Exchange Rates, International Trade, and Capital Flows | CFA Level I Economics

Today, we’re diving into the effects of exchange rates on international trade and capital flows. We’ll explore the relationship between the balance of trade and capital flows and learn about the elasticities approach and absorption approach. We’ll also discuss the Marshall-Lerner condition and the J-curve effect.

Understanding Balance of Trade and Capital Flows

When a country spends more on imports than it earns from exports, it experiences a trade deficit. This deficit can be financed by borrowing from foreign countries or selling assets to foreigners. From the balance of payments perspective, a current account deficit must be exactly matched by an offsetting capital account surplus. The impact of changing exchange rates on the balance of payments can be studied from two different angles: the impact on imports and exports, and the impact on capital flows.

Elasticities Approach: The Impact of Exchange Rates on Imports and Exports

The elasticities approach focuses on how exchange rate changes affect total expenditures on imports and exports. A country that wants to reduce its trade deficit needs to depreciate its currency. Currency depreciation makes imports more expensive in domestic currency terms and exports less expensive in foreign currency terms. This should increase exports and decrease imports, reducing the trade deficit. However, it’s essential to consider the price elasticity of demand for export goods and import goods to determine the actual outcome.

EXAMPLE

What happens when demand curves are inelastic?

Suppose both the demand for exports and imports are inelastic. In this case, currency depreciation decreases the foreign price of exports, but the quantity demanded may increase only slightly. Consequently, the total value of exports might decrease instead of increasing. Similarly, the depreciation increases the domestic price of imports, but the quantity demanded may decrease only slightly. As a result, the value of imports might increase instead of decreasing. If both of these effects occur, the trade deficit could widen instead of narrowing.

Marshall-Lerner Condition and J-Curve Effect

The Marshall-Lerner condition is a formula that considers the proportion of total trade that is exports and imports, and the price elasticity of demand for exports and imports. If this condition is satisfied, currency depreciation will decrease the trade deficit.

However, there can be a delay between currency depreciation and the desired effects due to pre-existing contracts. This temporary effect is called the J-curve effect. Initially, the trade deficit may widen instead of narrowing. Eventually, when changes in order quantities take effect, the Marshall-Lerner conditions come into play, and currency depreciation begins to narrow the trade deficit.

Absorption Approach: The Impact of Exchange Rates on Capital Flows

The absorption approach is a macroeconomic technique that studies the effect of exchange rates on capital flows. It’s based on the fundamental relationship between the balance of trade, national savings, and private investments. When a country has a trade deficit, it doesn’t save enough to fund its investments, so it relies on foreign capital.

To reduce the trade deficit, currency depreciation must increase national income relative to expenditure, or increase national saving relative to domestic investment. The impact of depreciation depends on the current level of capacity utilization in the economy.

When operating at less than full employment, currency depreciation makes domestic goods more attractive, increasing national income and savings, which can reduce the trade deficit. Conversely, when the economy is operating at full employment, an increase in domestic spending can lead to higher domestic prices, reversing the relative price changes of currency depreciation and potentially returning the balance of trade to its previous deficit.

Another factor to consider is the wealth effect. Currency depreciation can result in a decline in the value of domestic assets, causing savers to initially spend less and save more to rebuild wealth. This can temporarily improve the balance of trade. However, as the real wealth of savers increases over time, the positive impact on saving will decrease, eventually returning the economy to its previous state and balance of trade.

Conclusion

We’ve covered the relationship between exchange rates, international trade, and capital flows. We delved into the elasticities approach and the absorption approach, and discussed the Marshall-Lerner condition and the J-curve effect. While some concepts may be challenging to grasp, it’s essential to understand the impact of exchange rates on trade balances and capital flows for a well-rounded understanding of international economics.