Transition from chapter 1 to chapter 2

1
Transition from chapter 1 to chapter 2
2

• BoP 0
• FA private (and Govt)
• CA is balance on account
• FA is balance on (capital and)
  account
• CB is change in central bank foreign
• FA includes the accounts
• i.e US bank balance abroad (in for curr.) incr
  (-)
• and For bank balance in US (in ) incr ()

3

• Flexible exchange rate
• start w/ CA FA
• Assume US demand for IM ? CA (CAlt 0)
• Immediate adjustment
• US must pay for new imports
• either w/ (FC) or w/
• Either US bank balance abroad (in FC) ( )
• Or foreign bank balance in US (in ) (
  )
• So FA turns gt0 and BoP still 0

4

• Short term adjustment through foreign exchange
  market
• Means that demand for foreign currency (FC)
• Means that supply of held by foreigners

FC/
/FC
S
S
S
D
D
D
Q of
Q of FC
Depreciation of equivalent to
Appreciation of FC
5

• Then US demand for Import
• while foreign demand for US goods i.e. X
• hence CA X - IM

6

• Fixed exchange rate
• Same situation but the ______ depreciate

FC/
/FC
S
S
S
Fixed ER
D
D
D
Q of
Q of FC
The bold segment shows excess _______ for foreign
currency on the first graph and excess ______ of
dollar on the second graph at the fixed ER. Need
for ___________ by the Central Bank(s)
7

• 2 possibilities
• Unilateral intervention - the Fed uphold the ER
  by _______ FC to the public at the _______ ER.
• Concerted intervention - the Fed _____ FC to the
  public and the foreign central bank ____ dollars
  (to soak out the excess supply of ).
• No short run adjustment through the market forces
  possible - ___________ remains.

8

• Intervention and the Central Bank

Assets
Liabilities
Monetary Base
When the CB sells FC to the public, the public
pays with _________ currency i.e. the liabilities
of the CB ________ - the monetary base (MB) and
thus the money supply (M) _________.
9

• Short run monetary adjustment - Keynesian
• (P fixed)
• The monetary contraction slows down demand
  overall and also demand for _________- thus
  __________ the CA.
• The opposite effect will happen to the trade
  partner - there will be a monetary _________ due
  to the increase in FC at their CB which will
  __________ the economy and the demand for import
  (i.e. the export of the other country) thus
  ______ their CA.

10

• Medium run adjustment - classical (P flexible)
• M and P are proportional - economy ______ at FE
• As the money supply contracts, the price level
  ________ resulting in a real ___________ (an
  __________ in RER) and an _____________ in the
  countrys international competitiveness - thus
  _________ equilibrium in the CA.
• Again the opposite will happen to the trade
  partner - the monetary expansion resulting in an
  ______ in their price level and a ____________ in
  the trade partners international
  competitiveness.

11
Adjustment Mechanismwith Various Exchange
RateArrangements

• Flexible Exchange Rate
• Fixed Exchange Rate

12

• Flexible Exchange Rate
• Adjustment through supply and demand for foreign
  currency.
• The S D equilibrium determines the equilibrium
  price of the foreign currency in terms of the
  domestic currency i.e. the _______________.

13

• The determinants of the demand
• for foreign currency
• We need to go back to the balance of payments
  and find out which agents need foreign currency.
• In the current account
• US ____________ - to pay for imports of foreign
  goods and services
• US _____ who must pay dividends to foreigners
  holding their stocks
• The US _________ planning to send money to the
  victims of the tsunami

14

• In the financial account
• US ____________ who reshuffle their portfolio
  into Canadian bonds
• US ___________ who plan to carry out some FDI
  into Indian IT
• US ___________ rebuilding some destroyed schools
  you know where
• US ___________ in the process of rebuilding its
  foreign reserves
• The demand for foreign currency is a _________
  demand.

