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

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

• Chapter 6
• International Trade, Exchange Rates, and
  Macroeconomic Policy

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• 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.

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• 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.

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• 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.

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• 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

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• 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.

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• 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.

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Figure 6-2 Foreign Exchange Rates of the Dollar
Against Four Major Currencies, Quarterly,
19702005 (1 of 2)
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Figure 6-2 Foreign Exchange Rates of the Dollar
Against Four Major Currencies, Quarterly,
19702005 (2 of 2)
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• 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.

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Figure 6-3 Determination of the Price in Swiss
Francs of the Dollar
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• 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.

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• 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

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• 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.

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• 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

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• 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.

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• 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.

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• 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

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• 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.

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• (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.

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• 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.

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• 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)

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• 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

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Figure 6-8 Effect of an Increase in the Money
Supply with Fixed Exchange Rates
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• 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.

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Figure 6-9 Effect of a Fiscal Policy Stimulus
with Fixed Exchange Rates
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• 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.

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Figure 6-10 Effect of a Monetary and Fiscal
Policy Stimulus with Flexible Exchange Rates
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• 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.

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• 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.

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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
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• 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.

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Summary of Monetary and Fiscal Policy Effects in
Open Economies
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Table 6-1 The U.S. Balance of Payments, Selected
Years
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Figure 6-1 The U.S. Current Account Balance and
Its Net International Investment Position,
19752004
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Table 6-2 Daily Quotations of Foreign Exchange
Rates
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Figure 6-2 Foreign Exchange Rates of the Dollar
Against Four Major Currencies, Quarterly,
19702005
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International Perspective Big Mac Meets PPP
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Figure 6-4 Nominal and Real Effective Exchange
Rates of the Dollar, 19702004
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Figure 6-5 Foreign Official Holdings of Dollar
Reserves as a Percent of U.S. GDP
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Figure 6-6 U.S. Real Net Exports and the Real
Exchange Rate of the Dollar, 19702004
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Figure 6-7 The U.S. Real Corporate Bond Rate and
the Real Exchange Rate of the Dollar, 19702004
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