Examining Currency Wars Using a Kinked Demand Curve Model

Kinked DemandCompetitive currency wars follow the same general course as a gasoline station price war. Consumers will flock to the lowest price, and the moment’s price leader will serve at a loss in hopes of making up for it in other lines of business. More often than not, competing parties will proceed to undercut each other’s prices until they reach a market-breaking point, and the costs of business force the competitors to bring their prices back up to their equilibrium point.

This sort of situation has been modeled by economists as being almost exclusive to oligopolistic type industries, and has been studied to provide us with a variety of insights about how it is that a variety of fascinating situations can arise in the business environment. However, most relevant to our interests today are how it is that the oligopolist’s kinked demand curve (as demonstrated in the above example of a gas station) is representative of a competitive currency environment, also known as a currency war.

The kinked demand curve model illustrates how it is that exporting countries in competition cannot benefit from taking on policies that increase the value of their currency, because its importing customers would shortly switch over to competing countries to make up for the price difference. The reasoning behind this is that the goods being exported are generally interchangeable (ie. a barrel of oil is a barrel of oil), and that the importing countries are only really interested in getting the best price possible for their goods. The end result is that the real prices of a good will generally stay the same, because a country cannot increase their selling price without being undercut, but can take on a great deal more business for every dollar that they reduce their real price.

However, because it is so economically beneficial to provide a low price, the competition in the markets will drive the prices of goods down to the most efficient point (ie. the point at which vendors cannot afford to reduce their prices any more). Essentially, this all just means that it is worth more in terms of profits for an exporting country to reduce the price of their goods than it is to increase their price. This then leads us to an interesting situation where we can see how it is that exporters don’t actually sell goods as much as they sell a currency, and its underlying value as a function of inflation.

Since an importing country is going to place the same price (in terms of their domestic currency) on an imported good, in terms of real value, regardless of its cost currency, exporting countries can only really compete with each other through the value of their respective currencies. This is because of the way in which providing a direct discount on the sale-price of the commodity in question would create an immediate loss without benefit for the exporter, and eventually drive it out of business.

However, by discounting the value of its currency, a country is able to empower its importing customers to purchase more of its product, which will actually create more demand for the currency as a result of more business. As the importing countries purchase up the deflated currency, they are actually supporting the inflationary policy, which can then be used to subsidize the exporting companies in a way that allows them to continue exporting their goods at an artificial profit.

With respect to the kinked demand curve model, we can look at the above scenario to see how it is that exporting countries might benefit from reducing the value of their currencies. However, because of the way in which the real value of the exported good is still all the same to the importing country, it is important to remember how it is that relative-value comes into place. Specifically, exporting countries that are both deflating the value of their own currencies at the same time and rate will simply be remaining competitive. This begins to illustrate how it is that a currency war can be destructive to the economies of exporting countries, as they must each reduce their prices to the point of breakage.

Despite the damage that each incremental drop in currency value might invoke, the kinked demand curve model shows us how it is that the detriments of leaving a currency price above that of its competition is worse than those associated with an inflationary monetary policy. Essentially, it is less damaging to an economy to continue deflating the value of its currency than it is to losing the exports it would gain or maintain with deflation.

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