III. EXTERNAL BALANCE

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III. EXTERNAL BALANCE EXCHANGE RATE

• EC21B INTERMEDIATE MACROECONOMICS II

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THE BALANCE OF PAYMENTS

• The Balance of Payments are
• The record of a countrys transactions with the
  rest of the world (international transactions)
• The record of sources (supply) and uses (demand)
  of foreign exchange.
• The balance of payments are part of the national
  income accounts
• Data on Jamaicas Balance of payment are
  published by the Bank of Jamaica

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THE BALANCE OF PAYMENTS

• Any transaction that involves a flow of funds
  into Jamaica is a credit item and is entered with
  a plus sign.
• Any transaction which involves a flow of funds
  out of Jamaica is a debit item and is entered
  with a minus sign.
• The Balance of Payment is made up of a Current
  Account and a Capital Account

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THE BALANCE OF PAYMENTS

• The Current Account
• Records the nations current international
  transactions, including exports and imports of
  goods and services, income from foreign
  investments, and transfers to and from other
  countries.
• Current account can be divided into 3 components
• Net export of goods services
• Net income from abroad
• Net unilateral transfers

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THE BALANCE OF PAYMENTS

• Net Export of Goods Services
• Is simply a countries exports minus its imports
  of goods (merchandise) and services
• Trade balance refers to the difference between a
  countries merchandise exports and imports

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THE BALANCE OF PAYMENTS

• Net Income from Abroad
• Is income receipts from abroad minus income
  payment to residents of other countries.
• Net Unilateral Transfers
• Unilateral transfers are payments from one
  country to another that do not correspond to any
  purchase of good, service or asset. (e.g. foreign
  aid)

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THE BALANCE OF PAYMENTS

• Current Account
• A. Goods Balance
• Exports ve
• Imports -ve
• Trade Balance -ve (NB. Ja Import oriented)
• B. Services
• Transportation -ve (e.g. freight)
• Travel ve (e.g. tourism)
• Other -ve (e.g. hire of consultants)
• Net Exports of Gods Services (A B)

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THE BALANCE OF PAYMENTS

• C. Income
• Compensation of Employees ve
• Investment Income -ve
• (debt servicing)
• D. Current transfers
• Official ve
• (grants of money to govt)
• Private ve
• (large bulk of remittances and private grants)
• Current account balance (A B C D)

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THE BALANCE OF PAYMENTS

• A positive balance on the current account means
  the country has a current account surplus and a
  deficit if balance is negative
• When a country runs a current account deficit it
  must finance this deficit by borrowing from
  foreigners.
• The Capital Account
• Records purchases and sale of assets both
  financial (stocks bonds) and capital (land,
  building, machinery etc.)

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THE BALANCE OF PAYMENTS

• Capital Account
• A. Capital
• Official ve
• Private /- ve
• B. Financial
• Official ve
• Private ve

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THE BALANCE OF PAYMENTS

• A negative balance on the capital account
  represents a build up of reserves while a
  positive balance represents a reduction in the
  countries reserves.
• Balance of Payment Identity
• Current account Capital account Zero
• X Z 0
• X ( R, Ex) Net exports (Current account)
• Z (R) Capital Account

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THE BALANCE OF PAYMENTS

• A current account deficit must be financed by
  capital coming in. Similarly, a current account
  surplus is financed by an increase in reserves
  excess capital)

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DETERMINANTION OF THE EXCHANGE RATE

• The Nominal exchange rate is the price at which
  local currency is exchanged for foreign currency
  and can also be viewed as the ratio at which two
  currencies are traded for each other.
• It determines how expensive foreign goods are
  compared to local goods.

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DETERMINANTION OF THE EXCHANGE RATE

• Currency Appreciation
• Is an increase in the value of one nations
  currency relative to another nations currency.
• When the exchange rate rises (appreciates),
  foreign goods become cheaper compared with home
  goods. This means that the dollar can now
  purchase more units of a foreign currency.

