CAVE.6607.cp16.

p291-306 6/6/06 12:00 PM Page 291

CHAPTER 16

The Foreign Exchange Market

and Trade Elasticities

T
he foreign exchange market is where domestic money (for example, dollars) is
traded for foreign money (for example, pounds sterling). The exchange rate is
usually defined as the price of the foreign currency in terms of the domestic cur-
rency, although it could as easily have been the reverse.1 This convention will be fol-
lowed here. Note that a depreciation, a decrease in the value of the domestic currency,
is an increase in the exchange rate because it is an increase in the price of foreign cur-
rency. Some find it counterintuitive that a decrease in the value of the currency is
called an increase in the exchange rate. Yet just as economists often talk about an
increase in the prices of commodities rather than the equivalent depreciation of
money’s purchasing power over commodities, so it is often intuitive to talk about an
increase in the price of foreign currency rather than the equivalent decrease in the
value of the domestic currency.
We are simplifying when we speak of the exchange rate for a country. In reality,
each country has many exchange rates, one for every other currency in the world. The
United States, for example, has the dollar/yen rate, the dollar/pound rate, and so on.
Although these exchange rates tend to be correlated, the measure of the movements in
the home country’s currency depends on which exchange rate is used.To get a good idea
of the value of the currency overall, it is necessary to use an exchange rate index, known
as the effective exchange rate, which computes a weighted average of the exchange rates
against each of the individual countries. Typically the weights used are the countries’
shares in trade.

16.1 The Flow of Supply and Demand for Foreign Exchange

In the foreign exchange market, as in other markets, supply and demand are central.
The proceeds from exports, and other credit items in the balance of payments, generate
the supply of foreign exchange or foreign currency. Import spending and other debit
items generate the demand for foreign exchange. In Figure 16.1 we measure the quan-
tities of foreign exchange supplied and demanded on the horizontal axis, and the price

1
In the United Kingdom, for example, the practice is to speak in terms of the dollar/pound rate, an exception
to the general rule because the pound is the domestic currency.

291
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 292

292 Chapter 16 ■ The Foreign Exchange Market and Trade Elasticities

FIGURE 16.1
Increase in Demand for Foreign Currency
When the demand for foreign currency shifts out from D to D9, the result depends on the
exchange rate regime. Panel (a) illustrates a floating exchange rate: An increase in the price
of foreign currency is necessary to equilibrate the private market. Panel (b) illustrates a fixed
exchange rate: The central bank intervenes by supplying the excess amount demanded, out of
its foreign exchange reserves.

(a) Floating Exchange Rate (b) Fixed Exchange Rate

Price of Price of
foreign foreign
exchange exchange
(E in $/£) D′ S (E in $/£) D′ S

D D

BP deficit
0 Quantity of foreign exchange (£) 0 Quantity of foreign exchange (£)

of foreign exchange—the exchange rate E—on the vertical axis. We can think of the
supply and demand for foreign exchange as functions of the currency’s price—the
exchange rate—just as the supply and demand for any commodity are functions of its
price. Unless otherwise specified, supply and demand refer to private sources (i.e.,
transactions on the current account and private capital account, not official reserve
transactions by the central bank). In Figure 16.1 the supply curve and demand curve
are (for the moment) simply assumed to slope the conventional ways: upward and
downward, respectively.
The behavior of the exchange rate varies considerably depending on which regime
is in effect: floating exchange rates or fixed exchange rates. Under pure floating, the
exchange rate is whatever it must be to equilibrate supply and demand in the private
market. Consider an increase in the demand for foreign exchange, an outward shift of
the curve in Figure 16.1(a) from D to D9. Such an outward shift in the demand for for-
eign currency could result, for example, from an increase in demand for imports or
from an increase in investors’ demand for foreign assets. Under floating, the increased
demand for foreign currency causes an increase in its price, the exchange rate, just as
an increase in demand for a commodity causes an increase in the price of the commod-
ity. E goes up.
With a completely fixed or “pegged” exchange rate, conversely, the central bank
stands ready to buy or sell foreign currency whenever private supply and demand are
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 293

