International_Economics_Tenth_Edition (1)

changes among nations. Some U.S. exporters may be able to offset the price-increasing effects of an appreciation in the dollar's exchange value by reducing profit margins to maintain competitiveness. Perceptions concerning long-term trends in exchange rates also promote price rigidity: U.S. exporters may be less willing to raise prices if the dollar's appreciation is viewed as temporary. The extent to which industries implement pricing strategies depends significantly on the substitutability of their product: The greater the degree of product differentiation (as in quality or service), the greater control producers can exercise over prices; the pricing policies of such producers are somewhat insulated from exchange-rate movements.

Is there any way in which companies can offset the impact of currency swings on their competitiveness? Suppose the exchange value of the Japanese yen appreciates against other currencies, which causes Japanese goods to become less competitive in world markets. To insulate themselves from the squeeze on profits caused by the rising yen, Japanese companies could move production to affiliates located in countries whose currencies have depreciated against the yen. This would be most likely to occur if the yen's appreciation is sizable and is regarded as being permanent. Even if the yen's appreciation is not permanent, shifting production offshore can help reduce the uncertainties associated with currency swings. Indeed, Japanese companies have resorted to offshore production to protect themselves from an appreciating yen.

Cost-Cutting Strategies of Manufacturers in Response to Currency Appreciation

For years, manufacturers have watched with dismay as the home currency surges to new heights, making it harder for them to wring profits out of exports. This tests their ingenuity to become more efficient in order to remain competitive on world markets. Let us consider how Japanese and American manufacturers responded to appreciations of their home currencies.

Appreciation of the Yen:

Japanese Manufacturers

From 1990 to 1996, the value of the Japanese yen relative to the U.S. dollar increased by almost 40 percent. In other words, if the yen

and dollar prices in the two nations had remained unchanged, Japanese products in 1996 would have been roughly 40 percent more expen-

sive, compared with U.S. products, than they were in 1990. How then did Japanese manufacturers respond to a development that could have had disastrous consequences for their competitiveness in world markets?

Japanese firms remained competitive by using the yen's strength to cheaply establish integrated manufacturing bases in the United States and in dollar-linked Asia. This allowed Japanese firms to play both sides of fluctuations in the yen/dollar exchange rate: using cheaper dollar-denominated parts and materials to offset higher yen-related costs. While they maintained their U.S. markets, many Japanese companies also used the strong yen to purchase cheaper components from around the world and ship them home for assembly. That provided a competitive edge in Japan for these firms.

Consider the Japanese electronics manufacturer Hitachi, whose TV sets were a global production effort in the mid-1990s, as shown in Figure 14.1 on page 420. The small tubes that projected information onto Hitachi TV screens came from a subsidiary in South Carolina, while the TV chassis and circuitry were manufactured by an affiliate in Malaysia. From Japan came only computer chips and lenses, which amounted to 30 percent of the value of the parts used. By sourcing TV production in countries whose currencies had fallen against the yen, Hitachi was able hold down the dollar price of its TV sets in spite of the rising yen.

To limit their vulnerability to a rising yen, Japanese exporters also shifted production from commodity-type goods to high-value products. The demand for commodities-for example, metals and textiles-is quite sensitive to price changes because these goods are largely indistinguishable,

From Japan, Hitachi procured semiconductors and lenses. Thus,

only 30% of the value of the parts used were yen-denominated.

The small tubes that project information onto the screen came from Hitachi Electric Devices U.S.A. in South Carolina. Denominated in dollars.

The chassis, including circuit board, came from another Hitachi

subsidiary, Consumer Products Malaysia, in Selangor, Malaysia. Denominated in dollars.

except by price. Customers, therefore, could easily switch to non-japanese suppliers if an increase in the yen shoved the dollar price of japanese exports higher. In contrast, more sophisticated, high-value products-for example, transportation equipment and electrical machinery-are less sensitive to price increases. For these goods, factors such as embedded advanced technology and high-quality standards work to neutralize the effect on demand if prices are driven up by an appreciating yen. Shifting production from commodity-type products to high-value products from 1990 to 1996 enhanced the competitiveness of japanese firms.

