International_Economics_Tenth_Edition (1)

Exchange Rate Pass-Through

Exchange rate pass-through denotes the impact of a change in the exchange rate between exporting and importing countries on local-currency prices of imports. Two factors determine the extent of pass-through: the responsiveness of markups to competitive conditions and the degree of returns to scale in the production of the imported qood.'

If the typical foreign firm setsthe price of a good exported to the United States as a constant markup over marginal cost (with price and marginal cost measured in the dollar), then complete pass-through occurs when returns to scaleare constant, implying constant marginal cost. In this situation, a dollar appreciation of, say, 10 percent lowers the foreign firm'smarginal cost measured in dollars by the same amount. With a constant markup, the dollar price of the imported good must then decline by 10 percent.

Pass-through will be less than complete (partial) when returns to scale are decreasing, implying increasing marginal cost. Again assume that the foreign firm setsthe price of a good exported to the United States as a constant markup over marginal cost. The increase in U.S. demand for the imported good brought by a dollar appreciation now puts upward pressure on the foreign firm'smarginal cost. Thus when measured in dollars, marginal cost

-1Giovanni Olivei, "Exchange Rates and the Prices of Manufacturing

Products Imported into the United States." New Enqland Economic Review, First Quarter 2002, pp. 4-6.

constant, because a firm'smarket share is relatively small. In an oligopoly setting, however, the markup will usually depend on the good's dollar price and the dollar price of competing goods, as well asthe strength of demand for both the imported and the competing goods,

To illustrate how the markup may respond to changes in the dollar price of the imported good, let us consider an example in which a monopolist foreign firm, say, Toyota, sells all of its output to the United States. We assume that the demand curve D depicted in Figure 14.4(a) on page 440 represents the U.S. demand for Toyotas as a function of the dollar price of Toyotas. Profit maximization

requires equalization of marginal revenue and marginal cost, both expressed in dollars, which occurs at the intersection of the schedules MR and MCo' Note that the marginal cost schedule is horizontal, implying constant returns to scale. Toyota sets the profitmaximizing price Po as a markup over marginal cost, with 00 denoting the quantity of Toyotas demanded at price Po.

Figure 14.4(b) illustrates how a dollar appreciation affects the dollar price of Toyotas. The appreciation lowers the dollar cost of producing Toyotas, and thus the marginal cost schedule shifts down by the same

proportion of the appreciation." The graph shows that at the new equilibrium the difference between the dollar price of Toyotas, P" and marginal cost, MC" is larger than at the old equilibrium. This signals that the foreign firm charges a higher markup (in dollars) over

'The assumption that Toyota's costs in dollars decline by the same percentage of the dollar appreciation implies that the change in the exchange rate has no impact on the Japanese price of inputs used in the production of Toyotas. This is a reasonable approximation for labor inputs, but it is an unrealistic assumption when Toyota heavily relies on imported raw materials and energy. In this case, a dollar appreciation would raise Toyota's price of imported raw materials and energy. Allowing for this effect would lower the extent of exchange rate pass-through, other things being equal.

production cost. The graph also shows that as a consequence of the higher markup, the decline in the dollar price of Toyotas is smaller than the dollar appreciation, implying partial pass-through.

Figure 14.4(c) illustrates the opposite case of a dollar depreciation. The depreciation raises the dollar cost of producing Toyotas, and thus the marginal cost curve shifts up. At the new equilibrium, the dollar price of Toyotas increases by less than the increase in marginal cost resulting from the depreciation. This implies that the firm charges a lower markup (in dollars) over production cost, implying partial pass-through.

The example in Figure 14.4shows that exchange rate pass-through can be less than complete even in the presence of constant returns to scale. As the reader can verify, increasing marginal cost (that is, decreasing returns to scale) would lower the extent of exchange rate pass-through. Conversely, decreasing marginal cost (increasing returns to scale) would increase the extent of pass-through.

