Deck 14: Exchange-Rate Adjustments and the Balance of Payments

Question 1

How does a currency depreciation affect a nation's balance of trade?

Answer 1

The depreciation of a currency is the devaluation of the currency, making it worth less in the global market. This alters the exchange rate for that currency, which affects the relative price level, costs, incomes, and the purchasing power of money balances. All of these are factors that have roles in a nation's balance of trade.
For example, suppose the U.S. dollar depreciates. This means that foreign currencies can purchase more dollars with fewer amounts of their respective currency. This would lower U.S. export prices in terms of foreign currency and prompt foreign consumers to purchase more U.S. goods sold abroad. An increase in exports affects America's balance of trade.

Question 2

Three major approaches to analyzing the economic impact of currency depreciation are (a) the elasticities approach, (b) the absorption approach, and (c) the monetary approach. Distinguish among the three.

Answer 2

There are three major approaches to analyzing the effect of currency depreciation on an economy: the elasticity approach, the absorption approach, and the monetary approach. The elasticity approach states that currency depreciation has the highest effects when the elasticity of demand is high, meaning that consumer demand for goods is sensitive to changes in the price level. It emphasizes the relative price effects of depreciation.
The absorption approach focuses on the income effects of depreciation. It states that a decrease in domestic expenditure relative to income is necessary in order for currency depreciation to promote trade equilibrium.
Lastly, the monetary approach emphasizes the effects that currency depreciation has on the overall purchasing power of money. When depreciation alters the purchasing power of money, domestic expenditure levels are affected as well.

Question 3

What is meant by the Marshall-Lerner condition? Do recent empirical studies suggest that world elasticity conditions are sufficiently high to permit successful depreciations?

Answer 3

The Marshall-Lerner condition defines the general rule that determines the actual outcome of currency depreciation, whether it helps, hurts, or would not affect a nation's trade balance. It states that depreciation would improve the trade balance if the currency-depreciating nation's demand elasticity for imports and the foreign demand elasticity for the nation's exports sum up to exceed one. If this sum is less than one, then currency depreciation would worsen the nation's trade balance and if this sum is equal to one, then the trade balance would be unaffected by depreciation.
Recent empirical studies suggest that demand elasticity around the world is sufficiently high. This means that currency depreciation generally leads to improved trade balances for countries whose currency is devaluing

Question 4

How does the J-curve effect relate to the time path of currency depreciation?

Question 5

What implications does currency pass-through have for a nation whose currency depreciates?

Question 6

According to the absorption approach, does it make any difference whether a nation's currency depreciates when the economy is operating at less than full capacity versus at full capacity?

Question 7

How can currency depreciation-induced changes in household money balances promote payments equilibrium?

Question 8

Suppose ABC Inc., a U.S. auto manufacturer, obtains all of its auto components in the United States and that its costs are denominated in dollars. Assume the dollar's exchange value appreciates by 50 percent against the Mexican peso. What impact does the dollar appreciation have on the firm's international competitiveness? What about a dollar depreciation?

Question 9

Suppose ABC Inc., a U.S. auto manufacturer, obtains some of its auto components in Mexico and that the costs of these components are denominated in pesos; the costs of the remaining components are denominated in dollars. Assume the dollar's exchange value appreciates by 50 percent against the peso. Compared to your answer in study question 8, what impact will the dollar appreciation have on the firm's international competitiveness? What about a dollar depreciation?

Question 10

Assume the United States exports 1,000 computers at a price of $3,000 each and imports 150 UK autos at a price of £10,000 each. Assume that the dollar/pound exchange rate is $2 per pound.
a. Calculate, in dollar terms, the U.S. export receipts, import payments, and trade balance value. b. Suppose the dollar's exchange value depreciates by 10 percent. Assuming that the price elasticity of demand for U.S. exports equals 3.0 and the price elasticity of demand for U.S. imports equals 2.0, does the dollar depreciation improve or worsen the U.S. trade balance? Why? c. Now assume that the price elasticity of demand for U.S. exports equals 0.3 and the price elasticity of demand for U.S. imports equals 0.2. Does this change the outcome? Why?