16.1 ■ The Flow of Supply and Demand for Foreign Exchange 293

not equal at the fixed rate. The official exchange rate would only by coincidence be the
rate that precisely equates private supply and demand. Under this regime, an increase
in demand, illustrated in Figure 16.1(b), would result in an excess demand for for-
eign currency that must be met by sales of foreign currency by the central bank. From
our discussion of the balance-of-payments accounts, we know that the country runs a
balance-of-payments deficit. The central bank keeps the domestic currency from
depreciating by buying up the excess supply of the domestic currency. Obviously, the
central bank can continue this only as long as it has foreign exchange reserves. (The
other country’s central bank also could use its own currency to buy up the unwanted
domestic currency, if it were willing to do so.) There are policy changes, which will be
examined later, that the domestic government can make to reduce the deficit instead
of financing it, but such policies generally take time to have an effect. If the deficit con-
tinues, eventually the central bank will run out of foreign exchange reserves and will be
forced to withdraw support from the domestic currency. The central bank must then
either (1) set a new, higher exchange rate at which it will stand ready to sell foreign
exchange from then on, or (2) cease foreign exchange operations and allow the market
to determine the rate. The first option constitutes a devaluation of the currency, the
second the floating of the currency.2

Deriving Supply and Demand for Foreign

Exchange from Exports and Imports
What determines the supply and demand for foreign exchange? Three assumptions
together will provide a preliminary answer to this question. We are, in effect, going to
derive the shapes of the curves in Figure 16.1.
Assumption 1. Assume (until Part V of this book) that there are no net capital
flows (KA 5 0). Thus the private supply and demand for foreign exchange are deter-
mined entirely by the trade account. Most of the results in this part of the book would
be unaffected if it were assumed that capital flows were constant or exogenous, without
necessarily being zero. In the 1950s capital flows indeed consisted largely of govern-
ment loans (e.g., lending to Europe under the Marshall Plan after World War II) and
foreign direct investments that were not very responsive to short-term factors such as
the interest rate.
Furthermore, assume now that two goods are traded: an importable good and an
exportable good. Thus the first assumption is that the balance of payments is simply
sales of the export minus spending on the import.
Assumption 2. Assume (through the remainder of this chapter) that domestic res-
idents look only at prices expressed in domestic currency. Thus, in the case of domestic
consumers, the demand for imports depends only on the price of the import expressed
in domestic currency. In the case of domestic firms, the supply of exports depends only

2
The appendix to this chapter shows how stability in the foreign exchange market depends on the slopes of the
supply and demand curves in Figure 16.1(a). This analysis holds whether or not the curves are derived from
exports and imports, as in the next subsection. Chapter 21 will discuss the mechanics of how foreign exchange
is actually bought and sold, most of it by banks.
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 294

294 Chapter 16 ■ The Foreign Exchange Market and Trade Elasticities

on the price of the export expressed in domestic currency. Similarly, assume that foreign
residents look only at prices expressed in foreign currency when choosing the demand
for the home country’s exports (in the case of foreign consumers) or the supply of
imports to the home country (in the case of foreign firms). Changes in demand arising
from changes in income are ignored. This assumption, representing the defining charac-
teristic of the “elasticity approach” to devaluation, will be relaxed in Chapter 17.
Assumption 3. Finally, assume for now that firms set a price for their product and
then meet any forthcoming demand. In other words, assume that supply is infinitely
elastic. This assumption can be regarded as a special case that is only a realistic descrip-
tion of the short run. In light of Assumption 2, the price at which domestic firms supply
exportables with infinite elasticity must be set in domestic currency—call it P—and the
price at which foreign firms supply the home country with importables must be set in
foreign currency—call it P*. Assumption 3 will be relaxed later as well.
By Assumption 3, output levels are determined by demand. The demand for
imports, MD, is a decreasing function of the import’s price expressed in domestic cur-
rency, which is the fixed price in foreign currency times the exchange rate.
M 5 MD(EP *)
If a Range Rover costs £20,000 and the exchange rate is $2.00 / £, then the price to
an American is ($2.00 / £)(£20,000) 5 $40,000. Americans will buy fewer Range Rovers
when the dollar price goes up, without distinguishing whether it is the exchange rate or
the pound price that has changed. Figure 16.2 graphs prices in terms of foreign cur-
rency to facilitate calculation of export revenue and import spending. Thus the import
demand curve is drawn for a given exchange rate, E. A change in E would shift the
entire MD curve. The demand for exports, XD, is a decreasing function of their price
expressed in foreign currency, which is the fixed price in domestic currency divided by
the exchange rate.
X 5 XD(P/ E)
If a Ford costs $20,000 and the exchange rate is $2.00 / £, then the price in Britain
is $20,000 / ($2.00 / £) 5 £10,000. British buyers will buy fewer Fords when the pound
price goes up, regardless of whether it is the dollar price that rose or the exchange rate
that fell.
A devaluation, an increase in E, lowers the price of exports to foreigners. This is
a movement down the curve, increasing the quantity of exports demanded, XD, in
Figure 16.2(b). The devaluation also raises the price of imports to domestic residents,
reducing their demand, MD. This is represented in Figure 16.2(a) as a proportionate
downward shift of the entire import demand curve because the curve was drawn con-
tingent on the exchange rate.3

