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Chapter 13 Economic Policy in an Open Economy

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... Fix the Exchange Rate ... The spot exchange rate can also remain unchanged, even ... How can they keep the exchange rate at $.08 if the supply and demand ... – PowerPoint PPT presentation

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Title: Chapter 13 Economic Policy in an Open Economy


1
Chapter 13 Economic Policy in an Open Economy
  • How many more fiascos will it take before
    responsible people are finally convinced that a
    system of pegged exchange rates is not a
    satisfactory financial arrangement?
  • (Milton Friedman,
    1992)

2
The Goals of This Chapter
  • Illustrate why it is difficult to keep exchange
    rates constant.
  • Explain how foreign exchange market intervention
    works and why it cannot permanently fix exchange
    rates.
  • Introduce purchasing power parity (PPP) and
    review the evidence on how well it explains
    long-run exchange rates.
  • Introduce the aggregate demand/aggregate supply
    (AD/AS) macroeconomic model, which determines
    price levels.
  • Combine the AD/AS model, purchasing power parity,
    and the interest parity condition into a general
    exchange rate model.
  • Explain the trilemma and show how attempts to
    defy the trilemma has caused recent financial
    crises.

3
Floating Versus Fixed Exchange Rates
  • Floating Exchange Rate An exchange rate that
    permitted to vary in accordance with the changes
    in the supply and demand for foreign exchange.
  • Fixed Exchange Rate An exchange rate that is
    intentionally prevented from changing by means of
    specific government policies that influence the
    supply and demand for foreign exchange.

4
Why It Is Hard to Fix the Exchange Rate
  • The interest parity condition, et Etetn(1
    r)/(1 r)n, suggests that the spot exchange
    rates will remain the unchanged if all variables
    on the right-hand side of the equation stay the
    same, that is if
  • Expectations about future exchange rates, Etetn,
    do not change
  • Rates of return on assets are the same at home
    and abroad, that is r r.

5
Why It Is Hard to Fix the Exchange Rate
  • The spot exchange rate can also remain
    unchanged, even when one of the right-hand
    variables changes, provided that
  • Policy makers immediately adjust domestic
    policies when expectations change.
  • This latter condition requires a countrys
    policy makers to stay attuned to exchange rates
    and adjust their economic policies to satisfy the
    interest parity condition, regardless of any
    other policy objectives they might have.

6
Using Intervention To Fix the Exchange Rate
  • Suppose that the equilibrium exchange rate is
    .10, as shown in the Figure.
  • Suppose also that policy makers in the U.S. or
    Mexico seek to keep the the exchange rate fixed
    at .08 per peso.
  • How can they keep the exchange rate at .08 if
    the supply and demand curves are as shown?

7
Using Intervention To Fix the Exchange Rate
  • The exchange rate e .08 can be established by
    the U.S. or Mexican central banks intervening in
    the foreign exchange market.
  • The Banco de México could create pesos and sell
    them on the foreign exchange market, or the U.S.
    Federal Reserve Bank could sell reserves of
    pesos.
  • In either case, the supply of pesos would
    increase from S to S and the exchange rate would
    fall to .08.

8
Using Intervention To Fix the Exchange Rate
  • From the Mexican perspective, the equilibrium
    exchange rate is e .10, or q/e 10 pesos.
  • The required intervention to keep the exchange
    rate at e .08, or 1/e 12.5 pesos, appears
    as an intentional increase in the supply of
    dollars by the central banks.

9
Intervention is Not a Long-run Tool
  • The weakness of using intervention to fix
    exchange rates is that central banks can seldom
    continue supplying the necessary amounts of
    foreign exchange for long periods of time.
  • Another problem is that foreign exchange market
    intervention alters countries money supplies,
    and such de facto monetary policy may conflict
    with other macroeconomic goals.

10
Purchasing Power Parity (PPP)
  • The PPP theory assumes that the foreign exchange
    rates fundamental role is balancing
    international trade, and that arbitrage equalizes
    the prices everywhere.
  • The PPP theory is normally interpreted to imply
    that the exchange rate reflects the overall price
    levels in each country.
  • If P represents a general price index for the
    home economy and P is a similar general price
    index overseas, then the PPP theory says that
  • e P/P.

