Question

During the 1997–1998 Asian crisis, the exchange rates of Asian currencies declined substantially against the dollar, which caused the prices of Asian products to decline from the perspective of the United States and many other countries. Consequently, the demand for Asian products increased and sometimes replaced the demand for products of other countries. For example, the weakness of the Thai baht during this period caused an increase in the global demand for fish frome Thailand and a decline in the demand for similar products from the United States (Seattle). Therefore, we can conclude that a strong local currency is expected to reduce the current account balance if the traded goods are price-inelastic (not sensitive to price changes).

Do you agree with this statement?

Please comment on effects of price sensitivity on the movement of exchange rates in both importing and exporting countries.

Answer 1

Therefore, we can conclude that a strong local currency is expected to reduce the current account balance if the traded goods are price-inelastic (not sensitive to price changes).

Do you agree with this statement?

No, the statement is largely incorrect. In fact it's the other way round.

A strong local currency is expected to reduce the current account balance if the traded goods are price elastic (sensitive to price changes).

Any country's local currency can be valued in terms of currencies of other countries. This is achieved through exchange rate.

Now assume, the local currency strengthens with respect to foreign currencies. This will make the export from this country to other importing countries expensive. Thus the demand for goods will decrease. Similarly, the other way round. If the local currency weaken in comparison to the foreign currencies, the export from the country to the other importing countries will become cheaper. Thus the demand for goods will increase. Thus, a strong local currency is expected to reduce the current account balance only if the traded goods and services are price elastic and their demand is sensitive to price changes. If the traded goods and services are price inelastic as stated in the given question, the strengthening or weakening of the local currency will have no impact or a very small impact on the current account balance.

hence, we disagree with the statement.

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Please comment on effects of price sensitivity on the movement of exchange rates in both importing and exporting countries.

Movement of exchange rates in both importing and exporting companies are dependent upon price sensitivity of good and services traded. Let's look at this example:

Let's assume two countries A and B with currencies C_A and C_B. Here A is the exporting country and B is the importing country. If there is a depreciation in the value of C_A, let's examine the impact under the following two situations:

1. If goods and services traded by the exporting country A are say price inelastic or price insensitive, then the decline in their foreign prices will have a very small increase in their demand in the importing country B. The small increase in demand will not be able to change the exchange rates much.
2. If goods and services traded by the exporting country A are say price elastic or price sensitive, then the decline in their foreign prices will have a relatively larger increase in their demand in the importing country B. This increase in demand will then shift the demand curve outward and slowly increase the foreign price back to equilibrium level. This in turn will push the exchange rate back to equilibrium levels.

Thus, movement of exchange rates in both importing and exporting companies are dependent upon price sensitivity of good and services traded.