Robert J. Gordon, Macroeconomics, 10 th edition, 2006, Addison-Wesley

1. Robert J. Gordon, Macroeconomics, 10th edition, 2006, Addison-Wesley Chapter 6: International Trade, Exchange Rates, and Macroeconomic Policy

2. An economy with positive NX must lend to foreigners (lending or foreign investment) while an economy with negative NX must borrow from foreigners. • We also learned that government budget deficit can be financed partially or totally by foreign borrowing depending on the size of the economy. • A small open economy can borrow the entire deficit without crowding out, while a large economy influences world interest rates and thus crowd out private investment. • The trilemma • Is the impossibility to maintain simultaneously : • Independent control of domestic monetarypolicy • Fixed exchange rates • Free flowsof capital with other nations.

3. The current account and the balance of payments (BOP) • Current account equals NX plus two additional components (are not part of GDP); • Net flow of international investment income, these do not represent production in the domestic economy. They are added to the Gross National product not GDP. • Net international transfers, e.g., remittances, they are also excluded from GDP. • The current account and the capital account • BOP is divided into two parts. • The current account, which records all types of flows for current income and output.

4. The capital account, records purchases and sales of foreign assets by citizens and purchases and sales of foreign assets by foreigners. • BOP outcome • When total credits are greater than debits, the country is said to run a BOP surplus, i.e., it will receive more foreign money for credits than domestic money it pays for debits. The opposite is called a BOP deficit. • The overall BOP surplus or deficit is the sum of the current account and capital account. Current account balance + capital account balance = BOP outcome.

5. Foreign borrowing and international indebtedness • A current account deficit must be financed either by borrowing from foreign firms, households and governments. IT must increase its indebtedness. • A current account surplus implies a reduction in indebtedness or an increase in the countries net investment surplus. Change in international investment position = current account balance

6. Exchange rates • The price of one currency in terms of another is called the foreign exchange rate. It can be shown in two ways, • The dollar per yen $ 0.009437 per yen. • The yen per dollar yen 106.00 per $. • Note: the two rates are equivalent (1/106 = .009437) • But it is conventional (in USA) to express the foreign exchange rate as the foreign currency per dollar, i.e., Yen 106.00 per $. Except for the British pound and the euro. • Changes in exchange rates • A higher number means that the dollar experiences an A lower number indicates a depreciation. ¥/$ decreases from 106.25 to 1.06 and the €/$ rate declines from .7798 to .7769, indicating a depreciation of the dollar against the euro.

7. Sometimes the depreciation is high over time, e.g., the €/$ rate. • The market for foreign exchange • Tourists when they travel to any country they need to exchange their currency into that country’s currency • Banks that have too much of too little of foreign money can trade for what they need in the foreign exchange market. • The results of trading in foreign exchange are illustrated for four foreign nations.

8. Figure 6-2 Foreign Exchange Rates of the Dollar Against Four Major Currencies, Quarterly, 1970–2005 (1 of 2)

9. Figure 6-2 Foreign Exchange Rates of the Dollar Against Four Major Currencies, Quarterly, 1970–2005 (2 of 2)

10. The factors that determine the foreign exchange rate and influences its fluctuations can be summarized on the a demand supply diagram like those used in figure 6-3 • Why people hold dollars and Swiss Francs • People in many countries may find dollars or Swiss Francs more convenient or safer than their own currencies. Sellers in these countries also accept dollars and Swiss Francs. • A change in preferences of people will shift the demand curve for dollars and thus exchange rates. • Demand for currencies is driven from the demand for its imports and capital outflows. It also has a supply driven from the demand of its exports and capital inflows.

11. Figure 6-3 Determination of the Price in Swiss Francs of the Dollar

12. What explains the slopes of the demand and supply curves for dollars in figure 6-3. D0 will be vertical if the price elasticity for Swiss demand for US imports is zero. • If price elasticity is negative the demand curve will be negatively slopped. Look at figure 6-3 • The analysis for S0 is different. S0 will be vertical if the price elasticity of the US demand for Swiss imports is -1 (since revenues in foreign exchange will be the same with changes in exchange rate). only if the price elasticity is greater than unity (in absolute terms) S0 will be positively slopped. • How governments can influence foreign exchange rates. • If exchange rate of the dollar is higher than market equilibrium, people must accept a lower rate for it to induce foreigners to accept it.

