Currency Pegs, Devaluation, and Comparative Advantage in Trade
Summary
The document discusses how exchange-rate movements can change countries’ relative costs in international trade. In the example, currencies in several Asian economies depreciated during the 1997 crisis while Hong Kong’s currency remained linked to the US dollar. As a result, goods and services priced in the depreciated currencies became cheaper in dollar terms, while Hong Kong prices did not adjust in the same way, potentially reducing Hong Kong’s comparative advantage.
The response distinguishes a loss of relative advantage from the idea that regulation abolishes comparative advantage. It also cautions that exchange rates are influenced by financial flows as well as trade balances. A currency peg can reduce exchange-rate volatility, but it carries associated costs. The document offers a qualitative explanation, not a quantitative model of trade or exchange-rate adjustment.
Key ideas
- Currency depreciation can lower a country’s goods prices when measured in another currency.
- A currency peg can leave domestic prices relatively unchanged while competitors’ prices fall.
- Exchange-rate regulation can affect relative competitiveness without eliminating comparative advantage.
- Financial flows as well as trade balances can influence exchange rates.
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Full text
# the law of comparative advantage and exchange rate # the law of comparative advantage and exchange rate I'm reading Steven N. S. Cheung 's "Economic Explanation" (2001). In vol 2 ch 2 section 2, he mentions Comparative Cost, or "the law of comparative advantage". after quoting the britain/spain clothes/wine example of D. Ricardo, he says, > ... each country has its own comparative advantage, however, this presumes barter or same currency. If there're different currencies and the exchange rate is regulated, in some situation the so-called "Purchasing Power Parity" would not work. ... for example during the 1997 Asian Financial Crisis, almost all Asian countries' currencies depreciated, while HKD was tied to USD, so Hong Kong lost quite some Comparative advantage. What I don't get is, why currency exchange rate regulation would disable the comparative advantage? Currencies are just agent of trading, exchange rate won't disable the comparative advantage, so exchange rate change shall also not disable it, right? ## Answer by SCallan (score 1, accepted) https://quant.stackexchange.com/a/9454 I haven't read the text you mention, but I'd note that the text says that Hong Kong lost some comparative advantage, not that exchange rate regulation disabled the comparative advantage. So after the Asian currency crisis, the dollar price of goods and services from Indonesia was lower because of the currency devaluation whereas the dollar price of those goods and services were unchanged in Hong Kong (excluding price changes from economic impact of the crisis). While trade balances are influential, short and long term financial flows can have an overwhelming impact on exchange rates. Currency regulation can reduce exchange rate volatility, but there are related costs.
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