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INTERNATIONAL MONETARY THEORY

INTERNATIONAL MONETARY THEORY. BOP ADJUSTMENTS LECTURE 2. ADJUSTMENT MECHANISMS. TWO DISTINTIC APPROACHES: Automatic mechanisms which suggest that there is no need to worry about BOP deficits, as BOP would adjust itself automatically

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INTERNATIONAL MONETARY THEORY

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  1. INTERNATIONAL MONETARY THEORY BOP ADJUSTMENTS LECTURE 2

  2. ADJUSTMENT MECHANISMS TWO DISTINTIC APPROACHES: • Automatic mechanisms which suggest that there is no need to worry about BOP deficits, as BOP would adjust itself automatically • Policy-induced adjustments in BOP are warranted as automatic mechanisms do have adverse side effects and limitations

  3. AUTOMATIC MECHANISMS: CLASSICAL(David Hume) • Classical model assumes metallic (gold/silver) currency standard, full employment, flexible prices, price-elastic demand , inelastic supply • Inflow of gold/silver into Surplus Country results in: increased money supply, higher prices, increased imports, reduced exports • Outflow of gold/silver from Deficit Country leads to: reduced money supply, lower prices, increased export, reduced imports • Adjustment is through changes in prices and costs, with unchanged output or employment *[Demand-side explanations]

  4. EMPIRICAL FINDINGS(Taussig, Williams, Viner) • Empirical studies into the balancing process under fixed and flexible exchange rates • Evidence: adjustments too fast and too smooth, despite little gold movement or price change and price-inelastic demand • The puzzle cast serious doubts on the classical theory, but was not resolved until the advent of the Keynesian model

  5. AUTOMATIC MECHANISM: KEYNESIAN MODEL • Smooth and rapid balancing process (without much price change or price-elastic demand) is explained in terms of changes in output and employment • Surplus (increased exports) entails increased output and employment, leads to increased income and increased imports • Deficit (reduced exports) results inlower output, employment, income and imports *[Supply-side explanations]

  6. KEYNESIAN MECHANISM LIMITATIONS * It provides only a partial explanation: (1) BOP surplus is part of the savings; as income rises so will savings (domestic and external). Surplus may fall but need not disappear (2) Hike in interest rate by CB may dampen output and employment and impede BOP adjustment. * Extent of adjustment depends on the natureof disturbance (speculative capital transfers have little impact on output and employment)

  7. ABSORPTION MODEL(Alexander) • BOP is viewed as a relation between aggregate receipts and aggregate expenditures: Y = C+I+(X-M); (X-M) = Y-(C+I) • Deficit leads to exchange of domestic currency into foreign currency; reduced cash balances lead to tighter credit and lower expenditures and imports. So, deficit disappears! • Surplus leads to exchange of foreign currency into local currency, increased cash balances, easiercredit and increasedexpenditures and imports.Thus, surplus goes away!

  8. AUTOMATIC ADJUSTMENTS THROUGH EXCHANGE RATE CHANGES • BOP adjusts itself through flexible exchange rates • BOP Deficit causes home currency todepreciate, making imports more expensive and exports cheaper: X would rise and M would fall. Thus, the deficit problem is solved! • BOP Surplus causes home currency to appreciate, rendering imports cheaper and exports more expensive: X would fall and M would rise. Hence, surplus does not last long!

  9. WHAT’S WRONG WITH AUTOMATIC BALANCING MECHANISMS? Conflict betweeninternalstability and externalequilibrium • Classical: external equilibrium through domesticprice instability • Keynesian: external balance through domesticups and downs in output and employment • Thus, something must give in! A question of trade-off. • But, countries want stability in all: prices, output and employment: hence the call for policy initiatives

  10. WHAT’S WRONG WITH ….(cont’d) • Absorption mechanism would work only if CB would not intervene through bank rates, allows reserves to rise and fall, and has large reserves (external balance through unstable reserves!) • Flexible exchange rates would correct BOP imbalances if demand for X and M are price elastic (external balance through volatile exchange rates!) • Again, there are policy conflicts and trade-off: there will be external equilibrium, but no stable reserves or stable exchange rates. Stability in all is desired

