International_Economics_Tenth_Edition (1)

foreign firms increased their profit margins on goods shipped to the United States. Therefore, the dollar price of such foreign goods did not decrease by the full amount of the dollar appreciation. The experience of the U.S. import sector thus shows that there was only a modest passthrough of changing currency values to changes in import prices during these periods.

The lower portion of the table considers U.S. exports. During the 1977-1980 period of dollar depreciation and the 1980-1985 period of dollar appreciation, the profit margins of U.S. exporters changed by small amounts compared to the changes in the dollar's exchange rate. This may have been caused by the large size of the home market in the United States: Pricing decisions by U.S. companies may have been more closely tied to domestic market conditions than to global conditions. As a result, there was significant passthrough of changing currency values to changes in export prices during these periods. Conclusion:

The foreign-currency prices of U.S. exports are more likely to have a significant pass-through of exchange-rate changes than the dollar prices of U.S. imports are. Let us consider two examples of partial currency pass-through.

Dollar Depreciation

of the 1980s

Following an appreciation in value during the early 1980s, the U.S. dollar began to depreciate in 1985. By 1986, the value of the dollar had fallen more than 25 percent against the currencies of the major U.S. trading partners on a trade-weighted basis and more than 47 percent against the japanese yen. Other things being equal, the dollar depreciation should have led to higher U.S. exports and lower U.S. imports. But other things were not equal. Foreign manufacturers, particularly the japanese, were not willing to sacrifice their share of the U.S. market without a struggle.

Industry

me,e <- ~f (7tOi'r.

-toY1'if\¥ rn<...e.s

t VI,,'1\- ~ IA. h'-') l- )

\)~ Sh')CtnU).

1- f\{;( +-

t)tl/70( +

r

x-.(\J.J\.o"

74.9%....A~c.;~~.{'l\

6.8

4.1

-9.6

-6.9 -17.1

4.2

8.7

1.0

5.3

4.5

17.7

Rather than permit increases in the prices of their goods sold in the United States, Japanese firms absorbed the dollar depreciation in reduced profits-and even losses-which triggered accusations of dumping by their U.S. competitors. But Japanese companies could not cut profits or absorb losses indefinitely. Therefore, many concerns attempted to reduce manufacturing costs, either by leaving Japan for lower-cost sites such as South Korea or by overhauling products and factories in Japan. The result was only a partial passthrough of the dollar depreciation into retail price increases in the United States.

Prior to the dollar depreciation, Japanese automakers enjoyed an estimated 12 percent profit margin on their exports to the United States-nearly double that of U.S. companies. As

a way of compensating for the depreciating dollar, throughout 1986 Japanese automakers pared profits by some $518 per vehicle. Yet foreign businesses could not persistently operate on razor-thin profit margins because they would lack money for product development and sales promotion. Eventually the businesses would have to reduce their emphasis on market share, and the U.S. trade deficit would shrink. However, it was estimated that if foreigners kept profit margins thin, they could preserve their market share for two years or longer.

U.S. imports also remained strong because of pricing policies of U.S. companies. As foreign prices inched upward as a result of the dollar depreciation, many U.S. businesses followed the price increases, although at a slower rate. In

In 2003, the Japanese yen's exchange value was appreciating against the dollar. Japanese exporting companies realized that a more costly yen would result in smaller profits if they converted their dollar profits back into yen. How could the Japanese protect their profits? By moving production overseas and thus lesseningthe amount of money they convert from dollars to yen.

During the 1990s, executives at Japan's large auto and electronics companies were apprehen- sive about an appreciating yen that reduced their profits by slashing the value of overseas earnings when translated into yen. By 2003, however, the harm caused by an appreciating yen was not nearly asgreat for Japan'sexporters, including consumer electronics firms and auto manufacturers, due to their increasing efforts to locate production in the United States and other offshore markets. Although the yen's appreciation hindered Japan'scompanies, it did not stop them in their tracks.

