Chapter 23 – Price Adjustments and Balance of Payments.ppt

Chapter 23 – Price Adjustments and Balance of Payments Disequilibrium Price adjustments This chapter examines the REAL economy changes in traded goods and services in response to exchange rate changes important consideration of the conditions under which market reactions lead to a return to equilibrium examine adjustment mechanism under fixed exchange rates consider short-run and long-run … how does the foreign sector lead to changes in home prices? Foreign Exchange Market(Exports and Imports) So far, demand for foreign exchange has been a downward sloping curve supply of foreign exchange has been upward sloping Foreign Exchange Market(Exports and Imports) Let’s examine why? Then consider how this might not be the case Expenditure switching Changes in exchange rate lead to expenditure switching Given a rise in the foreign exchange rate Price of foreign goods rise relative to home-produced goods consumers buy fewer imports and more home produced goods foreign consumer buy more of our exports, swithching away from their own goods These changes are called ‘expenditure switching’ Elasticities Approach The adjustment of demand and expenditure switching will affect the total revenue for a country depending on the elasticities of demand for imports in both countries Therefore, when we ignore interest rates and focus on expenditure switching and the price adjustment mechanism to explain a return to equilibrium, we are using the elasticities approach to the foreign exchange market. Price adjustment Now let’s examine how price adjustment works. This will also show how elasticities come into play Table 1 shows the demand and cost of goods at various prices in each currency, as the exchange rate changes. Price adjustment The first two columns are exchange rates, bracketed where it is relevant to the other country Third column is the price from the country of origin. Fourth is the price in the importing country (converted by exchange rate) Fifth is the quantity deman