  11. POLICY-ORIENTED APPROACH(Meade & Tinbergen) Number of policy objectives must equal number of policy instruments • 2 objectives (internal & external balance); 2 instruments (income & price adjustments) • Income/expenditure adjustments (monetary & fiscal) • Price adjustments (exchange rates & wages) • Both tools will have to be used simultaneously • The use of only one will cause policyconflicts

  12. POLICY CONFLICTS • Case 1: BOP deficit + excess supply of domestic goods;expenditure adjustment only • External balance calls for a decrease in expenditure , while internal balance warrants an increase • Case 2: BOP deficit + excess domestic demand (inflation); exchange rate adjustment only • External balancecalls for depreciation; internal balance demands an appreciation

  13. POLICY MODEL • In a closed economy, IS curve denotes S=I; LMcurve denotes eqbm in money market (d=s) • In an open economy, real-sector market eqbm is shown by IXG=SMT (injections=leakages) • LM curve for the money market applies to open economy as well • 3rd market in an open economy (forex market): BB line shows external balance (surplus above BB line; deficit below BB line)

  14. POLICY MODELFixed Exchange Rates [Ref: Fig 1] • Start with internal equilibrium with full employment Y at Point A with BOP deficit • Equilibrium in all 3 markets at Point A*: How? • IXG-SMT curve shifted byexpansionary fiscal policy via reduced tax and/or increased govt exp. • LM curve shifted by tight money policy via reduced money supply/increased interest rate *Note: 2 policy goals, 2 policy instruments *Result: full employment Y, BOP balance, higher interest rate.

  15. Figure 1(Fiscal Expansion + Tight Monetary Policy) B LM' i LM A* i2 A i1 IXG' – SMT' IXG - SMT B Full employment Y* Y

  16. Figure 1A • 2 objectives • int balance with full employment • external balance • 2 instruments • fiscal policy • monetary policy

  17. POLICY MODEL Flexible Exchange rates [Ref: Fig 2-3] • r replacesiin the vertical axis • LMcurve can’t be shown asihas disappeared • IXG-SMTcurve steeperthan BB line • At Point E: ext balance but no full employment • AtE* [Fig 2] both ext and int balance (fiscal expansion + exch rate depreciation) • Monetary easing shiftsIXG-SMTto right and BB to left; eqbm atE* with exch rate depreciation [Fig 3]:2 instruments (monetary & foreign exch)

  18. Figure 2(Fiscal Stimulus + XR Depreciation) IXG - SMT r IXG' – SMT' B E* r2 E r1 E' B Y Y1 Y* Full employment

  19. Figure 2A • 2 objectives • int balance with full employment • external balance • 2 instruments • fiscal policy • exchange rate policy

  20. Figure 3(Monetary Easing + XR Depreciation) IXG - SMT IXG' – SMT' r B' E* r2 B E r1 B' B Y Y1 Y* Full employment

  21. Figure 3A • 2 objectives • int balance with full employment • external balance • 2 instruments • monetary policy • exchange rate policy

  22. SUMMING UP • Persistent BOP imbalance suggests serious malaise which needs to be corrected by policy measures; automatic mechanisms inadequate • Perfect balance is not feasible. Policy objective should be to reduce imbalance to sustainablelevels and not to eliminate it altogether • One country’s deficit is another’s surplus, sothe burden of adjustment must rest on both • Bilateralbalance doesn’t matter in economic terms; multilateralbalance does

  23. DEVALUATION ANAYSIS

  24. THE ROLE OF EXCHANGE RATE • The Classical Model is no longer relevant: No gold standard, inflexible prices, no full employment • Fluctuations in output and employment not acceptable even to Keynes himself! • Most countries do not have enough reserves to allow absorption mechanism to work • Hence the focus on exchange rates to solve BOP imbalances

  25. CAN DEVALUATION IMPROVE TRADE BALANCE? * ELASITICITY APPROACH Marshall-Learner Condition: sum of the elasticity of demand for M & Xmust exceed unity(given elastic supply) for devaluation to improve balance of trade * ABSORPTION APPROACH Efficacy of devaluation depends on the net impact on output (Y) and absorption (C+I)

  26. ELASTICITY APPROACH *A 10% devaluation will raise M prices at home (equivalent to a 10% upward ‘shift’ in Sm) *A 10% devaluation will lower X prices abroad (equivalent to 10% ‘shift’ in Dx) • Pre-devaluation M = Pm1.Qm1 • Post-devaluation M’= Pm2.Qm2 • Pre-devaluation X = Px1.Qx1 • Post-devaluation X’ = Px2.Qx2

