1、salvatore: international economics, 10th edition 2010 john wiley & sons, inc.,international economicstenth edition,the price adjustment mechanism with flexible and fixed exchange rates dominick salvatore john wiley & sons, inc.,chapter s i x t e e n,16,salvatore: international economics, 10th editio

2、n 2010 john wiley & sons, inc.,in this chapter:,introduction adjustment with flexible exchange rates effect of exchange rate changes on domestic prices and the terms of trade stability of foreign exchange markets elasticities in the real world adjustment under the gold system,salvatore: internationa

3、l economics, 10th edition 2010 john wiley & sons, inc.,introduction,assumptions international private capital flows take place only as passive responses to cover temporary trade imbalances. the nation wants to correct a deficit in its current account by exchange rate changes.,salvatore: internationa

4、l economics, 10th edition 2010 john wiley & sons, inc.,adjustment with flexible exchange rates,price adjustment mechanism relies on depreciation and devaluation of currency to adjust current account and balance of payments. income adjustment mechanism relies on income changes in the nation and abroa

5、d to make the adjustments. elasticity of the demand and supply curves will determine effectiveness of adjustment mechanisms.,figure 16-1 balance-of-payments adjustments with exchange rate changes.,figure 16-2 derivation of the u.s. demand and supply curves for foreign exchange.,salvatore: internatio

6、nal economics, 10th edition 2010 john wiley & sons, inc.,effect of exchange rate changes on domestic prices and the terms of sale,the greater the devaluation or depreciation of the dollar, the greater its inflationary impact, and the less feasible is the increase of the exchange rate for correcting

7、balance of payments deficits.,salvatore: international economics, 10th edition 2010 john wiley & sons, inc.,effect of exchange rate changes on domestic prices and the terms of sale,depreciation of the currency increases prices of both exports and imports in terms of domestic currency. terms of trade

8、 can rise, fall or remain unchanged, depending on the relative magnitude of the price changes.,salvatore: international economics, 10th edition 2010 john wiley & sons, inc.,stability of foreign exchange markets,unstable foreign exchange market - when a disturbance from equilibrium pushes the exchang

9、e rate further away from equilibrium. supply curve is negatively sloped and more elastic than the demand curve of foreign exchange. flexible exchange rate system increases (rather than reduces) a balance of payments disequilibrium.,salvatore: international economics, 10th edition 2010 john wiley & s

10、ons, inc.,stability of foreign exchange markets,stable foreign exchange market - when a disturbance from equilibrium gives rise to automatic forces that push exchange rate back to equilibrium. supply curve is positively sloped, or if negatively sloped, is less elastic than the demand curve of foreig

11、n exchange.,figure 16-3 stable and unstable foreign exchange markets.,salvatore: international economics, 10th edition 2010 john wiley & sons, inc.,stability of foreign exchange markets,marshall-lerner condition - sum of the price elasticities of demand for imports and demand for exports is (in abso

12、lute terms) indicates degree of foreign exchange market stability: greater than 1 = stable foreign exchange market devaluation required to correct bop deficit. less than 1 = unstable foreign exchange market revaluation required to correct bop deficit. equal to 1 = change in exchange rate leaves bala

13、nce of payments unchanged.,salvatore: international economics, 10th edition 2010 john wiley & sons, inc.,elasticities in the real world,empirical evidence suggests that the marshall-lerner condition holds for the foreign exchange market, indicating a stable market. quantity response to price change

14、must be measured over longer time periods for accurate elasticity measures.,figure 16-4 the identification problem.,salvatore: international economics, 10th edition 2010 john wiley & sons, inc.,elasticities in the real world,junz and rhomberg (1973) identified five possible lags in quantity response

15、s to price changes in international trade: recognition lag before price change becomes evident. decision lag to take advantage of price changes. delivery lag of new orders placed replacement lag to use up available inventories before placing new orders. production lag to change output mix resulting

16、from price changes.,salvatore: international economics, 10th edition 2010 john wiley & sons, inc.,elasticities in the real world,j-curve effect a nations trade balance may actually worsen soon after devaluation or depreciation before improving later on. this occurs because import prices tend to rise

17、 faster than export prices, with quantities initially not changing much. over time, export prices catch up with import prices so initial deterioration in trade balance is reversed, generating a j-shaped pattern to exchange rate movements.,figure 16-5 the j-curve.,salvatore: international economics,

18、10th edition 2010 john wiley & sons, inc.,adjustment under the gold standard,the gold standard operated from about 1880 to outbreak of world war i in 1914. attempt to reestablish gold standard after the war failed in 1931 during great depression. advantages and disadvantages of gold standard also ap

19、ply to fixed exchange system (bretton woods, or gold-exchange standard) operating from world war ii until its collapse in 1971.,salvatore: international economics, 10th edition 2010 john wiley & sons, inc.,adjustment under the gold standard,under the gold standard, each nation specified the gold con

20、tent of its currency: 1 gold coin contained 113.0016 grains of gold $1 gold coin contained 23.22 grains of gold this implies a fixed exchange rate, or mint parity, of: r = $/ = 113.0016 / 23.22 = $4.87/,salvatore: international economics, 10th edition 2010 john wiley & sons, inc.,adjustment under th

21、e gold standard,the cost of shipping gold from new york to london was approximately 3 cents. so, the actual exchange rate would always lie between $4.84/ (gold import point) and $4.90/ (gold export point).,salvatore: international economics, 10th edition 2010 john wiley & sons, inc.,adjustment under

22、 the gold standard,the tendency of the dollar to depreciate (rise above gold export point) was countered by gold shipments from the united states. gold outflows = size of u.s. balance of payments deficit. the tendency of the dollar to appreciate (fall below gold import point) was countered by gold s

23、hipments to the united states. gold inflows = size of u.s. balance of payments surplus.,salvatore: international economics, 10th edition 2010 john wiley & sons, inc.,adjustment under the gold standard,the price-specie-flow mechanism is the automatic adjustment mechanism under the gold standard. if a

24、 trade imbalance exists, gold will flow from the country with a trade deficit to the country with a trade surplus. the fall in gold supplies in the trade deficit country reduces its money supply and pushes its price level lower. the increase in gold supplies in the trade surplus country increases it

25、s money supply and raises its price level.,salvatore: international economics, 10th edition 2010 john wiley & sons, inc.,adjustment under the gold standard,the price level movement is based on the quantity theory of money: mv = pq where m = money supply v = velocity of circulation of money p = general price index q = physical output,salvatore: international economics, 10th edition 2010 john wiley & sons, inc.,adjustment under the gold standard,as the price level falls in the country with a trade deficit, exports of its goods and services will be encouraged. as the price level increases in the