Economics of International Finance Prof. M. El-Sakka CBA. Kuwait University Economics of...

Economics of International Finance Economics of International Finance Prof. M. El-Sakka Prof. M. El-Sakka CBA. Kuwait University CBA. Kuwait University

Economics of International FinanceEconomics of International FinanceEcon. 315Econ. 315

Chapter 4Chapter 4

The Price Adjustment with Flexible The Price Adjustment with Flexible and Fixed Exchange Ratesand Fixed Exchange Rates


Objectives:Objectives: Examining how a nation’s current account is affected by price changes Examining how a nation’s current account is affected by price changes

under fixed and flexible exchange rates. under fixed and flexible exchange rates.

AssumptionsAssumptions

We assume no We assume no autonomous international private capital flowsautonomous international private capital flows, i.e., they , i.e., they take place as a response to temporary trade balances.take place as a response to temporary trade balances.

Current account is corrected Current account is corrected only by exchange rate changesonly by exchange rate changes. .

Since this approach is based on trade flows and the speed of adjustment Since this approach is based on trade flows and the speed of adjustment depends on how responsive (depends on how responsive (elasticelastic) imports are to price changes ) imports are to price changes (exchange rate changes), it is also called (exchange rate changes), it is also called tradetrade or or elasticityelasticity approach. approach.

Adjustment with Flexible Exchange RatesAdjustment with Flexible Exchange Rates

Current account is corrected by a depreciation (Current account is corrected by a depreciation (a flexible exchange ratea flexible exchange rate) ) or a devaluation (or a devaluation (a fixed or pegged exchange ratea fixed or pegged exchange rate). ).

Depreciation or devaluation operates on Depreciation or devaluation operates on pricesprices to bring about an to bring about an adjustment in the current accountadjustment in the current account and BOP, i.e., affects the relative prices and BOP, i.e., affects the relative prices of exports and imports. of exports and imports.


BOP adjustments with exchange rate changesBOP adjustments with exchange rate changes Look at figure 1, where USA and EMU are assumed to be the only two Look at figure 1, where USA and EMU are assumed to be the only two

economies in the world. There are economies in the world. There are nono international capital flows, such that international capital flows, such that the US demand and supply for € reflects the US demand and supply for € reflects only trade in goods and servicesonly trade in goods and services..

At R = $1/ €1, the US demand for € is 12 bn, while supply is only €8 bn, At R = $1/ €1, the US demand for € is 12 bn, while supply is only €8 bn, i.e., a deficit € 4 bn. i.e., a deficit € 4 bn.

If demand and supply for euros are D€ and S€, a 20% devaluation would If demand and supply for euros are D€ and S€, a 20% devaluation would equilibrate BOP at €10 bn (point E). equilibrate BOP at €10 bn (point E).

If demand and supply for euros are less elastic D€’ and S€’ a 20% If demand and supply for euros are less elastic D€’ and S€’ a 20% devaluation would not equilibrate BOP at €10 bn. A 20% devaluation devaluation would not equilibrate BOP at €10 bn. A 20% devaluation would reduce the deficit to €3 bn, and 100% devaluation (R = $2/ €1) would reduce the deficit to €3 bn, and 100% devaluation (R = $2/ €1) would completely eliminate the deficit (point E’). would completely eliminate the deficit (point E’). Why?Why?

The scale of depreciation depends on The scale of depreciation depends on how elastic is the demand and how elastic is the demand and supply for foreign currencysupply for foreign currency (imports and exports). (imports and exports).


Figure 1 Balance-of-Payments Adjustments with Exchange Rate Changes.

A deficit is corrected by a20% devaluation

A deficit is corrected bya 100% devaluation

The 20% devaluation would reduce the deficit but not to correct for it


Derivation of the demand curve for foreign exchange.Derivation of the demand curve for foreign exchange. Look at panel A of figure 2. the demand for imports is DLook at panel A of figure 2. the demand for imports is DMM at at

R=$1/€1 while the European supply of imports is SR=$1/€1 while the European supply of imports is SMM. Suppose . Suppose

that the euro price for a unit of imports is Pthat the euro price for a unit of imports is PMM = €1, and the = €1, and the

quantity of imports = 12 bn units (this corresponds to point B’ in quantity of imports = 12 bn units (this corresponds to point B’ in figure 1 (i.e., figure 1 (i.e., 12 bn units 12 bn units ×× €1 = €12 bn€1 = €12 bn).).

