Asset Approach to Balance of Payments
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Transcript Asset Approach to Balance of Payments
International Economics
Portfolio Balance Models
1
Asset Market Approach to
Exchange Rates
2
Asset Markets Approach
• Asset Markets or Portfolio Balance approach
focuses on capital flows due to changes in assets
held by residents
– assumes that financial markets to keep international
demand for stocks of national assets equal to their supply.
• Foreign & domestic bonds are imperfect substitutes.
• Characterize asset-holdings of residents as:
– Domestic money, implicit cost of interest rate i.
– Domestic government bonds yielding interest rate i.
– Foreign government bonds yielding i* + xa where xa is
the expected % change in the exchange rate (UIPC).
3
Domestic Money Market
1. Domestic Money Market
• Money Demand
- + +
L = m( i, i*+xa, Y, P)W
– m( ) is the percent of Wealth, W, held as domestic money.
– Signs of i and i*+xa reflect opp. cost of holding money.
• Money Supply
Ms = M0
– Assuming money stock set by domestic central bank.
• Equilibrium
M0= m(i, i*+xa, Y, P)W= L
– Assuming only domestic residents hold domestic money.
4
Domestic Bond Market
2. Domestic Bond Market
• Bond Demand
+ - Bd = b( i, i*+xa, Y, P)W
– b( ) is the percent of Wealth, W, held as domestic bonds.
– Signs of Y and P reflect transaction demand for money.
• Bond Supply
Bs = B0
– Assuming bond stock set by domestic government.
• Equilibrium
B0= b(i, i*+xa, Y, P)W= Bd
5
Foreign Bond Market
3. Foreign Bond Market
• Bond Demand
- +
- B*d = b*( i, i*+xa, Y, P)W
– b*( ) is the percent of Wealth, W, held as foreign bonds.
• Bond Supply
B*s = eB*0
– Assuming bond stock set by foreign government.
– Must multiply B* by e to convert into domestic currency.
• Equilibrium
eB*0= b*(i, i*+xa, Y, P)W= B*d
– Assuming domestic residents do not hold foreign money.
6
Overall Asset Markets Model
Domestic Money, (MM Curve)
M0= m(i, i*+xa, Y, P)W
Domestic Bonds, (BB Curve)
B0= b(i, i*+xa, Y, P)W
Foreign Bonds, (FF Curve)
eB*0= b*(i, i*+xa, Y, P)W
Wealth Identities
W = M + B + eB*0 and m() + b() + b*() = 1
7
Asset Markets Approach
• Features of the Model
– Wealth identity ensures that equilibrium in two of the
markets implies third market is also in equilibrium.
– Wealth share identity means that changes in desire to hold
one asset imply adjustments in one or both of the others.
• Asset Markets Approach Diagrams
– Begin by looking at interactions between the three markets
induced by policy events.
– Then derive single diagram that summarizes the three
markets equilibrium. Relate shifts in individual markets to
shifts in market curves (MM, BB, FF) on this single
diagram.
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Increase in Domestic
Bond Supply
9
Increase in Domestic Bonds
i
Ms
PB =
1/i
0
B s1
B s0
i1
i0
Md1
Md0
Domestic Money Market
P*B =
1/(i*+xa)
Bd
M
Domestic Bond Market
B
Increase in Domestic Bonds
Direct Effects (Curve Shifts)
B*s
1. Supply of Domestic Bonds rises, PB falls.
Wealth increases by amount of new bonds
Indirect Effects (Adjustments)
2. Rise in W raises Md. Domestic i rises.
?
B*d0
Foreign Bond Market
B*
3. Rise in W raises B*d, capital outflows but
rise in i lowers B*d. Effect on e uncertain.
4. Rise in W raises Bd partly offsets 1.
10
Deriving Portfolio Balance Diagram
•
Working with the three markets directly is cumbersome and hides the
dependence of the markets through the Wealth identity.
• Portfolio Balance Diagram (Axes are e and i)
– Derive relationship between e and i in each market.
o
Note that as e rises, eB* rises, and so wealth, W, rises.
– Money Market, MM Curve
o
Rise in e, leads to rise in W, which raises Md. To keep Ms = Md requires rise
in i. MM curve is upward-sloping in e-i diagram.