Then, there's the japanese auto industry. To offset the rising yen, japanese automakers cut the yen prices of their autos and thus realized falling unit-profit margins. They also reduced manufacturing costs by increasing worker productivity, importing materials and parts whose prices were denominated in currencies that had depreciated

against the yen, and by outsourcing larger amounts of a vehicle's production to transplant factories in countries whose currencies had depreciated against the yen.

In 1994, Toyota Motor Corporation announced that its competitivenesshad been eroded by as much as 20 percent as a result of the yen's recent appreciation. Toyota therefore convinced its subcontractors to cut part prices by 15 percent over three years. By using common parts in various vehicles and shortening the time needed to design, test, and commercialize automobiles, Toyota was also able to cut costs. Moreover, Toyota pressured japanese steelmakers to produce lesscostly galvanized sheet steel for use in its vehicles. Finally, Toyota reintroduced less expensive models with fewer options in an effort to reduce costs and prices and thus recapture sales in the mid- size-family-car segment of the market.

Foreign-made parts, once rejected by Japanese automakers as inferior to domestically produced

When East Asia'scurrenciescrashed in 1997, many analysts predicted that a flood of cheap, East Asian exports would pour into the United States. As things turned out, however, EastAsia'sexport boom met resistance.

The crash of EastAsia'scurrencies provided an opportunity for Vigor International President Wang Yu-Ien. Like many Asian middlemen who exported handicrafts and garments to big retailers in the United States, Taipei-based Vigor relied heavily on low-cost factories in China. With the Thai baht, Malaysian ringgit, Indonesian rupiah, and Philippine peso all suddenly trading at less than half their old values against the dollarwhile China'srenminbi remained stable-Wang anticipated that bargains would be abundant in EastAsia. But after a swing through East Asia in 1998,Wang returned empty-handed. Why? Most East Asian manufacturers sought foreign orders. However, they so lacked cash that they could not purchasethe imported materials needed to run their factories. That made it much more difficult to generate the exports.

To the depressed economies of East Asia, the situation was frustrating. They had anticipated that their cheaper currencies would translate into a big increase in export competitiveness in everything from computer chips to toys, thus permitting their countries to quickly recover from the economic decline. However, this expectation did not materialize for many exporters. EastAsian exporters could sell at a discount, but not so much that they could steal much market share from U.S. rivals.

EastAsian exporters met resistance when nervous local suppliers, fearful of more currency depreciations, demanded dollars up front. Other key suppliers went bankrupt. Moreover, the region'sfinancial systems were so squeezed that many manufacturers could not get financing to

fill exports. For many normally sound manufacturers, getting export financing from shell-shocked Asian banks was nearly impossible. A manager at a trading branch of an elite Korean conglomerate said his firm faced difficulty in all export areas, including machinery, electronics, automobiles, and textiles. Also, furniture makers noted that they were not able to purchase imported raw materials. To fill export orders, they had to draw down inventories. Financing costs also soared in EastAsia after the currency crash. Interest rates in some countries tripled to around 30 percent, as panicked central banks attempted to stabilize currencies. The increases in financial costs added to the costsof goods sold abroad.

True, the depreciation in Southeast Asian currencies made the labor costs of EastAsian manufacturers more competitive. However; this advantage was offset by higher import costscaused by depreciating currencies. Most EastAsian producers purchased most of their raw materials and components from abroad and thus were sensitive to exchange-rate fluctuations. For example, Nike noted that 65 percent of the materials of its shoes made in Indonesia were imported. Inflation of raw-material coststhus negated most of the price cuts that would normally be expected to occur following a large depreciation in currency values.

In the United States, retailers initially expected discounts of 35 percent to 75 percent on items purchased from East Asia as a result of the currency realignment. However, East Asian manufacturers found that they could not afford to cut prices much more than 10 percent. This dampened the tidal wave of cheap exports going to the United States. Moreover, the Asian crisis amplified the commitment of u.s. producers to reduce costs and prices in an effort to protect their share of the market.

parts, became much less alien to them in the 1990s. Foreign parts steadily made their way into Japanese autos, helped by both the strong yen and Japanese automakers' urgency to slash costs. Moreover,

Japanese auto-parts makers set up manufacturing operations in Southeast Asia and South America to cut costs; these parts were then exported to Japan for assembly into autos.