  27. ELASTICITY APPROACH (cont’d)[Ref: Fig 4] • Clearly Px2.Qx2 > Px1.Qx1 • If Dm is price elastic, Pm2.Qm2 < Pm1.Qm1 (in which case, trade balance would improve) • If Dm is price-inelastic, Pm2.Qm2 > Pm1.Qm 1 (in which case, trade balance may deteriorate) • BOT would improve after devaluation, ifsum of the price elasticity of Dx and Dm exceeds 1 (Marshall-Learner Condition)

  28. Figure 4: 10% Devaluation Price of imports (m) Price of exports (x) Home Currency S'M Home Currency SX SM Pm2 Px2 Pm1 Px1 D'X DX DM Qm1 Qty of m Qx1 Qty of X Qm2 Qx2 Px2 . Qx2 > Px1 . Qx1 Pm2 . Qm2 > or < Pm1 . Qm1 ? BoT increase or decrease ?

  29. ELASTICITY APPROACH (cont’d)[Ref: Fig 5] • Case 1: assume (a) price-elastic demand for M (e>1); (b) perfectly price-inelastic demand for X (e=0); (c) BOT eqbm. i.e. to start with Pm1.Qm1=Px1.Qx1; (d) 10% devaluation Pm2.Qm2 < Pm1.Qm1 Px2.Qx2 = Px1.Qx1 Clearly Px2.Qx2 > Pm2.Qm2 (BOT Surplus) *Note: Sum of demand elasticity > 1

  30. Figure 5: 10% Devaluation (Case 1) Price of imports (m) Price of exports (x) Home Currency S'M Home Currency SX SM = Px2 Px1 Pm2 Pm1 DM DX Qm1 Qx2 Qx1 = Qty of m Qty of X Qm2 Pm2.Qm2 < Pm1.Qm1 (em > 1) m , x unchanged so BoT  Px2.Qx2 = Px1.Qx1 (eX = 0) Sum of demand elasticity > 1

  31. ELASTICITY APPROACH (cont’d)[Ref: Fig 6] • Case 2: assume (a) perfectly price-inelastic demand for M (e=0); (b) price-elastic demand for X (e>1); (c) BOT eqbm: (d) 10% devaluation • Pm1.Qm1 = Px1.Qx1 Pm2.Qm2 > Pm1.Qm1by 10% Px2.Qx2> Px1.Qx1 by more than 10% Clearly Px2.Qx2 > Pm2.Qm2 (BOT Surplus) *Note: Sum of demand elasticity exceeds 1

  32. Figure 6: 10% Devaluation (Case 2) Price of imports (m) Price of exports (x) Home Currency Home Currency S'M SX SM Px2 Pm2 Px1 Pm1 D'X DX DM = Qm2 Qm1 Qx2 Qx1 Qty of m Qty of X Pm2.Qm2 > Pm1.Qm1 (by 10%) Px2.Qx2 > Pm2.Qm2 (BoT) Px2.Qx2 > Px1.Qx1 (by >10%) Sum of demand elasticity > 1

  33. ELASTICIY APPROACH (cont’d)[Ref: Fig 7] • Case 3: Assume (a) perfectly inelastic supply of M, (b) price-elastic demand for M (e>1), (c) perfectly inelastic supply of X, and (d) price-elastic demand for X (e>1) Pm2.Qm2 = Pm1.Qm1 (no change) Px2.Qx2 > Px1.Qx1 by 10% So, BOT improves. Again, sum of demand elasticity exceeds 1.

  34. Figure 7: 10% Devaluation (Case 3) Price of imports (m) Price of exports (x) Home Currency Home Currency SX SM Px2 Pm1 = Pm2 Px1 DM D'X DX = Qm2 Qm1 Qx1 = Qx2 Qty of m Qty of X Pm2.Qm2 = Pm1.Qm1 (no change) therefore (BoT ) Px2.Qx2 > Px1.Qx1 (by10%) Sum of demand elasticity > 1

  35. ABSORPTION APPROACH • Functional identity: Y = C+I + (X-M) ………….[1] • Rearranging: (X-M) = Y-(C+I)……………………..[2] • Simplifying/substituting: B = Y-A ………………[3] • dB = dY- dA………………………………………………[4] • Current income must exceed currentabsorption in order that dB becomes positive