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DETERMINANTION OF THE EXCHANGE RATE

• There are two ways in which to quote the exchange
  rate
• Indirect quote gives how much local currency is
  required to purchase one unit of the foreign
  currency. E.g. J50 US 1
• Direct quote tells how much one unit of the
  local currency is worth in foreign currency.
• E.g. J1 US0.02
  

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DETERMINANTION OF THE EXCHANGE RATE

• Real Exchange Rate
• The real exchange rate is equal to the average
  nominal foreign exchange rate between a country
  and its trading partner, adjusted for inflation.
  (Adapted from Gordon)
• The nominal exchange rate is the relative price
  of the currency of two countries while the real
  exchange rate is the relative price of the goods
  of two countries.

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DETERMINANTION OF THE EXCHANGE RATE

• It therefore can be viewed as the rate at which
  we can trade the goods of one country for the
  goods of another. (i.e. the terms of trade)
• It is the real exchange rate that is of
  importance to economists as it is a major
  determinant of net exports.

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DETERMINANTION OF THE EXCHANGE RATE

• Real exchange Rate
• Nominal ex. Rate Price of domestic goods
• Price of foreign goods
• Let e nominal exchange rate
• p price level of domestic good
• p- price level of foreign good
• q - real exchange rate

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DETERMINANTION OF THE EXCHANGE RATE

• If the real exchange rate appreciates (increases)
  foreign goods (imports) are relatively cheap and
  domestic goods (exports) are relatively expensive
  for foreigners. This appreciation would lead to a
  reduction in domestic profits
• If the real exchange rate depreciates, imports
  become expensive while exports become cheaper.

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DETERMINANTION OF THE EXCHANGE RATE

• Purchasing Power Parity (PPP)
• Holds that the prices of identical goods should
  be the same in all countries, differing only by
  the cost of transportation and any import duties.
• It is simply the law of one price applied to the
  international market

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DETERMINANTION OF THE EXCHANGE RATE

• In other words PPP states that if international
  arbitrage is possible then a dollar must have the
  same purchasing power in every country
• If this was not the case and a dollar could
  purchase more banana locally there would be
  opportunities for profit by buying the banana in
  Jamaica and selling abroad. This would drive up
  the price of banana relative to the foreign price

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DETERMINANTION OF THE EXCHANGE RATE

• The nominal exchange rate will adjust to equate
  price of tradable goods across countries.
• Assuming that goods are identical and freely
  transportable.

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DETERMINANTION OF THE EXCHANGE RATE

• Why PPP does not hold?
• There is no free mobility of goods as there is a
  transaction cost to moving goods across
  international borders
  
• Tradable goods are not always perfect
  substitutes. (differentiation of goods)
• Many goods are not easily traded. E.g. haircuts
  might be more expensive in Tokyo than NY but
  arbitrage opportunities would not arise as it is
  impossible to transport haircuts.

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DETERMINANTION OF THE EXCHANGE RATE

• Real exchange Rate The Trade Balance
• A negative relationship exists between the real
  exchange rate and the trade balance.
• The lower the real exchange rate, the less
  expensive are domestic goods relative to foreign
  goods, and the greater are net exports.

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DETERMINANTION OF THE EXCHANGE RATE

• Real Exchange Rate The Trade balance

Real ex. rate (q)
X(q)
X (Net Exports)
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DETERMINANTION OF THE EXCHANGE RATE

• The Determinants of The Real Exchange Rate
• The real exchange rate is negatively related to
  net exports
• From our BOP identity the trade balance must
  equal the net capital outflow which in turn
  equals saving minus investment.
• Savings is fixed by the consumption function
• Investment is fixed by the investment function
  and the world exchange rate.