Appreciation of the Dollar: u.s. Manufacturers

From 1996 to 2002, U.S. manufacturers were alarmed as the dollar appreciated by 22 percent on average against the currencies of major u.s. trading partners. This resulted in U.S. manufacturers seeking ways to tap overseas markets and defend their home turf.

Take American Feed Co., a Napoleon, Ohio, company that makes machinery used in auto plants. In 2001, the firm reached a deal with a similar manufacturing company in Spain. Both companies produce machines that car factories use to unroll giant coils of steel and feed them through presses to make parts. According to the pact, when orders come in, management of the two companies meet to decide which plant should make which parts, in essence divvying up the work to keep both factories operating. As a result, American Feed can share in the benefits of having a European production base without having to take on the risks of building its own factory there. Also, the company redesigned its machines to make them more efficient and less expensive to build. These efforts chopped about 20 percent off the machines' production costs.

Then, there's Sipco Molding Technologies, a Meadville, Pennsylvania, tool-and-die maker who also had to cut costs to survive the dollar's appreciation. For years, Sipco had a partnership with an Austrian company, which designed a special line of tools that Sipco once built in the United States. Because of the strong dollar, however, the Austrian company assumed the responsibility of designing and making the tools, while Sipco simply resold them. Although these efforts helped the firm cut costs, it resulted in a loss of jobs for 30 percent of its employees.

Though officials of the U.S. government have met with manufacturing and labor groups to discuss complaints about a strong dollar, they generally insist that market forces should determine the dollar's value. As Treasury Secretary Paul O'Neill put it in 2002, "The great companies don't worry about a weak dollar or a strong dollar."

Requirements for a Successful Depreciation

We have seen that currency depreciation tends to improve a nation's competitiveness by reducing its costs and prices, while currency appreciation implies the opposite. Under what circumstances will currency depreciation succeed in reducing a payments deficit?

Several approaches to currency depreciation must be considered, and each of them will be dealt with in a separate section. The elasticity approach emphasizes the relative price effects of depreciation and suggests that depreciation works best when demand elasticities are high. The absorption approach deals with the income effects of depreciation; the implication is that a decrease in domestic expenditure relative to income must occur for depreciation to promote payments equilibrium. The monetary approach stresses the effects depreciation has on the purchasing power of money and the resulting impact on domestic expenditure levels.

The Elasticity Approach to Exchange-Rate Adjustment

Currency depreciation affects a country's balance of trade through changes in the relative prices of goods and services internationally. A trade-deficit nation may be able to reverse its imbalance by lowering its relative prices, so that exports increase and imports decrease. The nation can lower its relative prices by permitting its exchange rate to depreciate in a free market or by formally devaluing its currency under a system of fixed exchange rates. The ultimate outcome of currency depreciation depends on the price elasticity of demand for a nation's imports and the price elasticity of demand for its exports.

Recall that elasticity of demand refers to the responsiveness of buyers to changes in price. It indicates the percentage change in the quantity demanded stemming from a 1 percent change in price. Mathematically, elasticity is the ratio of the percentage change in the quantity demanded to

the percentage change in price. This can be symbolized as

" - 8Q . 8P

Elastiaty - Q -r- p

The elasticity coefficient is stated numerically, without regard to the algebraic sign. If the preceding ratio exceeds 1, a given percentage change in price results in a larger percentage change in quantity demanded; this is referred to as relatively elastic demand. If the ratio is less than 1, demand is said to be relatively inelastic, because the percentage change in quantity demanded is less than the percentage change in price. A ratio precisely equal to 1 denotes unitary elastic demand, meaning that the percentage change in quantity demanded just matches the percentage change in price.

Next we investigate the effects of a currency depreciation on a nation's balance of trade-that is, the value of its exports minus imports. Suppose the British pound depreciates by 10 percent against the dollar. Whether the British trade balance will be improved depends on what happens to the dollar inpayments for Britain's exports as opposed to the dollar outpayments for its imports. This, in turn, depends on whether the U.S. demand for British exports is elastic or inelastic and

British Pound Depreciation: ImprovedTrade Balance

whether the British demand for imports is elastic or inelastic.