3
If the vertical axes had been expressed in domestic currency instead of foreign currency, the devaluation
would have been an upward movement along the import demand curve and an upward shift of the export
demand curve, instead of the other way around. (The effect on the quantities would have been the same as in
Figure 16.2.) The general rule is that a devaluation is a movement along the curve that describes the behavior
of the people (domestic or foreign residents) whose currency is on the vertical axis; it shifts the curve that
describes the behavior of the people whose currency is not on the axis.
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 295

16.1 ■ The Flow of Supply and Demand for Foreign Exchange 295

FIGURE 16.2
Effect of a Devaluation on Trade
Panel (a) shows how a devaluation lowers the quantity of imports. Panel (b) shows how the
devaluation raises the quantity of exports. The effects on import spending and export revenue,
respectively, are shown by the areas of the shaded rectangles.

(a) Imports (b) Exports

Price in Price in
foreign foreign
currency, currency,
P* P/E

MD (EP* ) XD (P/E )

MD (E ′P* )

P* P/E

P/E ′

0 M 0 X

Now consider the market for foreign exchange. Assumption 1 means that the
demand for foreign exchange is identical to import spending: In the absence of borrow-
ing, foreign exchange must be obtained on the market to pay for imports. Import
spending is quantity times the foreign currency price. The supply of foreign exchange is
identical to export revenue: All foreign exchange earned through exports is cashed in
on the foreign exchange market. Export revenue is export quantity times foreign cur-
rency price. So the demand for foreign currency prior to the devaluation is P*M, the
shaded rectangular area in Figure 16.2(a), and the supply is (P / E)X, the shaded area in
Figure 16.2(b). The net supply of foreign exchange is
(P/E )X 2 P *M
which is also the trade balance measured in foreign currency, TB*.
The appendix to this chapter considers the question of stability in the foreign
exchange market: Does an increase in the exchange rate increase the net supply of for-
eign exchange? This question is identical to this one: Does a devaluation improve the
trade balance? The two questions are the same because no capital flows have been
assumed. Domestic consumers cannot borrow abroad to get the foreign exchange
they need for imports, so the trade balance is the same as the net supply of foreign
exchange. We will now derive the condition under which the answer to the two ques-
tions is yes.
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 296

