BASIC THEORIES OF THE BALANCE OF PAYMENTS
Topic 17.1
The Elasticities Approach
The elasticities approach requires strong assumptions:
- there is no trade in assets
- there is no macroeconomic consideration of employment conditions - what if an economy is at full output and cannot increase output?
Relative price determines consumption patterns through substitution effects.
As relative demands and supplies for goods change, relative prices will adjust.
The elasticities approach is concerned with the way changing relative prices of domestic and foreign goods will change the balance of trade.
Elasticity measures the responsiveness of quantity to changes in price.
Ed = %ΔQd / %ΔP
Es = %ΔQs / %ΔP
where:
Ed = elasticity of demand
Es = elasticity of supply
Qd = quantity demanded
Qs = quantity supplied
The ‘law of one price’ is the concept that.
P = e.P*
where:
P = price of a good in domestic currency
P* = price of a foreign good in foreign currency
e = exchange rate
an example
If the good in questions is identical shoes that are produced and sold in Japan and also produced and sold the U.S.:
P = $50
P* = ¥500
E = 1/100 [units are $/¥]
Then P=eP* holds true
For the law of one price to hold there are strong assumptions:
- no transport costs
- these are traded goods
- these are identical goods
arbitrage is perfect
If we extend this relationship to all the goods in a country we call this ‘purchasing power parity’, PPP.
Under PPP the P, P* are the general price levels in the two countries:
P = e.P*
where:
P = domestic price level
P* = foreign price level
For PPP to hold the assumptions are even stronger, especially the assumption that all goods are traded. While shoes are traded goods haircuts are not. This form of PPP is called ‘absolute PPP’. A weaker form of PPP is ‘relative PPP’.
%Δe = %ΔP - %ΔQP*
Relative PPP says that differences in inflation rates are reflected in the exchange rate.
Absolute PPP requires that both the levels and rates of change in P, P* must be matched.
Relative PPP does not require that levels of P, P* must follow the formula.
The elasticities approach uses two concepts:
- the law of one price
- elasticity
The elasticities approach to the balance of trade provides an analysis of how devaluations will affect the balance of trade depending on elasticities of supply and demand for goods and for foreign exchange.
There is a condition for a devaluation to improve the balance of payments: The Marshall-Lerner Condition.
Marshall-Lerner Condition
A devaluation will improve a country’s trade balance and provide a stable foreign exchange market if the domestic elasticity of demand for imports plus the foreign elasticity of demand for imports is more than 1.
This is an application of the fact that high elasticities are ‘good’.
The J Curve
The J curve is a phenomenon whereby a devaluation will temporarily worsen the balance of payments even if the Marshall-Lerner Condition is satisfied.
It arises from having trade contracts which cannot be rewritten immediately.
If U.S. export prices are fixed in $ and imports are fixed in ¥ and the dollar devalues then (temporarily) the U.S. receives the same $ revenue from exporting but has to pay more (in $) for the same quantity of imports. So there is a trade deficit.
The Pass-Through Period
The currency contract period is the period after a devaluation when contracts reflect pre-negotiation prices.
Pass-through analysis considers the ability of international prices to adjust in the short-run.
‘Pricing to market’ behavior occurs when exporters deliberately adjust profit margins to limit the pass-through of higher prices to importers. In the previous example this would occur if the Japanese exporters chose to lower their ¥ prices to allow for the fact that the $ has fallen in value.
