The Exchange Rate and the Macro Economy

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The Exchange Rate and the Macro Economy
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A National Income Accounting

• GNP Gross National Product The value of all
  final goods and services produced
• GNP national income (Y), or total output
  equals total income
• Four possible uses for a countrys output/income
  
• Consumption
• Investment
• Government Purchases
• Net exports

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Basic Identity

• Y C I G X M
• Current Account X-M
• Y C I G CA
• The Current Account As Savings Minus Investment
• National saving S Y C G.
• Domestic investment is I.
• Y C I G CA.
• So
• CA S I,
• or the current account is the amount by which
  national savings exceeds domestic investment.

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• The current account reflects whether a country is
  saving abroad (CA surplus) or borrowing to pursue
  additional consumption/investment at home (CA
  deficit).
• C I G represents domestic residents spending
  or absorption
• Y represents national income
• CA Y C I G represents the excess of
  income over spending domestically

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CA and the nations wealth

• A positive CA implies national income is greater
  than domestic spending.
• The economy is making more than it is consuming
  or investing itself (the difference is foreign
  spending on domestic goods).
• A current account surplus implies an economy is
  accumulating foreign assets (on net). A deficit
  implies decrease in net foreign assets.

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• Net Foreign Assets Where wealth is held not
  level of wealth.
• Suppose the Country A has wealth of 100. 99
  invested at home and one abroad.
• Country B has wealth of 10. 9 invested in
  Country A and one at home.
• Country As net foreign assets Assets abroad
  (1) minus foreign assets in A (9) minus 8.
• Country B has NFA of plus 8.

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Why run deficits or surpluses?

• Life-cycle model implies that saving occurs when
  current income is high relatively to permanent
  income (adjusted for impatience and interest
  rate).
• Investment takes place where marginal product of
  capital is high.
• Growth economies should run deficits.
• Why might Japan run surpluses?

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Public and Private Saving

• S(private) Y T C.
• S(govt) T G.
• S S(private) S(govt).
• CA S(private) S(govt) I.
• S(private) I (G T).
• Holding constant private activity, an increase in
  the government deficit lowers the current account
  surplus (or increases the deficit).

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The Balance of Payments

• The financial account (formerly capital
  account) records all international purchases or
  sales of assets.
• When an American purchases a foreign asset, it
  shows up as a debit on the U.S. financial account
  (it is a negative entry because the U.S.
  imports a foreign asset).
• An increase in international reserves is an
  important entry in the financial account.
• Capital account now refers to non-market
  transfers of wealth (e.g. sovereign debt
  forgiveness).

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The Balance of Payments Identity
Current Account Private (non-ORT) Financial
Account Official Reserve Transactions Capital
Account 0

• Implications
• A current account deficit must be matched by a
  financial account surplus.
• That is, a CA deficit is matched by a capital
  inflow as foreign countries purchase the US
  assets that fund Americas spending over income.

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B Open Economy Macro

• Disposable Income and the Current Account
• Determinants of Aggregate Demand
• Consumption
• C(Yd)
• YdY-T is disposable income.
• C increases with income.
• However, C increases less than one for one with
  income.

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• Y is short-run income level. YF is the long-run
  (full employment) income level.
• As Y increases while holding YF fixed, there is
  an incentive to save some of the additional
  income for the future.
• ? C increases with Y, but so does savings.
• Current Account As disposable income increases,
  consumers increase purchases of imports. All
  else equal, CA declines. (In equilibrium, all
  else cannot stay equal as saving also increases.)

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• Real Exchange Rate and the Current Account
• As domestic goods become cheap relative to
  foreign goods (q ?), the volume of exports
  increase and the volume of imports fall.
• Effect on the current account depends on the
  value effect.
• Assume that volume effect outweighs the value
  effect and the CA improves following a real
  exchange rate depreciation.
• In the short run, prices are sticky and so
  nominal exchange rate movements result in real
  exchange rate movements.
• E? ? CA ?
• CA(q, Yd)
• The model takes Investment (I) as given. (In
  practice investment decreases as the real
  interest rate increases.)
• Government purchases (G) contribute to aggregate
  demand as well.
• Assume that deficits are not offset by private
  savings (no Ricardian equivalence.)

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• Aggregate Demand
• C(Yd)IGCA(q,Yd)
• DD(q, Yd, I, G)

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Goal Equilibrium determination of exchange rates
and output in the SR

• Output Market Equilibrium
• Asset Market Equilibrium
• Short Run Prices are sticky. We assume that
  supply can move to meet changes in demand without
  large movements in price (especially if there is
  unemployment) in the short-run.
• In the long-run, prices adjust and Y converges to
  YF.

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Output Market Equilibrium DD curve
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Factors that Shift the D Curve

• A change in G.
• A change in T.
• A change in I.
• A change in P/P.
• A change in the consumption function.
• A demand shift between foreign and domestic
  goods.
• A change in E is a movement along the D curve
  not a shift!

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Asset Market Equilibrium The AA Curve

• What pair of E and Y keeps the money and currency
  market in equilibrium.
• By UIP

• For a given Money Supply and Price level
• An increase in Y ? Money Demand ? ? r ?? E
  ?

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Factors that Shift the A Curve

• A change in the Money Supply.
• A change in P.
• A change in Ee.
• A change in r.
• A change in the money demand function.

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Short-Run Equilibrium for an Open Economy