296 Chapter 16 ■ The Foreign Exchange Market and Trade Elasticities

The Marshall-Lerner Condition

The effect of a devaluation on the trade balance can be decomposed into three factors.
(1) A devaluation reduces the real quantity of imports (the number of Range Rovers
imported, in the example) and, because their nominal price is fixed in foreign currency,
clearly reduces the amount of foreign exchange spent on imports. The rectangular area
in Figure 16.2(a) shrinks. This factor helps improve the trade balance. (2) The devalua-
tion also increases the real quantity of exports. This factor also helps the trade balance.
(3) Any given quantity of exports earns less foreign exchange than before because
their nominal price is set in domestic currency. This factor hurts the trade balance.
The net effect on foreign currency export revenue is unclear. The size of the rec-
tangular area in Figure 16.2(b) may either increase or decrease, depending on the elas-
ticity of export demand. If the demand response (factor 2) is small enough, export
revenue may actually fall. This will be the case if the elasticity of export demand is less
than 1. Export revenue could fall, and yet be outweighed by a reduction in imports, so
that the total trade balance would still improve. However, if the demand response on
the import side (factor 1) is also small enough, the trade balance will actually worsen:
The net supply of foreign exchange will fall. (The various cases are explored further in
the appendix.)
At this point a fourth assumption is added to those required by the elasticities
approach.
Assumption 4. Assume that the economy is initially in a position of balanced
trade (TB 5 0). Given this, the necessary and sufficient condition for the devaluation to
improve the trade balance, or for the foreign exchange market to be stable, is the
Marshall-Lerner condition. The supplement to Chapter 3 includes a derivation of the
Marshall-Lerner condition. Here, with price levels fixed in each country, the exchange
rate plays the role of the price of foreign goods in terms of domestic. The condition is
eX 1 eM . 1
where eX and eM are the elasticities of demand for exports and imports, respectively. For
example, if exports have an elasticity of exactly one, a devaluation leaves export rev-
enue unchanged in foreign currency (the second and third factors just described cancel
out); then, if import demand has any elasticity, the devaluation reduces imports, thereby
improving the trade balance. Alternatively, if imports are more-than-unit elastic and
exports have any elasticity, or if both elasticities are greater than half, then the third fac-
tor will be outweighed by the first two and the trade balance again will improve.4
We have discussed the supply and demand for foreign exchange, but we could as
easily have discussed the demand and supply of domestic exchange. Assuming again
that the starting point is a position of balanced trade, the Marshall-Lerner condition
applies unchanged to the question of the trade balance expressed in domestic currency.5

4
The proof of the Marshall-Lerner condition in the present context (i.e., where the exchange rate takes the
role of the relative price) is given in the supplement to this chapter.
5
The proof of the Marshall-Lerner condition in terms of domestic currency is left to the student in Problem 5a
at the end of the chapter.
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 297

16.2 ■ Empirical Effects of Devaluation on the Trade Balance 297

The model can be generalized in two directions. First, Assumption 4 can be

relaxed. In particular, note that in practice a country seldom devalues unless it starts
from a position of deficit, rather than balanced trade: TB , 0, or EP*M . PX. Now, it
makes a difference whether the trade balance is measured in terms of domestic cur-
rency or foreign currency. If trade is measured in terms of domestic currency, the nec-
essary condition for a devaluation to improve the trade balance is more stringent: The
elasticities must be higher than those given by the Marshall-Lerner condition.6 The
economic reason is that, given the relatively large initial value for imports, M, the valu-
ation effect on import spending is more negative. For example, the import elasticity
could be almost as high as one, and yet if the export elasticity—even though positive—
is not high enough, the trade balance could worsen. A 10 percent devaluation may raise
exports, yet this accomplishes little if exports initially were a small number; meanwhile,
the already large import bill falls.
Another generalization involves relaxing Assumption 3—that firms exhibit infi-
nitely elastic supply. The supplement to this chapter (second half) considers this gen-
eral case.
According to general equilibrium theory, consumer demand should be a function
not of nominal prices but of relative prices and real income. The elasticities approach
is frequently criticized for the partial equilibrium nature of Assumption 1. (Partial
equilibrium means that some important variables are held constant.) For example, an
increase in demand for a country’s exports should raise its real income and thus raise
its demand for imports, but in the elasticities model there are no such effects. Chap-
ter 17 begins to remedy this deficiency by introducing income as a variable in the
import demand function.

16.2 Empirical Effects of Devaluation on the Trade Balance

Clearly, much depends on the magnitude of the import and export elasticities. Are they
large enough in practice for a devaluation to improve the trade balance? It is now time
to turn to the empirical evidence.

Elasticity Pessimism
A view known as elasticity pessimism suggests that actual trade elasticities are too low
to satisfy the Marshall-Lerner condition. Several factors have contributed to this view
historically. First, floating exchange rates in the 1930s were unstable, in that they were
highly variable. The appendix to this chapter shows that the Marshall-Lerner condition
is also the necessary condition for a stable foreign exchange market under floating
rates. Thus highly variable exchange rates seemed to imply low trade elasticities.
Second, many countries on fixed exchange rates have found their trade balance wors-
ening after a devaluation, rather than improving.