11
The Evidence on Purchasing Power Parity
  • In the short run, there is virtually no
    correlation between price movements and exchange
    rate movements.
  • In the long run, exchange rates do reflect
    purchasing power parity.
  • The adjustment of exchange rates toward their
    purchasing power parities is very slow.
  • Therefore, countries relative inflation rates
    are not helpful in explaining how an exchange
    rate will move during the next week or month, but
    it does describe long-run exchange rate movements
    very well.

12
The Aggregate Demand/Aggregate Supply Model
  • Purchasing Power Paritys success in explaining
    long-run exchange rates does not make it a useful
    exchange rate model.
  • A complete exchange rate model needs to go one
    step further and explain what determines national
    price levels.
  • Fortunately, macroeconomics has a
    well-established model to explain price levels
    the aggregate demand/aggregate supply (AD/AS)
    macroeconomic model.
  • This model lets us highlight the many variables
    that affect an economys price level and, hence,
    also distinguishes the variables that influence
    long-run exchange rates.

13
The Aggregate Demand/Aggregate Supply Model The
Demand Side of the Economy
  • The economys demand for output, Y, can be
    divided into consumer demand, C, investment, I,
    government goods and services, G, and net exports
    minus imports, X - IM Y C I G X - IM.
  • We can then focus on the determinants of each of
    these categories of demand.
  • For example, consumer income depends on the value
    of income, Y, taxes, T, and transfers, Tr C
    f(Y, T-, Tr).
  • The function f(.) reflects peoples preferences
    about how to allocate their income.

14
The Aggregate Demand/Aggregate Supply Model The
Demand Side of the Economy
  • The demand for investment goods (capital) depends
    on the returns to investment at home and abroad,
    r and r, the opportunity cost of alternative
    uses of the resources used for investment (the
    interest rate on loanable funds), and the overall
    level of output that capital helps to produce, Y.
  • Real money supplies matter for interest rates,
    which implies that M/P and M/P, the latter the
    foreign real money supply, also matter.
  • Hence, an economys investment function may look
    like I f(Y, r, r, M/P, M/P).

15
The Aggregate Demand/Aggregate Supply Model The
Demand Side of the Economy
  • Government expenditures, G, are usually a
    function of political forces, POL.
  • They also depend on taxes, T, which in turn
    depend on overall income and output, Y, in the
    economy.
  • Monetary policies at home and abroad affect the
    costs of borrowing, and transfers, Tr, affect a
    governments spending constraints and borrowing
    needs.
  • Therefore, the government expenditure function
    may look like G f(POL, Y, T, Tr, M/P, M/P).

16
The Aggregate Demand/Aggregate Supply Model The
Demand Side of the Economy
  • In an open economy, exports and imports depend on
    all of the domestic and foreign variables that
    influence domestic and foreign C, I, and G.
  • Thus, the trade balance is a function of all the
    variables in the C, I, and G equations X-IM
    f(C, C, I, I, G, G,P/P, e).

17
The Aggregate Demand/Aggregate Supply Model The
Demand Side of the Economy
  • By summing the sources of domestic demand in all
    four categories of demand, total aggregate demand
    for the economys output is YD C I G X -
    IM f(Y,Y,T,T,Tr,Tr,r, r,M/P,
    M/P,POL,POL,P/P, e).
  • This equation seems to have a lot of variables,
    but it is still a gross simplification of the
    real world.
  • The important point here is that even in a simple
    model it is very difficult to determine precisely
    what aggregate demand will be because there are
    so many variables that influence aggregate demand.

18
The Aggregate Demand/Aggregate Supply Model The
Demand Side of the Economy
  • In the AD/AS model, the aggregate demand curve is
    a downward-sloping line.
  • The position of the line depends on all the
    variables that influence demand.
  • In relation to the price level, the AD curve is
    downward-sloping because prices effect the real
    money supply, M/P, and a countrys competitive
    position in international trade the lower the
    price level, the higher M/P and (EX IM).

19
The Aggregate Demand/Aggregate Supply Model The
Supply Side of the Economy
  • In the short run, given the level of technology,
    the steady state level of output depends on the
    depreciation rate,d and the saving rate, s.
  • In the long-run, the supply side of the economy
    is determined by economic growth, which is driven
    by technological progress.

20
The Aggregate Demand/Aggregate Supply Model The
Supply Side of the Economy
  • Aggregate supply, AS, is a function of both the
    short-run variables of the Solow model and the
    long-run variables of the Schumpeterian model
  • AS g(K, L, d, s, p, ß, i, R)
  • A prediction of an economys long-run productive
    capacity should focus on the Schumpeterian
    variables, of course.