Toyota and other exporters began decreasing their exposure to exchange-rate fluctuations in the 1980s by expanding production abroad, a strategy that was accelerating at the turn of the century. By 2003, Honda produced 75 percent of the cars it sold in the United Statesin North American factories, up from 60 percent in the previous decade. Also, Nissan opened a $1 billion factory in Canton, Mississippi, to manufacture minivans, sport-utility vehicles, and pickup trucks. With the new plant, Nissan almost doubled its manufacturing capacity in North America to

1.35 million vehicles. Nissan management noted that they were attempting to take foreign exchange out of the equation as much as possible.

Back in 1996, Toshiba Corp. exported about $6 billion more in goods than it imported. This meant that the firm's salescouldtheoretically decline by 6 billion yen ($54 million) each time the yen appreciated against the dollar by one yen. Sincethen, Japan's largestsemiconductor

producer has succeeded in slashing its net dollar exposure by locating manufacturing abroad and increasing dollar-based imports of parts. In 1996, Toshiba started a plant in Indonesia to manufacture color-TV sets; it also opened a factory in the Philippines to produce hard-disk and optical-disk drives. Other factories in Asia followed, including a personal-computer plant in China. By 2003, Toshiba produced more than 30 percent of its goods abroad, compared with 17 percent in 1995; and it exported only $1 billion of goods more than it imported.

Besides moving production abroad, Japan's big auto and electronics companies have increasingly shifted development, engineering, and design operations abroad. That also helps reduce exchange-rate risk by keeping even more of their costsand revenues denominated in a single currency. For example, in 2004 Toyota opened a design studio in Michigan, allowing the firm to perform in the United States all the stages in the process of manufacturing new vehicles, from design to engineering and production.

In 2003, Matsushita Electric Industrial, producer of Panasonic brand equipment, increased efforts to make its overseas divisions as selfsufficient as possible. In the past, Matsushita repatriated revenue earned overseas, which exposed the firm not only to exchange-rate risk but also to high Japanese corporate taxes. Now, it strives to reinvest money earned abroad in manufacturing and research facilities located in each region. Although the strategy was mainly aimed at making Matsushita more productive and quicker in responding to local customers' needs, some of the result has been to reduce the amount of money Matsushita exchanges from dollars or euros to yen.

Source: "Japanese Firms Practice Yen Damage Control." The Wall Street Journal. September 26,2003, p. A7.

Currency pass-through also had implications for u.s. exporters. A factor that contributed to sluggish u.s. exports was that U.S. prices in foreign markets did not fall proportionate to the dollar depreciation, implying partial pass-through. Throughout 1986, many U.S. exporters sought to restore profit margins, which had deteriorated when the dollar was so strong in the early 1980s, by maintaining or even increasing export prices.

Dollar Depreciation of

2003-2004

During 2003-2004, the U.S. dollar steadily depreciated against foreign currencies such as the yen and euro. As we have learned, the dollar decline would generally be expected to reduce u.s. imports and increase its exports, thus causing a decrease in its trade deficit. Yet the falling dollar was not doing what it was supposed to do. Why?

Part of the blame could be ascribed to the nature of the global economy. Excess capacity

prices in the United States. And because the falling dollar wasn't causing more inflation, the Federal Reserve did not increase interest rates, which would limit the growth of the U.S. economy and its desire for imports.

Excess capacity and strong competition around the world discouraged foreign producers from attempting to increase prices in the United States, even though their costs increased in dollar terms. Rather, they tolerated decreased profit margins or tried to slash costs in other ways to maintain market share. For example, Kellwood Co., a major American marketer of garments such as Calvin Klein, noted that some of its Asian suppliers, such as sewing factories and fabric mills, inquired about increasing their prices because of higher costs. But apparel was an industry with sizable world overcapacity, and suppliers knew that if they increased prices, there were many competitors in other countries that Kellwood could turn to. These suppliers refrained from raising their prices, which allowed Kellwood's prices on Calvin Klein garments to remain unchanged.

Also, a price war in the U.S. car market contributed to flat prices. The price war resulted in German auto companies selling some luxury models in the United States at lower prices than could be obtained in Europe. For example Volkswagen AG's luxury Audi A8L listed for $68,500 in the United States in 2004, a third less than its dollarequivalent price in Europe. VW officials noted that they did not realize much profit on the sale of this vehicle to Americans.

