1 00:00:00,990 --> 00:00:01,590 Welcome back. 2 00:00:01,590 --> 00:00:07,680 As we examine the effects of exchange rates on international trade and capital flows we first start 3 00:00:07,680 --> 00:00:12,080 with understanding the relationship between the balance of trade and capital flows. 4 00:00:12,180 --> 00:00:17,460 We shall own the elasticities approach and absorption approach to explain the effect of exchange rates 5 00:00:17,580 --> 00:00:19,770 on trade and capital flows. 6 00:00:19,770 --> 00:00:27,350 Let's get rolling you probably know that when you spend more than you earn you eventually need to borrow 7 00:00:27,410 --> 00:00:31,510 or sell assets to finance the excess spending. 8 00:00:31,590 --> 00:00:38,100 That's the same for countries when a country spends on imports more than it earns from exports. 9 00:00:38,100 --> 00:00:43,980 The trade deficit is financed either by borrowing from foreign countries or selling assets to foreigners 10 00:00:45,700 --> 00:00:51,550 from the balance of payments point of view a current account deficit must be exactly matched by an offsetting 11 00:00:51,550 --> 00:00:52,900 capital account surplus. 12 00:00:53,770 --> 00:00:59,110 So what we're trying to say here is we can study the impact of changing exchange rates on the balance 13 00:00:59,110 --> 00:01:07,090 of payments from two different angles the impact on imports and exports and the impact on capital flows 14 00:01:08,960 --> 00:01:15,660 the elasticities approach focuses on the impact of exchange rate changes on imports and exports while 15 00:01:15,660 --> 00:01:22,730 the absorption approach focuses on the impact on capital flows before we proceed to discuss the two 16 00:01:22,730 --> 00:01:23,750 approaches. 17 00:01:23,750 --> 00:01:29,000 You may recall from the balance of payments lesson that there are three accounts the current account 18 00:01:29,420 --> 00:01:32,420 capital account and financial account. 19 00:01:32,420 --> 00:01:36,980 So what happened to the financial account perhaps for simplicity. 20 00:01:36,980 --> 00:01:42,170 The CFA curriculum refers to Capital Account to include financial account as well. 21 00:01:42,170 --> 00:01:50,230 Put this lesson the elasticities approach focuses on how exchange rate changes affect total expenditures 22 00:01:50,530 --> 00:01:52,930 on imports and exports. 23 00:01:52,990 --> 00:01:59,200 To think of it simply if a country wants to reduce its trade deficit it needs to depreciate its currency 24 00:02:00,070 --> 00:02:05,950 depreciation of the domestic currency will make imports more expensive in domestic currency terms and 25 00:02:06,010 --> 00:02:13,370 exports less expensive in foreign currency terms thus depreciation of the domestic currency will increase 26 00:02:13,430 --> 00:02:19,670 exports and decrease imports and would seem to unambiguously reduce the trade deficit. 27 00:02:19,670 --> 00:02:23,130 However this may not always be the case. 28 00:02:23,180 --> 00:02:28,290 We need to be clear that it is not the change in quantity of imports and exports that matters. 29 00:02:28,490 --> 00:02:33,080 But the change in total expenditures on imports and exports. 30 00:02:33,260 --> 00:02:39,410 This means that we need to study the price elasticity of demand for export goods and import goods to 31 00:02:39,410 --> 00:02:47,360 determine if the desired change can be achieved consider if both demand curves are inelastic a depreciation 32 00:02:47,390 --> 00:02:54,170 in the domestic currency decreases the foreign price of exports but the quantity demanded may only increase 33 00:02:54,230 --> 00:02:55,850 a little. 34 00:02:55,860 --> 00:03:03,700 This means that the total value of exports decrease instead of the intention to increase it likewise. 35 00:03:03,770 --> 00:03:10,520 A depreciation in the domestic currency increases the domestic price of imports but the quantity demanded 36 00:03:10,820 --> 00:03:13,490 may only decrease a little. 