Re: Fixed vs. flexible exchange rates

["Leigh Harkness" <Leigh@xxxxxxxxxxxxxxxxxxxx>]

Henry

You have gone into a great deal of detail about trade theories but the real
test
of theory is in reality.

I am attaching a graph of the current account deficit and the growth of bank
credit in New Zealand.  Actually, it is a graph of what the Reserve Bank of
New Zealand in their table C4: Balance sheets: M3 Institutions calls "NZ
dollar
funding - NZ resident".  Other might call it commercial bank deposits but
the RBNZ appear to consider that these domestic currency deposit of NZ
residents fund the loans.

I have lagged the current account deficit one year.

There are 14 years of data here and over that time, the exchange rate,
elasticities, government deficits and surpluses and micro-economic reform
have changed but the relationship between the bank credit funded from NZ
residents has not changed.

I can send you the Excel Spreadsheet if you wish and you can get the data
off the RBNZ website yourself and do the calculations.  The data is readily
available.

Where are the Marshall Lerner conditions in this country?  If you cannot
find
it in a small economy like NZ, how can you expect to find such relationships
in more complex economies?

The basis of economics is the facts, not the theories.  The theories are
only useful if they explain the facts.

Leigh








----- Original Message -----
From: "Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>
To: <pkt@xxxxxxxxxxxxxxxx>
Sent: Tuesday, April 29, 2003 10:52 AM
Subject: Re: Fixed vs. flexible exchange rates