If the dollar depreciates by 20% pushes the DIf the dollar depreciates by 20% pushes the DMM down to to D down to to DMM’, ’,

SSM M remains unchanged, remains unchanged, Why?.Why?. For the US to continue to demand For the US to continue to demand

12 bn units the euro price of US imports would have to fall to P12 bn units the euro price of US imports would have to fall to PMM

= €0.8, i.e., by exactly the 20% depreciation of the dollar in = €0.8, i.e., by exactly the 20% depreciation of the dollar in order to leave the dollar’s price of European imports order to leave the dollar’s price of European imports almostalmost unchanged (point H on Dunchanged (point H on DMM).).


It is obvious that DIt is obvious that DMM’’ should not be parallel (compare points J-G should not be parallel (compare points J-G and H-B’) and H-B’)

With DWith DMM’ and S’ and SM M the price of imports is Pthe price of imports is PMM = €0.9 and Q = €0.9 and QM M = 11 = 11 bn. the US will move to point E’ and demand of the € would be bn. the US will move to point E’ and demand of the € would be (11 bn.(11 bn. ×× 0.9 = 9.9 bn) ≈ 10 bn. 0.9 = 9.9 bn) ≈ 10 bn.

So: at R=$1/€1 the demand was € 12 bn, (point B in figure 1) So: at R=$1/€1 the demand was € 12 bn, (point B in figure 1) and at R=$1.2/€1 the demand was 10 bn, (and at R=$1.2/€1 the demand was 10 bn, (point E in figure 1point E in figure 1). ). Therefore, D€ is derived from the demand and supply of imports. Therefore, D€ is derived from the demand and supply of imports. (If demand for imports is less elastic, the demand for euros (If demand for imports is less elastic, the demand for euros would be D€ ‘ in figure 1)would be D€ ‘ in figure 1)

Only in the unusual case where the demand for imports is Only in the unusual case where the demand for imports is vertical, the quantity demanded of the foreign currency remains vertical, the quantity demanded of the foreign currency remains constant after devaluation. However, constant after devaluation. However, the less elastic is the the less elastic is the demand for euros, the steeper is the demanddemand for euros, the steeper is the demand. .


Figure 2 Derivation of the U.S. Demand and Supply Curves for Foreign Exchange

Panel A

A compromise price € .9 per unit

at which BOP is in eq.

If the $ depreciates by 20%, DM shifts down.

PM should go down to € .8 (by 20%)

for US to continue buying 12 bn. units


Derivation of the supply curve for foreign exchange.Derivation of the supply curve for foreign exchange.

Look at panel B of figure 2. SLook at panel B of figure 2. SXX is the supply of US exports, and D is the supply of US exports, and DXX is the is the

European demand for US exports. If the US price in euros is € 2, the quantity European demand for US exports. If the US price in euros is € 2, the quantity of exports would be 4 bn and supply of euros would be 2 of exports would be 4 bn and supply of euros would be 2 ×× 4 = € 8 bn (point 4 = € 8 bn (point A in figure 1). A in figure 1).

With A devaluation of 20% of the dollar DWith A devaluation of 20% of the dollar DXX remains unchanged but S remains unchanged but SXX would would

shift down to Sshift down to SXX’. The price of exports would be €1.6 for each unit, this will ’. The price of exports would be €1.6 for each unit, this will

encourage European to demand more and there will be a movement toward E’ encourage European to demand more and there will be a movement toward E’ on DX which is an increase in the quantity exported by US from 4 bn to 5.5 on DX which is an increase in the quantity exported by US from 4 bn to 5.5 bn. (i.e., 5.5x1.8≈ €10 bn).bn. (i.e., 5.5x1.8≈ €10 bn).

