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

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Title: Robert J. Gordon, Macroeconomics, 10th 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 monetary policy
  • Fixed exchange rates
  • Free flows of 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
    countrys 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,
19702005 (1 of 2)
9
Figure 6-2 Foreign Exchange Rates of the Dollar
Against Four Major Currencies, Quarterly,
19702005 (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, e100 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 gt 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 fixed e, 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 flexible e, monetary policy stimulus
    generates excess supply of money and lowers e
    till supply and demand are in balance again.
  • In short under perfect 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
    boast interest 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
34
(No Transcript)
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,
19752004
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,
19702005
39
International Perspective Big Mac Meets PPP
40
Figure 6-4 Nominal and Real Effective Exchange
Rates of the Dollar, 19702004
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, 19702004
43
Figure 6-7 The U.S. Real Corporate Bond Rate and
the Real Exchange Rate of the Dollar, 19702004
44
(No Transcript)
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