Open Economy Macro: Exchange Rate And Trade Policy

1
Open Economy Macro Exchange Rate And Trade
Policy

• Chapter 16

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Laugher Curve

• A party of economists was climbing in the Alps.
• After several hours they became hopelessly lost.

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Laugher Curve

• One of them studied the map for some time,
  turning it up and down, sighting on distant
  landmarks, consulting his compass, and finally
  the sun.

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Laugher Curve

• Finally, he said, OK, see that big mountain over
  there?

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The Balance of Payments

• The balance of payments is a countrys record of
  all transactions between its residents and the
  residents of all foreign countries.

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The Balance of Payments

• The current account is the part of the balance of
  payments account in which all short-term flows of
  payments are listed.

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The Balance of Payments

• The capital account is the part of the balance of
  payments account in which all long-term flows of
  payments are listed.

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The Balance of Payments

• The government can influence the exchange rate by
  buying and selling official reservesgovernment
  holdings of foreign currencies.

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The Balance of Payments

• The buying and selling of official reserves is
  recorded in the official transactions account.

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The Balance of Payments

• The buying and selling of official reserves is
  recorded in the official transactions account.

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The Current Account

• The difference between the import and export of
  goods is sometimes called the balance of
  merchandise trade.

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The Current Account

• Although the popular press often uses this
  measure, the merchandise trade balance is not a
  good summary because services are an important
  component of trade.

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The Current Account

• Trade in services is just as important as trade
  in goods.

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The Current Account

• There is no reason that the goods and services
  sent into a country must equal the goods and
  services sent out in a particular year.

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The Current Account

• The last component of the current account is net
  transfers, which include foreign aid, gifts, and
  other payments to individuals not exchanged for
  goods and services.

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The Capital Account

• In order to buy U.S. assets foreigners need
  dollars , so net capital inflows represent a
  demand for dollars.

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The Capital Account

• In thinking about what determines a currencys
  value, it is important to remember both the
  demand for dollars to buy goods and services and
  the demand for dollars to buy assets.

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The Capital Account

• Because the balance of payments consists of both
  the capital account and the current account, if
  the capital account is in surplus and the trade
  account is in deficit, there can still be a
  balance of payments surplus.

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The Capital Account

• In the 1980s, the inflow of capital into the U.S.
  greatly exceeded the outflow of capital from the
  U.S., and this trend has continued into the late
  1990s.

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The Capital Account

• As a consequence, the U.S. is a net debtor
  nationthe amount foreigners own in the U.S, is
  greater than the amount U.S. citizens own abroad.

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The Official Transactions Account

• The current account and the capital account
  measure the private and non-U.S. government
  supply of and demand for dollars.

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The Official Transactions Account

• The net amount of the current account and the
  capital account is called

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The Official Transactions Account

• A balance of payments deficit will put downward
  pressure on the value of a nations currency.

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The Official Transactions Account

• When a government buys its own currency to hold
  up the currencys price, we say that the
  government has supported its currency.

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The Official Transactions Account

• When it sells its currency, it is attempting to
  depress the value of its currency.

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The Official Transactions Account

• Because they are an accounting identity, the
  current, capital, and official transactions
  accounts must sum to zero.

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The Official Transactions Account

• The supply of currency, including governments,
  must equal the demand for currency, including
  governments.

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1987 Balance of Payments Accounts
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1987 Balance of Payments Accounts
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1999 Balance of Payments Accounts
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1999 Balance of Payments Accounts
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Exchange Rates

• Supply and demand play a central role in any
  discussion of exchange rates.
• When comparing the currencies of two countries,
  the supply of one currency equals the demand for
  another currency.

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Exchange Rates

• In order to demand one currency, you must supply
  another.

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Exchange Rates and the Balance of Payments

• A deficit in the balance of payments means that
  the private quantity supplied of a currency
  exceeds the private quantity demanded.
• A surplus in the balance of payments means the
  opposite.

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Exchange Rates and the Balance of Payments

• Equilibrium is where the quantity supplied a
  currency equals the quantity demanded.

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The Supply of and Demand for Francs
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Fundamental Forces Determining Exchange Rates

• Fundamental analysis is a consideration of the
  fundamental forces that determine the supply of
  and demand for currencies.

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Fundamental Forces Determining Exchange Rates

• These fundamental forces include a countrys
  income, changes in a countrys prices, and the
  interest rate in a country.