6
You are asked to show this in Problem 5b at the end of the chapter.
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 298

298 Chapter 16 ■ The Foreign Exchange Market and Trade Elasticities

This is especially true of oil importers. Because the demand for oil is relatively
inelastic in the short run, many small countries discover that a devaluation against the
dollar raises their oil import bill proportionately when expressed in domestic currency,
thus worsening their trade balance. When a deficit country is advised to devalue its cur-
rency, it often argues that its elasticities are too low for a devaluation to help.
A third factor that originally contributed to the rise of elasticity pessimism was
that early econometric estimates of the demand elasticities were low, frequently less
than half. However, there were a number of problems with these estimates. They
ignored the possible simultaneous existence of an upward-sloping supply relationship,
problems of aggregation, errors in the measurement of the variables, and the crucial
role of time lags.7 Some studies measure only relatively short-run elasticities, but abun-
dant evidence indicates that the factor of time is important. Elasticities are higher in
the long run, which makes the Marshall-Lerner condition more likely to hold.

The J-Curve
Some studies that allow for lags of import demand in response to changes in relative
prices have found that only about 50 percent of the full quantity adjustment takes
place in the first three years; 90 percent occurs in the first five years. For example, the
dollar depreciated substantially between 1985 and 1987, but because of these lags, the
favorable effect on the quantities of exports and imports did not begin to show up until
the end of 1986, and the effect on the dollar trade balance did not begin to show up
until the end of 1987.
In this case, contrary to what we have assumed, dollar prices of imports did not
respond immediately or fully to the exchange rate. Many importers, rather than passing
exchange rate changes immediately through to import prices, at first absorbed in their
profit margins much of the difference between foreign currency prices and domestic
currency prices. The delayed pass-through to import prices added an extra lag at the
beginning, before the elasticities could even begin to come into play. The United States
is unusual in how small a portion of an exchange rate change tends to be immediately
passed through to import prices.
There are a number of reasons why demand elasticities rise over time, and why the
quantities demanded are slow to respond even after the change in the exchange rate is
passed through to import prices. First, there is a lag because of the imperfect dissemina-
tion of information, during which importers recognize that relative prices have changed.
Second, there is a lag in deciding to place a new import order. In the case of firms’
imports of inputs, it may take months or years before inventories are depleted or
machinery is worn out and replacements are needed. Also, a firm may be tied to a par-
ticular supplier, through implicit or explicit contracts. In the case of consumers’ imports,

7
Faulty measurement of prices is particularly common in foreign trade. For example, importers in some coun-
tries underinvoice, that is, they understate the price of their imports so as to minimize the import duty they
must pay. Also, where laws require exporters to turn over all their foreign exchange earnings to the govern-
ment, exporters might understate their prices to retain some of the scarce foreign exchange for themselves.
Such measurement errors in the price data make it more difficult to discern a statistical relationship.
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 299

16.2 ■ Empirical Effects of Devaluation on the Trade Balance 299

changing habits takes time. For example, when the price of energy jumps, continued
strong demand causes many observers to assert that energy demand is essentially
inelastic. With the passage of time, however, energy demand falls considerably. The
adjustment process requires not only overcoming the momentum of old patterns of
consumption but also changing where people live and what kind of cars they drive.
Third, after a new import order has been placed, there may be production and
delivery lags before it is filled. Much internationally traded merchandise is still trans-
ported by ship, requiring weeks or months in transit. Payment is typically not made
before delivery, even though the contract may have been signed months earlier.
The fourth reason why trade quantities respond more fully with the passage of
time, and the reason that can potentially draw out the process the longest, is that pro-
ducers sometimes relocate their factories to the country where costs are lower because
of an exchange rate advantage, regardless of whether it is the home country of the pro-
ducer or the country where the goods are sold. For example, when the yen appreciated
strongly from 1985 to 1995, some Japanese firms that had previously been exporting
with great success found that they were losing out to competition from countries with
lower cost. To compete more effectively, they moved some operations to other coun-
tries with lower-valued currencies. Sales in the world market that were previously
counted under Japan’s exports came to be counted under the host countries’ exports.
Thus the response of export and import quantities after an exchange rate change is
greater in the long run than in the short run because companies are able to relocate
their plant and equipment. The transition costs are large. For this reason, a company is
unlikely to relocate until the change in the exchange rate has lasted long enough to
convince the company that the fluctuation is not transitory. Such an endurance test
may take as long as five or ten years. Indeed, even after the exchange rate has returned
to old levels, a company that decided to move operations abroad when the dollar was
high might never move back, after having incurred the costs of moving. The word
hysteresis is used to describe such not-easily-reversed reactions.
The tendency of the elasticities to rise over time results in the commonly observed
phenomenon of the J-curve. The trade balance following a devaluation is observed first
to worsen and then to improve, in the J-like pattern of Figure 16.3. (The figure assumes
an initial trade balance of zero.) At the moment of the devaluation, quantities have had
no time to adjust and the Marshall-Lerner condition fails. In fact, if quantities do not
respond at all initially, then only the negative valuation effect remains: The trade bal-
ance worsens by the initial level of exports times the percentage decrease in their for-
eign currency value caused by the devaluation.8 However, as time passes, export
demand begins to pick up and import demand begins to fall. A point is reached where
the curve crosses the zero axis, which means that the elasticities are high enough to
sum to one and the trade balance is back at zero. After that point, the Marshall-Lerner
condition holds and the trade balance moves into surplus. The surplus must run for a