So at R = $2/ €1, the supply of euros is €8 bn (point A in figure 1), at R = So at R = $2/ €1, the supply of euros is €8 bn (point A in figure 1), at R = $2.4/ €1, The supply of euros is 10 (point E in figure 1). The supply of euros $2.4/ €1, The supply of euros is 10 (point E in figure 1). The supply of euros is driven from the supply and demand for US exports.is driven from the supply and demand for US exports.

If demand for exports is less elastic there could be a movement form point A If demand for exports is less elastic there could be a movement form point A to point C instead of E in figure 1. to point C instead of E in figure 1.


Panel B

Figure 2 Derivation of the U.S. Demand and Supply Curves for Foreign Exchange

If the $ depreciates by 20%, SX shifts

and PX should go down to € 1.6 (by 20%)

This encourages demand for US exports

that pushes the price up to 1.8 euros

the price of exports € 1.8 per unit

at which BOP is in eq.


The Effect of Exchange Rate on Domestic Prices and the Terms of TradeThe Effect of Exchange Rate on Domestic Prices and the Terms of Trade

1.1. Depreciation or devaluation stimulates the production of import Depreciation or devaluation stimulates the production of import substitutes and exports leading to a rise in prices, i.e., depreciation is substitutes and exports leading to a rise in prices, i.e., depreciation is inflationaryinflationary. The greater the depreciation or devaluation, the greater is . The greater the depreciation or devaluation, the greater is the inflationary impact, and the the inflationary impact, and the less flexibleless flexible is the increase in exchange is the increase in exchange rates as a method of correcting deficit in BOP. rates as a method of correcting deficit in BOP.

2.2. A depreciation or devaluation is also likely to affect the nations terms of A depreciation or devaluation is also likely to affect the nations terms of trade TOT (the ratio between export prices and import prices), since trade TOT (the ratio between export prices and import prices), since TOT are either measured in domestic prices or in foreign currency, a TOT are either measured in domestic prices or in foreign currency, a depreciation or devaluation will cause TOT to increase, fall, or remain depreciation or devaluation will cause TOT to increase, fall, or remain unchanged. unchanged.

Look at figure 2. after depreciation, the price of exports PLook at figure 2. after depreciation, the price of exports PXX = €2 (point A’ = €2 (point A’

in the right panel) and Pin the right panel) and PMM = €1 (point B’ in panel A). Hence TOT (P = €1 (point B’ in panel A). Hence TOT (PXX / P / PMM

=2/1 = 2 or 200%). After a 20% depreciation P=2/1 = 2 or 200%). After a 20% depreciation PXX = €1.8 (point E’ in panel = €1.8 (point E’ in panel

B) and PB) and PM M = € 0.9 (point E’ in panel A), so TOT = 1.8/0.9 = 2 or 200%. = € 0.9 (point E’ in panel A), so TOT = 1.8/0.9 = 2 or 200%.

TOT remain unchanged. But in general we expect TOT to change in case TOT remain unchanged. But in general we expect TOT to change in case of depreciation. of depreciation.


The Dutch DiseaseThe Dutch DiseaseWhen an industrial nation begins to exploit a domestic natural resource When an industrial nation begins to exploit a domestic natural resource previously imported, the nation’s exchange rate might appreciate to previously imported, the nation’s exchange rate might appreciate to cause the nation’s loss of international competitiveness in its traditional cause the nation’s loss of international competitiveness in its traditional industrial sector, and even face deindustrialization. industrial sector, and even face deindustrialization. Does it apply to Does it apply to Kuwait?.Kuwait?.

Stability of Foreign Exchange Markets:Stability of Foreign Exchange Markets:

1.1. Stable Foreign Exchange MarketStable Foreign Exchange Market: when disturbances from the : when disturbances from the equilibrium exchange rate give rise to automatic forces that push equilibrium exchange rate give rise to automatic forces that push exchange rate back to the equilibrium level. exchange rate back to the equilibrium level.

2.2. Unstable Foreign Exchange MarketUnstable Foreign Exchange Market: when disturbances from the : when disturbances from the equilibrium exchange rate push the exchange rate further away from the equilibrium exchange rate push the exchange rate further away from the equilibrium level.equilibrium level.

A foreign exchange market is stable when the supply curve of foreign A foreign exchange market is stable when the supply curve of foreign exchange is positively slopped or if it is less elastic (steeper) than the exchange is positively slopped or if it is less elastic (steeper) than the demand curve for foreign exchange.demand curve for foreign exchange.