Depending on the size of the demand elasticities for British exports and imports, Britain's trade balance may improve, worsen, or remain unchanged in response to the pound depreciation. The general rule that determines the actual outcome is the so-called Marshall-Lerner condition. The Marshall-Lerner condition states: (1) Depreciation will improve the trade balance if the currency-depreciating nation's demand elasticity for imports plus the foreign demand elasticity for the nation's exports exceeds 1.

(2) If the sum of the demand elasticities is less than 1, depreciation will worsen the trade balance. (3) The trade balance will be neither helped nor hurt if the sum of the demand elasticities equals 1. The Marshall-Lerner condition may be stated in terms of the currency of either the nation undergoing a depreciation or its trading partner. Our discussion is confined to the currency of the currency-depreciating country, Great Britain.

Case 1:

Improved trade balance.

Referring to Table 14.3, assume that the British demand elasticity for imports equals 2.5 and the U.S. demand elasticity for British exports equals 1.5; the sum of the elasticities is 4.0. Suppose the pound depreciates by 10 percent against the dollar.

An assessment of the overall impact of the depreciation on Britain's payments position requires identification of the depreciation's impact on import expenditures and export receipts.

If prices of imports remain constant in terms of foreign currency, then a depreciation increases the home-currency price of goods imported. Because of the depreciation, the pound price of British imports rises 10 percent. British consumers would thus be expected to reduce their purchases from abroad. Given an import demand elasticity of 2.5, the depreciation triggers a 25 percent decline in the quantity of imports demanded. The 10 percent price increase in conjunction with a 25 percent quantity reduction results in approximately a 15 percent decrease in British outpayments in pounds. This cutback in import purchases actually reduces import expenditures, which reduces the British deficit.

How about British export receipts? The pound price of the exports remains constant, but after depreciation of the pound, consumers in the United States find British exports costing 10 percent less in terms of dollars. Given a U.S. demand elasticity of 1.5 for British exports, the 10 percent British depreciation will stimulate foreign sales by 15 percent, so that export receipts in pounds will increase by approximately 15 percent. This strengthens the British payments position. The 15 percent reduction in import expenditures coupled with a 15 percent rise in export receipts means

that the pound depreciation will reduce the British payments deficit. With the sum of the elasticities exceeding 1, the depreciation strengthens Britain's trade position.

Case 2:

Worsened trade balance.

In Table 14.4, the British demand elasticity for imports is 0.2 and the U.S. demand elasticity for Britishexports is 0.1; the sum of the elasticitiesis 0.3. The 10 percent pound depreciation raises the pound price of imports by 10 percent, inducing a 2 percent reduction in the quantity of imports demanded. In contrast to the previous case, under relatively inelastic conditions the depreciation contributes to an increase, rather than a decrease, in import expenditures of some 8 percent. As before, the pound price of British exports is unaffected by the depreciation, whereas the dollar price of exports falls 10 percent. U.S. purchases from abroad increase by 1 percent, resulting in an increase in pound receipts of about 1 percent. With expenditures on imports rising 8 percent while export receipts increase only 1 percent, the British deficit will tend to worsen. As stated in the Marshall-Lerner condition, if the sum of the elasticities is less than 1, currency depreciation will cause a deterioration in a nation's trade position.

The reader is left to verify that a nation's trade balance remains unaffected by depreciation if the sum of the demand elasticities equals 1.

Although the Marshall-Lerner condition provides a general rule as to when a currency depreciation will be successful in restoring payments equilibrium, it depends on some simplifying assumptions. For one, it is assumed that a nation's trade balance is in equilibrium when the depreciation occurs. If there is initially a very large trade deficit, with imports exceeding exports, then a depreciation might cause import expenditures to change more than export receipts, even though the sum of the demand elasticities exceeds 1. The analysis also assumes no change in the sellers' prices in their own currency. But this may not always be true. To protect their competitive position, foreign sellers may lower their prices in response to a depreciation of the home-country's currency; domestic sellersmay raise home-currency prices so that the depreciation's effects are not fully transmitted into lower foreign-exchange prices for their goods. However, neither of these assumptions invalidates the Marshall-Lerner condition's spirit, which suggests that currency depreciations work best when demand elasticities are high.

country's trade balance. The extent to which price changes affect the volume of goods traded depends on the elasticityof demand for imports and exports. If the elasticities were known in advance, it would be possible to determine the proper exchange-rate policy to restore payments equilibrium. Without such knowledge, nations often have been reluctant to change the par values of their currencies.