Moreover, Japan's Toyota Motor Corp. protected itself against dollar oscillations by manufacturing 60 percent of the vehicles it sold in North America locally. Although Toyota did increase prices on some luxury Lexus and sport-utility vehicles, they increased by only 0.4 percent. The base price of the LS430 Lexus sedan remain unchanged at $55,125.

Researchers at the New York Federal Reserve Bank have found that a fluctuation in the exchange rate has a far smaller effect on U.S. import prices than in other countries. As seen in Table 14.8, just 26 percent of a change in the exchange rate is passed through to import prices in the United States in the short run, the researchers found, compared with 53 percent in France, 59 percent in Germany, and 88 percent in Japan. That helps explain why the dollar's depreciation in the early 2000s caused far less concern in the United States than overseas.

The Dollar and

U.S. Manufacturing

As we have learned, a dollar appreciation can affect the revenues and costs of If.S, manufacturers. Concerning revenues, a stronger dollar pushes up the prices of U.S. goods in export markets, making those goods less attractive to foreign buyers and ultimately resulting in reduced export sales for U.S. producers. Also a stronger dollar can jeopardize the domestic sales of U.S. manufacturers by giving the foreign producers that have penetrated U.S. markets a competitive edge in pricing. For example, if the dollar appreciates against the yen, then Japanese producers selling to U.S. markets will find that their dollar revenues

translate into more yen than in the past. This increase in their "local currency profit" enables the Japanese producers to reduce the prices they charge in U.S. markets and thus to draw customers away from rival u.s. producers.

A stronger dollar also affects the costs of u.s. manufacturers. In recent years, u.S. firms have increasingly relied on foreign equipment and components in producing their goods. When the dollar rises, the cost of such imported inputs falls. The resulting savings can at least partially offset the revenue losses associated with a dollar appreciation and thereby help to stabilize industries' profits. Indeed, for some industries, the cost benefits of the appreciation may outweigh the adverse revenue effects.

Economists at the Federal Reserve Bank of New York have captured both the revenue and cost sides of an industry's exposure to dollar movements by constructing a measure called "net external orientation." This measure is computed as the share of an industry's total revenues that is derived from exports less the share of its total spending that is attributable to imported inputs.

An industry has a positive (negative) net external orientation when its export revenues are greater (less) than its imported input costs.

To assess the vulnerability of u.s. manufacturers to a rise in the dollar's exchange value, refer to Table 14.9 on page 434. In many industries, exports represent a large fraction of total revenues: Chemicals, industrial machinery, electronic equipment, transportation, equipment, and instruments generate more than 15 percent of their revenues through exports. This shared focus on exports would seem to suggest that the profitability of all these industries would suffer significantly under a dollar appreciation. But once we take into account the offsetting effects of imported input use, we find that these industries would not, in fact, all fare alike with a rise in the dollar.

In the electronic equipment industry, exports account for 24.2 percent of revenues, while imported inputs account for a much smaller share of costs-l1.6 percent. Subtracting the imported input share from the export share yields a relatively high net external orientation of 12.6 percent. By contrast, in the transportation equipment industry,

the share of total revenues attributable to exports is a sizable 17.8 percent, but spending on imports15.7 percent of total spending-largely offsets the high export share, producing a net external orientation of only 2.1 percent. The contrasting net figures for the two industries indicate that a strong dollar is likely to have significant adverse effects on the profitability of u.s. electronic equipment manufacturers, while the profitability of the transportation equipment industry should be more insulated from exchange-rate effects. As Table 14.9 shows, the industries most likely to be hurt by a stronger dollar are those with high net external orientationtobacco, industrial machinery, electronic equipment, and instruments. For some industries, such as petroleum refining and leather products, the cost benefits of a dollar appreciation outweigh and adverse revenue effects.

u.s. manufacturing industries are becoming increasingly sensitive to changes in the international value of the dollar. This increased sensitivity is large-

ly attributable to the growing reliance of this sector on international trade. Firms now export a greater share of their products than in the past and make more extensive use of foreign parts and materials in the production of their goods.

