CHAPTER 14
EXCHANGE-RATE ADJUSTMENTS AND THE BALANCE OF PAYMENTS
CHAPTER OVERVIEW
This chapter considers exchange-rate adjustments and the balance of payments. The chapter notes that currency
depreciation (devaluation) can affect a nation’s trade position through its impact on relative prices, incomes, and
purchasing power of money balances.
The chapter first considers the situation where all of a firm’s inputs are acquired domestically and their costs are
denominated in the domestic currency. As a result, an appreciation in the domestic currency’s exchange value
increases a firm’s costs by the same proportion, in terms of the foreign currency.
The chapter emphasizes the elasticities approach to depreciation. According to this approach, currency depreciation
leads to the greatest improvement in a country’s trade position when demand elasticities are high. The time path of
currency depreciation can be explained in terms of the J-curve effect and the extent to which exchange-rate
changes lead to changes in import prices and export prices is explained by the pass–through effect.
Finally, the chapter notes the importance of the absorption approach to devaluation. According to this view, a
devaluation may initially stimulate a nation’s exports and production of import-competing goods. But this will
promote excess domestic spending unless real output can be expanded or domestic absorption reduced. The result
would be a return to a payments deficit.
After completing the chapter, students should be able to:
BRIEF ANSWERS TO STUDY QUESTIONS
1. Currency devaluation affects a country’s trade balance via its impact on relative prices (elasticities approach),
2. See Question 1.
3. The Marshall-Lerner condition refers to the elasticities approach to devaluation. It suggests that devaluation
4. The J-curve effect implies that due to time lags between the response of goods traded to relative price
5. The extent to which changing currency values lead to changes in import and export prices is known as the
7. The monetary approach suggests currency devaluation affects the domestic price level and the purchasing
power of money balances, which lead to changes in domestic expenditures and the level of imports.
9. The 50 percent dollar appreciation results in a less-than 50 percent increase in the firm’s production cost in
terms of the peso.
10. a. Export quantity 1000
Export price $3000
Export receipts $3 million
Instructor’s Manual 3
c. Because the sum of the export-demand elasticity and the import-demand elasticity are less than
1.0, the U.S. trade balance will worsen.