LECTURE Oct 5th. Determinants of Balance of Trade and Payments

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1 LCTUR Oct 5th Hamza Ali Malik con 3114: International Finance Fall 2006 Determinants of Balance of Trade and Payments The lasticities Approach The elasticities approach to the balance of trade emphasizes changes in the prices of goods and services (that are exported and imported) as the main determinant of a nation s BoT and the exchange rate. In particular, it provides an analysis of how devaluations will affect the BoT depending on the elasticities of supply and demand for FORX and foreign goods. Generally speaking, elasticity measures the responsiveness of quantity to changes in price. For example, elasticity of demand can be defined as: % Q d = % P If If d > 1 elastic demand; d < 1 inelastic demand 1

2 Moreover, elasticity also determines what happens to total revenue (TR) following a price change. xample: P Q TR (P*Q) Inelastic lastic P Q TR P Q TR Thus X (of home country s exports) becomes important in determining export revenue and M (of home country s imports) determines import bill as international price change. xports of the home good give rise to supply of FORX (export revenue), while imports by the home country give rise to a demand for FORX (import bill). PQ SS( X ) DD(P * Q M ) Qty of FORX 2

3 DD is downward sloping because as (appreciates), for the given P*, the home currency price of the foreign goods, P M, falls (given import more demand for FORX. P M = P * ), so want to Note that we need M > 1 to have a negatively sloped demand for FORX. M > 1 means that the import bill (P M Q M ) should go up in case of an appreciation. If the demand for imports is inelastic, M < 1, then the import bill may actually go down after appreciations leading to a positively sloped demand curve! SS is upward sloping because a rise in (depreciation) lowers the price of the home country s exports in the foreign country, P *, for the given price of exports, P X, in the home country, (P X / = P * ), so exports supply of FORX. The slope of SS depends upon X for the home country s exports in the foreign country. If > 1, X TR (P* Q X ) goes up as exchange rate depreciates and SS is upward sloping. However, if < X 1, the SS function will be backward sloping (i.e. more negative than the DD curve). Note that elasticities approach is a theory of the BoT and can only be a theory of the BoPs in a world without capital flows. That is, capital flows are treated as exogenous shocks. 3

4 Capital flows can be brought into this model as shift parameters on the SS or DD function. For example, an increase in interest rate,i, in the domestic economy is expected to attract capital inflows SS shifts to the right (appreciation). xample: What is the underlying logic behind the possibility of a positively sloped demand curve for foreign exchange? Would the foreign exchange market be necessarily unstable if the demand curve is positively sloped? Clearly explain the issue of instability and its implications for the exchange rate. Answer: The demand curve for foreign exchange could be positively sloped if the demand elasticity for imports is less than 1. A positively sloped demand curve means that as exchange rate goes up (depreciates) the quantity of FORX demand goes up. (Remember: quantity of FORX demanded comes from the import bill). As exchange rate goes up, price of imported goods increases. If the demand elasticity for these imported goods is too small, then quantity imported will fall by a small amount leading to an increase in the import bill. FORX market would not be necessarily unstable if the demand curve is positively sloped. The only condition for stability is that it should be steeper than the supply curve. The implication of instability for the exchange rate is that if due to an unforeseen shock the initial equilibrium is disturbed, say the exchange rate depreciates, then it will continue depreciating rather than reverting back to a stable equilibrium. S D S D Stable Q FORX Unstable Q FORX 4

5 Policy Analysis Suppose there is an increase in demand for FORX. There are several possible responses to this shift in demand. SS DD Qty of FORX i) - Let the R freely float, i.e. let. ii) - Can peg the R, if CB increases the supply of FORX. iii) - Impose controls on demand or supply of FORX. iv) - Impose quotas or tariffs on foreign trade. 5

Aggregate Supply and Demand

Aggregate Supply and Demand Aggregate demand is the relationship between GDP and the price level. When only the price level changes, GDP changes and we move along the Aggregate Demand curve. The total amount of goods and services,