CURRENCY CONTRACT PERIOD Immediately following a devaluation, contracts negotiated prior to the

exchange rate change become due. This period is called the currency contract period. Figure 12.3 illustrates the timing of events.

Contracts are signed at time t 1 . After the contracts are established, there is a currency devaluation at time t 2 . Then the payments specified in the contracts are due at a later period t 3 . The effects of such existing contracts on the balance of trade depend on the currency in which the contract is denominated. For instance, let us suppose that the United States devalues the dollar. Before the devaluation the exchange rate is $1 per unit of foreign currency (to simplify matters, we will assume only one foreign currency); afterward the rate jumps to $1.25. If a U.S. exporter has contracted to sell $1 worth of goods to a foreign firm payable in dollars, the exporter will still earn $1. However, if the export contract was written in terms of foreign currency (let FC stand for foreign currency), then the exporter expected to receive FC1, which would be equal to $1. Instead, the devaluation leads to FC1 5 $1.25, so the U.S. exporter receives an unexpected

Determinants of the Balance of Trade 231

gain from the dollar devaluation. On the other hand, consider an import contract where a U.S. importer contracts to buy from a foreign firm. If the contract calls for payment of $1, then the U.S. importer is unaffected by the devaluation. If the contract had been written in terms of foreign currency so that the U.S. importer owes FC1, then the importer would have to pay $1.25 to buy the FC1 that the exporter receives. In this case the importer faces a loss because of the devaluation.

In the simple world under consideration here, we would expect sellers to prefer a contract in the currency expected to appreciate, whereas buyers would prefer contracts written in terms of the currency expected to depreciate. Table 12.1 summarizes the possible trade balance effects during the currency contract period.

Table 12.1 divides the effects into four cells. Cell I represents the case in which U.S. export contracts are written in terms of foreign currency, although import contracts are denominated in dollars. In this case the dollar value of exports will increase since the foreign buyer must pay in foreign currency, which is worth more after the devaluation. Because imports are paid for with dollars, the devaluation will have no effect on the dollar value of U.S. imports. As a result, the balance of trade must increase.

Cell II indicates the trade balance effects when U.S. exports and imports are paid for with foreign currency. Since the dollar devaluation

Table 12.1 U.S. Trade Balance Effects During Currency Contract Period Following a Devaluation U.S. Export contracts

U.S. Import contracts written in written in

Foreign currency Foreign currency

Dollars

I. Exports increase

II. Exports increase

Imports constant

Imports increase

Balance of trade

Initial surplus:

increases

balance of trade increases

232 International Money and Finance

increases the value of foreign currency, the dollar values of both exports and imports will increase. The net effect on the U.S. trade balance depends on the magnitude of U.S. exports relative to imports. If exports exceed imports, so that there is an initial trade surplus, then the increase in export values will exceed the increase in imports and the balance of trade will increase. Conversely, if there is an initial trade deficit, so that imports exceed exports, then the increase in imports will exceed the increase in exports and the balance of trade will decrease.

If both exports and imports are payable in dollars, then the balance of trade is unaffected by a devaluation, as indicated in Cell III. But if exports are payable in dollars and imports require payment in foreign currency, the dollar value of exports will be unaffected by the devaluation and import values will increase; in this case the trade balance decreases as in Cell IV. Note that only in the case of Cell IV is there a decline in the trade balance during the currency contract period following a devaluation. A decline could also occur in Cell II, although only if there is an initial trade deficit. The key feature of Table 12.1 is that foreign-currency-denominated imports provide a necessary condition for the U.S. trade balance to take the plunge observed in the J-curve phenomenon during the currency contract period.

CURRENCY CONTRACT PERIOD Immediately following a devaluation, contracts negotiated prior to the