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Changes in a Countrys Income

• When a countrys income falls, the demand for
  imports falls.
• Then demand for foreign currency to buy those
  imports falls.

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Changes in a Countrys Income

• This means that the supply of the countrys
  currency to buy the foreign currency falls.

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Changes in a Countrys Prices

• If the U.S. has more inflation than other
  countries, foreign goods will become cheaper.
• U.S. demand for foreign currencies will tend to
  increase, and foreign demand for dollars will
  tend to decrease.

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Changes in a Countrys Prices

• This rise in U.S. inflation will shift the dollar
  supply to the right and the dollar demand to the
  left.

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Changes in Interest Rates

• A rise in U.S. interest rates relative to those
  abroad will increase demand for U.S. assets.

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Changes in Interest Rates

• Demand for dollars will increase, while
  simultaneously the supply of dollars will
  decrease as fewer Americans sell their dollars to
  buy foreign assets.

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Changes in Interest Rates

• A fall in U.S. interest rates or a rise in
  foreign interest rates will have the opposite
  effect.

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Exchange Rate Determination Is More Complicated
Than It Seems

• Large exchange rate fluctuations in response to
  changing expectations make trading difficult and
  have significant real effect on economic activity.

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Exchange Rate Determination Is More Complicated
Than It Seems

• If the market expects exchange rates to change,
  it will become a self-fulfilling prophesy.

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Exchange Rate Determination Is More Complicated
Than It Seems

• The resulting fluctuations serve no real purpose,
  and cause problems for international trade and
  the countrys economy.

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International Trade Problems From Shifting Values
of Currencies

• Large fluctuations make real trade difficult, and
  cause serious real consequences.
• It is these consequences that have led to calls
  for government to fix or stabilize their exchange
  rates.

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How a Fixed Exchange Rate System Works

• One way the government can set the exchange rate
  is to make its currency nonconvertible.
• Most western economies have agreed not to use
  this approach.

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How a Fixed Exchange Rate System Works

• A second way is for government to adopt a fixed
  exchange rate policy.

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Fixing the Exchange Rate

• The government can fix its exchange rate by
  exchange rate intervention.
• Exchange rate intervention buying or selling a
  currency to affect its price.

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Direct Exchange Rate Intervention

• Currency support is the buying of a currency by a
  government to maintain its value at above its
  long-run equilibrium value.

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Direct Exchange Rate Intervention

• A country can maintain a fixed exchange rate only
  as long as it has the official reserves (foreign
  currencies) to maintain this constant rate.

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Direct Exchange Rate Intervention

• Once it runs out of official reserves, it will be
  unable to intervene, and then must either borrow
  or devalue its currency.

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Direct Exchange Policy
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The Supply of and Demand for Francs
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How a Fixed Exchange Rate System Works
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Currency Stabilization

• A more practical long-run exchange rate policy is
  currency stabilization.
• Currency stabilization the buying and selling
  of a currency by the government to offset
  temporary fluctuations in supply and demand for
  currencies.

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Currency Stabilization

• In currency stabilization, the government is not
  trying to change the long-run equilibrium.
• It is simply trying to keep the exchange rate at
  that long-run equilibrium.

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Currency Stabilization

• In currency stabilization, the government is not
  trying to change the long-run equilibrium.

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Currency Stabilization

• Currency stabilization minimizes the possibility
  that the government will run out of official
  reserves.

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Currency Stabilization

• If a nation runs out of official reserves, it
  must adjust its economy if it wants to maintain a
  fixed exchange rate.

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Currency Stabilization

• Given the small level of official reserves
  relative to the enormous level of private
  trading, significant amounts of stabilization are
  impossible.

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Currency Stabilization

• Strategic currency stabilization is often used
  when there a government has a small level of
  official reserves.

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Currency Stabilization

• Strategic currency stabilization is the process
  of buying and selling at strategic moments to
  affect the expectations of traders, and hence to
  affect their supply and demand.

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Stabilizing Fluctuations Versus Deviating From
Long-Run Equilibrium

• In theory, it is important to distinguish whether
  the problem is long- or short-run equilibrium.
• In practice, it is difficult to do so.

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Stabilizing Fluctuations Versus Deviating From
Long-Run Equilibrium

• The long-run equilibrium rate can only be guessed
  at since no definitive empirical measure of this
  rate exists.

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Estimating Long-Run Equilibrium Exchange Rates

• Purchasing power parity is one way economists
  have of estimating the long-run equilibrium rate.