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DETERMINANTION OF THE EXCHANGE RATE

• Net exports S I (Net capital outflow)

S - I
Real ex. rate (q)
q
X(q)
X (Net Exports)
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DETERMINANTION OF THE EXCHANGE RATE

• At the equilibrium real exchange rate, the supply
  of dollars available from the net capital outflow
  balances the demand for dollars by foreign buyers
  or net exports.

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NET EXPORTS

• In a closed economy, all output is sold
  domestically, and expenditure is divided into
  three components consumption, investment and
  government purchases.
• In an open economy, some output is sold
  domestically and the remainder sold abroad.
  expenditure would now be divided into four
  components as we add Net exports (X).
• i.e. Exports minus Imports.

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NET EXPORTS

• Y C I G X
• Net Exports is determined by
• Real Exchange Rate As Q X
• Income higher income make consumers spend more
  on imported products with no significant impact
  on exports so net exports decrease.
• Y X

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NET EXPORTS

• Net Export Function
• X g mY n EP
• PW
• X g mY nQ
• The net export function summarizes how exports
  depend negatively on both income and the real
  exchange rate.
• E.G. X 600 -0.1Y 100Q

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NET EXPORTS

• Since the exchange rate and interest rate move
  together in order to keep trade flows and capital
  flows equal to each other they can be used
  interchangeable in our analysis.
• This positive relationship between the real
  exchange rate and the interest rate is given by

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NET EXPORTS

• It is the rise in the domestic interest rate
  relative to foreign interest rates that brings
  about the rise in the exchange rate.
• So the net export function can be expressed as
• X g mY nR

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NET EXPORTS

• IS Curve and Net Exports
• IS curve describes combination of interest rates
  and income.
• Incorporating net exports and increase in
  interest rate raises the exchange rate and
  decreases net exports. This reduces the impact of
  interest rate on investment and makes the IS
  curve flatter than in closed economy.

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NET EXPORTS

• The presence of net exports also reduces the size
  of the multiplier and this tends to make the IS
  curve steeper.
• Net exports depend negatively on income so as
  income increases people import more so increased
  spending not passed on to the domestic economy so
  size of multiplier is reduced.

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NET EXPORTS

• The IS curve is derived algebraically by
  substituting functions for consumption,
  investment and net exports into the income
  identity.
• Y C I G X
• C a b(1 - t)Y
• I e dR
• X g mY -nQ

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NET EXPORTS
Solve for R
R is positively related to Government spending
and negatively related to income and the real
exchange rate. Appreciation of the dollar shifts
the IS curve down.
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NET EXPORTS

• IS curve is downward sloping due to
• Negative response of investment to the interest
  rate (d)
• Negative response of net exports to the interest
  rate (nv)
• As X g mY n(cvR)

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NET EXPORTS

• Substituting out real exchange rate
• IS curve is flatter in an open economy as is now
  more sensitive to R.

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NET EXPORTS

• LM curve and Net Exports
• The inclusion of net exports (open economy) has
  no impact on the LM curve the analysis remains
  the same.
• The LM curve is obtained by equating Money supply
  and Money Demand

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EXCHANGE RATES IN THE SHORT LONG RUN

• How policies Influence the Real Exchange rate in
  the Short Run
• Expansionary Monetary Policy (MS )
• An increase in the money supply shifts the LM
  curve outwards. It lowers interest rate and
  stimulates investments so net capital schedule
  shifts out.
• Decline in interest rate depreciates the exchange
  rate increasing net exports and income
• Increase in income causing an increase in imports
  so decrease net exports

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EXCHANGE RATES IN THE SHORT LONG RUN

• Therefore, two offsetting effect of monetary
  expansion exports increase but imports might rise
  by a greater amount
• End result interest rate falls, the dollar
  depreciates and income increases

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EXCHANGE RATES IN THE SHORT LONG RUN

• Expansionary Fiscal Policy
• (increase in government spending or tax cut)
• This increases aggregate expenditure (IS shifts
  out) and the interest rate rises.
• Rise in interest rate reduces investment spending
  (net capital schedule shifts in) and exchange
  rate appreciates
• Higher exchange rate reduces exports and
  increases imports (net export falls).
• Increase in govt spending crowds out export
  industries and investment increases trade deficit
  or reduces trade surplus and increases income.