37 00:03:13,490 --> 00:03:20,310 This means that the value of imports increase instead of the intention to decrease it if both of these 38 00:03:20,310 --> 00:03:26,730 effects play out the trade deficit actually widens instead of narrowing the central bank policy maker 39 00:03:26,820 --> 00:03:34,430 may get fired for this to help our poor friend Let's teach him the conditions for the change in exchange 40 00:03:34,430 --> 00:03:38,710 rate to have the desirable effects on the trade balance. 41 00:03:38,720 --> 00:03:45,140 This is the generalized Marshall learner condition which is based on the proportion of total trade that 42 00:03:45,140 --> 00:03:51,930 is exports and imports and the price elasticity of demand for exports and imports. 43 00:03:51,980 --> 00:03:59,330 If this condition is satisfied a depreciation of the domestic currency will decrease a trade deficit. 44 00:03:59,410 --> 00:04:06,850 For example if the proportion of exports is 40 percent and 60 percent for imports and the price elasticities 45 00:04:06,850 --> 00:04:12,790 are one point five and one point eight respectively then this amount is greater than zero and the trade 46 00:04:12,790 --> 00:04:16,200 deficit will narrow in this case. 47 00:04:16,270 --> 00:04:23,640 Imports decrease and exports increase narrowing the trade deficit. 48 00:04:23,690 --> 00:04:28,890 In the case where the proportions of import expenditures and export revenues are equal. 49 00:04:29,060 --> 00:04:31,890 This condition reduces to this. 50 00:04:32,120 --> 00:04:40,620 This is most often cited as the classic Marshall loner condition so in general the higher the elasticity 51 00:04:40,620 --> 00:04:46,380 of demand for both export goods and import goods the stronger is the effect of exchange rate changes 52 00:04:46,650 --> 00:04:48,980 on the trade deficit. 53 00:04:49,000 --> 00:04:56,110 For this reason the compositions of export goods and import goods should be studied elasticity of demand 54 00:04:56,170 --> 00:05:01,690 is generally greater for goods with close substitutes goods that represent a high proportion of overall 55 00:05:01,690 --> 00:05:10,030 expenditures on some luxury goods conversely goods that have lower elasticity of demand are goods that 56 00:05:10,030 --> 00:05:17,770 are few or no good substitutes goods that represent a small proportion of overall expenditures and necessities 57 00:05:18,890 --> 00:05:22,370 if the economy primarily imports and exports such goods. 58 00:05:22,400 --> 00:05:29,150 The effect of a currency depreciation may have limited impact or even adverse impact on the trade deficit 59 00:05:30,370 --> 00:05:33,830 ideally if the Marshall learner condition is satisfied. 60 00:05:33,850 --> 00:05:39,910 We wish to see an immediate effect where the trade deficit narrows once the domestic currency is depreciated 61 00:05:41,790 --> 00:05:45,190 however there may be a delay in the effect. 62 00:05:45,210 --> 00:05:50,640 This is because the quantity of imports and exports have not adjusted due to order contracts that were 63 00:05:50,640 --> 00:05:52,310 placed earlier. 64 00:05:52,320 --> 00:05:55,590 However the domestic currency is now weaker. 65 00:05:55,590 --> 00:06:01,380 So while quantities shipped may not have changed import expenditures goes up as the weaker domestic 66 00:06:01,380 --> 00:06:07,860 currency means more units are required to pay for foreign goods so in the short run during this delay 67 00:06:08,130 --> 00:06:13,420 the trade deficit may widen instead of narrowing eventually. 68 00:06:13,450 --> 00:06:19,300 When changes in order quantities take effect the Marshall learner conditions take effect and the currency 69 00:06:19,300 --> 00:06:28,860 depreciation begins to narrow the trade deficit this effect is called the J curve effect one shortcoming 70 00:06:28,890 --> 00:06:34,830 of the elasticities approach is that it only considers the microeconomic relationship between exchange 71 00:06:34,830 --> 00:06:37,100 rates and trade balances. 72 00:06:37,230 --> 00:06:43,380 It ignores capital flows which must also change as a result of a currency depreciation but improves 73 00:06:43,380 --> 00:06:50,230 the balance of trade the absorption approach is a macroeconomic technique that focuses on the effect 74 00:06:50,230 --> 00:06:55,940 of exchange rates on capital flows in the lesson on balance of payments. 