The Role of the Exchange Rate in the Adjustment Process in a Partial Equilibrium Framework
As was clarified in Sect. 11.4, the balance of payments considered here is the balance on goods and services, and its adjustment through exchange-rate changes relies upon the effect of the relative price of domestic and foreign goods1 (considered as not p
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12.1 Introduction As was clarified in Sect. 11.4, the balance of payments considered here is the balance on goods and services, and its adjustment through exchange-rate changes relies upon the effect of the relative price of domestic and foreign goods l ( considered as not perfectly homogeneous) on the trade flows with the rest ofthe world. This relative price, or (international) terms of trade is defined by the ratio (12.1 )
where Px represents export prices 2 (in terms of domestic currency) , Pm represents import prices (in terms of a single reference foreign currency), and r is the exchange rate of the country under consideration. The presence of r is necessary owing to the fact that Px and Pm are absolute prices expressed in different currencies, and must be made homogeneous to permit comparisons. From the point of view of the consumer, n represents the relative price of foreign and domestic goods on which - in accordance with standard consumer's theory demand will depend. From the point of view of the country as a whole, n represents the amount of imports that can be obtained in exchange for a unit of exports (or the amount of exports required to obtain one unit of imports) 3. Therefore an increase in n is also defined as an improvement in the terms of trade, as it means that a greater amount of imports can be obtained per unit of exports (or, equivalently, that a smaller amount of exports is required per unit of imports). It should also be noted that it is irrelevant whether n is defined as above or as 1
-P r x
n=--, Pm
(12.1.1 )
1 For brevity we shall henceforth use goods in the broad sense (i.e., including services), and, similarly, trade flows in the sense of flows of goods and services. 2 Prices - both export and import prices - will usually be measured by index numbers. 3 This has the same meaning as the term-of-trade notion defined in the pure theory of international trade. See Part I, passim.
G. Gandolfo, International Economics II © Springer-Verlag Berlin Heidelberg 1987
12.1 Introduction
11.79
since the two formulae are mathematically equivalent. From the economic point of view, it is easy to see that in (12.1 ) domestic and foreign prices have been made homogeneous by expressing the latter in domestic currency before taking their ratio, whilst in (12.1.1) they have been made homogeneous by expressing the former in foreign currency; the ratio is of course the same. The terms of trade 11: can therefore serve both the domestic and the foreign consumer for the relevant pricecomparison. The domestic consumer, as mentioned above, will compare the price of domestic goods (identical to those exported) with that of imported goods by translating this price into domestic currency terms (in practice this will be done by the importer) , for example (if the home country is the USA), US$ 2.5 (price of a certain domestic commodity) with US$ (0.125 x FF 10) = US$ 1.25, i.e. the equivalent in dollars of a French commodity costing ten French francs per unit, given the exchange rate of 0.125. The French consu
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