Stable Foreign Exchange Market:Stable Foreign Exchange Market:Look at figure 3; in panel A: R = $1.2 = €1 at equilibrium. If R fell to R Look at figure 3; in panel A: R = $1.2 = €1 at equilibrium. If R fell to R $1= €1 $1= €1 excess demand of € (deficit in US BOP = € 4 bn). This would excess demand of € (deficit in US BOP = € 4 bn). This would automatically push R back to equilibrium R ($1.2 = €1) and vice versa automatically push R back to equilibrium R ($1.2 = €1) and vice versa when R increases to $1.4 = €1. Hence the foreign exchange market is when R increases to $1.4 = €1. Hence the foreign exchange market is stable. stable.

In panel B, supply is negatively slopped but steeper (inelastic) than the In panel B, supply is negatively slopped but steeper (inelastic) than the demand. When the rate falls to R $1= €1 demand. When the rate falls to R $1= €1 excess demand (deficit in excess demand (deficit in BOP = € 1.5 bn) which automatically pushes R towards equilibrium R BOP = € 1.5 bn) which automatically pushes R towards equilibrium R ($1.2 = €1) and vice versa when R increases to $1.4 = €1. Hence the ($1.2 = €1) and vice versa when R increases to $1.4 = €1. Hence the foreign exchange market is stable. foreign exchange market is stable.

Unstable Foreign Exchange Market:Unstable Foreign Exchange Market:

In panel C, the supply curve is negatively slopped, but is flatter (more In panel C, the supply curve is negatively slopped, but is flatter (more elastic) than the demand. When R falls to R $1= €1 elastic) than the demand. When R falls to R $1= €1 excess supply of € excess supply of € of € 1.5 bn which pushes R away from equilibrium. If R = $1.4= €1 of € 1.5 bn which pushes R away from equilibrium. If R = $1.4= €1 excess demand for € which automatically pushes R up away from excess demand for € which automatically pushes R up away from equilibrium. Thus the foreign exchange market is unstable. equilibrium. Thus the foreign exchange market is unstable.


FIGURE 3 Stable and Unstable Foreign Exchange Markets.

Panel A Panel B Panel C


When foreign exchange market is unstable, a When foreign exchange market is unstable, a flexible exchange flexible exchange rate system increases, rather than reduces, BOP deficitrate system increases, rather than reduces, BOP deficit. The . The revaluation or appreciation not depreciation is required to revaluation or appreciation not depreciation is required to eliminate the BOP deficit, while devaluation is required to correct eliminate the BOP deficit, while devaluation is required to correct for BOP surplus.for BOP surplus.

Determining whether the foreign exchange market is Determining whether the foreign exchange market is stable is stable is importantimportant. If the foreign exchange market is stable, . If the foreign exchange market is stable, elasticityelasticity of the of the demand for foreign exchange and supply of foreign exchange demand for foreign exchange and supply of foreign exchange become become importantimportant..

The Marshall-Learner ConditionThe Marshall-Learner Condition

The condition that tells us whether the foreign exchange market is The condition that tells us whether the foreign exchange market is stable or unstable is the Marshall-Learner condition (M.L.C). The stable or unstable is the Marshall-Learner condition (M.L.C). The simplified version of the M.L.C is that if supply curve of imports simplified version of the M.L.C is that if supply curve of imports and exports are infinitely elastic, and exports are infinitely elastic, the M.L.C indicates that a stable the M.L.C indicates that a stable foreign exchange market occurs if the sum of price elasticities of foreign exchange market occurs if the sum of price elasticities of demand and supply of foreign exchange in absolute terms is demand and supply of foreign exchange in absolute terms is greater than one.greater than one.


If the sum of elasticities of demand and supply of foreign If the sum of elasticities of demand and supply of foreign exchange is exchange is less than oneless than one 1, the foreign exchange market is 1, the foreign exchange market is unstableunstable. .

If the sum of elasticities of demand and supply of foreign If the sum of elasticities of demand and supply of foreign exchange is exchange is oneone, the , the BOP will remain unchangedBOP will remain unchanged. .


