply of
Foreign Exchange
S' £
e$/£
S£
E$/£
S£
e'eq
e'eq
eeq
eeq
D£
D' £
D£
D '£
£
£
Market Stability and the
Price Adjustment Mechanism
 This price adjustment depends on the
slope of the supply and demand
curves for foreign exchange.
 Supply curves can be backwardsloping.
 If supply curve is steeper than demand
curve, the market is still stable.
 If supply curve is flatter than demand
curve, the market is unstable.
Demand and Supply of
Foreign Exchange
e$/£
S£
e£/$
S$
D£
£
In this case, if e is too high,
there is an excess supply and
e will fall.
D$
$
In this case, if e is too high,
there is an excess demand
and e will rise.
Explaining the BackwardSloping Supply Curve
 As the dollar becomes more expensive,
two effects happen:
 More pounds are required to buy each unit
of imports from the U.S.
 The number of units imported falls due to
the increase in price in terms of pounds.
 It’s easy to see these effects by
considering the price elasticity of
demand
 arc
Q /Q1  Q2  / 2

P /P1  P2  / 2
Explaining the BackwardSloping Supply Curve
 Example:
 Suppose the depreciation of the dollar
causes the U.K. price of the imported
good to increase from £16 to £22, and
this causes quantity demanded to fall
from 120 units to 100 units.
 arc
Q /Q1  Q2  / 2 20 / 120  100  / 2


 0.58
P /P1  P2  / 2
6 /16  22  / 2
 If foreign demand for home goods is
inelastic, supply of foreign exchange
is downward-sloping.
Exchange Market Stability:
The Marshall-Lerner Condition
 If home-country demand is elastic, a
depreciation will improve the current
account balance.
 The increased price of imports reduces total
expenditures on imports and the reduced price
of exports to foreigners causes an increase in
their expenditures.
 If home-country demand is inelastic, a
depreciation will have an ambiguous effect
on the current account balance.
 The increased price of imports will increase
total expenditures on imports, possibly
offsetting the foreign country’s increased
expenditures on exports.
Exchange Market Stability:
The Marshall-Lerner Condition
 The Marshall-Lerner Condition: The
foreign exchange market will be
stable as long as
X
 DX   DM  1
M
where
X = expenditures on exports
M = expenditures on imports
ηDX = price elasticity for home exports
ηDM = price elasticity for imports.
Exchange Market Stability:
The Marshall-Lerner Condition
 Some empirical studies
suggest these demand
elasticities may be low.
 However, the general
consensus is that these
elasticities are large enough
that the foreign exchange
market is stable.
Price Adjustment Process:
Short Run vs. Long Run
 When the Marshall-Lerner condition
holds, changes in the exchange
rate bring about appropriate
switches in expenditures between
domestic and foreign goods.
 A home currency depreciation
leads to a substitution of domestic
goods for imports.
 A home currency depreciation
causes foreigners to switch to
home country exports.
Price Adjustment Process:
Short Run vs. Long Run
Short-run elasticities of supply and demand
tend to be smaller in absolute value than longrun elasticities.
Consumers don’t adjust immediately to
relative price changes; it’s not unusual for the
quantity demanded of imports and the amount
of foreign exchange needed to not respond to
changes in the exchange rate.
The supply of exports may
not adjust immediately in
response to changes in
exchange rates due to lags
in recognition, decisionmaking, production, and
delivery.
Price Adjustment Process:
The J-Curve
If the short-run elasticities are low, the
market for foreign exchange may be
unstable.
A depreciation may initially lead to a
further depreciation, since demand for
the foreign currency outstrips supply.
Therefore the current account deficit
worsens.
Eventually, the current account deficit
shrinks and a new equilibrium is attained.
The J-Curve
X-M
point of
depreciation
(X-M) = f(e,time)
time
Price Adjustment Mechanism in a
Fixed Exchange Rate System
Rather than allowing the foreign
exchange market to determine the
value of foreign exchange, countries
sometimes fix or “peg” the value of
their currencies.