During the 1940s and 1950s, there was considerable debate among economists concerning the empirical measurement of demand elasticities. Several early studies suggested low demand elasticities. Those findings led to the formation of the elasticity pessimist school of thought, which contended that currency depreciations and appreciations would be largely ineffectual in promoting changes in a nation's trade balance. By the 1960s, most economists considered themselves elasticity optimists, estimating the demand elasticities for most nations to be rather high. Table 14.5 shows estimated price elasticities of demand for total imports and exports by country.

Empirical Measurement:

Import/Export Demand

Elasticities

The Marshall-Lerner condition illustrates the price effects of currency depreciation on the home-

J -Curve Effect: Time Path

of Depreciation

Empirical estimates of price elasticities in international trade suggest that, according to the Marshall-Lerner condition, currency depreciation is

likely to improve a nation's trade balance. A basic problem in measuring world price elasticities, however,is that there tends to be a timelag between changes in exchange rates and their ultimate effect on real trade. One popular description of the time path of trade flows is the so-called J-curve effect. This view suggests that in the very short run, a currency depreciation will lead to a worsening of a nation's trade balance. But as time passes, the trade balance will likely improve. This is because it takes time for new information about the price effectsof depreciation to be disseminated throughout the economy and for economic units to adjust their behavior accordingly.

A currency depreciation affects a nation's trade balance through its net impact on export receipts and import expenditures. Export receipts and import expenditures are calculated by multiplying the commodity's per-unit price times the quantity being demanded. Figure 14.2 illustrates the process by which depreciation influences export receipts and import expenditures.

The immediate effect of depreciation is a change in relative prices. If a nation's currency depreciates 10 percent, it means that import prices initially increase 10 percent in terms of the home currency. The quantity of imports demanded will then fall according to home demand elasticities. At the same time, exporters will initially receive 10 percent more in home currency for each unit of foreign currency they earn. This means they can

Depreciation Flowchart

Currency Depreciotion

;/ X

~~

Demand Elcsticities

become more competitive and lower their export prices measured in terms of foreign currencies. Export sales will then rise in accordance with foreign demand elasticities. The problem with this process is that for depreciation to take effect, time is required for the pricing mechanism to induce changes in the volume of exports and imports.

The time path of the response of trade flows to a currency's depreciation can be described in terms of the j-curve effect, so called because the trade balance continues to get worse for awhile after depreciation (sliding down the hook of the J) and then gets better (moving up the stem of the J). This effect occurs because the initial effect of depreciation is an increase in import expenditures: The home-currency price of imports has risen, but the volume is unchanged owing to prior commitments. As time passes, the quantity adjustment effect becomes relevant: Import volume is depressed, whereas exports become more attractive to foreign buyers.

Advocates of the j-curve effect use the depreciation of the British pound as an example. In 1967, the British balance of trade showed a $1.3 billion deficit. This was followed by a 14.3 percent depreciation of the pound in November 1967. The initial impact of the depreciation was negative: In 1968, the British balance of trade showed a $3 billion deficit. After a lag, however, the British balance of trade improved, with a reduction in the growth of imports and a rise in the growth of exports. By 1969, the British balance of trade showed a $1 billion surplus; by 1971, the surplus was $6.5 billion.

Another example of the J-curve effect is the experience of the u.s. balance of trade during the 1980s and 1990s. As seen in Figure 14.3, between 1980 and 1987 the U.s. trade deficit expanded at a very rapid rate. The deficit decreased substantially between 1988 and 1991. The rapid increase in the trade deficit that took place during the early 1980s occurred mainly because of the appreciation of the dollar at the time, which resulted in a steady increase in imports and a drop in U.S. exports. The depreciation of the dollar that began in 1985 led to a boom in exports in 1988 and a drop in the trade deficit through 1991.

