The Effect of Elasticity on Imports and Exports - The Interest Rate Transmission Mechanism

Image: The price elasticity of demand for copper may be relatively inelastic as the UK depends on importing it to produce products such as copper wire. Copyright: Clay Fowler, stock.xchng

The analysis so far has assumed a simple relationship between the exchange rate, the price of imports and exports and the subsequent demand for imports and exports. In reality, the outcome will be dependent on the effect of the price elasticity of demand for both imports and exports.

The price elasticity of demand (PED) relates proportionate changes in price to proportionate changes in demand. When the exchange rate appreciates or depreciates, the relative prices of imports and exports change.

Image: The price elasticity of demand for cars exported from the UK may be relatively elastic as there are substitutes available elsewhere in the world. Copyright: Camilo Jimenez, stock.xchng

Let's assume that following a rise in the interest rate, the exchange rate has appreciated causing a 5% rise in export prices and a 5% fall in import prices.

Let's further assume that the price elasticity of demand for imports is inelastic at -0.3. This might reflect the fact that the UK, as a small island, is dependent on the import of a variety of raw materials and products which it cannot produce itself. Now let us assume that the price elasticity of demand for exports is elastic at -1.6. This might reflect the fact that we produce goods for which there are substitutes available elsewhere in the world.

First of all, try and work out what will happen to the balance of payments as a result of the assumptions we have now made.

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