8
If it takes time before the exchange rate change is passed through to domestic prices of imports, the initial
worsening in the trade balance is spread over a longer period. The downward sweep of the J would then be
more round than as shown in the figure.
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 300

300 Chapter 16 ■ The Foreign Exchange Market and Trade Elasticities

FIGURE 16.3 TB
The J-Curve
In the aftermath of a devaluation,
the trade balance (1) worsens initially
because of the perverse valuation
effect, then (2) gradually improves over (3)
time as the elasticities rise, and finally +
(3) surpasses its starting point when the 0 Time
Marshall-Lerner condition is satisfied. –

(1) (2)

while if the reserves accumulated are to outweigh the reserves lost during the initial
period of deficit.
All this assumes that exporters in the home country continue to supply whatever
quantity is demanded at the same fixed price. This may get increasingly harder, espe-
cially if they are operating close to full capacity. The exporters in the devaluing country
will be tempted to raise their prices in response to the increasing demand.Alternatively,
their workers may demand higher wages in response to the greater cost of imported
consumer goods, and the firms will be “forced” to pass through the higher labor costs in
the form of higher prices. However, we will stay with the fixed-price assumption until
Chapter 19.

16.3 Summary
The exchange rate is defined as the price of foreign exchange in terms of domestic cur-
rency. Under a floating exchange rate system, the central bank does not intervene in the
foreign exchange market, and the exchange rate is determined by supply and demand
in the market: An increase in the demand for foreign exchange causes an increase in the
price of foreign exchange (a depreciation of the domestic currency). Under a fixed
exchange rate system, an increase in demand for foreign exchange means that the cen-
tral bank has to supply the difference—the net demand for foreign exchange, which is
the balance-of-payments deficit—out of its foreign exchange reserves.
This chapter adopted the first and simplest model of what determines the balance
of payments. Part IV does not include capital flows; this chapter looked only at the
effect of the exchange rate on the trade balance, holding constant the level of income,
interest rate, price level, and other macroeconomic variables that we introduce in sub-
sequent chapters. A devaluation of the currency (or, under floating exchange rates, a
depreciation) increases the quantity of exports demanded by foreign residents and
decreases the quantity of imports, working to improve the trade balance. A third effect
that works to worsen the trade balance, however, is the higher cost in domestic currency
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 301

Chapter Problems 301

of any given quantity of imports that have prices set in foreign currency. Only if the sum
of the import and export elasticities is high enough, as in the Marshall-Lerner condition,
will the quantity effects dominate and the trade balance improve after the devaluation.
Empirically, the elasticities do appear to be high enough for a devaluation to
improve the trade balance, but only after enough time has passed. In the short run, the
trade balance often worsens, which gives rise to the J-curve pattern of response.

CHAPTER PROBLEMS

1. The newspaper reports that the dollar/euro exchange rate has risen.
a. Does this news mean that the value of the dollar has risen or fallen? The value of
the euro?
b. Does this mean that the dollar/yen rate is more likely to have gone up than down?
c. Does this mean that the euro/yen rate is more likely to have gone up than down?
(Hint: If neither the dollar/yen rate nor the euro/yen rate has changed, what does
that imply for the dollar/euro rate?)
2. Assume that the United States is currently exporting 10 million calculators at a price of
$10 apiece and importing .002 million BMWs at a price of 100,000 euros apiece, and
that the current exchange rate is 50 cents per euro. Calculate in a table the effect of a
10 percent devaluation of the dollar on each of 12 variables under each of four sets of
assumptions about the elasticities (assuming infinitely elastic supply and no income
effects). Round off.