To summarize, the two determinants of exchange rate pass-through, the responsiveness of markups to competitive conditions and the degree of return to scale in production, can interact in different ways to produce different outcomes.

One reason why developing nations choose to anchor their currencies to a key currency is that it is used as a means of international settlement. Consider a Norwegian importer who wants to purchase Argentinean beef over the next year. If the Argentine exporter is unsure of what the Norwegian krone will purchase in one year, he might reject the krone in settlement. Similarly, the Norwegian importer might doubt the value of Argentina's peso. One solution is for the contract to be written in terms of a key currency. Generally speaking, smaller nations with relatively undiversified economies and large foreign-trade sectors have been inclined to anchor their currencies to one of the key currencies.

Maintaining an anchor to a key currency provides several benefits for developing nations. First, the prices of the traded products of many developing nations are determined primarily in the markets of industrialized nations such as the United States; by anchoring, say, to the dollar, these nations can stabilize the domestic-currency prices of their imports and exports. Second, many nations with high inflation have anchored to the dollar (the United States has relatively low inflation) in order to exert restraint on domestic policies and reduce inflation. By making the commitment to stabilize their exchange rates against the dollar, governments hope to convince their citizens that they are willing to adopt the responsible monetary policies

necessary to achieve low inflation. Anchoring the exchange rate may thus lessen inflationary expectations, leading to lower interest rates, a lessening of the loss of output due to disinflation, and a moderation of price pressures.

In maintaining fixed exchange rates, nations must decide whether to anchor their currencies to another currency or a currency basket. Anchoring to a single currency is generally done by developing nations whose trade and financial relationships are mainly with a single industrial-country partner.

Developing nations with more than one major trading partner often anchor their currencies to a group or basket of currencies. The basket is composed of prescribed quantities of foreign currencies in proportion to the amount of trade done with the nation anchoring its currency. Once the basket has been selected, the currency value of the nation is computed using the exchange rates of the foreign currencies in the basket. Anchoring the domesticcurrency value of the basket enables a nation to average our fluctuations in export or import prices caused by exchange-rate movements. The effects of exchange-rate changes on the domestic economy are thus reduced.

Rather than constructing their own currency basket, some nations anchor the value of their currencies to the special drawing right (SDR), a basket of four currencies established by the IMP. The IMF

requires that the valuation of the SDR basket be reviewed every five years; the basket is to include, in proportional amounts, the currencies of the members having the largest exports of goods and services during the previous five years. The currencies comprising the basket as of 2003, along with their amounts and percentage weights, are listed in Table 15.4.

The idea behind the SDR basket valuation is to make the SDR's value more stable than the foreigncurrency value of any single national currency. The SDR is valued according to an index based on the moving average of those currencies in the basket. Should the values of the basket currencies either depreciate or appreciate against one another, the SDR's value would remain in the center. The SDR would depreciate against those currencies that are rising in value and appreciate against currencies whose values are falling. Nations desiring exchange-rate stability are attracted to the SDR as a currency basket against which to anchor their currency values.

IFixed Exchange-

Rate System

Few nations have allowed their currencies' exchange values to be determined solely by the forces of supply and demand in a free market. Until the industrialized nations adopted managed floating exchange rates in the 1970s, the practice generally was to maintain a pattern of relatively

TABCI II 1.4

Special Drawing Right Valuation, April 30, 2003

fixed exchange rates among national currencies. Changes in national exchange rates presumably were to be initiated by domestic monetary authorities when long-term market forces warranted it.

Par Value and Official

Exchange Rate

Under a fixed exchange-rate system, governments assigntheir currencies a par value in terms of gold or other key currencies. By comparing the par values of two currencies, we can determine their official exchange rate. For example, the official exchange rate between the U.S. dollar and the British pound was $2.80 ::: £1 as long as the United States bought and sold gold at a fixed price of $35 per ounce and Britain bought and sold gold at £12.50 per ounce (35.00/12.50::: 2.80). The major industrial nations set their currencies' par values in terms of gold until gold was phased out of the international monetary system in the early 1970s.