> Marshall-Lerner condition
>
> The Marshall Lerner Condition shows the conditions under which a change
> in the exchange rate of a country's currency leads to an improvement or
> worsening of a country's balance of payments.
>
> Under a floating exchange rate regime a balance of payments
> disequilibrium should automatically be restored to equilibrium without
> the need for government policy. In the case of a fixed exchange rate, a
> devaluation or a revaluation may be used to restore disequilibrium.
>
> However, this is based on certain key assumptions which, some economists
> argue, do not apply to certain LDCs. The assumptions concern the extent
> to which a change in import and export prices affect the quantity of
> imports and exports demanded.
>
> The inflows and outflows of foreign currency recorded in a country's
> balance of payments account are dependent on these price changes.
> Crucially the price elasticity of demand will determine the impact of
> the price change on the quantity of exports demanded and the quantity of
> foreign exchange earned.
>
> If the exchange rate of a country decreases then the price of its
> exports will fall and the price of imports rises. Initially one might
> expect little to happen to the amount of exports and imports demanded as
> consumers take time to change their preference from imported goods to
> domestically produced goods. In addition, foreign consumers will take
> time to adjust from domestic goods to foreign exports. If this was the
> case the balance of payments might be expected to worsen as the value of
> exports would decrease and the value of imports would increase.
> J-curve - effects of a depreciation
>
> The diagram above shows the effect of a depreciation of the currency on
> the balance of payments on current account. In the short term the
> balance of payments worsens as the deficit grows. This is the so-called
> J curve effect.
>
> After a while the situation improves as the deficit gets smaller and
> then moves to surplus. In the longer time period once consumers'
> preferences have adjusted to the changes in imports and export prices
> then the amount of exports and imports will change. The amount by which
> they change will determine the effect on the balance of payments on
> current account. The extent of the change will depend upon the price
> elasticity of demand for imports and exports.
>
> If demand for exports is first assumed to be relatively price elastic
> then the fall in the price of exports caused by the fall in the exchange
> rate will lead to a proportionately greater increase in the quantity of
> exports demanded. This would improve the balance of payments.
>
> If demand for imports is also assumed to be relatively price elastic
> then the rise in the price of imports caused by the fall in the exchange
> rate will lead to a proportionately greater decrease in the quantity
> demanded of imports. This would also improve the balance of payments on
> current account. This is illustrated in the diagram above. The
> importance of the price elasticity of demand for imports and exports is
> thus crucial.
>
> If a balance of payments disequilibrium is to be restored then it is
> important that the PED coefficient for exports is greater than 1 and
> that the PED coefficient for imports is greater than 1. This is embodied
> in a condition called the Marshall Lerner Condition and this states that:
> "Provided that the sum of the price elasticity of demand coefficients
> for exports and imports is greater than one then a fall in the exchange
> rate will reduce a deficit and a rise will reduce a surplus."
>
> If the Marshall Lerner Condition is not met and the sum of the price
> elasticity of demand for exports and imports is less than one, then a
> fall in the exchange rate will bring about a worsening of the balance of
> payments. The fall in the price of exports will lead to a
> proportionately smaller increase in the number of exports demanded and
> the rise in the price of imports will lead to a proportionately smaller
> reduction in the amount demanded. Both of these factors will contribute
> to a deterioration of the balance of payments.
>
> In assessing the likely impact of a policy that will lead to a fall in
> the value of the currency consideration must be given to the price
> elasticity of demand for both the exports and imports.
>
> http://www.bized.ac.uk/virtual/dc/trade/theory/th12.htm
>
> Warren Mosler wrote:
> >
> >>I think those with those who think that a fixed
> >>exchange rate is the
> >>problem and a flexible exchange rate is the solution
> >>-- suffer from a
> >>failure to understand the lack of Marshall -Lerner
> >>conditions in modern day
> >>international trade so that devaluation exacerbates
> >>the problem -- as those
> >>who speak about the J-curve are implying for in the
> >>short-run the downward
> >>slope in the J is almost inevitable and -- you will
> >>note as I demonstrate
> >>in my book,it is assumed thatthe  upward slope of
> >>the J kicks in --in the
> >>longer run, the Marshall-Lerner condition kicks in.
> >
> >
> > But again, here you imply imports are a 'problem?'
> > And that a weaker exchange rate won't reduce imports.
> > But imports are a benefit, not a cost.  And exports
> > are the cost of imports.
> >
> >>Of course it is the basis an excellent substitute
> >>for everything else --
> >>price elasticities are very large if not infinite.
> >>
> >>This assumption -- often implicit and therefore not
> >>specified --of high
> >>elasticities assures that a flexible price system
> >>will clear all markets at
> >>full employment --
> >
> >
> > I agree that is an incorrect assumption.  What I have
> > said is that a country with a flexible exchange rate
> > can maintain full employment regardless at all times,
> > via elr, for example, or even more mainstream demand
> > management.
> >
> > at least in the long run -- when
> >
> >>we are all dead. In the
> >>short-run interim in which we all live, there can be
> >>many painful, and
> >>perhaps even deadly,  income effects of flexible
> >>exchange rates.
> >
> >
> > Yes, that domestic full employment policy can turn to
> > the advantage of the domestic standard of living.
> > These 'deadly' income effects are generally due to
> > imports 'costing jobs' and income.  But with a
> > floating exchange rate the domestic govt. can simply
> > hire the unemployed to make sure their income is
> > continued or manage additional net spending to make
> > sure there is sufficient agg demand to keep domestic
> > income high enough.
> >
> > Warren
> >
> >
> >
> >>For a further discussion see my article "Are Fixed
> >>Exchange Rates the
> >>Problem and Flexible Exchange Rates the Solution?"
> >>in the Spring 2003 issue
> >>of the EASTERN ECONOMIC JOURNAL.
> >>
> >>Paul
> >>
> >>Paul
> >>
> >>
> >
> >
> >
> > =====
> > Warren Mosler, www.mosler.org
> > c/o James River Capital Corp
> > 5007 Chandler's Wharf, Suite 201/202
> > Christiansted, USVI  00820
> > 340-719-8813 office phone
> > 340-719-8804 Fax
> > Primary email contact:  mosler@xxxxxxxxxxxxxx
> >
> > __________________________________
> > Do you Yahoo!?
> > The New Yahoo! Search - Faster. Easier. Bingo.
> > http://search.yahoo.com
> >
>
>
>

Attachment: NZ Bank Funding and CAD.pdf
Description: Adobe PDF document