Elasticities in the Real World. Elasticities in the Real World.

Elasticities Estimates Elasticities Estimates M.L.C postulates a stable foreign exchange market if the sum of price M.L.C postulates a stable foreign exchange market if the sum of price

elasticities of Delasticities of DMM and D and DXX exceeds one in real absolute terms. However, the exceeds one in real absolute terms. However, the sum of elasticities of Dsum of elasticities of DMM and D and DXX should be should be substantially greater than onesubstantially greater than one to make depreciation feasible as a method of correcting a deficit in BOP. to make depreciation feasible as a method of correcting a deficit in BOP.

Before world war II Before world war II MarshallMarshall argued that price elasticities in argued that price elasticities in international trade are high (stable foreign exchange markets). This was international trade are high (stable foreign exchange markets). This was not basednot based on empirical support ( on empirical support (prewar optimismprewar optimism).).

Econometric estimates, after the WWII however, show that the sum of Econometric estimates, after the WWII however, show that the sum of price elasticities of Dprice elasticities of DMM and D and DXX is is either less than 1either less than 1 or barely exceed 1or barely exceed 1. . prewar optimism was replaced by prewar optimism was replaced by post war pessimismpost war pessimism..

Are foreign exchange markets unstable? finding an explanation.Are foreign exchange markets unstable? finding an explanation.

1. The identification problem1. The identification problem Orcutt in 1950 argued that regression techniques led to gross Orcutt in 1950 argued that regression techniques led to gross

underestimation of underestimation of the price elasticities of Dthe price elasticities of DMM and D and DXX and that Marshall and that Marshall was correct. He argued that estimates of elasticities suffer from was correct. He argued that estimates of elasticities suffer from identificationidentification problem. problem.


Look at figure 4. points E and E’ are equilibrium points observed before Look at figure 4. points E and E’ are equilibrium points observed before and after depreciation of the $, with non of the curves being observed. and after depreciation of the $, with non of the curves being observed. The downward shift from SThe downward shift from SXX to S to SXX* depreciation does not affect the * depreciation does not affect the foreign demand for US exports. If such a change occurs, the estimated foreign demand for US exports. If such a change occurs, the estimated foreign demand for exports is Dforeign demand for exports is DXX. But E and E* are also consistent with . But E and E* are also consistent with DDXX’ and D’ and DXX’’ which are elastic. The identification problem results from ’’ which are elastic. The identification problem results from using Dusing DXX even if the actual demand is D even if the actual demand is DXX’ which is elastic. This ’ which is elastic. This underestimates the price elasticities in international trade. underestimates the price elasticities in international trade.

2. The Effect of Lags2. The Effect of Lags Junz and Rhomberg (1973) have identified possible lags in quantity Junz and Rhomberg (1973) have identified possible lags in quantity

response to price changes in international trade: response to price changes in international trade: These lags explain the These lags explain the low value of elasticities in the short run:low value of elasticities in the short run:

1. Recognition lag: before the change in price is evident1. Recognition lag: before the change in price is evident 2. Decision lag: lag to take advantage of the price rise2. Decision lag: lag to take advantage of the price rise 3. Delivery lag: lag of new orders to be placed3. Delivery lag: lag of new orders to be placed 4. replacement lag: to use up available inventories before new orders are 4. replacement lag: to use up available inventories before new orders are

placedplaced 5. Production lag: to change the output mix as a result of price changes.5. Production lag: to change the output mix as a result of price changes.


FIGURE 4 The Identification Problem.

Instead of using

The elastic demand curves

Estimates used the inelastic demand


By not taking these lags and only takes the quantities in the years of a By not taking these lags and only takes the quantities in the years of a price change led to a underestimation of price elasticities. Hence short price change led to a underestimation of price elasticities. Hence short run elasticities are likely to be much smaller than long run elasticities. run elasticities are likely to be much smaller than long run elasticities.

3. The J curve and revised elasticity estimates.3. The J curve and revised elasticity estimates. The BOP may worsen soon after the depreciation before improving later The BOP may worsen soon after the depreciation before improving later

on. This is due to the tendency of the domestic currency price of imports on. This is due to the tendency of the domestic currency price of imports to rise faster than export prices with quantities initially not changing to rise faster than export prices with quantities initially not changing very much. very much.