13. But some countries may prevent the depreciation of the dollar, because it will make their exports expensive to sell. • How they do that? Look at figure 6-3, the Switzerland government can purchase the distance AB to maintain the dollar appreciated at a rate of CHF 2.00/$. • Real exchange rates and purchasing power parity. • The real exchange rate (e) is equal to the nominal rate (e’) adjusted for differences in inflation rates between the two countries. e = e’ × p/pf • Suppose that in 2005 e and e’ for the Mexican peso is 10/$, the price level in the two countries is 100 10 pesos/$ = 10 pesos × 100/100

14. Assume that in 2006 pf is 200 while the US price remains fixed at 100 5 pesos/$ = 10 pesos × 100/200 • The dollar experienced a real depreciation against the peso. If the opposite is true the dollar would experience a real appreciation. • Countries experience high inflation, find their nominal exchange rate depreciates, while their real exchange rate remains roughly unchanged. • Suppose that e jumps from 10 to 20 pesos/$ (nominal depreciation), hence; 10 = 20 × 100/200 no real depreciation • Countries with rapid inflation usually witness nominal depreciation without any major change in real exchange rate.

15. We care about e more than e’, because it is a major determinant of NX. When e appreciates M become cheaper an X become expensive, business profits go down and unemployment increases and vice versa. • The theory of purchasing power parity • PPP states that in open economies prices of traded goods should be the same everywhere, therefore e should be constant (1); 1 = e’ × p/pf • Swapping the left hand side and solve for e’ e’ = pf/p

16. PPP and inflation differentials ∆e’/e’ = pf - p • Growth rate of e’ = growth rate of pf – p. the term ∆e’/e’ is positive when there is an appreciation of a currency. The term pf – p is the inflation differential between foreign and domestic inflation. • Why PPP breaks down • New inventions • Discovery of new deposits of raw materials • Higher demand for a currency e.g., to deposit in banks. • Non-traded goods • Government policy e.g., subsidization.

17. Exchange rate systems • Flexible exchange rate system • Exchange rate is free to change, a depreciation and appreciation would correct for deficit or surplus of BOP. • Fixed exchange rate system • The central bank agreed to finance any surplus or deficit in BOP. To do so CB maintains foreign exchange reserves and stands ready to buy or sell dollars as needed to maintain the foreign exchange rate of its currency.

18. Determinants of net exports • Net exports and the foreign exchange rate • Effect of real income. NX = NXa – nxY • NXa is the autonomous component of net exports (determined mainly by foreign income). • nx is the fraction of real income spent on imports. During expansions imports would be high (NX will be low) while during recessions imports will be low (NX will be high). • Effect of the foreign exchange rate • When exchange rate appreciates X tends to decline and M tend to increase, NX go down. To reflect this negative relationship NX = NXa – nxY – ue. e.g., NX = 1000 - .1Y – 2e

19. Suppose that Y = 8000, e=100 NX would be zero. An appreciation in e to 150 would reduce NX to -100. • The real exchange rate and interest rate • The demand for dollars and the fundamentals • The demand for dollars is to buy American products or assets. Why the outside world hold dollars, The fundamentals include changes in the world wide to buy American goods, e.g., an invention of new products in USA (+ve), or outside USA (-ve), • But fundamentals change slowly, therefore they are not responsible for volatile changes in e. sharp ups and downs in e are due to the desire of foreigners to buy American securities. If American securities are attractive (+ve effect), or foreign securities became more attractive (-ve effect). Relative attractiveness depends on (average) interest rate differentials.

20. (r-rf) if r > rf US securities would be more attractive, and vice versa. a rise in US interest should thus cause an appreciation and vice versa. • Interest rates and capital mobility • Interest rates affect e through capital mobility. • Perfect capital mobility if residents of one country can buy any desired assets with very low commissions and fees, interest rates would be tightly linked. If rf increases, the demand for foreign securities increases, which raises r relative to rf. • Any event the a country tends to change r relative to rf will generate a huge capital movement that will soon eliminate the (r-rf), e.g., capital expansion lowers r and causes capital outflows which bring r back to its original level.

21. The tow adjustment mechanisms: fixed and flexible rates • Perfect capital mobility implies that fiscal and monetary policies do not affect domestic interest rates r. • With fixede, a stimulative monetary policy will not reduce domestic r but instead causes will lead the country to a loss of international reserves as the capital account causes a BOP deficit. • In a pure flexiblee, monetary policy stimulus generates excess supply of money and lowers e till supply and demand are in balance again. • In short underperfect capital mobility both monetary and fiscal policy lose control over r. under fixed e monetary stimulus causes a loss of reserves, and fiscal stimulus causes reserves to increase. • Under flexible e monetary stimulus causes depreciation and fiscal stimulus causes an appreciation, and vice versa.