BEFORE THE AFTER THE 10%

DEVALUATION DEVALUATION
5
(a) (b) (c) (d) (e)
Export
1
Elasticity: 0 ⁄2 1 4

Import
1
Elasticity: 0 0 ⁄2 1
(1) Export quantity 10m
(2) Import quantity .002m
(3) Export price $10

5
Expressed (4) Import price
in (5) Export earnings
$ (6) Import spending
(7) Trade balance
(8) Export price

5
Expressed (9) Import price 100,000 euros
in (10) Export earnings
euros (11) Import spending
(12) Trade balance
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 302

302 Chapter 16 ■ The Foreign Exchange Market and Trade Elasticities

3. a. In the example from Problem 2, comment on the trade balances in (b) and (c) ver-
sus those in (d) and (e).
b. In which case is spending on imports in dollars very close to what it was before the
devaluation? Why?
c. In which case are earnings from exports in euros very close to what they were
before the devaluation? Why?
d. Starting from a position of importing .003 million BMWs, with everything else
remaining the same, what would be the initial trade balance in dollars? For given
elasticities, for example, (d), would the devaluation cause the trade balance to
improve (i.e., the trade deficit decrease) by more than, less than, or the same
amount as in Problem 2? (A numerical answer is not necessary but is fine if you
can’t do it intuitively.)
4. The trade balance expressed in domestic currency, with prices normalized to 1, is
TB 5 X(E) 2 EM(E).
a. Illustrate the effect of a devaluation graphically; that is, repeat Figure 16.2,
but with domestic-currency prices on the vertical axis.
b. If the import elasticity is greater than 1 and the export elasticity is greater than 0,
then the Marshall-Lerner condition holds. Is this condition sufficient to imply
that TB, the trade balance expressed in domestic currency, improves? (You may
assume the starting point is TB 5 0.) Explain why, in terms of export revenue and
import spending.

Extra Credit
5. a. If you know calculus, prove that the Marshall-Lerner condition is still the correct
condition necessary and sufficient for a devaluation to improve TB, the trade bal-
ance expressed in domestic currency, starting from TB 5 0.
b. Starting from TB , 0, is the Marshall-Lerner condition too strong or too weak for
a devaluation to improve the trade balance?
c. The trade balance expressed in domestic currency is equal to the exchange rate
times the trade balance expressed in foreign currency: TB 5 E TB*.
i. Does it follow that if the trade balance is in surplus when expressed in foreign
currency, then it is also in surplus when expressed in domestic currency?
ii. Does it follow that dTB / dE 5 E dTB* / dE? Why not?
iii. If initially TB , 0, which is greater: the left-hand side in the preceding ques-
tion or the right-hand side?
iv. Which side is greater if initially TB . 0?
v. Which is greater if initially TB 5 0?
d. Assume we start from a position of deficit, and the elasticities sum approximately
to one.
i. Notice from the supplement to Chapter 16 that if E M . X initially, the
Marshall-Lerner condition is more than sufficient to imply dTB* / dE . 0.
For example, if both elasticities are half, that is enough for a devaluation to
improve the trade balance in foreign currency. Conversely, from 5(b) we know
that dTB / dE , 0 under these conditions. Can the trade balance improve in
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 303

Appendix 303

terms of foreign currency while worsening in terms of domestic currency?

(Refer to your answers to Questions c (ii) and c (iii).)
ii. If a devaluation brings the trade deficit back to zero in terms of foreign cur-
rency, then it must also do so in terms of domestic currency, because E times
zero is zero. There is an apparent contradiction between this fact and the
answer to (i). What is it? How do you reconcile the apparent contradiction?
6. It is possible (if old-fashioned) to stay within the partial equilibrium elasticities
approach and yet relax the assumption that supply is infinitely elastic. The Bickerdicke-
Robinson-Metzler condition for a devaluation to improve the trade balance is

eMeX (1 1 sM 1 sX) 2 sMsX (1 2 eM 2 eX)

.0
(sM 1 eM)(sM 1 eX)

where sM and sX are the supply elasticities of imports and exports, respectively.
a. Prove that in the limit, as sM and sX go to infinity, the formula reduces to the
Marshall-Lerner condition.
b. Does the presence of the supply elasticity terms make the condition more or less
stringent than the Marshall-Lerner condition?