75 00:06:55,950 --> 00:07:02,520 We learnt this fundamental relationship between the balance of trade national savings and private investments 76 00:07:03,570 --> 00:07:05,030 from this relationship. 77 00:07:05,070 --> 00:07:10,410 We can see that a trade deficit means the country does not save enough to fund its investment in plants 78 00:07:10,410 --> 00:07:11,730 and equipment. 79 00:07:11,730 --> 00:07:16,200 The additional amount to fund domestic investment must come from foreigners. 80 00:07:16,200 --> 00:07:22,890 So there is a surplus in the capital account to offset the deficit in the trade account equivalently. 81 00:07:22,930 --> 00:07:28,220 The equation is equal to the difference between national income and total expenditure. 82 00:07:28,410 --> 00:07:34,110 You can look at national income as the total domestic production of goods and services and total expenditure 83 00:07:34,440 --> 00:07:37,980 as the total domestic absorption of goods and services. 84 00:07:38,110 --> 00:07:45,440 Is a trade deficit when a country absorbs more than it produces so we can see that in order to reduce 85 00:07:45,440 --> 00:07:51,710 the trade deficit a depreciation of the domestic currency must increase national income relative to 86 00:07:51,710 --> 00:07:58,400 expenditure we can also view this as a requirement that national saving increase relative to domestic 87 00:07:58,400 --> 00:08:05,580 investment in physical capital whether a currency depreciation has these effects depends on the current 88 00:08:05,580 --> 00:08:12,830 level of capacity utilization in the economy when an economy is operating at less than full employment. 89 00:08:12,930 --> 00:08:18,810 The currency depreciation makes domestic goods and assets relatively more attractive than foreign goods 90 00:08:18,840 --> 00:08:20,710 and assets. 91 00:08:20,720 --> 00:08:26,180 The resulting shift in demand away from foreign goods and towards domestic goods will increase both 92 00:08:26,180 --> 00:08:28,890 national income and savings. 93 00:08:28,940 --> 00:08:35,710 This can bring about a reduction in the trade deficit in a situation where the economy is operating 94 00:08:35,710 --> 00:08:36,970 at full employment. 95 00:08:37,000 --> 00:08:43,030 An increase in domestic spending will translate to higher domestic prices which can reverse the relative 96 00:08:43,030 --> 00:08:48,880 price changes of the currency depreciation resulting in a return to the previous deficit in the balance 97 00:08:48,880 --> 00:08:56,060 of trade however there can be another effect at play which is the wealth effect. 98 00:08:56,360 --> 00:09:03,020 The currency depreciation does result in a decline in the value of domestic assets so savers may initially 99 00:09:03,020 --> 00:09:07,050 want to spend less and save more to rebuild wealth. 100 00:09:07,180 --> 00:09:14,110 This can improve the balance of trade initially but as the real wealth of savers increases over time 101 00:09:14,590 --> 00:09:20,530 the positive impact on saving will decrease eventually returning the economy to its previous state and 102 00:09:20,530 --> 00:09:28,400 balance of trade and that concludes this lesson on the relationship between exchange rates international 103 00:09:28,400 --> 00:09:30,720 trade and capital flows. 104 00:09:30,740 --> 00:09:36,330 Admittedly the last part is a bit hard to digest treated as a bonus if you can understand. 105 00:09:36,470 --> 00:09:38,630 So don't spend too much time on it. 106 00:09:39,460 --> 00:09:46,950 And congratulations you've completed this course on economics and you're one step closer to CFA success. 107 00:09:47,200 --> 00:09:52,000 Do head onto the bonus section after this where we have some goodies in store for you. 108 00:09:52,000 --> 00:09:55,390 Thank you for using PrEP nuggets as your exam companion. 109 00:09:55,450 --> 00:09:57,510 We wish you all the best for the exam.