Question

Assume that the United States exports \(1,000 \mathrm{com}\) puters costing \(\$ 3,000\) each and imports 150 U.K. autos at a price of \(£ 10,000\) each. Assume that the dollar/pound exchange rate is \(\$ 2\) per pound. a. Calculate, in dollar terms, the U.S. export receipts, import payments, and trade balance prior to a depreciation of the dollar's exchange value. b. Suppose the dollar's exchange value depreciates by 10 percent. Assuming that the price elasticity of demand for U.S. exports equals \(3.0\) and the price elasticity of demand for U.S. imports equals \(2.0\), does the dollar depreciation improve or worsen the U.S. trade balance? Why? c. Now assume that the price elasticity of demand for U.S. exports equals \(0.3\) and the price elasticity of demand for U.S. imports equals \(0.2\). Does this change the outcome? Why?

Short answer

a. The initial export receipts are \$3,000,000, import payments are \$3,000,000, and the trade balance is \$0. b. The following dollar depreciation improves the trade balance as it becomes positive, due to relatively high price elasticities. c. When price elasticities are low, the depreciation results in a worsened trade balance because the proportionate change in quantities demanded for exports and imports is less than proportionate change in prices.

Step-by-step solution

Calculate export receipts, import payments and initial trade balance

Firstly, calculate the initial export receipts by multiplying the total export units with the unit price in dollars. The initial export receipts can be calculated as \( 1,000 * \$3,000\). Similarly, calculate the initial import payments. Here, import price is given in pounds so convert it to dollars using the exchange rate. The import payments can be calculated as \( 150 * £10,000 * \$2\). Lastly, compute the initial trade balance by subtracting the import payments from the export receipts.

Calculate exports, imports and trade balance after dollar depreciation

Subsequently, calculate the changes in exports and imports due to a 10 percent depreciation of the dollar. Use the price elasticity of demand to estimate changes. New exports can be estimated as \( \$3,000,000 * 1.10^3 \) and new imports price as \( £3,000,000 * .9^2 \). Convert the new imports price into dollars. Recompute the trade balance using the new figures.

Determine the impact of depreciation on trade balance

Compare the initial and new trade balances. If the new balance is higher than the initial, the depreciation improved the trade balance, and vice versa. Justify this result using the concept of price elasticity of demand.

Repeat calculations for new set of elasticities

Now repeat the step 2 and 3 using the new set of price elasticities. Conclude whether the outcome changes or not, and explain the reasons behind this.

Key concepts

Price Elasticity of Demand

The price elasticity of demand is a measure that indicates how demand for a good or service responds to changes in its price. A product with a high price elasticity implies that consumers will be significantly more or less likely to buy it when the price changes. Conversely, a product with low price elasticity means that demand is relatively insensitive to price changes.

For example, in the context of international trade outlined in the exercise, if the U.S. can enjoy a high price elasticity of demand for its exports, a decrease in price (due to currency depreciation) leads to a proportionally larger increase in quantity demanded, potentially boosting overall export revenue. This concept helps in understanding whether a country's trade balance will improve or worsen when its currency depreciates.

• If price elasticity of demand for exports is higher than 1, revenue will increase with a price decrease (currency depreciation).
• If price elasticity of demand for imports is higher than 1, expenditure on imports will decrease when their price in the domestic currency increases due to depreciation.

Currency Depreciation

Currency depreciation refers to the fall in value of one currency relative to another. In the exercise, a 10 percent depreciation of the dollar implies that it now takes more dollars to buy the same number of pounds sterling.

When a currency depreciates:

• Exports become cheaper for foreign buyers as they need to spend less of their currency to buy the same amount of goods.
• Imports become more expensive for the domestic country as it requires more of its devalued currency to purchase goods from abroad.

With currency depreciation, countries aim to boost their economy by making their exports more competitive internationally. However, the impact on the trade balance depends on how the volume of exports and imports responds to the change in prices, which is where the price elasticity of demand comes into play.

International Trade Economics

International trade economics explores the interchange of goods and services across international boundaries. It assesses the effects of policies and economic conditions on trade flows, balance of payments, exchange rates, and more.

In our textbook example, the U.S. trade balance initially considers the value of exports and imports before currency depreciation. However, when looking at the trade balance post-currency depreciation, we must not just evaluate it in dollar terms but also consider the economic implications of changing demand elasticities.

Effects of Elasticities on Trade Balance

When price elasticities of demand for exports and imports are greater than 1, trade balances tend to improve with currency depreciation because the volume response is strong enough to offset the price effect.

The exercise demonstrates how differing elasticities can lead to different outcomes. If elasticities are less than 1, the volume response to price changes is weak, and a devalued currency may not lead to a better trade balance. This approach to examining trade balance helps learners understand the importance of both currency exchange rates and demand responsiveness in international trade economics.