Gradual Trade Flow Adjustment and Current Account Dynamics

Gradual Trade Flow Adjustment
and Current Account Dynamics
An important assumption underlying the DD-AA model is that, other things equal, a real
depreciation of the home currency immediately improves the current account while a real
appreciation causes the current account immediately to worsen. In reality, however, the
behavior underlying trade flows may be far more complex than we have so far suggested,
involving dynamic elements—on the supply as well as the demand side—that lead the current
account to adjust only gradually to exchange rate changes. In this section we discuss
some dynamic factors that seem important in explaining actual patterns of current account
adjustment and indicate how their presence might modify the predictions of our model.
The J-Curve
It is sometimes observed that a country’s current account worsens immediately after a real
currency depreciation and begins to improve only some months later, contrary to the assumption
we made in deriving the DD curve. If the current account initially worsens after
a depreciation, its time path, shown in Figure 17-18, has an initial segment reminiscent of
a J and therefore is called the J-curve.
Yf
Exchange
rate, E
Output, Y
E1
2
1
3
DD
AA
4
XX
Figure 17-17
How Macroeconomic Policies
Affect the Current Account
Along the curve XX, the current
account is constant at the level
. Monetary expansion
moves the economy to point 2
and thus raises the current account
balance. Temporary fiscal
expansion moves the economy
to point 3 while permanent fiscal
expansion moves it to point 4;
in either case, the current account
balance falls.
CA = X
448 PART THREE Exchange Rates and Open-Economy Macroeconomics
Current account (in
domestic output units)
Long-run
effect of
real depreciation
on the
current
account
Real depreciation
takes place and
J-curve begins
End of J-curve
Time
3
2
1
Figure 17-18
The J-Curve
The J-curve describes the time
lag with which a real currency
depreciation improves the current
account.
The current account, measured in domestic output, can deteriorate sharply right after a
real currency depreciation (the move from point 1 to point 2 in the figure) because most
import and export orders are placed several months in advance. In the first few months
after the depreciation, export and import volumes therefore may reflect buying decisions
that were made on the basis of the old real exchange rate: The primary effect of the depreciation
is to raise the value of the pre-contracted level of imports in terms of domestic
products. Because exports measured in domestic output do not change, while imports
measured in domestic output rise, there is an initial fall in the current account, as shown.
Even after the old export and import contracts have been fulfilled, it still takes time for
new shipments to adjust fully to the relative price change. On the production side, producers
of exports may have to install additional plant and equipment and hire new workers. To
the extent that imports consist of intermediate materials used in domestic manufacturing,
import adjustment will also occur gradually as importers switch to new production techniques
that economize on intermediate inputs. There are lags on the consumption side as
well. To expand significantly foreign consumption of domestic exports, for example, it
may be necessary to build new retailing outlets abroad, a time-consuming process.
The result of these lags in adjustment is the gradually improving current account shown
in Figure 17-18 as the move from point 2 to point 3 and beyond. Eventually, the increase
in the current account tapers off as the adjustment to the real depreciation is completed.
Empirical evidence indicates for most industrial countries a J-curve lasting more than
six months but less than a year. Thus, point 3 in the figure is typically reached within a
year of the real depreciation, and the current account continues to improve afterward.12
The existence of a significant J-curve effect forces us to modify some of our earlier
conclusions, at least for the short run of a year or less. Monetary expansion, for example,
12See the discussion of Table 17A2-1 in Appendix 2 of this chapter.
CHAPTER 17 Output and the Exchange Rate in the Short Run 449
can depress output initially by depreciating the home currency. In this case, it may take
some time before an increase in the money supply results in an improved current account
and therefore in higher aggregate demand.
If expansionary monetary policy actually depresses output in the short run, the domestic
interest rate will need to fall further than it normally would to clear the home money
market. Correspondingly, the exchange rate will overshoot more sharply to create the
larger expected domestic currency appreciation required for foreign exchange market
equilibrium. By introducing an additional source of overshooting, J-curve effects amplify
the volatility of exchange rates.
Exchange Rate Pass-Through and Inflation
Our discussion of how the current account is determined in the DD-AA model has assumed
that nominal exchange rate changes cause proportional changes in real exchange
rates in the short run. Because the DD-AA model assumes that the nominal output prices
and cannot suddenly jump, movements in the real exchange rate, , correspond
perfectly in the short run to movements in the nominal rate, . In reality, however,
even the short-run correspondence between nominal and real exchange rate movements,
while quite close, is less than perfect. To understand fully how nominal exchange rate
movements affect the current account in the short run, we need to examine more closely
the linkage between the nominal exchange rate and the prices of exports and imports.
The domestic currency price of foreign output is the product of the exchange rate and
the foreign currency price, or . We have assumed until now that when rises, for
example, remains fixed so that the domestic currency price of goods imported from
abroad rises in proportion. The percentage by which import prices rise when the home
currency depreciates by 1 percent is known as the degree of pass-through from the
exchange rate to import prices. In the version of the DD-AA model we studied above, the
degree of pass-through is 1; any exchange rate change is passed through completely to
import prices.
Contrary to this assumption, however, exchange rate pass-through can be incomplete.