The Absorption Approach

According to the elasticities approach, currency depreciation offers a price incentive to reduce imports and increase exports. But even if elasticity conditions are favorable, whether the home country's trade balance will actually improve may depend on how the economy reacts to the depreciation. The absorption approach' provides insights

'Sidney S. Alexander. "Effects of a Devaluation on a Trade Balance," IMF Staff Papers, April 1952. pp. 26J-278.

into this question by considering the impact of depreciation on the spending behavior of the domestic economy and the influence of domestic spending on the trade balance.

The absorption approach starts with the idea that the value of total domestic output (Y) equals the level of total spending. Total spending consists of consumption (C), investment (I), government expenditures (G), and net exports (X - M). This can be written as

Y = C + I + G + (X - M)

The absorption approach then consolidates C + I + G into a single term A, which is referred to as absorption, and designates net exports (X - M) as B. Total domestic output thus equals the sum of absorption plus net exports, or

This can be rewritten as

B = Y-A

This expression suggests that the balance of trade (B) equals the difference between total domestic output

(Y) and the level of absorption (A). If national output exceeds domestic absorption, the economy's trade balance will be positive. Conversely, a negative trade balance suggests that an economy is spending beyond its ability to produce.

The absorption approach predicts that a currency depreciation will improve an economy's trade balance only if national output rises relative to absorption. This means that a country must increase its total output, reduce its absorption, or do some combination of the two. The following examples illustrate these possibilities.

Assume that an economy faces unemployment as well as a trade deficit. With the economy operating below maximum capacity, the price incentives of depreciation would tend to direct idle resources into the production of goods for export, in addition to diverting spending away from imports to domestically produced substitutes. The impact of the depreciation is thus to expand domestic output as well as to improve the trade balance. It is no wonder that policy makers tend to view currency depreciation as an effective tool

approaches are therefore complementary.

'See Donald S. Kemp, "A Monetary View of the Balance or Payments," Review, Federal Reserve Bank of St. Louis, April 1975, pp. 14-22; and Thomas M. Humphrey, "The Monetary Approach to Exchange Rates: Its Historical Evolution and Role in Policy Debates." Economic Review, Federal Reserve Bank of Richmond, July-August 1978, pp. 2-9.

approach, currency depreciation may induce a temporary improvement in a nation's balance-of- payments position. For example, assume that equilibrium initially exists in the home country's money market. A depreciation of the home currency would increase the price level-that is, the domestic-currency prices of potential imports and exports. This increase would increase the demand for money, because larger amounts of money are needed for transactions. If that increased demand is not fulfilled from domestic sources, an inflow of money from overseas occurs. This inflow results in

a balance-of-payments surplus and a rise in international reserves. But the surplus does not last forever. By adding to the international component of the home-country money supply, the currency depreciation leads to an increase in spending (absorption), which reduces the surplus. The surplus eventually disappears when equilibrium is restored in the home country's money market. The effects of depreciation on real economic variables are thus temporary. Over the long run, currency depreciation merelyraises the domestic price level.

1.Currency depreciation (devaluation) may affect a nation's trade position through its impact on relative prices, incomes, and purchasing power of money balances.

2.When all of a firm's inputs are acquired domestically and their costs are denominated in the domestic currency, an appreciation in the domestic currency's exchange value tends to increase the firm's costs by the same proportion, in terms of the foreign currency. Conversely, a depreciation of the domestic currency's exchange value tends to reduce the firm's costs by the same proportion in terms of the foreign currency.

3.Manufacturers often obtain inputs from abroad (foreign sourcing) whose costs are denominated in terms of a foreign currency. As foreign-currency-denominated costs become a larger portion of a producer's total costs, an appreciation of the domestic currency's exchange value leads to a smaller increase in the foreign-currency cost of the firm's output and a larger decrease in the domestic cost of the firm's output---eompared to the cost changes that occur when all input costs are denominated in the domestic currency. The opposite applies for currency depreciation.

4.By increasing (decreasing) relative U.S. production costs, a dollar appreciation (depreciation) tends to raise (lower) Ll.S. export prices in terms of a foreign currency, which induces a decrease (increase) in the quantity

of U.S. goods sold abroad; similarly, a dollar appreciation (depreciation) tends to raise (lower) the amount of U.S. imports.

