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Lecture 7 Balance of Payments Adjustment Theory

This document summarizes key theories related to balance of payments adjustments through exchange rate changes. It discusses three main approaches: 1) The elasticity approach focuses on the price effects of devaluation and how it works best when demand is elastic. The Marshall-Lerner condition states that devaluation improves the trade balance if the sum of foreign and domestic price elasticities is greater than 1. 2) The absorption approach emphasizes the impact on domestic spending behavior. Devaluation only improves the trade balance if output rises relative to domestic absorption. 3) The monetary approach argues devaluation has temporary effects and only raises domestic prices long-term by increasing the money supply and attracting capital inflows. Government policies aim to restore

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2K views4 pages

Lecture 7 Balance of Payments Adjustment Theory

This document summarizes key theories related to balance of payments adjustments through exchange rate changes. It discusses three main approaches: 1) The elasticity approach focuses on the price effects of devaluation and how it works best when demand is elastic. The Marshall-Lerner condition states that devaluation improves the trade balance if the sum of foreign and domestic price elasticities is greater than 1. 2) The absorption approach emphasizes the impact on domestic spending behavior. Devaluation only improves the trade balance if output rises relative to domestic absorption. 3) The monetary approach argues devaluation has temporary effects and only raises domestic prices long-term by increasing the money supply and attracting capital inflows. Government policies aim to restore

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Lecture 6 Balance of Payments Adjustment Theory

Exchange-Rate Adjustments and the Balance of Payments


- Automatic mechanisms may restore BOP equilibrium, but at the cost
of recession or inflation
- As an alternative, governments allow exchange rates to change:
o Floating exchange rates, determined by markets, or
o Devaluing or revaluing fixed exchange rates

Exchange rate effects on costs & prices


- The impact of appreciation or depreciation on costs depends on the
proportion of inputs priced in foreign vs. domestic currency:
o As foreign-currency denominated costs rise as a proportion of
total costs, exchange rate changes have less effect on the
foreign currency price and more effect on the domestic price
o If foreign-currency costs are a small part of total costs,
exchange rate changes have more impact on foreign currency
price of the product and less on domestic price
Generally, currency appreciation increases the costs of
exports in foreign currency terms, which hurts total exports
(while depreciation encourages exports by decreasing the costs of
exports in foreign currency terms) -> Effect on prices is modified by
the ability & willingness of sellers to change their prices

Requirements for successful devaluation


- When can devaluation correct a BOP deficit? There are three
approaches which form the cornerstone behind IMF adjustment
programs:
o Elasticity approach: Emphasizes price effect -> devaluation
works best when demand is elastic
o Absorption approach: Focus on income effects -> Domestic
spending must fall, too, price effect is not sufficient
o Monetary approach: Focus on change in purchasing power
of money and effect on domestic spending

1) Elasticity approach (Neoclassical)


- Impact of currency devaluation depends on price elasticity of
domestic demand for imports and of foreign demand for
exports -> The less either foreign or domestic demand responds to
price changes, the less effect a devaluation will have on the
payments imbalance

- Marshall-Lerner condition:
Devaluation will improve the trade balance if domestic price
elasticity of demand for imports plus foreign price
elasticity of demand for exports is greater than 1 (in
absolute values, since price elasticity of demand is always
negative)
Devaluation will worsen the trade balance if the sum of the
absolute values of the two elasticities is less than 1
If the sum is equal to 1, devaluation will have no effect

Devaluation and time horizon


a) J-curve effect: in short run, devaluation worsens trade balance,
but with time the balance improves (3-5 years) -> due to
recognition lags, delivery lags, replacement lags, production lags
b) Currency contract period: The period immediately following a
devaluation when contracts signed prior to a devaluation are settled
-> Effects of contracts on the balance of trade depends on currency
of the contracts
-> Even if a devaluation occurs, the payments are settled in the
exchange rates that prevailed when contracts were signed
c) Currency Pass-Through: Effect of devaluation depends on how
quickly producers pass on higher or lower costs to their customers,
hence adjustment of domestic and foreign prices to a
devaluation
When a currency is devalued, prices of imported goods are
expected to be more expensive since the currency they are paid in
is appreciating while prices of exported goods are expected to
be cheaper since the currency they are received in will be
depreciating

2) Absorption approach (Keynesian)


- Emphasizes the impact of devaluation on spending behavior of
domestic economy
- Balance of trade is the difference between total domestic
output and domestic absorption:
Positive balance means output exceeds domestic spending
Negative balance means spending exceeds total production
- Devaluation will only improve the trade balance if output rises
relative to domestic absorption:
If an economy is operating below capacity, a devaluation will
shift resources into export production and encourage spending
on import substitutes
If an economy is operating at full employment, production
cannot rise -> trade balance can only be cut by slowing the
domestic economy/cutting domestic absorption

3) Monetary approach (Monetarist)


- Elasticity and absorption approaches apply only to the trade
balance -> Monetary approach includes capital and financial
account
- Devaluation may induce a temporary improvement in the BOP ->
Devaluation increases the domestic price level, increasing demand
for local money (which results in higher interest rates) and drawing
or attracting foreign capital flows
- In the long run, the inflow of money increases domestic
spending, increasing imports and returning the economy to the
starting point
Devaluation affects the real economy only temporarily, the
only long run effect is to raise the domestic price level
(inflation)
Phillips-curve: Natural rate of unemployment, monetary policy will
only lead to inflation in the long run

Balance of Payments Adjustments


- If part of the BOP is in deficit or surplus for a period of time,
mechanisms are needed to restore equilibrium
- Adjustment mechanisms can be:
Automatic: through economic processes
Discretionary: Through deliberate government policies

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