SUGGESTIONS FOR FURTHER READING

Bergsten, C. Fred, ed. International Adjustment and Financing, The Lessons of

1985–1991 (Washington, DC: Institute for International Economics, 1991). Did the
1985–1897 dollar depreciation reduce international trade imbalances as promised?
At least one contributor, Paul Krugman, answers yes.
Mussa, Michael. “Exchange Rate Adjustments Needed to Reduce Global Payments
Imbalances.” In C. Fred Bergsten and John Williamston, eds., Dollar Adjustment:
How Far? Against What? (Washington, DC: Institute for International Economics,
2004), pp. 113–138. The same issue, with respect to the sharp rise in U.S. deficits
after 2001.

APPENDIX

Stability of the Foreign Exchange Market

The focus now turns from the comparative statics of the foreign exchange market, con-
sidered in Section 16.1, to the question of stability under a floating exchange rate. The
theoretical question of whether a market equilibrium is stable (as in Chapter 3) is not
the same as the question of whether the market price moves around a lot. The theoret-
ical question is the following: If an equilibrium price is displaced slightly, will it tend to
return to its original value?
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 304

304 Chapter 16 ■ The Foreign Exchange Market and Trade Elasticities

(a) E (b) E
S
S

ED ED
D D′ D D′
0 0
Quantity of foreign exchange Quantity of foreign exchange

(c) E

D D′

FIGURE 16.A.1 S

Stability in the Foreign Exchange Market

The market is stable if the increase in the price of
foreign exchange that results from an increase in
demand for foreign exchange works to eliminate the ED
excess demand. In cases (a) and (b) the market is stable, 0
but in (c) it is not. Quantity of foreign exchange

Think of foreign exchange traders as individuals who buy from and sell foreign
exchange to each other on the floor of centralized exchanges in New York and else-
where, or, in the case of the trading divisions of banks, on a network of telephones and
computer terminals. Assume that whenever foreign exchange traders find that demand
exceeds supply, they raise the exchange rate; whenever supply exceeds demand, they
lower it. Consider the following three cases.
1. Assume that the demand curve slopes down and the supply curve slopes up, as in
Figure 16.A.1(a). If the curves are derived from import spending and export earn-
ings, respectively, this first case is the one where the elasticity of demand for
exports is greater than one. In response to an increase in demand, from D to D9,
the traders raise the exchange rate. This raises export revenue, reduces the excess
demand for foreign exchange, and thus constitutes a move toward the new equilib-
rium. The market is stable.
2. Next, assume that the demand curve slopes down and the supply curve slopes down
also, but more steeply, as in Figure 16.A.1(b). Again, in response to an increase in
demand, the traders raise the exchange rate, causing a move toward equilibrium.
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 305

Appendix 305

Again the market is stable. This is the case where the elasticity of demand for
exports is less than one (so the increase in the exchange rate lowers export rev-
enue) but the sum of the two elasticities is nevertheless high enough to satisfy the
Marshall-Lerner condition.
3. Finally, assume that both curves slope down, but the supply curve is less steep, as in
Figure 16.A.1(c). This is the case where the Marshall-Lerner condition fails. This
time, when the traders respond to the increase in demand by raising the exchange
rate, they cause a move away from the new equilibrium. At the higher exchange
rate, excess demand is even greater, so the traders raise the exchange rate again,
and the situation is farther still from equilibrium. The market is unstable.
These examples show that the required condition for stability is that the supply
curve slopes up or, if sloping downward, is steeper than the demand curve.
As a practical matter, a floating exchange rate usually will not shoot off to infinity.
One possibility is that there are two stable equilibria surrounding an unstable one,
much as is shown in Figure 3.A.1. Even if the market is stable in the technical sense,
however, it may be unstable in the sense that the market-clearing price is highly vari-
able. Very small changes in demand may produce large jumps in the exchange rate.
High variability in the exchange rate may create uncertainty and imply high costs for
importers and exporters. These are cited as an argument against floating exchange
rates. This chapter showed that if the demands for exports and imports are relatively
inelastic, then the curves representing the supply and demand for foreign exchange will
be relatively steep. Resulting exchange rates may be highly variable if the exchange
rate is called on to clear the trade balance.
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 306