ELASTICITIES APPROACH TO THE BALANCE OF TRADE Economic behavior involves satisfying unlimited wants with limited

resources. One implication of this fact of budget constraints is that consu- mers and business firms will substitute among goods as prices change to stretch their budgets as far as possible. For instance, if Italian-made shoes and U.S.-made shoes are good substitutes, then as the price of U.S. shoes rises relative to Italian shoes, buyers will substitute the lower-priced Italian shoes for the higher-priced U.S. shoes. The crucial concept for determining consumption patterns is relative price—the price of one good relative to another. Relative prices change as relative demand and supply for individual goods change. Such changes may result from

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A change in the exchange rate will change the domestic currency price of foreign goods. Suppose initially that a pair of shoes sells for $50 in the United States and h50 in Italy. At an exchange rate of h1 5 $1, the shoes sell for the same price in each country when expressed in a com- mon currency. If the euro is devalued to h1.2 5 $1, and shoe prices remain constant in the domestic currency of the producer, then shoes selling for h50 in Italy will now cost the U.S. buyer $41.67. After the devaluation, h1 5 $0.8333, so h50 5 $41.67, and the price of Italian shoes has fallen for U.S. buyers. Conversely, the price of $50 U.S. shoes to Italian buyers has risen from h50 to h60. The relative price effect of the euro devaluation should increase U.S. demand for Italian goods and decrease Italian demand for U.S. goods. How much quantity demanded changes in response to the relative price change is determined by the elasticity of demand.

In the beginning of economics courses, students learn that elasticity measures the responsiveness of quantity to changes in price. The elasticities approach to the balance of trade provides an analysis of how devaluations will affect the balance of trade depending on the elasticities of supply and demand for foreign exchange and foreign goods.

When demand or supply is elastic, it means that quantity demanded or supplied will be relatively responsive to the change in price. An inelastic demand or supply indicates that quantity is relatively unresponsive to price changes. We can make things more precise by using coefficients of

elasticity. For instance, letting ε d represent the coefficient of elasticity of

demand, we can write ε d as

ð12 :1Þ This implies that the coefficient of elasticity of demand is equal to the

ε d 5 %∆Q=%∆P

percentage change in the quantity demanded, divided by the percentage change in price. If the price increases by 5 percent and the quantity

demanded falls by more than 5 percent, then ε d exceeds 1 (in absolute value), and we say that demand is elastic. If the price increases by 5 percent, but quantity demanded falls by less than 5 percent, we would say

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the quantity supplied is relatively unresponsive to price, so that the supply is inelastic.

Elasticity will determine what happens to total revenue (sales price times quantities sold) following a price change. For example, an elastic demand is when quantity changes exceed that of the price change. In such a case, the total revenue will move in the opposite direction from the price change. Suppose the demand for black velvet paintings from Mexico is elastic. If the peso price rises 10 percent, the quantity demanded falls by more than 10 percent, so that the revenue received from sales will fall as a result of the price change. In contrast, if the demand for Colombian coffee is inelastic, then a 10 percent increase in price will result in a fall in the quantity demanded of less than 10 percent. The high coffee price increase more than makes up for the lost sales. Thus, coffee sales revenues rise following the price change. Obviously, the elasticity of demand is very important in determining export and import revenues when international prices change.

Now let us consider an example of supply and demand in the foreign exchange market. Figure 12.1 provides an example of the supply and demand for U.K. pounds. The demand curve labeled D is the demand for pounds, arising from the demand for British exports. The familiar downward slope indicates that the higher the price of pounds, the fewer the number of pounds demanded. The supply curve labeled S is the supply of pounds to the foreign exchange market. The upward slope

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indicates the positive relationship between the foreign exchange price of pounds and the quantity of pounds supplied. The point where the supply and demand curves intersect is the equilibrium point where the quantity of pounds demanded just equals the quantity supplied. Suppose initially

we have an equilibrium at E 0 and d 0 ; that is, d 0 is the quantity of pounds bought and sold at the exchange rate E 0 (the dollar price of a pound). Now suppose there is an increase in demand for pounds (say, because of an increase in demand for U.K. exports). There are several possible responses to this shift in demand:

1. With freely floating exchange rates, the pound will appreciate, so that the exchange rate rises to E 1 , and d 1 are bought and sold.

2. Central banks can peg the exchange rate at the old rate E 0 by provid- ing d 0 1 2d 0 from their reserves.

3. The supply and demand can be affected by imposing controls or quotas on the supply of, or demand for, pounds.

4. Quotas or tariffs could be imposed on foreign trade to maintain the old supply and demand for pounds. The elasticities approach recognizes that the effect of an exchange rate

change on the equilibrium quantity of currency being traded will depend on the elasticities of the supply and demand curves involved. It is important to remember that the elasticities approach is a theory of the balance of trade and can only be a theory of the balance of payments in a world without capital flows.

Suppose that in Figure 12.1 , the U.S. central bank (the Federal Reserve) decides to fix the exchange rate at E 0 . To do so the U.S. central bank has to supply pounds to the market from U.S. reserves in exchange for U.S. dollars. Now the old exchange rate E 0 is maintained because of the central bank’s addition of d 0 1 2d 0 to the market. If it becomes appar- ent that the increase in demand is a permanent change, then the Federal Reserve will have to devalue the dollar, driving up the dollar price of pounds. This, of course, means that U.K. goods will be more expensive to the United States, whereas U.S. goods will be cheaper to the United Kingdom. Will this improve the U.S. trade balance? It all depends on the

Determinants of the Balance of Trade 229

ade

Time

Balance of tr

Figure 12.2 The J curve. trade deficit and the excess demand for pounds could actually increase

following a devaluation. Such a response to a devaluation has been labeled

a J-curve. The J-curve effect refers to the pattern of the balance of trade, following a devaluation. If the balance of trade is viewed over time, the initial decrease in the trade balance is followed by a growing trade balance, because of inelastic demand, and results in the time pattern of the trade balance shown in Figure 12.2 .

Note in the figure that the trade balance is initially negative, falling over time. The devaluation occurs at point t 0 . Following the devaluation, the balance of trade continues to fall for a while before finally turning upward. The initial fall results from low elasticities in the short run. Over time, elasticities increase so that the balance of trade improves. This gen- eral pattern of the balance of trade falling before it increases traces a pat-

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devaluation increases the price of foreign goods to the home country and decreases the price of domestic goods to foreign buyers, there is a short- run period during which the balance of trade falls. We now consider the reasons for why there may be low elasticities in the short run, to see what the possible underlying reasons are for a J-curve. We can identify two different periods following a devaluation. Immediately following a devaluation the contracts that have already been negotiated become revalued. Such a period is called the currency contract period. Once the contracts have expired there may still be a limited response by traders. The short run period following the expiration of contracts is called the pass through analysis. During this period the traders have limited changes in the quantities in response to the new set of prices, but over time the response becomes complete. We will discuss each of these two short run responses.

ELASTICITIES APPROACH TO THE BALANCE OF TRADE Economic behavior involves satisfying unlimited wants with limited