Over time QOver time QXX rises and Q rises and QMM falls so that the initial deterioration of the falls so that the initial deterioration of the BOP is halted and then reversed. This is known as the J curve effect BOP is halted and then reversed. This is known as the J curve effect because the response of the trade balance to a depreciation looks like the because the response of the trade balance to a depreciation looks like the curve of a J.curve of a J.

Empirical studies confirmed the existence of the J curve effect and came Empirical studies confirmed the existence of the J curve effect and came up with high long term elasticities, i.e., real world elasticities are high up with high long term elasticities, i.e., real world elasticities are high enough to ensure stability of the foreign exchange market in the short enough to ensure stability of the foreign exchange market in the short run and a fairly elastic demand for and supply of foreign exchange in the run and a fairly elastic demand for and supply of foreign exchange in the long run. long run.


FIGURE 5 The J-Curve.

Immediate deterioration of BOP

BOP improves

BOP deterioration halts

Deterioration lowers over time


4. 4. Currency pass throughCurrency pass through The increase in the domestic price of imported commodity may be The increase in the domestic price of imported commodity may be

smaller than the amount of depreciation even after lags, i.e., the pass smaller than the amount of depreciation even after lags, i.e., the pass through from depreciation to the domestic prices may be less than through from depreciation to the domestic prices may be less than complete, e.g., a 10% depreciation may result in a complete, e.g., a 10% depreciation may result in a less thanless than 10% increase 10% increase in domestic currency prices of the imported commodity. in domestic currency prices of the imported commodity. WhyWhy??

Exporters often having established a large share in domestic market may Exporters often having established a large share in domestic market may be willing to absorb at least some of the price increase they could charge be willing to absorb at least some of the price increase they could charge out of their profits. A foreign company may increase the price of exports out of their profits. A foreign company may increase the price of exports by 6% and accept a 4% reduction in the price of its exports when the by 6% and accept a 4% reduction in the price of its exports when the nation’s currency depreciates by 10% to avoid the risk of losing foreign nation’s currency depreciates by 10% to avoid the risk of losing foreign markets by large increases in the price of their exports. This is known as markets by large increases in the price of their exports. This is known as the beachhead effect. the beachhead effect.


Adjustment under the gold standardAdjustment under the gold standard

The Gold standardThe Gold standard

Operated from about 1880 to the outbreak of the WW I. After the war, Operated from about 1880 to the outbreak of the WW I. After the war, there was an attempt to reestablish the gold standard but this failed in there was an attempt to reestablish the gold standard but this failed in 1931. It is also unlikely that it will be reestablished in the future. But it is 1931. It is also unlikely that it will be reestablished in the future. But it is important to understand its advantages and disadvantages.important to understand its advantages and disadvantages.

Under the gold standard each country defines the gold content of its Under the gold standard each country defines the gold content of its currency and stands ready to currency and stands ready to buybuy or or sellsell any amount of gold at that any amount of gold at that price. Based on that exchange rates are determined. price. Based on that exchange rates are determined.

For example, the £ contains 113 grains of gold while the $ contains 23.2 For example, the £ contains 113 grains of gold while the $ contains 23.2 grains. The dollar price of the £ is 113/23.2 = 4.87. this is called the grains. The dollar price of the £ is 113/23.2 = 4.87. this is called the mint mint parityparity. .

Since shipping currencies between New York and London cost gold Since shipping currencies between New York and London cost gold (about 3 cents), the exchange rate between the $ and £ could never (about 3 cents), the exchange rate between the $ and £ could never fluctuate by more than fluctuate by more than 3 cents above or below the mint parity3 cents above or below the mint parity. .


FIGURE 6 Gold Points and Gold Flows.