15

• To simplify, lets assume that the demand for
  foreign currency has only one determinant - the
  demand for imports.
• When the exchange rate E increases (the
  ______), the price of imports PIM in _______
  as
• PIM PIMFC E
• so the quantity of import demanded QIM _______
  as they become _______ expensive for the US.
• However the foreign price of imports PIMFC
  __________.
• so the total demand for FC equal to PIMFC QIM
  must _____ resulting in a ________ sloping demand
  curve.

16
When E increases, the demand for FC _____.
/FC
D
Q of FC
17

• The determinants of the supply
• of foreign currency
• In the current account
• US ______ - receipts for exports of US goods and
  services
• US _______ receiving dividend income on their
  foreign stock holdings.
• ______ by the sheik of Arabia to Harvard
  University to endow a professorship.

18

• In the financial account
• Foreign ____________ who reshuffle their
  portfolio into US bonds.
• Foreign ____________ who plan to set up new
  factories in the US.
• Foreign __________ remodeling their embassy in
  Washington.
• Foreign __________ selling back to the US.
• The supply of foreign currency is a ___________
  supply.

19

• To simplify, lets assume that the supply of
  foreign currency has only one determinant - the
  supply of ___________.
• This case is more complicated because we are now
  2 steps removed from the __________ of foreign
  currency.
• Indeed the supply of export is really the
  _____________ for our goods and services.
• When the exchange rate E increases (the
  ___________), the price of export PX in does
  _____ change, but, for the foreign importers, the
  price of our goods converted into their currency
  i.e. in FC _____ as PXFC PX /
  E.

20

• so the quantity of export supplied QX ________
  as they become _____ expensive for the
  foreigners.
• The question is what happens to the _______
  supply of FC which is equal to PXFC QX
• Indeed PXFC ______ while QX _______ so the result
  is ambivalent.
• Assuming high elasticities, the percentage change
  (increase) in quantities is _______ than the
  percentage change (drop) in price, thus resulting
  in an ________ in the supply of FC i.e. an
  _______ sloping supply curve.

21
When E increases, the supply of FC _________
/FC
S
Q of FC
Assuming high elasticities cf Marshall Lerner
conditions
22
Foreign Exchange Market Equilibrium
/FC
S
E
D
Q of FC
The intersection of the supply and the demand for
foreign currency determines the ____________
exchange rate E and the ________ of FC traded.
23
Impact of a change in the demand or in the
supply of FC The demand curve or the supply
curve may shift due to a change in _______ or
to a change in __________ in anyone of the trade
partner. For instance US consumers are told that
bananas are very good for their health and the
demand for bananas shots up (the US does not
produce bananas). This triggers an ___________
in the demand for FC (to buy the bananas).
24
Impact of a shift in demand with a flexible
exchange rate arrangement
/FC
S
E
E
D
D
Q of FC
The ___________ from E to E to restore
equilibrium in the FC market while the quantity
of FC traded ___________.
25
Impact of a shift in supply with a flexible
exchange rate arrangement
/FC
S
Story Dubai decides to buy a fleet of Boeing
for their national airline.
S
E
E
D
Q of FC
The ____________ from E to E to restore
equilibrium in the FC market while the quantity
of FC traded ___________.
26

• Fixed Exchange Rate
• Adjustment through intervention by Central Bank
  (CB or Fed in the US) in the market for foreign
  currency.
• The CB commits itself into upholding a specific
  ER and adds its own supply or its own demand to
  the market to keep the exchange rate fixed.

27
Foreign Exchange Market Equilibrium
Fixed exchange rate Ef market is in
equilibrium at the fixed ER Ef
/FC
S
Ef
D
Q of FC
28
Case 1 Increase in demand of FC and intervention
by CB
Goal to keep ER at Ef
To stop the from ________ to E, the Fed must
_______ (sell) quantity ED of FC at the fixed ER
Ef thus ________ the FC and __________ the
/FC
S
E
Ef
D
ED
D
Q of FC
29
Case 2 Increase in supply of FC and intervention
by CB
To stop the from __________ to E, the Fed must
_____ quantity ED of FC at the fixed ER Ef thus
________ the FC and _________ the
Goal to keep ER at Ef
S
/FC
S
ES
Ef
E
D
Q of FC
30
Intervention and the money supply case 1

• To prevent the from depreciating, the Fed must
  __________ the excess _______ of FC to the public
  (the importers mainly).
• So the Fed _____ FC in the foreign exchange
  market and receives payments in ___.
• The FC were part of its assets so the Feds
  assets _____ while the payments from the public
  to the Fed correspond to a __________ of the
  Feds liabilities towards the public.