Today, many developing nations choose to define their par values in terms of certain key currencies. Under this arrangement, the monetary authority first defines its official exchange rate in terms of the key currency. It then defends the fixed parity by purchasing and selling its currency for the key currency at that rate. Assume, for example, that Bolivian central bankers fix their peso at 20 pesos e US$l, whereas Ecuador's sucre is set at 10 sucres e US$1. The official exchange rate between the peso and sucre becomes 1 peso :::

0.5 sucre.

446 Exchange-Rate Systems and Currency Crises

Exchange-Rate Stabilization

A first requirement for a nation participating in a fixed exchange-rate system is to determine an official exchange rate for its currency. The next step is to set up an exchange-stabilization fund to defend the official rate. Through purchases and sales of foreign currencies, the exchange-stabilization fund attempts to ensure that the market exchange rate does not move above or below the official exchange rate.

In Figure 15.1, assume that the market exchange rate equals $2.80 per pound, seen at the intersection of the demand and supply schedules of British pounds, Do and So. Also assume that the official exchange rate is defined as $2.80 per pound. Now suppose that rising interest rates in Britain cause U.S. investors to demand additional pounds to finance the purchase of British securities; let the demand for

,

pounds rise from Do to D 1 in Figure 15.1(a). Under free-market conditions, the dollar would depreciate from $2.80 per pound to $2.90 per pound. But under a fixed exchange-rate system, the monetary authority will attempt to defend the official rate of $2.80 per pound. At this rate, there exists an excess demand for pounds equal to £40 billion; this means that the British face an excess supply of dollars in the same amount. To keep the market exchange rate from depreciating beyond $2.80 per pound, the U.S. exchange-stabilization fund would purchase the excess supply of dollars with pounds. The supply of pounds thus rises from So to 51, resulting in a stabilization of the market exchange rate at $2.80 per pound.

Conversely, suppose that increased prosperity in the United Kingdom leads to rising imports from the United States; the supply of pounds thus

increases from, say, So to SI in Figure 15.1(b). At the official exchange rate of $2.80 per pound, there exists an excess supply of pounds equal to £40 billion. To keep the dollar from appreciating against the pound, the u.s. stabilization fund would purchase the excess supply of pounds with dollars. The demand for pounds thus increases from Do to D1, resulting in a stabilization of the market exchange rate at $2.80 per pound.

This example illustrates how an exchangestabilization fund undertakes its pegging operations to offset short-term fluctuations in the market exchange rate. Over the long run, however, the official exchange rate and the market exchange rate may move apart, reflecting changes in fundamental economic conditions-income levels, tastes and preferences, and technological factors. In the case of a fundamental disequilibrium, the cost of defending the existing official rate may become prohibitive.

Consider the case of a deficit nation that finds its currency weakening. Maintaining the official rate may require the exchange-stabilization fund to purchase sizable quantities of its currency with foreign currencies or other reserve assets. This may impose a severe drain on the deficit nation's stock of international reserves. Although the deficit nation may be able to borrow reserves from other nations or from the IMF to continue the defense of its exchange rate, such borrowing privileges are generally of limited magnitude. At the same time, the deficit nation will be undergoing internal adjustments to curb the disequilibrium. These measures will likely be aimed at controlling inflationary pressures and raising interest rates to promote capital inflows and discourage imports. If the imbalance is persistent, the deficit nation may view such internal adjustments as too costly in terms of falling income and employment levels. Rather than continually resorting to such measures, the deficit nation may decide that the reversal of the disequilibrium calls for an adjustment in the exchange rate itself. Under a system of fixed exchange rates, a chronic imbalance may be counteracted by a currency devaluation or revaluation.

Devaluation and Revaluation

Under a fixed exchange-rate system, a nation's monetary authority may decide to pursue balance- of-payments equilibrium by devaluing or revalu-

ing its currency. The purpose of devaluation is to cause the home currency's exchange value to depreciate, thus counteracting a payments deficit. The purpose of currency revaluation is to cause the home currency's exchange value to appreciate, thus counteracting a payments surplus.