An increase in the demand for imports deficit and a depreciation of $sell gold abroad

An increase in the

demand for exports

Appreciation of $

buy gold from abroad

Gold sold in US, exported to London to buy £ at $ 4.90 Instead of buying£ in US at $ 4.94

Gold is imported from London

due to selling the surplus of

£ there at 4.84 instead of 4.80 in US


None would pay more than $ 4.90 for £1 since he/she could None would pay more than $ 4.90 for £1 since he/she could purchase $ 4.87 of gold in the US, ship it to London at 3 cents and purchase $ 4.87 of gold in the US, ship it to London at 3 cents and exchange it for £1 at the bank of England (central bank). Thus the exchange it for £1 at the bank of England (central bank). Thus the US supply of £ becomes infinitely elastic at the rate of $ 4.90 for £1. US supply of £ becomes infinitely elastic at the rate of $ 4.90 for £1. This was the This was the gold export pointgold export point of the US of the US

On the other hand, the $/£ rate can’t fall below $ 4.84 because no On the other hand, the $/£ rate can’t fall below $ 4.84 because no one would accept less than 4.84 for the £. He could always one would accept less than 4.84 for the £. He could always purchase £ worth of gold in London and ship it to New York at a purchase £ worth of gold in London and ship it to New York at a cost of 3 cents and exchange it for $ 4.87 (i.e. 4.84 net) as a result cost of 3 cents and exchange it for $ 4.87 (i.e. 4.84 net) as a result the demand curve becomes infinitely elastic (horizontal) at the rate the demand curve becomes infinitely elastic (horizontal) at the rate of $ 4.84 / £1. This is the gold import point of the US. Exchange of $ 4.84 / £1. This is the gold import point of the US. Exchange rate is prevented from moving outside the gold points by US gold rate is prevented from moving outside the gold points by US gold sales or purchases. sales or purchases.

The price-specie-flow mechanismThe price-specie-flow mechanism

The automatic adjustment mechanism under the gold standard. The automatic adjustment mechanism under the gold standard. The price-specie-flow mechanism is working as followsThe price-specie-flow mechanism is working as follows


Under the gold standard money supply would fall in the deficit nation Under the gold standard money supply would fall in the deficit nation and rise in the surplus nation causing prices to fall in the deficit and rise and rise in the surplus nation causing prices to fall in the deficit and rise in the surplus nation. Exports of the deficit nation would be encouraged in the surplus nation. Exports of the deficit nation would be encouraged and imports would be discouraged until deficit is eliminated. This is and imports would be discouraged until deficit is eliminated. This is based on the quantity theory of money:based on the quantity theory of money:

M . V = P . QM . V = P . Q As the deficit nation lost gold, M falls. A reduced M by 10% encourages As the deficit nation lost gold, M falls. A reduced M by 10% encourages

exports and discourages imports. The opposite would take place in the exports and discourages imports. The opposite would take place in the surplus nation (due to gold inflow) internal prices increases and surplus nation (due to gold inflow) internal prices increases and discourage exports, and encourage imports until deficit and surplus are discourage exports, and encourage imports until deficit and surplus are eliminated. eliminated.

Note that while adjustment under the flexible exchange rate system relies Note that while adjustment under the flexible exchange rate system relies on high price elasticities of exports and imports, in the deficit surplus on high price elasticities of exports and imports, in the deficit surplus nation, adjustment under the gold standard relies on changing internal nation, adjustment under the gold standard relies on changing internal prices of each nation. The adjustment under the gold standard relies also prices of each nation. The adjustment under the gold standard relies also on high price elasticities of exports and imports in the deficit and surplus on high price elasticities of exports and imports in the deficit and surplus nation, so that the volume of exports and imports respond readily and nation, so that the volume of exports and imports respond readily and significantly to price changes. significantly to price changes.


M.V = P.Q

Deficit nation M↓ P ↓ imports ↓

and exports ↑ bop equilibrium

Surplus nation M ↑ P ↑ imports ↑

and exports ↓ bop equilibrium

The price-specie-flow mechanismThe price-specie-flow mechanism


Key Terms•Devaluation Gold standard

•Dutch disease Mint parity

•Stable foreign exchange market Gold export point

•Unstable foreign exchange market Gold import point

•Marshall-Lerner condition Price-specie flow mechanism

•Elasticity pessimism Quantity theory of money

•Identification problem Rules of the game of the gold standard

•J-curve effect Pass-through effect

Economics of International Finance Prof. M. El-Sakka CBA. Kuwait University Economics of...

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