31

• Impact of Intervention on the Central Bank
  Balance Sheet

Assets
Liabilities
Currency Commercial Bank Reserves
Domestic assets Domestic Bonds Foreign Assets
Foreign Bonds Foreign Currency Gold
Monetary Base
When the CB sells FC to the public, the public
pays with domestic currency i.e. the liabilities
of the CB ________ - the monetary base (MB) and
thus the money supply (M) ________.
32
Sterilization

• Since a decrease in the money supply is
  ____________, the government may wish in certain
  circumstances (a recession for instance) to avoid
  worsening the state of the economy.
• In this case the government can __________ the
  impact of intervention on the money supply by
  performing an ________________ of the same size
  but in the __________ direction to cancel out
  (sterilize) the effect on the money supply.

33

• Impact of Intervention followed by Sterilization
  on the Central Bank Balance Sheet

Assets
Liabilities
Currency Commercial Bank Reserves
Domestic assets Domestic Bonds Foreign Assets
Foreign Bonds Foreign Currency Gold
Monetary Base
As the CB sells FC to the public, it also _____
domestic bonds from the public thus putting back
in circulation the currency wiped by the sale of
FC to the public. The monetary base (MB) and
thus the money supply (M) thus ___________________
__.
34

• Exercise rework slides 30 to 33 in the case of
  excess supply of FC (Case 2)

35
National Income Accounting in the Open Economy

• It is clear that exports are foreign demand for
  ____ goods and services and so ________ to the
  total demand for domestic output.
• On the other hand, imports are domestic demand
  for goods produced ______ so they will detract
  from total demand for domestically produced
  output as they are income earned domestically
  that does not add to demand for domestically
  produced output.

36
Demand Z for domestic production Y

• is defined as Z C I G X - ?IM
• C, I and G are total demand from _________,
  _______ and the ________, so Zt can be broken
  down into demand for _________ produced goods and
  services and demand for ________ goods and
  services. X is export, IM import and ? the real
  exchange rate.
• With C Cd ? Cf
• I Id
  ? If
• and G Gd ? Gf
• The subscript d corresponds to domestically
  produced
• and the subscript f corresponds to imported.

37

• The imported goods and services are expressed in
  baskets of __________ goods. So they must be
  converted into baskets of ________ goods using
  the ______ exchange rate ? EP/P
• Since Z is defined as the demand for domestically
  produced goods and C, I and G also include the
  demand for imported goods, the latter has to be
  _________ away from Z.
• So we have
• Z Cd ? Cf Id ? If Gd ? Gf X
• - ? Cf - ? If - ? Gf
• and -? Cf - ? If - ? Gf -
  ?IM

38
Definitions - Summary

• Z is the total demand - domestic and foreign -
  for domestically produced goods and services.
• C I G is the domestic demand for ____ goods -
  produced domestically or abroad
• it is called __________
• X - ?IM is the net foreign demand for domestic
  goods - the balance of ____ - net ______
• IM are the imports expressed in _______ units
  (baskets) - so imports must be converted into
  domestic units (baskets) using the real ER ?

