Welcome back.
As we examine the effects of exchange rates on international trade and capital flows we first start
with understanding the relationship between the balance of trade and capital flows.
We shall own the elasticities approach and absorption approach to explain the effect of exchange rates
on trade and capital flows.
Let's get rolling you probably know that when you spend more than you earn you eventually need to borrow
or sell assets to finance the excess spending.
That's the same for countries when a country spends on imports more than it earns from exports.
The trade deficit is financed either by borrowing from foreign countries or selling assets to foreigners
from the balance of payments point of view a current account deficit must be exactly matched by an offsetting
capital account surplus.
So what we're trying to say here is we can study the impact of changing exchange rates on the balance
of payments from two different angles the impact on imports and exports and the impact on capital flows
the elasticities approach focuses on the impact of exchange rate changes on imports and exports while
the absorption approach focuses on the impact on capital flows before we proceed to discuss the two
approaches.
You may recall from the balance of payments lesson that there are three accounts the current account
capital account and financial account.
So what happened to the financial account perhaps for simplicity.
The CFA curriculum refers to Capital Account to include financial account as well.
Put this lesson the elasticities approach focuses on how exchange rate changes affect total expenditures
on imports and exports.
To think of it simply if a country wants to reduce its trade deficit it needs to depreciate its currency
depreciation of the domestic currency will make imports more expensive in domestic currency terms and
exports less expensive in foreign currency terms thus depreciation of the domestic currency will increase
exports and decrease imports and would seem to unambiguously reduce the trade deficit.
However this may not always be the case.
We need to be clear that it is not the change in quantity of imports and exports that matters.
But the change in total expenditures on imports and exports.
This means that we need to study the price elasticity of demand for export goods and import goods to
determine if the desired change can be achieved consider if both demand curves are inelastic a depreciation
in the domestic currency decreases the foreign price of exports but the quantity demanded may only increase
a little.
This means that the total value of exports decrease instead of the intention to increase it likewise.
A depreciation in the domestic currency increases the domestic price of imports but the quantity demanded
may only decrease a little.
This means that the value of imports increase instead of the intention to decrease it if both of these
effects play out the trade deficit actually widens instead of narrowing the central bank policy maker
may get fired for this to help our poor friend Let's teach him the conditions for the change in exchange
rate to have the desirable effects on the trade balance.
This is the generalized Marshall learner condition which is based on the proportion of total trade that
is exports and imports and the price elasticity of demand for exports and imports.
If this condition is satisfied a depreciation of the domestic currency will decrease a trade deficit.
For example if the proportion of exports is 40 percent and 60 percent for imports and the price elasticities
are one point five and one point eight respectively then this amount is greater than zero and the trade
deficit will narrow in this case.
Imports decrease and exports increase narrowing the trade deficit.
In the case where the proportions of import expenditures and export revenues are equal.
This condition reduces to this.
This is most often cited as the classic Marshall loner condition so in general the higher the elasticity
of demand for both export goods and import goods the stronger is the effect of exchange rate changes
on the trade deficit.
For this reason the compositions of export goods and import goods should be studied elasticity of demand
is generally greater for goods with close substitutes goods that represent a high proportion of overall
expenditures on some luxury goods conversely goods that have lower elasticity of demand are goods that
are few or no good substitutes goods that represent a small proportion of overall expenditures and necessities
if the economy primarily imports and exports such goods.
The effect of a currency depreciation may have limited impact or even adverse impact on the trade deficit
ideally if the Marshall learner condition is satisfied.
We wish to see an immediate effect where the trade deficit narrows once the domestic currency is depreciated
however there may be a delay in the effect.
This is because the quantity of imports and exports have not adjusted due to order contracts that were
placed earlier.
However the domestic currency is now weaker.
So while quantities shipped may not have changed import expenditures goes up as the weaker domestic
currency means more units are required to pay for foreign goods so in the short run during this delay
the trade deficit may widen instead of narrowing eventually.
When changes in order quantities take effect the Marshall learner conditions take effect and the currency
depreciation begins to narrow the trade deficit this effect is called the J curve effect one shortcoming
of the elasticities approach is that it only considers the microeconomic relationship between exchange
rates and trade balances.
It ignores capital flows which must also change as a result of a currency depreciation but improves
the balance of trade the absorption approach is a macroeconomic technique that focuses on the effect
of exchange rates on capital flows in the lesson on balance of payments.
We learnt this fundamental relationship between the balance of trade national savings and private investments
from this relationship.
We can see that a trade deficit means the country does not save enough to fund its investment in plants
and equipment.
The additional amount to fund domestic investment must come from foreigners.
So there is a surplus in the capital account to offset the deficit in the trade account equivalently.
The equation is equal to the difference between national income and total expenditure.
You can look at national income as the total domestic production of goods and services and total expenditure
as the total domestic absorption of goods and services.
Is a trade deficit when a country absorbs more than it produces so we can see that in order to reduce
the trade deficit a depreciation of the domestic currency must increase national income relative to
expenditure we can also view this as a requirement that national saving increase relative to domestic
investment in physical capital whether a currency depreciation has these effects depends on the current
level of capacity utilization in the economy when an economy is operating at less than full employment.
The currency depreciation makes domestic goods and assets relatively more attractive than foreign goods
and assets.
The resulting shift in demand away from foreign goods and towards domestic goods will increase both
national income and savings.
This can bring about a reduction in the trade deficit in a situation where the economy is operating
at full employment.
An increase in domestic spending will translate to higher domestic prices which can reverse the relative
price changes of the currency depreciation resulting in a return to the previous deficit in the balance
of trade however there can be another effect at play which is the wealth effect.
The currency depreciation does result in a decline in the value of domestic assets so savers may initially
want to spend less and save more to rebuild wealth.
This can improve the balance of trade initially but as the real wealth of savers increases over time
the positive impact on saving will decrease eventually returning the economy to its previous state and
balance of trade and that concludes this lesson on the relationship between exchange rates international
trade and capital flows.
Admittedly the last part is a bit hard to digest treated as a bonus if you can understand.
So don't spend too much time on it.
And congratulations you've completed this course on economics and you're one step closer to CFA success.
Do head onto the bonus section after this where we have some goodies in store for you.
Thank you for using PrEP nuggets as your exam companion.
We wish you all the best for the exam.