The Interest Rate Transmission Mechanism

The Effect of Elasticity: Exports Inelastic, Imports Elastic

Now look at what might happen if the price elasticities were different. Assume that the PED for imports is -1.2 and the PED for exports is -0.9.

Assume that, as before, the price of exports rises by 5% and the price of imports falls, also, by 5%. Again, try and work out the solution before looking at the answer.

The Solution

You can start and stop/reset the animation using the buttons provided or by tabbing to the animation and pressing s to start and q to stop. The main introductory page features further accessibility information on these resources.

The animation shows a graph with price on the vertical axis and quantity on the horizontal axis. The graph depicts the demand for exports with the demand curve sloping downwards from left to right drawn relatively steep. A price of P1 is marked on the vertical axis and the related quantity of exports demanded at this price of Q1. A shaded box under the demand curve linking these two points illustrates the total revenue earned from exports. The animation shows the price increasing from P1 to P2 and is so doing the effect on the revenue earned as the area under the curve moves to reflect the changes. The end of the animation has the total revenue earned from exports at a higher price of P2 as more than that earned at the original price of P1.

• The rise in the price of exports by 5% will now result in a fall in demand by 0.9 x 5 = 4.5%
• The % change in demand is less than the % change in price - export revenue will rise

We would have expected the demand for exports to fall and maybe we would have assumed the amount earned from exports would fall but because demand for exports is relatively inelastic, revenue has actually risen despite the rise in price.

You can start and stop/reset the animation using the buttons provided or by tabbing to the animation and pressing s to start and q to stop. The main introductory page features further accessibility information on these resources.

The animation shows a graph with price on the vertical axis and quantity on the horizontal axis. The graph depicts the demand for imports with the demand curve sloping downwards from left to right drawn relatively steep. A price of P1 is marked on the vertical axis and the related quantity of imports demanded at this price of Q1. A shaded box under the demand curve linking these two points illustrates the total revenue earned from imports. The animation shows the price falling from P1 to P2 and is so doing the effect on the revenue earned as the area under the curve moves to reflect the changes. The end of the animation has the total revenue earned from imports at a lower price of P2 as more than that earned at the original price of P1.

• The fall in the price of imports will lead to the demand for imports rising by 1.2 x 5 = 6%
• The % change in demand is greater than the % change in price - expenditure on imports will rise

Assuming the rise in the expenditure on imports in greater than the rise in the revenue earned from exports, the balance of payments will move into deficit (or the deficit will get wider).

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