39
Marshall-Lerner condition

• In principle, one would think that a depreciation
  (or a devaluation) should result in an
  ______________ in the balance of trade.
• A cheaper means that US goods will be ______
  for the foreign buyers of our goods and they will
  ________ their purchases,
• ? _______ exports from our point of view
• More expensive FC means that foreign goods will
  be ______ expensive for us and we will buy ___
• ? _______ imports from our point of view

40

• However we were referring to _______ or _________
  of imports and exports. The balance of trade
  will actually improve only if there is an
  _________ in the value of export minus the
  value of import.
• So will the value of export ________ and
• will the value of import ________
• as a result of a depreciation (or
  devaluation)?
• We will show that the value of exports
  increases ____________ while the value of
  imports may _______ or _______.
• Finally if the value of imports increases and
  this increase is greater than the increase in the
  value of exports, then the balance of trade will
  definitely _______ as a result of a depreciation.

41

• Lets be more rigorous.
• Assumptions
• short run - prices are fixed and the nominal and
  real ER are proportional so we can focus on E
  only.
• Assume P P 1 then ? E
• The balance of trade X - ? IM becomes X - EIM
• A depreciation is an _________ in E
• X - volume of exports __________
• IM - volume of imports ________
• EIM may _______ or __________

42

• Assume that all the prices remain fixed in term
  of their own currency.
• PX is the price of export (in ) and PM the price
  of imports (in FC)
• So the balance of trade is PXX - EPMIM
• EPM is the foreign price of imports converted
  into
• The depreciation does not affect PX but X
  increases
• so the value of exports PXX
• However EPM the price of imports converted into
• ________ while IM ________,
• so the value of imports in EPMIM may
  or

43

• If the deterioration on the import side is
  greater than the improvement on the export side,
  the balance of trade will __________.
• How can we predict whether there will be an
  increase in the value of imports?
• If the increase in price of imports results in a
  ________ reduction in the quantity demanded i.e.
  import demand is _______, then the value of
  imports will _________.
• Moreover if the decrease in the price of export
  results only in a _______ increase in the value
  of export i.e. export supply (foreign demand for
  our exports) is ________. The increase in the
  value of exports may not be large enough to _____
  the increase in the value of imports and the
  balance of trade will _________________.

44

• Elasticities are defined as
• change in quantity/ change in price
• Low elasticities 1 correspond to __________
  demand or supply.
• Marshall-Lerner conditions
• A depreciation/devaluation will improve the
  balance of trade only if the sum of the absolute
  value of the elasticities of supply of exports
  ex (i.e. foreign demand for our exports) and
  domestic demand for imports em are
• ex em lt1

45

• Example

E PX X PM PM EPM M BT PX X - EPMM
1 1 FC1 2 FC1 1 2 2 - 2 0
2 1 FC0.5 3 FC1 2 1.9 3 - 3.8 -0.8
46

• Lets approximate the elasticities in this
  example
• em change in IM / change in PM
• (1.9-2)/1.95/(2-1)/1.5 - 0.0769
  _______

The elasticity of export supply is the elasticity
of foreign import demand for our good. To
calculate it we must convert the domestic price
of export into FC ex change in X / change
in PX/E (3-2)/2.5 / (.5-1)/.75 -
0.6 ______ The sum of the 2 absolute
values is 0.6769 lt 1
47

• Example Calculate whether M-L is fulfilled

E PX X PM PM EPM M BT PX X - EPMM
1 1 FC1 2 FC1 1 2
2 1 FC0.5 4 FC1 2 .5
48

• Lets approximate the elasticities in this
  example
• em change in IM / change in PM
• ( )/ /(2-1)/1.5

The elasticity of export supply is the elasticity
of foreign import demand for our good. To
calculate it we must convert the domestic price
of export into FC ex change in X / change
in PX/E ( )/ /
(.5-1)/.75 The sum of the 2 absolute values is
49
The J-curve

• Why does the balance of trade worsens immediately
  after a depreciation?
• Because quantities do not adjust ____________
  (orders are placed in advance - several months)
• Immediate effect of the depreciation (in )
• PM ___________ but QM ____________
• PX and QX are ______ affected
• So PXQX - PMQM _______
• Effect on monetary expansion more overshooting

50
The J-Curve
BT
t
t
t3
At time t3 quantities start to adjust to the
depreciation