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EXCHANGE RATES IN THE SHORT LONG RUN

• How policies Influence the Real Exchange rate in
  the Long Run
• Expansionary Monetary policy
• Increase in prices lower real money balance and
  interest rate begins to rise in order to maintain
  equilibrium
• The real exchange rate increases and net export
  falls. The adjustment continues until output
  returns to its potential level.
• Price level increases by initial increase in
  money supply and real exchange rate returns to
  its normal level. In long run money is neutral

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EXCHANGE RATES IN THE SHORT LONG RUN

• Expansionary Fiscal Policy
• An increase in government spending eventually
  brings about an upward adjustment in prices
• Reduction in real money balance increases
  interest rates and further reduces investment and
  net exports. Eventually output returns to its
  potential level and investment and net exports
  decline by the amount of increase in government
  spending
• Real exchange rate and interest rate is
  permanently higher.

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IMPLICATIONS OF VARIOUS EXCHANGE RATE REGIMES

• Flexible Exchange Rate
• Under a flexible exchange rate regime the foreign
  exchange rate is free to move about in order to
  establish an equilibrium between the quantities
  supplied and demanded by a nations currency

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IMPLICATIONS OF VARIOUS EXCHANGE RATE REGIMES

• Types of Flexible Exchange Rate Regimes
• Clean Float (Freely Floating) this means the
  central bank does not intervene into the market
• Dirty or Managed Float government allows the
  market to determine the exchange rate but steps
  in to halt excessive fluctuations

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IMPLICATIONS OF VARIOUS EXCHANGE RATE REGIMES

• Implications Flexible Exchange Rate
• Expansionary Fiscal Policy
• Government sets out to stimulate domestic
  spending by increasing purchases or cutting
  taxes.
• This increases planned expenditure causing IS
  curve to shift to the right.
• The exchange rate appreciates and income level
  remains the same

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IMPLICATIONS OF VARIOUS EXCHANGE RATE REGIMES

• Income remains the same as a rise in the interest
  rate relative to the world interest rate causing
  inflow of capital from abroad
• Capital inflow increases the demand for the
  domestic currency so appreciates it value and
  reduces net exports
• It is the fall in net exports that offsets the
  impact of the fiscal policy on income

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IMPLICATIONS OF VARIOUS EXCHANGE RATE REGIMES

• Monetary Policy
• An increase in the money supply causes a shift
  outwards of the LM curve raising income and
  lowering the exchange rate
• Since the interest rate is fixed at the world
  interest rate in an open economy the downward
  pressure on interest rates causes capital to flow
  out of the country.
• Capital outflow increases supply of domestic
  currency so exchange rate depreciates

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IMPLICATIONS OF VARIOUS EXCHANGE RATE REGIMES

• The fall in the exchange rate makes domestic
  goods inexpensive relative to foreign goods and
  stimulates net exports.
• Trade Policy
• Reduction in demand for imported goods (quota or
  tariff)

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IMPLICATIONS OF VARIOUS EXCHANGE RATE REGIMES

• Reduction in imports means an increase in net
  exports
• This increases planned expenditure so IS curve
  shifts out. This increases exchange rate with no
  impact on income

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IMPLICATIONS OF VARIOUS EXCHANGE RATE REGIMES

• Fixed Exchange Rates
• Under a fixed exchange arte regime the foreign
  exchange rate is fixed at a predetermined level
  for long periods of time and is determined solely
  by the central bank.