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Estimating Long-Run Equilibrium Exchange Rates

• Purchasing power parity (PPP) is a method of
  calculating exchange rates that attempts to value
  currencies at rates such that each currency will
  buy an equal basket of goods.

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Criticisms of the Purchasing Power Parity Method

• The difficulty with purchasing power parity is
  the complex nature of trade and consumption.
• The purchasing power parity will change as the
  basket of goods changes.
• Because of this there is no single measure of
  purchasing power parity.

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Criticisms of the Purchasing Power Parity Method

• Purchasing power parity measures leave out asset
  demand for a currency, an important element of
  demand for currencies.

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Criticisms of the Purchasing Power Parity Method

• The critics contend that the current exchange
  rate is the best estimate of the long-run
  equilibrium exchange rate.

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Alternative Exchange Rate Systems

• There are three exchange rate regimes
• Fixed exchange rate the government chooses an
  exchange rate and offers to buy and sell
  currencies at that rate.
• Flexible exchange rate determination of
  exchange rates is left totally up to the market.

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Alternative Exchange Rate Systems

• There are three exchange rate regimes
• Partially flexible exchange rate the government
  sometimes affects the exchange rate and sometimes
  leaves it to the market.

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Advantages of Fixed Exchange Rates

• They provide international monetary stability.
• They force governments to make adjustments to
  meet their international problems.

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Disadvantages of Fixed Exchange Rates

• They can become unfixed.
• When they are expected to become unfixed, they
  create enormous monetary instability.

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Disadvantages of Fixed Exchange Rates

• They force governments to make adjustments to
  meet their international problems.

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Fixed Exchange Rates and Monetary Stability

• If the government picks an exchange rate that is
  too high, its exports lag and the country loses
  official reserves.

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Fixed Exchange Rates and Monetary Stability

• If the government picks an exchange rate that is
  too low, it is paying more for its imports than
  it needs to and is building up official reserves.

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Fixed Exchange Rates and Monetary Stability

• At times fixed exchange rates can become highly
  unstable because expectations of a change in the
  exchange rate can force the change to occur.

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Fixed Exchange Rates and Policy Independence

• Fixed exchange rates provide international
  monetary stability and force governments to make
  adjustments to meet their international problems.
• If they become unfixed, they create monetary
  instability.

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Fixed Exchange Rates and Policy Independence

• Because most countries official reserves are
  limited, a country with fixed exchange rates is
  limited in its ability to conduct expansionary
  monetary and fiscal policies.

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Fixed Exchange Rates and Policy Independence

• Many countries run out of official reserves when
  a recession hits.

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Advantages of Flexible Exchange Rates

• They provide for orderly incremental adjustment
  of exchange rates, rather than large, sudden
  jumps.
• They help government in conducting domestic
  monetary and fiscal policies.

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Disadvantages of Flexible Exchange Rates

• They allow speculation to cause large jumps in
  exchange rates, which do not reflect market
  fundamentals.

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Disadvantages of Flexible Exchange Rates

• They allow government to be flexible in
  conducting domestic monetary and fiscal policies.

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Flexible Exchange Rates and Monetary Stability

• Proponents argue why not treat currency markets
  like any other market and let private market
  forces determine a currencys value?

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Flexible Exchange Rates and Monetary Stability

• Opponents argue that flexible exchange rates
  allow far too much fluctuation in exchange rates,
  making trade difficult.

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Flexible Exchange Rates and Policy Independence

• Flexible exchange rate regimes allow governments
  to be flexible in conducting domestic monetary
  and fiscal policy.

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Flexible Exchange Rates and Policy Independence

• Some argue that flexible exchange rates do not
  provide sufficient discipline for macro policy.

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Partially Flexible Exchange Rates

• Most nations have opted for a policy, partially
  flexible exchange rates, that stands between
  these two extremes.

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Partially Flexible Exchange Rates

• If policy makers believe there is a fundamental
  misalignment in a countrys exchange rate, they
  allow market forces to determine it.

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Partially Flexible Exchange Rates

• If they believe the currencys value is falling
  because of speculation, they step in and fix the
  exchange rate, either supporting or pushing down
  their currencys value.

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Partially Flexible Exchange Rates

• Partially flexible exchange rate regimes combine
  the advantages and disadvantages of fixed and
  flexible exchange rates.

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Which View Is Right?