One possible reason for incomplete pass-through is international market segmentation,
which allows imperfectly competitive firms to price to market by charging different prices
for the same product in different countries (recall Chapter 16). For example, a large foreign
firm supplying automobiles to the United States may be so worried about losing market
share that it does not immediately raise its U.S. prices by 10 percent when the dollar
depreciates by 10 percent, despite the fact that its revenue from American sales, measured
in its own currency, will decline. Similarly, the firm may hesitate to lower its U.S. prices
by 10 percent after a dollar appreciation of that size because it can thereby earn higher
profits without investing resources immediately in expanding its shipments to the United
States. In either case, the firm may wait to find out if the currency movement reflects a definite
trend before making price and production commitments that are costly to undo. In
practice, many U.S. import prices tend to rise by only around half of a typical dollar
depreciation over the following year.
We thus see that while a permanent nominal exchange rate change may be fully reflected
in import prices in the long run, the degree of pass-through may be far less than 1
in the short run. Incomplete pass-through will have complicated effects, however, on the
timing of current account adjustment. On the one hand, the short-run J-curve effect of a
nominal currency change will be dampened by a low responsiveness of import prices to
the exchange rate. On the other hand, incomplete pass-through implies that currency
movements have less-than-proportional effects on the relative prices determining trade
volumes. The failure of relative prices to adjust quickly will in turn be accompanied by a
slow adjustment of trade volumes.
P*
EP* E
E
P* q = EP*/P
P
450 PART THREE Exchange Rates and Open-Economy Macroeconomics
Notice also how the link between nominal and real exchange rates may be further
weakened by domestic price responses. In highly inflationary economies, for example, it is
difficult to alter the real exchange rate, , simply by changing the nominal rate , because
the resulting increase in aggregate demand quickly sparks domestic inflation, which
in turn raises . To the extent that a country’s export prices rise when its currency depreciates,
any favorable effect on its competitive position in world markets will be dissipated.
Such price increases, however, like partial pass-through, may weaken the J-curve.
P
EP*/P E
Our theoretical model showed that a permanent fiscal
expansion would cause both an appreciation of the
currency and a current account deficit. Although our
discussion earlier in this chapter focused on the role
of price level movements in bringing the economy
from its immediate position after a permanent policy
change to its long-run position, the definition of the
current account should alert you to
another underlying dynamic: The
net foreign wealth of an economy
with a deficit is falling over time.
Although we have not explicitly
incorporated wealth effects into
our model, we would expect people’s
consumption to fall as their
wealth falls. Because a country
with a current account deficit is
transferring wealth to foreigners,
domestic consumption is falling over time and foreign
consumption is rising. What are the exchange rate
effects of this international redistribution of consumption
demand in favor of foreigners? Foreigners have a
relative preference for consuming the goods that they
produce, and as a result, the relative world demand for
home goods will fall and the home currency will tend
to depreciate in real terms.
This longer-run perspective leads to a more complicated
picture of the real exchange rate’s evolution following
a permanent change such as a fiscal expansion.
Initially, the home currency will appreciate as the current
account balance falls sharply. But then, over time,
the currency will begin to depreciate as market participants’
expectations focus increasingly on the current
account’s effect on relative international wealth levels.
Data for the United States support this theoretical
pattern. The figure on page 451 plots data on the U.S.
current account and the dollar’s real exchange rate
since 1976. (In the figure, a rise in the exchange rate
index is a real dollar appreciation; a decline is a real
depreciation.) During the 1976–2009 period, there
were two episodes of sharply increased current account
deficits, both associated with fiscal expansions.
The first episode occurred when President Ronald
Reagan cut taxes and increased
military spending shortly after he
entered the White House in 1981.
You can see that the dollar’s initial
response was a substantial real appreciation.
After 1985, however,
the dollar began to decline sharply
even though the current account
deficit had not yet turned around.
The declining path of U.S. relative
wealth implied that the current
account would eventually return closer to balance, requiring
a fall in the relative price of U.S. products to
restrict imports and spur exports. Market expectations
of this development quickly pushed the dollar down.
Because of J-curve effects and the gradual effects of
wealth on spending levels, the current account did not
return to balance until the early 1990s.
The second episode of a sharply higher deficit
shows a similar pattern. In the late 1990s, U.S. investment
rose sharply as a result of the “dot com”
boom in new information technology and Internetbased
applications. Although that boom collapsed in
2000–2001, President George W. Bush, like Reagan,
embarked on a program of substantial tax cuts after
the 2000 election. At the same time, the 2001 terrorist
attacks on New York and Washington, followed
by the wars in Afghanistan and Iraq, led to higher
government spending.
Exchange Rates and the Current Account
CHAPTER 17 Output and the Exchange Rate in the Short Run 451
As the figure shows, once again the dollar appreciated
as the current account deficit worsened. But in
2002, as market expectations fixed on the unprecedented
size of the deficit and the need for a large eventual
dollar depreciation, the dollar began to depreciate.
As we shall see in later chapters, 2007 marked the start
of a global financial crisis and a long-lasting economic
slowdown for the United States (and, indeed, for other
industrial counties). The crisis and its repercussions
greatly magnified the decline in U.S. wealth implied
by the external trade deficit. Throughout this process
the trend of real dollar depreciation continued. As
of this writing, it remains to be seen how far that depreciation
will have to go.*
*For an overview of current account adjustment in the 1980s, including attention to the cases of Germany and Japan, see
Paul R. Krugman, “Has the Adjustment Process Worked?” Policy Analyses in International Economics 34 (Washington,
D.C.: Institute for International Economics, 1991). An influential model of exchange rates and the current account is
Rudiger Dornbusch and Stanley Fischer, “Exchange Rates and the Current Account,” American Economic Review 70
(December 1980), pp. 960–971. Their basic insight is based on the “transfer problem” discussed in Chapter 6.