FOREIGN EXCHANGE MARKET AND TRADE ELASTICITIES - PowerPoint Presentation

1. FOREIGN EXCHANGE MARKET AND TRADE ELASTICITIESIMQF course in International FinanceCaves, Frankel and Jones (2007) World Trade and Payments, 10e, Pearson

2. OutlineBasic definitionsForeing exchange (FX) market (supply and demand) under different FX regimesImpact of imports and exports on FX market supply and demandImpact of devalution on trade balance (theoretical framework and empirical evidence)

3. Basic definitionsExchange rate Price of foreign currency in terms of domestic currency (except in Britain)Direct: 1 EUR=118 RSDIndirect (UK): 1 RSD=0.0085 EURDepreciation (increase in the exchange rate) vs. appreciation (decrease in the exchange rate)Effective exchange rate Weighted average of the exchange rates against each of the individual countries Geometric meanWeights? Countries’ share in trade

4. Supply and Demand for Foreign ExchangeSupply of foreign exchange (FX)Exports proceedsOther credit items in the BoPDemand for FXImport spendingOther debit items in the BoPTypes of FX regimeFixed (pegged): FX rate set by the central bank/governmentFloating: FX rate is shaped by supply and demand at the FX marketFree floatingManaged floating („dirty floating“)

5. Increase in Demand for Foreign CurrencyFloating FX regime:Rise in demand triggers increase in FX rate and in the quantity of FXFX rate is determined so as to equilibrate demand and supplyFixed („pegged“) FX regime:Rise in demand triggers increase in the quantity of FX There is no price adjustment at the market, but rather the Central bank stands ready to buy or sell FX, in order to equilibrate demand and supply for the given FX rateIf demand rises, Central bank must sell foreign currency in order to meet excess demandBy interventions at the FX market, the Central bank makes impact on the FX rate How long and how much can the Central bank intervene at the FX market?Is there an (policy) alternative to Central bank intervention?What happens when the Central bank runs-out of the FX reserves?Devaluation (setting the new FX rate)Shift to floating FX regime (depreciation)

6. Increase in Demand for Foreign Currency

7. Deriving Supply and Demand for FX from Exports and ImportsAssumption 1: there are no net capital flows (KA=0)Supply and demand for FX entirely determined by the trade account (exports –imports)Instead of KA=0, the same would hold if the KA=const.Assumption 2: domestic residents look only at prices expressed in domestic currency, while foreign residents look only at prices in foreign currencyDemand for imported goods depends on the price of imported goods in domestic currency, while supply of exports depends only on the price of exported goods in domestic currencyEffect of changes in income on demand is ignored

8. Deriving Supply and Demand for FX from Exports and ImportsAssumption 3: supply is infinitely elastic (firm sets the price of the product and than meets any forthcoming demand)P is the price (in domestic currency) at which domestic firms supply exportables with infinite elasticityP* is the price (in foreign currency) at which foreign firms supply importablesE is exchange rate (price of foreign currency stated in domestic currency)Output levels are determined by demand, i.e. demand for imports is decreaseing function of the import’s price expressed in domestic currency (fixed price in foreign currency times FX (E))Demand for export is decreasing function of their price expressed in foreign currency (fixed price in domestic currency divided by FX)Devaluation (increase in E) lowers price of exports, triggering increase in exports, and rises the price of imports reducing demand for imports

9. Effect of a Devaluation on Trade

10. Effect of a Devaluation on TradeFX marketDemand for FX depends on imports, while supply of FX depends on exportsNet supply of FX:Net supply of FX equals the trade balance (TB), i.e. the difference between the exports revenue and the imports revenue

11. Does Devaluation Improve Trade Balance?- The Marshall-Lerner ConditionEffects of devaluation on trade balance:a) Reduction in the quantity of importsb) Increase in the quantity of exports c) Decrease in the FX inflow, as the prices are set in domestic currency (hurting trade balance)Net effect of devaluation on exports revenue depends on the elasticity of exports demand if it is small, e.g. less than 1, devaluation can trigger decline in exports revenue: (c) outweights (b)…but decline in exports revenue can be outweigthed by a reduction in imports, so the trade balance is improved (or TB can get worsen if import elasticity is low)Assumption 4: Economy is initially in a position of balanced trade (TB=0)For a devaluation to improve the trade balance (and to have the stable FX market), Marshall-Lerner condition should be met:e.g. exports elasticity is 1, (b) and (c) cancel each other, so if imports elasticity is positive, TB gets improvedHomework: Write down the proof of Marshall-Lerner condition

12. Does Devaluation Improve Trade Balance?- The Marshall-Lerner ConditionModel generalization: relaxing assumption 4Country devalues if it has a trade deficit (TB<0)If trade is measured in domestic currency, the necessary condition for a devaluation to improve the trade balance is: the elasticities must be higher than given by Marshall-Lerner conditionAs TB<0, initial quantity of import is large, so small devaluation triggers large absolute increase in imports (denominated in domestic currency), which means that exports response should be very strong to outweight the import effect

13. Empirical Effects of Devaluation on Trade BalanceEffects of devaluation on TB depend on exports and imports elasticitiesElasticity pessimismVolatility of FX in 1930s; Many countries with fixed FX regime saw their TB worsenning after devaluation (e.g. oil importers if price elasticity of demand in short run is low); Early econometric estimates of elasticities were low (below 0.5)…but when time lag is taken into account, elasticities in long run are higher

14. Empirical Effects of Devaluation on Trade BalanceThe J curveIt takes time for import demand to adjust to devaluationOnly 50% of the total quantity of import adjustment takes place in the first three years (90% - in 5 years)Why demand elasticities rise over time?Time lag in dissemination of information, during which importers recognize that relative prices have changedTime lag in deciding to place a new import order (devaluation does not affect current inventories) and time lag in changing consumer habits (e.g. replacing fuel with electricity)Time lag between placement of import order and delivery of goodsIt takes time for producers to relocate their factories to the countries where costs are lower becase of FX advantage E.g. The case of Yen appreciation from 1985 to 1995Production relocation hysteresisPlants realocation costs are high, so investors need to make sure that favorable FX in the host country is not transitory. When the plants are moved to the host country it might stay there even if the FX gets worsenThe J curve phenomenon – elasticities tend to rise over time, so the trade balance reaction to devaluation is J-curvedAt the moment of devaluation, nominal import rises, while nominal exports declines, as there is no quantity adjustment As the time passes, prices change, quantity of import declines, while the quantity of export risesMarshall-Lerner condition kicks-inHowever, it may be hard to meet all the demand for export (due to capacities limitation)Rise in prices, rise in wages?

15. The J-Curve

16. HomeworkBahmani-Oskooee, M., & Niroomand, F. (1998). Long-run price elasticities and the Marshall–Lerner condition revisited. Economics Letters, 61(1), 101-109.Bahmani, M., Harvey, H., & Hegerty, S. W. (2013). Empirical tests of the Marshall-Lerner condition: a literature review. Journal of Economic Studies, 40(3), 411-443.