What factors might explain the time lags in a currency depreciation's adjustment process? The

Year

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types of lags that may occur between changes in relative prices and the quantities of goods traded include the following:

•Recognition lags of changing competitive conditions

•Decision lags in forming new business connections and placing new orders

•Delivery lags between the time new orders are placed and their impact on trade and payment flows is felt

•Replacement lags in using up inventories and wearing out existing machinery before placing new orders

•Production lags involved in increasing the output of commodities for which demand has increased

Empirical evidence suggests that the trade-balance effects of currency depreciation do not materialize until years afterward. Adjustment lags may be four years or more, although the major portion of adjustment takes place in about two years. One study made the following estimates of the lags in the depreciation adjustment process for trade in manufactured goods: (1) The response of trade flows to relative price changes stretches out over a period of some four to five years. (2) Following

a price change, almost 50 percent of the full tradeflow response occurs within the first three years, and about 90 percent takes place during the first five years.1

IExchange Rate Pass-

Through

The J-curve analysis assumes that a given change in the exchange rate brings about a proportionate change in import prices.In practice, this relationship may be less than proportionate, thus weakening the influence of a change in the exchange rate on the volume of trade.

The extent to which changing currency values lead to changes in import and export prices is known as the exchange rate pass-through relationship. Pass-through is important because buyers have incentives to alter their purchases of foreign goods only to the extent that the prices of these goods change in terms of their domestic currency following a change in the exchange rate. This depends on the willingness of exporters to permit the change in the exchange rate to affect the prices they charge for their goods, measured in terms of the buyer's currency.

Assume that Toyota of japan exports autos to the United States and that the prices of Toyota are fixed in terms of the yen. Suppose the dollar's value depreciates 10 percent relative to the yen. Assuming no offsetting actions by Toyota, U.S. import prices will rise 10 percent. This is because 10 percent more dollars are needed to purchase the yen that are used to pay for the import purchases. Complete pass-through thus exists: Import prices in dollars rise by the full proportion of the dollar depreciation.

To illustrate the calculation of complete currency pass-through, assume that Caterpillar charges $50,000 for a tractor exported to japan. If the exchange rate is 150 yen per U.S. dollar, the price paid by the japanese buyer will be 7,500,000 yen. Assuming the dollar price of the tractor remains

'Helen Junz and Rudolf R. Rhomberg, "Price Competitiveness in Export Trade Among Industrial Countries," American Economic Review, May 1973, pp. 412-419.

constant, a 10 percent appreciation in the dollar's exchange value will increase the tractor's yen price 10 percent, to 8,250,000 yen (165 X 50,000 = 8,250,000). Conversely, if the dollar depreciates by 10 percent, the yen price of the tractor will fall by 10 percent, to 6,750,000. So long as Caterpillar keeps the dollar price of its tractor constant, changes in the dollar's exchange rate will be fully reflected in changes in the foreign-currency price of exports. The ratio of changes in the foreign-currency price to changes in the exchange rate will be 100 percent, implying complete currency pass-through.

Empirical evidence suggests, however, that the more typical real-world situation is partial passthrough, with significant time lags. Table 14.6 shows the percent of a change in the dollar's exchange rate that is passed-through into prices for selected U.S. imports. For example, just 21 percent of a change in the exchange rate is passed through to prices of imported chemicals. The estimates of Table 14.6 suggest that exchange rate pass-through is usually partial rather than complete; there is also a considerable degree of variation in pass-through across different industries. The effects of exchange rate pass-through are more fully discussed on "Exploring Further 14.1" at the end of this chapter.

What Determines Currency

Pass-Through?

What explains the magnitude of the pass-through effect? Data concerning U.S. trade show that changing profit margins are a significant factor in explaining the size of the pass-through effect. Researchers at the Federal Reserve analyzed prices and profit margins for the 1977-1980 period of dollar depreciation (15.5 percent) and the 1980-1985 period of dollar appreciation (74.9 percent). Table 14.7 on page 430 shows the evidence for U.S. imports and exports.

Concerning the evidence regarding U.S. imports, notice that during the period of dollar depreciation, foreign firms usually reduced profit margins. This meant that the dollar price of foreign goods sold in the United States did not increase by the full amount of the dollar depreciation. When the dollar appreciated during the period 1980-1985,