  36. ABSORPTION APPROACH (cont’d) • Devaluation affects A in 2 ways: (1)indirectlythrough income effect (alpha); (2) directlye.g. desire to hold additional cash (beta) • Effect on A: dA = alphadY - beta A………….[5] where alpha is marginal propensity to absorb and betaArepresents the direct effect • Substituting into equation [4], we get: dB = dY – alphadY – beta A ……….…………..[6]

  37. ABSORAPTION APPROACH (cont’d)[Ref: Fig 7] Case 1 • alpha < 1, so the absorption function isless steep relative to the 45 degree line where alpha = 1 • beta A < 0, so the absorption function shifts down (people spending less, holding more cash) [beta A > 0, if people spend more, don’t trust their own currency] • Incomeincreasesby dY1; A risestodA1 due to income effect (+ve dB); this is reducedby negative beta so that finally Arisesonly by dA’1, resulting in even bigger trade surplus

  38. ABSORPTION APPROACH (cont’d)[Ref: Fig 7] Case 2 • dY < 0 (incomefallsafter devaluation) • All other assumptions of Case 1 still hold • Incomeshrinksby dY2 • Absorptionfalls by dA2 due to income effect • Negative beta adds on so that Absorption fallsfinally by dA’2 • Incomefallsmore than Absorption: so dB’2 <0 • BOT worsens

  39. Figure 8: α < 1 ; βA (-ve) ΔA(+) Δy = ΔA (α=1) ΔA = α Δy ΔB1 > 0 ΔB'1 > 0 ΔA' = f (ΔY) ΔA1 ΔA'1 Δy(+) Δy(-) Δy2 Δy1 ΔA2 ΔB2 (-ve) [ y falls > A falls ] ΔA'2 Δy (-) BoT  Δy (+) BoT  ΔB'2 (-ve) income falls more than absorption (-)Δy > (-)ΔA ΔB'1 -ve income rises more than absorption Δy > ΔA ΔA(-)

  40. ABSORPTION APPROACH (cont’d)[Ref: Fig 8] Case 3 • alpha > 1, so the absorption function is steeper than the 45 degree line • All other assumption of Case 1 apply • Incomerisesby dY1; A rises by dA1 due to income effect (BOT worsens) but more than offset by the downward shift in the absorption function; so trade balance finally improvesby dB’1

  41. ABSORPTION APPROACH (cont’d)[Ref: Fig 8] Case 4 • dY< 0 (income falls after devaluation) • All other assumption of Case 3 hold • Income shrinks by dY2 • Absorptionfallsby dA2 due to income effect and falls furtherdue to the direct effect (dA’2) • Absorptionfalls more than income so that trade balanceimproves(dB’2 > 0)

  42. Figure 9: α > 1 ; βA (-ve) ΔA = α Δy (α>1) ΔA(+) ΔA' = f (ΔY) Δy = ΔA (α=1) ΔA1 ΔB1 -ve ΔB'1 +ve ΔA'1 Δy(+) Δy(-) Δy2 Δy1 indirect effect only ΔB1 –ve (ΔA > ΔY) ΔB2 (+ve) ΔB'2 (+ve) ΔA2 direct effect ΔB'1 +ve (ΔA < ΔY) ΔA'2 ΔA(-)

  43. SUMMARY & CONCLUSION (1) • In the Elasticity Approach, devaluation may or may not improve BOT (by extension BOP): much depends on supply and demand elasticity of X and M • In the Absorption Approach, too, there is no certainty that devaluation will improve BOT (by extension BOP): much depends on the net impact on output (Y) and absorption (C+I)

  44. SUMMARY & CONCLUSION (2) • Preceding observations have important implications for forex management • Tendency to devalue more than necessary to ensure stronger impact • Competitiveness gained by devaluation may be lost by rising costs at home or competitive devaluation by rivals • Getting prices right is crucial, but it’s tricky: leaving it all to the market forces is just as risky as market interventions by policymakers

  45. 2011 EXAM QUESTION • Demonstrate how currency devaluation would impact on a country’s balance of payments (BOP) through: (a) Changes in the relative prices of exports and imports [6 marks] (b) Changes in income and absorption (consumption and investment) [6 marks]

  46. END OF LECTURE 2 REST & REFLECT!

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