Differential Responses to Price and Exchange Rate Influences in the Foreign Trade of Selected Industrial Countries

Abstract

THE speed with which a country's imports and exports respond to exchange rate changes and inflation at home and abroad has important policy implications, but most of the work in this area has been somewhat conjectural. Some writers have pointed out that under a fixed exchange rate system, import and export flows may respond differently to price changes that result from changes in exchange rates than to those resulting from changes in national currency prices of exportable goods. Orcutt (1950, pp. 541-542) noted that trade flows may respond differently to small and temporary changes in prices than to large and fairly permanent changes, such as those caused by a devaluation. Among others, Leamer and Stem (1970, p. 34) interpreted Orcutt's point to mean that adjustment to large price changes stemming from devaluations will be more rapid than adjustment to small changes, but the long-run adjustment would be the same. Junz and Rhomberg (1973, p: 413) adduce reasons why the short-run response to a devaluation could be either faster than the response to a price change, because of the usually larger size of par value changes and the publicity that surrounds them, or slower, because of the large resource shifts necessary to correct large disequilibria that have accumulated over some period of time. The empirical evidence on the above suppositions appears inconclusive. Both T. C. Liu (1954) and Goldstein and Khan (1976) searched for evidence that trade flows responded differently to large than to small price changes. Although some of Liu' s results indicated the presence of a "quantum effect," Goldstein and Khan found that neither the size of the price elasticity nor the speed of adjustment seemed related to the size of the change in prices. Neither of these studies tested exchange -rate effects directly. The only direct test for different responses of trade flows to changes in prices and exchange rates is the 1973 study by Junz and Rhomberg. Using a pooled sample of 13 industrial countries, they concluded that the response to exchange rate changes is very similar to the response to price changes measured in local currency. The Junz-Rhomberg method, however, has certain shortcomings: they measure market-share changes, not trade flows directly; pooling the sample imposes the same parameters on each country in the pool; and measuring partial correlations with price and exchange rate variables lagged one period at a time yields no picture of the length or shape of the full response pattern through time. In this paper we estimate directly price and exchange rate response patterns, using quarterly import and export equations for six major industrial countries during the Bretton Woods period. Our results support two general conclusions: (a) the length of the full response lags on exchange rates during the fixed-rate period tended to be shorter than for changes in prices; and (b) the initial impact of exchange rate changes on trade flows tended to be greater than that of price changes.