21
The Aggregate Demand/Aggregate Supply Model
Shifts in the AD and AS Curves
  • Suppose that economic growth causes the AS curve
    to shift to the right.
  • All other things equal, the shift in the AS curve
    will cause the level of output to increase and
    the price level to decline.
  • A shift in aggregate demand will have similar,
    but opposite effects on the price level.
  • All other things equal, the outward shift in the
    AD curve will cause the price level to increase.

22
Long-Run Changes in the Price Level
  • Suppose that economic growth pushes the economys
    AS curve continually to the right.
  • The price will remain unchanged only if the AD
    curve also shifts to the right at the exact same
    rate as the AS curve shifts.

23
Long-Run Changes in the Price Level
  • Suppose that economic growth pushes the economys
    AS curve continually to the right.
  • The price level will fall if aggregate demand
    shifts out more slowly than aggregate supply.

24
Long-Run Changes in the Price Level
  • Suppose again that economic growth pushes the
    economys AS curve continually to the right.
  • If aggregate demand shifts out more rapidly than
    aggregate supply, then prices will rise.

25
The Relative Shifts in AD and AS
  • The AD curve will tend to automatically shift to
    the right when the AS curve shifts to the right
    because increasing output also increases income,
    and income is an important determinant of
    consumption, investment, and government
    expenditures.
  • But, the relationship between output and demand
    is not a neat one-for-one relationship.
  • There are many determinants of consumption,
    investment, government expenditures, and net
    exports, other than income, as shown in the
    functions for each of the components of aggregate
    demand.
  • Hence, it is not clear whether the two sets of
    curves will shift out at the same rate.

26
A Simple Exchange Rate Model
  • The logical model that results from the
    combination of the AD/AS macroeconomic model, the
    purchasing power parity (PPP) theory, and the
    interest parity (IP) condition can be summarized
    as follows
  • The interest parity condition relates spot
    exchange rates to the expected future exchange
    rates.
  • Exchange rates are expected to reflect countries
    relative price levels, as the PPP theory
    predicts.
  • The AD/AS macroeconomic model details the
    variables that determine an economys price level
    and, therefore, relates the expected future
    exchange rate to the variables that determine
    future aggregate demand and aggregate supply.

27
A Simple Exchange Rate Model
  • The spot exchange rate therefore depends on
    expectations of future price levels across all
    countries of the world.
  • If expectations about any one countrys future
    price level changes, all exchange rates will tend
    to change because triangular arbitrage links all
    exchange rates.
  • The task of accurately forecasting individual
    exchange rates is therefore likely to be subject
    to large errors given the enormous number of
    variables likely to influence price levels.
  • Frequent revisions of expectations are also
    likely as the enormous data set is continually
    revised and updated.

28
In the words of the international economist
Maurice Obstfeld
  • A country cannot simultaneously maintain fixed
    exchange rates and an open capital market while
    pursuing a monetary policy oriented toward
    domestic goals.
  • Governments may choose only two of the above.
  • The impossibility of simultaneously achieving
    these three goals is known as the trilemma.

29
The Trilemma and Recent Exchange Rate Crises
  • There are obvious parallels between the 1994
    Mexican crisis, 1997 Asian crisis, and the 2001
    Argentine crisis.
  • All of the countries concerned had made
    substantial economic policy changes, among which
    were the opening to international trade and
    international investment.
  • After financial account transactions were
    liberalized (globalized), foreign loans and
    investment had grown rapidly.
  • All the governments were openly committed to
    maintaining fixed or tightly controlled exchange
    rates.
  • That is, the countries had all picked
    globalization and fixed exchange rates from the
    trilemma menu.

30
The Trilemma and Recent Exchange Rate Crises
  • Thus, when external economic conditions or
    domestic policies shifted and became incompatible
    with the fixed exchange rate, speculation moved
    against the currencies.
  • Central banks were unable to intervene to the
    extent necessary to keep exchange rates constant,
    and the fixed exchange rates were eventually
    abandoned in favor of floating rates.
  • The resulting sharp fall in the currencies
    values triggered financial crises because foreign
    debt was contracted in terms of dollars.
  • The financial crises forced the countries to
    endure severe recessions and long adjustment
    periods.
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