PASS-THROUGH ANALYSIS The currency contract period refers to the period following a devaluation

when contracts negotiated prior to the devaluation come due. During this time it is assumed that goods prices do not adjust instantaneously to the change in currency values. Eventually, of course, as new trade contracts are negotiated, goods prices will tend toward the new equilibrium. Pass-through analysis considers the ability of prices to adjust in the short run. The kind of adjustment expected is an increase in the price of imported goods in the devaluing country and a decrease in the price of this country’s exports to the rest of the world. If goods prices do not adjust in this manner, then spending patterns will not be altered, so that

Determinants of the Balance of Trade 233

exports and a lower domestic demand for imports should bring about an improvement in the trade balance. In the short run, however, if the response to the new prices is so slow that the quantities traded do not change much, then the new prices could contribute to the J curve. For instance, if the demand for imports is inelastic, then buyers will be rela- tively unresponsive to the higher price of imports, and thus the total import bill could rise rather than fall after the devaluation. Such behavior is not unreasonable since it takes time to find good substitutes for the now higher-priced import goods. Eventually, such substitutions will occur. However, in the short run buyers may continue to buy imports in large enough quantities so that the now higher price results in a greater rather than a smaller value of domestic imports after the devaluation. The same explanation could hold on the other side of the market if foreign demand for domestic exports is inelastic. In this case, foreign buyers will not buy much more in the short run, even though the price of domestic exports has fallen.

Table 12.2 summarizes the possible effects following a U.S. devaluation during the brief pass-through period before quantities adjust. The worst case is presented in Cell IV. With an inelastic demand for U.S. imports and an inelastic demand for U.S. exports, there will be a full pass-through of prices.

The effects of a devaluation, summarized in Table 12.2 , assume that the inelastic demand or supply holds the quantity fixed. To illustrate the

Table 12.2 U.S. Trade Balance Effects During Pass-Through Period Following a Devaluation

U.S. Imports U.S. Exports

Inelastic demand Inelastic supply

Inelastic supply

I. Exports increase

II. Exports increase

Imports constant

Imports increase

Balance of trade

Initial surplus:

increases

balance of trade increases

234 International Money and Finance

pass-through effects we show the underlying supply and demand in Figure 12.4 . Figure 12.4a illustrates the case of perfectly inelastic demand for U.S. imports. Who demands U.S. imports? U.S. buyers, so the relevant price in Figure 12.4a is the dollar price of imports. Note that the U.S.

demand for imports is fixed at Q 0 . This means that in the short run, U.S. importers will buy Q 0 at any relevant price. After the devaluation, the supply curve shifts to the left, representing the fact that foreign exporters now want to charge a higher dollar price for their exports to the United States because the dollar is worth less. The vertical distance between the old and new supply curves indicates how much more sellers wish to charge for any given quantity. Since the demand curve is a vertical

line, fixed at Q 0 , sellers will be able to pass through the full amount of the desired price increase to importers; thus importers will be buying Q 0 at a higher price than before, and the total dollar value of imports will

Demand Demand ts

Supply (before)

Supply (after)

ts xpor

Supply (after)

Supply (before)

ice of impor

ice of e F oreign currency pr

Dollar pr 0 Q 0 0 Q F Quantity of imports

Quantity of exports (a)

(b)

Supply Supply

ice of impor

ice of impor F oreign currency pr Demand (before)

Demand (after)

Determinants of the Balance of Trade 235

increase. This is the situation in Cell IV of Table 12.2 , where the U.S. balance of trade decreases because of the full pass-through.

Figure 12.4b shows why exports remain constant in Cell IV. In this case the foreigners’ demand for U.S. exports is perfectly inelastic. Because foreign buyers purchase U.S. exports, the relevant price is the foreign cur-

rency price in Figure 12.4b . Foreign buyers want to purchase Q F amount of U.S. exports regardless of the price in the short run. Note that now the relevant price to foreign buyers is the foreign currency price. After the devaluation, the supply curve shifts to the right to reflect the fact that U.S. exporters are willing to sell goods for less foreign currency because foreign currency is now worth more. However, with the perfectly inelastic demand curve, there is a full pass-through, lowering the foreign currency price by the full amount of the devaluation. In other words, if the devaluation increased the value of foreign currency by 10 percent, the foreign currency price of U.S. exports falls by 10 percent and the total dollar value of U.S. exports remains constant.

Note that Cell III of Table 12.2 pairs the inelastic demand for U.S. exports, as just discussed, with an inelastic supply of U.S. imports. Figure 12.4c illustrates the effect of the inelastic supply. Since imports into the United States are supplied by foreign sellers, the relevant price is the foreign currency price in Figure 12.4c . In this case, foreign sellers will sell

Q F imports to the United States independent of price. After the devaluation, the U.S. demand for imports in terms of foreign currency shifts to the left, indicating that buyers are willing to pay fewer units of foreign currency than before for a given quantity of imports. Because the supply curve is perfectly inelastic, the foreign currency price of imports falls by the amount of the devaluation, and thus there is no pass-through. In other words, the pass-through effect is completely offset by a fall in the foreign currency price of imports. After a dollar devaluation we expect imports to become more expensive to the United States; yet with a perfectly inelastic import supply curve, as in Figure 12.4c , U.S. dollar import prices are unchanged so that the dollar value of imports is also unchanged.

Cell II of Table 12.2 couples the inelastic U.S. import demand, as pre-

236 International Money and Finance

amount of the devaluation. Thus, rather than having a devaluation pass- through lower U.S. export prices to foreigners, the increase in dollar prices has foreign buyers paying the same price as before (because the foreign currency price is unchanged). But the higher dollar price results in an increase in the dollar value of U.S. exports. Since the inelastic demand for U.S. imports also causes the dollar value of imports to increase, the net result for the balance of trade depends on whether initially exports exceeded imports, in which case the increase in exports after the devaluation will be larger than the import increase. If imports initially exceeded exports, then the devaluation will lower the trade balance.

Finally, we have the case of Cell I, where the balance of trade clearly increases during the pass-through period when quantities are fixed. The inelastic supply of U.S. exports leads to an increase in the dollar value of U.S. exports, whereas the inelastic supply of imports results in the value of imports holding constant.

The portrayal of perfectly inelastic supply and demand curves is made for illustrative purposes. We cannot argue that in the real world there is absolutely no quantity response to changing prices in the short run. The important contribution of the pass-through analysis is to indicate how changing goods prices in the short run, when the quantity response is likely to be quite small, can affect the balance of trade. If it is more rea- sonable to expect producers to be less able to alter quantities supplied than buyers can alter quantity demanded, then Cell I of Table 12.2 is the most likely real-world case. In this instance, the supplies of U.S. imports and exports are inelastic, so the U.S. trade balance should improve during the pass-through period.

PASS-THROUGH ANALYSIS The currency contract period refers to the period following a devaluation