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IMPLICATIONS OF VARIOUS EXCHANGE RATE REGIMES

• Implications of Fixed Exchange Rates
• Expansionary Fiscal Policy
• Policy shifts IS curve out putting upward
  pressure on the exchange rate
• But since central bank trades foreign and
  domestic currency in order to maintain the
  exchange rate
• Arbitrageurs sell foreign currency expanding the
  money supply which shifts LM curve out.
• Under a fixed exchange rate a fiscal expansion
  raises income

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IMPLICATIONS OF VARIOUS EXCHANGE RATE REGIMES

• Expansionary Monetary Policy
• This would shift LM out and put downward pressure
  on the exchange rate
• But since CB committed to maintain fixed exchange
  rate they buy domestic currency removing
  liquidity from the market and the LM curve moves
  to its original position
• Monetary policy is ineffectual under a fixed
  exchange rate
• Fixing exchange rate makes CB give up control
  over money supply

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IMPLICATIONS OF VARIOUS EXCHANGE RATE REGIMES

• Country with fixed exchange rate can either
  revalue or devalue their currency.
• Devaluation reduction in value of currency
• Revaluation increase in value of currency

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IMPLICATIONS OF VARIOUS EXCHANGE RATE REGIMES

• Trade Policy
• Shifts net export curve and Is curve outwards
  putting upward pressure on the exchange rate
• Money supply rises to keep exchange rate at fixed
  level so LM curve shifts out and raises income
• Trade restriction under fixed exchange induces
  monetary expansion rather than appreciation of
  the currency.

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IMPLICATIONS OF VARIOUS EXCHANGE RATE REGIMES

• Should Exchange rates be Floating or Fixed?
• Argument for floating is that it frees up
  monetary policy
• Argument for fixed is that it reduces exchange
  rate uncertainties so enhancing international
  trade.
• Fixed exchange rate ensures discipline of the
  government with regards to monetary authority
  (inflating economy)

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IMPLICATIONS OF VARIOUS EXCHANGE RATE REGIMES

• Choice between fixed or floating should be
  dependent on the countries level of international
  exposure and the goals of the government.

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IMPLICATIONS OF VARIOUS EXCHANGE RATE REGIMES

• Stabilizing the Exchange Rate
• Policy makers have been concerned about the
  fluctuations of the exchange rate and how it can
  be reduced
• The stabilization of the exchange rate requires a
  commitment on the part of the central bank to
  keep the interest rate constant.
• This would make the LM curve perfectly flat (MS
  geared to maintain interest rate)
• A change in spending shifts the IS curve and
  increase income.

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TRADE AND EXCHANGE RATE ISSUES

• Capital or Exchange Controls
• Capital controls (i.e. restriction of flow of
  capital across borders) would result in the world
  interest rate being different from the local
  interest rate
• It usually gives rise to informal markets e.g.
  trading of foreign exchange rate on the black
  market as with an excess demand people would be
  to pay more to acquire foreign exchange

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TRADE AND EXCHANGE RATE ISSUES

• Capital controls allow monetary policy to be more
  effective they have the disadvantage of reducing
  the efficiency of international capital markets

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TRADE AND EXCHANGE RATE ISSUES

• Protectionism vs. the Free Market
• Trade policies are policies designed to influence
  directly the amount of goods and services
  exported or imported.
• Protectionist Trade Policy protects domestic
  industries from foreign competition either by
  placing a tax on foreign imports (a tariff) or
  restricting the amount of goods and services that
  can be imported (a quota)

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TRADE AND EXCHANGE RATE ISSUES

• Policy makers might also impose an outright ban
  on certain imports
• Impact of Protectionist trade policy
• (e.g. ban on imported cars)
• Shifts net export schedule outwards as imports
  lower than exports and raises real exchange rate.
• Protectionist trade policy does not affect the
  trade balance. The increase in the real exchange
  rate lowers exports and increases imports.
• This increase in imports offsets the decrease in
  imports due to trade restriction.

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TRADE AND EXCHANGE RATE ISSUES

• Protectionist policies benefit certain groups
  within society but on average society is worse
  off as their level of international trade is
  reduced
• X Y R Q (X offset)