The terms devaluation and revaluation refer to a legal redefinition of a currency's par value under a system of fixed exchange rates. The terms depreciation and appreciation refer to the actual impact on the market exchange rate caused by a redefinition of a par value or to changes in an exchange rate stemming from changes in the supply of or demand for foreign exchange. The legal and economic effects of devaluation and revaluation are further discussed in "Exploring Further 15.1" at the end of this chapter.

Devaluation and revaluation policies work on relative prices to divert domestic and foreign expenditures between domestic and foreign goods. By raising the home price of the foreign currency, a devaluation makes the home country's exports cheaper to foreigners in terms of the foreign currency, while making the home country's imports more expensive in terms of the home currency. Expenditures are diverted from foreign to home goods as home exports rise and imports fall. In like manner, a revaluation discourages the home country's exports and encourages its imports, diverting expenditures from home goods to foreign goods.

Before implementing a devaluation or revaluation, the monetary authority must decide (1) if an adjustment in the official exchange rate is necessary to correct a payments disequilibrium, (2) when the adjustment will occur, and (3) how large the adjustment should be. Exchange-rate decisions of government officials may be incorrect-that is, ill timed and of improper magnitude.

In making the decision to undergo a devaluation or revaluation, monetary authorities generally attempt to hide behind a veil of secrecy.Just hours before the decision is to become effective, public denials of any such policies by official government representatives are common. This is to discourage currency speculators, who try to profit by shifting funds from a currency falling in value to one rising in value. Given the destabilizing impact that massive speculation can exert on financial markets, it is hard to criticize monetary authorities for being

448 Exchange-Rate Systems and Currency Crises

secretive in their actions. However, the need for devaluation tends to be obvious to outsiders as well as to government officials and in the past has nearly always resulted in heavy speculative pressures. Table 15.5 summarizes the advantages and disadvantages of fixed exchange rates.

Bretton Woods System of

Fixed Exchange Rates

An example of fixed exchange rates is the Bretton Woods system. In 1944, delegates from 44 member nations of the United Nations met at Bretton Woods, New Hampshire, to create a new international monetary system. They were aware of the unsatisfactory monetary experience of the 1930s, during which the international gold standard collapsed as the result of the economic and financial crises of the Great Depression and nations experimented unsuccessfully with floating exchange rates and exchange controls. The delegates wanted to establish international monetary order and avoid the instability and nationalistic practices that had been in effect until 1944.

The international monetary system that was created became known as the Bretton Woods system. The founders felt that neither completely fixed exchange rates nor floating rates were optimal;

!FABLE 15.5

instead, they adopted a kind of semifixed exchangerate system known as adjustable pegged exchange rates. The Bretton Woods system lasted from 1946 until 1973.

The main feature of the adjustable peg system was that currencies were tied to each other to provide stable exchange rates for commercial and financial transactions. When the balance of payments moved away from its long-run equilibrium position, however, a nation could repeg its exchange rate via devaluation or revaluation policies. Member nations agreed in principle to defend existing par values as long as possible in times of balance-of-payments disequilibrium. They were expected to use fiscal and monetary policies first to correct payments imbalances. But if reversing a persistent payments imbalance would mean severe disruption to the domestic economy in terms of inflation or unemployment, member nations could correct this [undamental disequilibrium by repegging their currencies up to 10 percent without permission from the IMF and by greater than 10 percent with the Fund's permission.

Under the Bretton Woods system, each member nation set the par value of its currency in terms of gold Of, alternatively, the gold content of the U.S. dollar in 1944. Market exchange rates were

.

Loss of independent monetary policy

Vulnerable to speculative attacks

Conducive to price inflation

Disorderly exchange markets can disrupt trade and investment patterns

Encourage recklessfinancial policies on the part of government