5.According to the elasticities approach, currency depreciation leads to the greatest improvement in a country's trade position when demand elasticities are high. Recent empirical studies indicate that the estimated demand elasticities for most nations are quite high.

6.The time path of currency depreciation can be explained in terms of the J-curve effect. According to this concept, the response of trade flows to changes in relative prices increases with the passage of time. Currency depreciation tends to worsen a country's trade balance in the short run, only to be followed by an improvement in the long run (assuming favorable elasticities).

7.The extent to which exchange-rate changes lead to changes in import prices and export prices is known as the pass-through relationship. Complete (partial) pass-through occurs when a change in the exchange rate brings about a proportionate (less than proportionate) change in export prices and import prices. Empirical evidence suggests that pass-through tends to be partial rather than complete.

8.The absorption approach emphasizes the income effects of currency depreciation. According to this view, a depreciation 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.

9.The monetary approach to depreciation emphasizes the effect that depreciation has on the purchasing power of money balances and

the resulting impacts on domestic expenditures and import levels. According to the monetary approach, the influence of currency depreciation on real output is temporary; over the long run, depreciation merely raises the domestic price level.

1.How does a currency depreciation affect a nation's balance of trade?

2.Three major approaches to analyzing the economic impact of currency depreciation are (a) the elasticities approach, (b) the absorption approach, and (c) the monetary approach. Distinguish among the three.

3.What is meant by the Marshall-Lerner condition? Do recent empirical studies suggest that world elasticity conditions are sufficiently high to permit successful depreciations?

4.How does the J-curve effect relate to the time path of currency depreciation?

5.What implications does currency passthrough have for a nation whose currency depreciates?

6.According to the absorption approach, does it make any difference whether a nation's currency depreciates when the economy is operating at less than full capacity versus at full capacity?

7.How can currency depreciation-induced changes in household money balances promote payments equilibrium?

8.Suppose ABC Inc., a U.S. auto manufacturer, obtains all of its auto components in the United States and that its costs are denominated in dollars. Assume the dollar's exchange value appreciates by 50 percent

against the Mexican peso. What impact does the dollar appreciation have on the firm's international competitiveness? What about a dollar depreciation?

9.Suppose ABC Inc., a U.S. auto manufacturer, obtains some of its auto components in Mexico and that the costs of these components are denominated in pesos; the costs of the remaining components are denominated in dollars. Assume the dollar's exchange value appreciates by 50 percent against the peso. Compared to your answer in study question 8, what impact will the dollar appreciation have on the firm's international competitiveness? What about a dollar depreciation?

10.Xtra' For a tutorial of this question, go to

~http://carbaughxtra.swlearning.com

Assume the United States exports 1,000 computers at a price of $3,000 each and imports 150 British autos at a price of £10,000 each. Assume that the dollar/pound exchange rate is 2 dollars per pound.

a.Calculate, in dollar terms, the U.S. export receipts, import payments, and trade balance prior to a depreciation of the dollar's exchange value.

b.Suppose the dollar's exchange value depreciates by 10 percent. Assuming that the price elasticity of demand for U.S. exports equals

3.0 and the price elasticity of demand for U.S. imports equals 2.0, calculate the U.S. export receipts, import payments, and trade balance. Does the dollar depreciation improve or worsen the U.S. trade balance? Why?

14.1 Changes in the exchange rate can have a significant impact on various sectors of the economy. For a detailed look at various countries'exports and imports of agricultural products to the United States, visit the home page of the U.S. Department of Agriculture/Foreign Agricultural Service. Set your browser to this URL:

http://www.fas.usda.gov

c.Now assume that the price elasticity of demand for U.S. exports equals 0.3 and the price elasticity of demand for U.S. imports equals 0.2. Does this change the outcome? Why?

14.2 The Council on Foreign Relations is a national organization that is committed to the study and debate of America's global role. Visit its Web site to view some of their recent studies on international finance and trade. Set your browser to this URL:

http://www.cfr.org