Question

Describe the two primary models of exchange rate determination using equations, narrative, and graphs, as necessary.

Answer 1

1) The Balance of Trade as a Determinant of Exchange Rates The BOP theory views exchange rates as determined in flow markets. Recall that we want to determine equilibrium exchange rates. The balance of trade approach simplifies the BOP approach. In this context, exchange rates will move to eliminate international trade imbalances. To simplify the theory, assume that the KA and OR are equal to zero. In this case, the BOP is equal to the CA. The current account is determined by the difference between exports (X) and imports (M). Both exports and imports are a function of the real exchange rate (Rt), domestic income (Yd) and foreign income (Yf). Therefore, CA = X - M = f(Rt, Yd,Yf). In general, at higher real exchange rates we should expect more exports and fewer imports, and higher current account surpluses; while at lower real exchange rates, the opposite should occur.
According to the balance of trade approach, the exchange rate moves in the required direction to compensate a trade imbalance. For example, suppose the trade balance is in equilibrium –i.e., CA=0. An increase in domestic income leads to an increase in demand for imports and therefore to a trade deficit (CA<0). Then, we should expect the exchange rate to depreciate to correct this imbalance. Using a similar argument, we should also expect a depreciation of the domestic currency, following an increase in domestic prices, a decrease in foreign prices, or a decrease in foreign income. Example IV.3: The drop in oil prices after the Gulf War led to a Venezuelan trade balance deficit; the value of the oil that Venezuela exported suddenly dropped, without a corresponding reduction in imports. This deficit forced the Venezuelan government to borrow abroad to offset the imbalance; it also led to a depreciation of the bolivar. This devaluation helped to equilibrate the CA. ¶ The balance of trade approach needs the estimation of trade elasticities with respect to changes in exchange rates. These elasticities are needed to measure the response of imports and exports to a change in exchange rates. To calculate the elasticities we need to distinguish between short-run elasticities and long-run elasticities. For example, because of contracts, in the short-run imports and exports are quite inelastic (insensitive) to changes in exchange rates. Then, contrary to what the balance of trade approach predicts, in the short-run, a devaluation might increase the CA imbalance. Over time, however, we should expect this CA imbalance to be reversed. This over-time phenomenon of the CA is called the J-curve. During the past twenty years, it has become quite clear that exchange rates did not work in the simple way considered by the balance of trade approach. There have been many situations when countries with trade surpluses have depreciating currencies, while countries with trade deficits have appreciating currencies.

2) The Absorption Approach to the Balance of Trade The absorption approach to the balance of trade (CA) studies how domestic spending on domestic goods changes relative to domestic output. That is, the CA is viewed as the difference between what the economy produces and what it consumes, or absorbs, for domestic purposes. Using basic macroeconomic identities, in equilibrium, we can write Y = C + I + G –T + (X - M), where C is consumption, I is private investment, G is government spending and T is national taxes. Absorption, A, is defined as the sum of C+I+G. If total output, Y, exceeds absorption, A, then the nation will export more to the rest of the world and the current account will increase. On the other hand, if absorption exceeds domestic output, the current account will fall. The absorption approach can analyze the effect of a devaluation on the trade balance. For example, if a government devalues its currency, a devaluation would tend to increase net exports and, then, domestic output only if the economy is not at the full employment level. If the economy is at the full employment level a devaluation will only result in inflationary pressures.
Rearranging terms in the previous equation, CA = S - [I + (G - T)], where S is after-tax private savings. Now, we can analyze how to reduce a CA deficit. To increase the CA, one of the following must happen: (1) S should be increased, for a given level of I and (G-T). (2) I must fall, for a given level of S and (G-T). (3) The government deficit G-T must fall, for a given level of S and I. Example IV.4: As a country, Japan has a high savings rate relative to the rest of the world. Many argue that this is the reason behind the persistent Japanese CA surpluses. One of the usual proposed solutions to reduce the persistent Japanese CA surplus is to increase the size of the Japanese government spending. ¶ The absorption approach helps us to understand the balance of trade. But this theory will only work as a theory of the BOP in a world without capital flows.