Advanced Search

The Interest Rate Transmission Mechanism

The Effect of Elasticity: Exports Inelastic, Imports Inelastic

Let us now look at the situation if both the demand for exports and imports was price inelastic and again, assume that the price of both exports and imports had changed by 5%.

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 price by 5% leads to demand for exports falling by 4.5% - as before, export earnings rise.

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 effect of elasticity on imports

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 expenditure on 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 expenditure on imports at a lower price of P2 as less than that earned at the original price of P1.

If the demand for imports, however, is also price inelastic, the fall in price only leads to a relatively small increase in demand and expenditure on imports would actually fall.

In such a situation, the balance of payments would move into surplus (or most likely in reality the deficit would shrink - the balance of payments would 'improve'.

The final effect of a change in the exchange rate as a result of a change in the interest rate will, therefore, depend on a series of complex relationships. Each good and service will have its own price elasticity of demand and in general what we might expect to happen will depend on the overall price elasticities of demand for imports in general and those of exports. We might expect the PED of imports for the UK to be relatively inelastic and the PED for exports to be relatively elastic but that is a considerable generalisation!

Previous: The Effect of Elasticity: Exports Inelastic, Imports Elastic | Index: Interest Rate Index