22. The IS-LM model in a small open economy • The assumption of perfect capital mobility introduces a new assumption in the IS-LM that (r-rf) is zero. • Any small change in r caused by shifts in monetary and fiscal policy will generate capital flows that will quickly bring the domestic interest rate into line with the unchanged foreign interest rate. • The BP schedule • Under perfect capital mobility BOP can be in equilibrium only at a single r equal to rf. Any higher interest rate will lead to unlimited capital inflows causing a huge BOP surplus. Any lower r will lead to unlimited capital outflows causing a huge BOP deficit. The BOP is in equilibrium only along the BP line, capital and current accounts are in equilibrium. (figure 6-8)

23. The analysis of fixed exchange rates • We will examine the effects of monetary and the fiscal expansion. We will assume that price level is fixed. • Monetary expansion • Figure 6-8, if real money supply increases LM shifts to the RHS, while IS is assumed to be unchanged, r will go down to r1. This generates huge capital outflows and loss of international reserves. To prevent such movements, the CB must boastinterest rate back to r by reversing the monetary stimulus. LM shifts back to LM0 and the economy returns back to E0. Monetary policy is impotent. • Fiscal expansion • With fixed exchange rates, the only way domestic policy makers can alter the real income is to use fiscal policy

24. Figure 6-8 Effect of an Increase in the Money Supply with Fixed Exchange Rates

25. Figure 6-9, a fiscal expansion shifts IS to the RHS which moves the economy to E2, r increases to r2, leading to huge capital inflows. International reserves increase and the since e is fixed, CB must increase MS until r returns to its initial level. • In a closed economy without capital inflows, the economy would move to point E3. • Perfect capital mobility with fixed r makes fiscal policy very effective. • Analysis with flexible exchange rates • The CB does nothing to prevent an appreciation or depreciation. Monetary policy becomes very effective while fiscal policy becomes ineffective.

26. Figure 6-9 Effect of a Fiscal Policy Stimulus with Fixed Exchange Rates

27. Figure 6-10. Note that the currency depreciates whenever the economy moves below the BP (increases NX and shifts IS to the RHS) and appreciates whenever it moves above the BP line (reduces NX and shifts IS to the LHS). • Monetary expansion • Shifts the LM to the RHS, capital outflows lead to a depreciation and NX increase such that IS shifts to IS1, till the economy arrives to E3, where the economy and BOP are in equilibrium at higher Y. • Fiscal expansion • Shifts IS to the RHS, capital inflows lead to an appreciation and NX decreases. IS falls back to its initial position E0.

28. Figure 6-10 Effect of a Monetary and Fiscal Policy Stimulus with Flexible Exchange Rates

29. LM does not shift and domestic crowding out is replaced by international crowding out which is complete in this case. The twin deficits are identical; trade deficit is the fiscal deficit. • Notes: • With fixed exchange rates, fiscal policy is highly effective and CB is forced to accommodate fiscal policy actions. Monetary policy is impotent. • With flexible exchange rates, monetary policy is highly effective, CB can stimulate the economy by causing the exchange rate to depreciate. Fiscal policy is impotent and international crowding out is complete.

30. Capital mobility and exchange rates in a large open economy • How a large economy differs from a small open economy • A large economy has a substantial control over its r, capital flows are not substantial to change r to equate rf. Capital mobility is imperfect to eliminate (r-rf). • Figure 6-11, for a small open economy BP is horizontal. In a large economy capital account surplus occurs with r is high, and a deficit occurs when r is low. • For a BOP balance any surplus in capital account must be offset by a deficit in current account which requires a high level of income, e.g., at point C. • For a BOP balance any deficit in capital account must also be offset by a surplus in current account caused by lower income e.g., at point A. BP slopes up for a large economy because capital mobility is positively related to r.

31. Figure 6-11 The BP Line in a Small and Large Open Economy Capital account surplus Must be with a C. account Deficit (needs large income Capital account deficit Must be with a C. account surplus (needs small income

32. Monetary and fiscal policy with fixed and flexible exchange rates • With fixed e monetary policy is impotent in a large economy, while fiscal policy is highly effective, but some what less than the case of a small open economy, since its stimulus is divided between an increase in real income and domestic r instead of being entirely directed toward an increase in real income. • With flexible e fiscal policy is impotent in a large economy, while monetary policy is highly effective, but since higher income must be accompanied by higher r (BP is upward slopping), there is some crowding out of domestic expenditures, and this must be offset by a larger stimulus to NX than in a small open economy requiring an even larger depreciation. See the following summary.

33. Summary of Monetary and Fiscal Policy Effects in Open Economies

35. Table 6-1 The U.S. Balance of Payments, Selected Years

36. Figure 6-1 The U.S. Current Account Balance and Its Net International Investment Position, 1975–2004

37. Table 6-2 Daily Quotations of Foreign Exchange Rates

38. Figure 6-2 Foreign Exchange Rates of the Dollar Against Four Major Currencies, Quarterly, 1970–2005

39. International Perspective Big Mac Meets PPP

40. Figure 6-4 Nominal and Real Effective Exchange Rates of the Dollar, 1970–2004

41. Figure 6-5 Foreign Official Holdings of Dollar Reserves as a Percent of U.S. GDP

42. Figure 6-6 U.S. Real Net Exports and the Real Exchange Rate of the Dollar, 1970–2004

43. Figure 6-7 The U.S. Real Corporate Bond Rate and the Real Exchange Rate of the Dollar, 1970–2004