 IFT Notes for Level I CFA® Program
IFT Notes for Level I CFA® Program

# Part 6

## 5.  Exchange Rates, International Trade, and Capital Flows

The effect of changes in exchange rates on a country’s trade balance can be analyzed using the following two approaches.

### 5.1. Exchange Rates and Trade Balance: The Elasticities Approach

• Focuses on the impact of exchange rate changes on the total value of exports and imports.
• The impact of currency appreciation or depreciation on trade balance depends on the elasticities of demand for imports and exports.
• High elasticity → more impact of changes in currency exchange rates.

Goods having high elasticity of demand:

• Goods with close substitutes.
• Luxury goods.
• Goods that account for a high proportion of consumer spending.

Goods having low elasticity of demand:

• Goods that few or no substitutes.
• Necessities.
• Goods that account for a small proportion of consumer spending.
• Marshall-Lerner Condition describes the combinations of export and demand elasticities such that depreciation (appreciation) of the domestic currency will move the trade balance toward surplus (deficit).
i.e. If ωεX + ωM − 1) > 0 → currency depreciation will reduce trade deficit.Where ε = elasticity; ω = the proportion of imports or exports in total trade; X= exports; M=imports.

Example

United Kingdom exports goods valued at £600 million and imports goods valued at £900 million from the United States. The demand elasticities for exports are 0.70 and imports are 0.60. Calculate the impact of a 10% depreciation of GBP (relative to us) on the overall trade deficit for the United Kingdom.

Solution:

UK’s exports:

As GBP depreciates relative to USD by 10%, UK’s exports will now be cheaper to the US citizens. They will in turn increase consumption of the now cheaper UK goods. Demand elasticity of export of 0.70 tells us that for a 10% decrease in GBP rate, exported quantity to the US will increase by 7% (10% * 0.70).

Change in exports = currency change % * initial export value * demand elasticity for export

= 10%*600*0.70 =  600 * 7% = £42 Million

UK’s exports increases by £42 Million.

Note: While considering the impact of price depreciation/appreciation on total exported value, only the source of change is the quantity demanded in foreign country. Income earned by a UK citizen in GBP doesn’t change as the goods are still priced at the same GBP level as before (despite the change in the exchange rate).

UK’s imports:

As GBP depreciates relative to USD by 10%, imports from US will now be costlier to the UK citizens in GBP terms. They will decrease consumption of the now costlier US goods. Demand elasticity of import of 0.60 tells us that for a 10% decrease in GBP rate (i.e. US goods have become costlier by 10% for UK citizens in GBP terms), imported quantity of US goods to the UK will decrease by 6% (10% * 0.60).

Thus impact on imported value in UK is twofold: a) import prices of US goods increase by 10% in GBP terms b) Quantity demanded of US goods by UK citizens decreases by 6%.

Net impact is the imported value is that it increases by: = 10% – 6% = 4%.

Change in imports = currency change % * initial export value * (demand elasticity for import -1)

= 10%*900*0.40 = 900 * 4% = £36 Million

UK’s imports increases by £36 Million.

Note: While considering the impact of price depreciation/appreciation on total imported value, both the change in the import quantity demanded and change in the price level are sources of change. In our example, US goods became costlier by 10% and the quantity demanded declined by 6%. As the price level increase was larger than drop in quantity demanded, total imported value increased by 4%.

 From UK’s perspective: Initial value (£) Change (£) Final value (£) Exports 600,000,000 +42,000,000 742,000,000 Imports 900,000,000 +36,000,000 936,000,000 Trade balance (300,000,000) +6,000,000 (294,000,000) Total trade 1,500,000,000 78,000,000 1,578,000,000

Marshall-Lerner condition =  ωεX + ωM − 1) = (600/1,500) * 0.7 + (900/1,500) * (0.6 – 1) =  0.04

Since, 0.04 > 0, a depreciation of the domestic currency will to increase in the trade balance towards surplus.

This value implies that, a 1% depreciation in domestic currency will increase trade balance by 0.04% of the total trade.

Thus in our example, for a 10% depreciation in GBP will increase trade balance by 0.4% of the total trade = 0.4% * 1,500,000,000 = £6,000,000.

• Impact on trade balances (X – M):
 ωX εX + ωM (εM − 1) > 0 Marshall-Lerner holds. ωX εX + ωM (εM − 1) < 0 Marshall-Lerner doesn’t hold. Domestic currency appreciates Trade balance moves towards deficit. (X-M) decreases. Trade balance moves towards surplus. (X–M) increases. Domestic currency depreciates Trade balance moves towards surplus. (X–M) increases. Trade balance moves towards deficit. (X–M) decreases.
• The J-Curve Effect:
• In the short-run, existing contracts make exports and imports relatively inelastic.
• Hence, currency depreciation initially increases the trade deficit.
• However, in the long run, elasticities increase and the trade deficit starts to reduce.
• This initial increase in deficit followed by a decrease when the Marshall-Lerner condition is met is termed as J-curve effect.

### 5.2. Exchange Rates and Trade Balance: The Absorption Approach

• This approach focuses on the impact of exchange rate changes on capital flows (As a trade deficit (surplus) must be offset by surplus (deficit) in capital account).

Exports – imports = (private savings – physical capital investment) + (tax revenue – government spending)

X – M = (S – I) + (T – G)

X – M = S + T – (I + G)

This can be expressed as:

Balance of trade = national income – total expenditure

Total expenditure represents the absorption of goods and services in an economy.

• Thus, for a currency exchange rate change to improve (reduce) trade balance; national income must increase (decrease) relative to expenditure. In other words, domestic savings must increase (decrease) relative to domestic investments in physical capital.
• If the economy is operating at less than full capacity utilization (full employment) → Domestic currency depreciation will increase consumption of domestic goods & assets and reduce consumption of foreign goods & assets (as their price increases) → national income will increase more than national expenditure → trade balance will increase.
• If the economy is operating at full capacity utilization → Domestic currency depreciation will increase consumption of domestic goods & assets and reduce consumption of foreign goods & assets (as their price increases) → as the economy is already at full utilization, domestic prices will also begin to rise returning the economy back to its original trade balance → However, domestic assets decline in value as weaker currency reduces future cash flows of businesses → decreased wealth would see the households saving more and spending less → trade balance improves as expenditure reduces.
• Elasticities approach is a microeconomic view as it focuses on relationship between exchange rates and trade balances.
• Whereas, absorption approach can be viewed as a macroeconomic view as it also focuses on capital flows.