• Which view is correct is much in debate.
• In order to decide, it is necessary to go beyond
  the arguments and look at the history of the
  various regimes.

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The View of Foreign Exchange Traders

• Most foreign-exchange traders feel their take on
  the market is better than that of governments.

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The View of Foreign Exchange Traders

• When these traders know that government might
  enter the market, they stop focusing on
  fundamentals and switch to trying to guess what
  the regulators will do.

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The View of Fed Economists

• Fed economists maintain that government
  intervention helps to stabilize currency markets.

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Trade Policy

• Trade policy involves government creating trade
  restrictions on imports in order to meet the
  balance of payments constraint without using
  traditional macro policy or exchange rate policy.

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Trade Policy

• Economists generally oppose such trade
  restrictions.

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Varieties of Trade Restrictions

• The most common trade restrictions are tariffs
  and quotas.
• Other trade restrictions are voluntary restraint
  agreements, embargoes, regulatory trade
  restrictions, and nationalistic appeals.

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Tariffs

• Tariffs, also called customs restrictions, are
  taxes governments place on internationally traded
  goodsgenerally imports.

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Tariffs

• Tariffs are the most-used and most-familiar type
  of trade restriction.

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Tariffs

• They make imported goods relatively more
  expensive than they otherwise would have been and
  thereby encourage the consumption of domestically
  produced goods.

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The Impact of Tariffs on Imported Goods
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Smoot-Hawley Tariff

• The most infamous tariff in U.S. history was the
  1930 Smoot-Hawley Act.
• It raised tariffs on imported goods by an average
  60 percent.
• Other nations retaliated, resulting in a collapse
  in world trade.

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Smoot-Hawley Tariffs

• The failure of this legislation brought on the
  General Agreement on Tariffs and Trade (GATT),
  the regular international conference to reduce
  trade barriers.

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Smoot-Hawley Tariffs

• GATT has been succeeded by the World Trade
  Organization (WTO) an organization committed to
  getting nations to agree not to impost new
  tariffs on other trade restrictions.

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Quotas

• Quotas are quantity limits placed on imports.
• Quotas differ from tariffs.
• Foreign producers prefer quotas to tariffs.

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Quotas

• In a tariff, the government receives the tariff
  payment.

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Quotas

• With quotas, an increase in domestic demand will
  be met by the less-efficient domestic producers.

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Voluntary Restraint Agreements

• To avoid imposing new tariffs on their goods,
  countries often enter into voluntary restraint
  agreements.
• Voluntary restraint agreements are those in which
  countries voluntarily restrict their exports.

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Voluntary Restraint Agreements

• The effect of voluntary restraint agreements is
  the same as the effect of quotas.

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Voluntary Restraint Agreements

• In the case of the voluntary quotas imposed on
  Japanese auto manufacturers, consumers lost since
  they paid higher prices both for domestic and
  imported cars.

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Embargoes

• An embargo is an all-out restriction on import or
  export of a good.
• Embargoes are usually created for international
  political reasons rather than for primary
  economic reasons.

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Regulatory Trade Restrictions

• Regulatory trade restrictions are indirect
  methods of imposing governmental procedural rules
  that limit imports.
• An example limiting or prohibiting foodstuffs to
  be imported if certain pesticides are used.

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Regulatory Trade Restrictions

• A second type of restriction involves making
  import and customs restrictions so detailed and
  time consuming that importers simply give up.

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Nationalistic Appeals

• Given two products of equal quality and appeal,
  Americans prefer to Buy American.

120
Nationalistic Appeals

• Some manufacturers will have cloth made and cut
  in a foreign nation, then brought into the U.S.
  where it is sewn together so that it can be
  advertised Made in U.S.A.

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Economist Dislike Trade Restriction Policies

• Despite the political popularity of trade
  restrictions, most economists support free trade.
• A free trade policy allows unrestricted trade
  among countries.

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Economist Dislike Trade Restriction Policies

• Trade restrictions lower aggregate output.

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Economist Dislike Trade Restriction Policies

• Trade restrictions lower international
  competition.

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Economist Dislike Trade Restriction Policies

• They often result in harmful trade wars that hurt
  everyone.

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Strategic Trade Policies

• Strategic trade policies are threats to implement
  tariffs to bring about a reduction in tariffs or
  some other concession from the other country.
• The threats must be credible.

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Open Economy Macro Exchange Rate And Trade
Policy

• End of Chapter 16

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