Price Adjustment Mechanism
with the Gold Standard
 From 1880 to 1914, countries pegged
their currencies to gold.
 This fixes countries’ exchange rates
with each other.
 For example, if the dollar is fixed at
$100 per ounce and the pound is
fixed at £50 per ounce, the “mint par”
exchange rate is $2/£.
 Governments must be prepared to
maintain the gold price by buying and
selling gold at the set price.
Price Adjustment Mechanism
with the Gold Standard
 Since the exchange rate is fixed,
some other mechanism must be in
force to balance demand for and
supply of foreign exchange.
 These “rules of the game” are
assumed to hold:
 no restraints on buying/selling gold
within countries; gold can move freely
between countries,
 money supply is allowed to change if a
country’s gold holdings change, and
 prices/wages are flexible.
Price Adjustment Mechanism
with the Gold Standard
 Suppose an increase in U.S. income
causes an increased demand for pounds.
 There will be upward pressure on the
exchange rate to eliminate the excess
demand for pounds.
 Buyers/sellers know that governments
stand ready to buy/sell pounds at mint
par, using gold as medium of exchange.
 Since it is costly to ship gold, the
exchange rate can vary slightly from mint
par.
Foreign Exchange Market
Under a Gold Standard
e$/£
S£
e$/£
S£
$2.04
$2.00
$1.96
$2.00
D£
D '£
£
Mint par
D£
£
Assuming transactions costs represent 2% of par value, the
exchange rate can vary between $1.96 and $2.04.
Price Adjustment Mechanism
with the Gold Standard
 Americans never need to pay more
than $2.04/£, since an unlimited
supply of pounds can be obtained at
this price.
 This price is called the gold export
point.
 The British never need to receive
fewer than $1.96/£, since at that
point gold will begin to move to the
U.S. to be exchanged for dollars.
 This price is called the gold import
point.
Price Adjustment Mechanism
with the Gold Standard
The exchange rate can vary in
between these narrow bands.
Prices cannot adjust through
exchange rate changes.
Instead, prices adjust through
changes in the money supply.
Price Adjustment Mechanism
with the Gold Standard
Assuming the quantity
theory holds,
Ms = kPY.
If gold leaves the country,
Ms falls and prices must fall
in response.
Assuming demand for
tradeable goods is elastic,
this should reduce
spending on imports and
increase receipts from
exports.
Price Adjustment Mechanism
with the Gold Standard
 The price adjustment mechanism under
the gold standard is triggered by changes
in the money supply related to flows of
gold.
 This adjustment depends on flexible
wages and prices – any rigidities will
hinder adjustment.
 Other adjustment may occur due the
effects of changes in the money supply
on interest rates and income.
 The gold standard works to keep
inflation in check.
Price Adjustment Mechanism
with a Pegged Rate System
A country can also fix its exchange rate
without reference to the value of gold.
The central bank must be ready to buy
foreign currency when the domestic
currency is strong, and sell foreign
currency when the domestic currency
is weak.
Central banks must hold a sufficient
supply of foreign currencies.
Price Adjustment Mechanism
with a Pegged Rate System
 The adjustment effects of such a
system are similar to a gold standard.
 Upward pressure on the exchange
rate caused by an increase in
demand for foreign exchange will
cause the central bank to sell foreign
exchange.
 This reduces the money supply,
thereby triggering adjustments to
interest rates, income, and prices.
Price Adjustment Mechanism
with a Pegged Rate System
 Similarly, downward pressure on
the exchange rate caused by an
increase in the supply of foreign
exchange will cause the central
bank to buy foreign exchange.
 This increases the money supply,
thereby triggering adjustments
to interest rates, income, and
prices.
Price Adjustment Mechanism
with a Pegged Rate System
 For these adjustments to occur, the
central bank must allow the actions
taken in the foreign exchange markets
to affect the domestic money supply.
 Bottom line: when a country adopts a
fixed exchange rate system, its
central bank loses effective control
over the money supply as a policy tool.
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