International Finance Discussion Papers

Exchange Rates, Prices, and External Adjustment in the United States and Japan Peter Hooper and Jaime Marquez 1993-456  (October 1993)

Abstract:  This paper studies the responsiveness of external balances--trade volumes and prices--to changes in exchange rates. Our objectives are twofold: to provide an analytical review of the literature in this area and to assess the influence of exchange rate movements on external adjustment in the two countries whose external imbalances have dominated all others over the past decade, the United States and Japan.

We find that the conventional partial-equilibrium model of the trade balance has performed generally quite well in predicting the path of the U.S. and Japanese external balance over the past decade. Second, in a partial�-equilibrium setting, exchange-rate changes have a significant and substantial influence on movements in external balances. This view is supported by a massive empirical literature focusing on the estimation of price elasticities in trade, by casual inspection of the data, and by our own econometric estimates of trade elasticities. Third, Japanese real trade flows appear to be considerably less responsive to exchange-rate changes than U.S. real trade flows. This asymmetry can be traced only in part to evidence that Japanese exporter and U.S. exporters differ in the extent to which they pass-through exchange-rate changes to the foreign-currency prices of their exports. Finally, Japanese exporters tend to pass-through significantly less of any given percentage exchange rate change than U.S. exporters. Part of that difference is attributable to the greater sensitivity of Japanese production costs to exchange rate changes--Japanese export prices fall when the yen appreciates, partly because the prices of petroleum and other imported raw materials in Japan tend to fall in proportion to the appreciation of the yen.

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