– Domestic Bond Market, BB Curve
o
o
B0= b(i, i*+xa, Y, P)W
Rise in e, leads to rise in W, which raises Bd. To keep Bs = Bd requires rise
in PB i.e. i falls. BB curve is downward-sloping in e-i diagram.
– Foreign Bond Market, FF Curve
o
M0= m(i, i*+xa, Y, P)W
eB*0= b*(i, i*+xa, Y, P)W
Fall in i, leads to rise in B*d. To keep B*s = B*d requires rise e. FF curve is
downward-sloping in e-i diagram.
We are assuming expected future spot exchange rate is constant throughout.
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Portfolio Balance Diagram
1. Increase in relative Ms shifts
MM back as i falls to raise Md.
Exchange Rate, e
MM
2. Increase in relative Bs shifts
BB out as i rises to raise Bd.
3. Increase in relative B*s shifts
FF down as e falls to raise xa,
and so B*d.
e0
FF
BB
i0
Domestic Interest Rate, i
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Increase in Domestic Bonds
1. Increase in domestic Bs shifts BB out..
Exchange
Rate, e
2. Rise in Wealth shifts MM out & i up
to keep MD equal to unchanged MS.
3. FF shifts out as wealth up but i up
may bring offsetting shift back.
4. Rise in wealth also partially offsets
original shift in BB (not shown).
MM0
MM1
e0
FF1
FF0
5. Results? Domestic i rises with
certainty but effect on spot e not
certain depends on shifts in FF.
Likely FF shift is small so e falls
BB1
BB0
i0
i1
Domestic Interest Rate, i
13
Open Market Operations
14
Open Market Operations
Ms1
i
Ms0
PB =
1/i
B s0
B s1
i1
i0
Md
Bd
Domestic Money Market
P*B =
1/(i*+xa)
M
Domestic Bond Market
B
Open Market Sale of Gov’t Bonds
Direct Effects (Curve Shifts)
B*s
1. Supply of Domestic Bonds rises, PB falls.
2. Domestic Money Supply falls, i rises.
B*d(i0)
B*d(i1)
Foreign Bond Market
B*
Indirect Effects (Adjustments)
3. Rise in i lowers B*d. Capital inflows.
4. Domestic currency appreciates, spot e
falls, raising xa and return on foreign bonds.
15
Open Market Operations
1. Central bank does Open Market Sale
of government bonds. Reduces MS.
Exchange Rate, e
2. MM shifts out as i rises to keep
MM0
MD equal to lower MS.
MM1 3. BB shifts out as bonds supply
increases, bond price (1/i) falls.
4. No change in foreign BS or FF.
e0
e1
FF
BB0
i0
i1
5. Lower i leads to capital outflows.
Result: e down, (foreign currency
depreciates). Assumed i* fixed but
outflows may cause i* to fall also.
BB1
Domestic Interest Rate, i
16
Short Run vs. Long Run Exchange Rate Overshooting
17
Exchange Rate Overshooting
• Feature of FX markets is that exchange rates “overshoot” new
equilibrium positions during adjustment to a market shock.
• Assume Home country is “small” relative to Rest of World and
that capital is perfectly mobile.
– UIPC holds, foreign & domestic assets are perfect substitutes.
– Asset markets adjust more rapidly to external shocks than goods markets.
• Equilibrium involves both Asset market equilibrium and Goods
market equilibrium simultaneously.
• Goods Market Equilibrium (e = P/P* i.e. Relative PPP holds)
– Higher P implies rise in e (depreciation) to keep Absolute PPP.
• Asset Market Equilibrium (i = i* + xa i.e. UIPC holds)
– Higher P, implies higher Md, which implies higher i, so i > i* + xa.
– Capital flows in, strengthens e which raises xa leads to i = i* + xa.
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Overshooting in Monetary Model
Perfect Capital Mobility
Domestic Money Market
Interest rates
RF1
M/P0
M/PLR
M/PSR
RF0
Rise in future price
level, leads to expected
future dep’n of
currency. Shifts RF
outwards in SR & LR.
RD0
i0
RD1
i1
eSR
Spot Rate, e
eLR
e0
L( i, Y0)
Domestic MS
19
Dornbusch Overshooting Model
Domestic
Price level, P
Absolute PPP
e = P/P*
Higher P leads to higher Md
which raises i > i* + xa. Must
have fall in e (xa up) for UIPC.
P0
e0
UIPC
i = i* + xa
Spot EXR, e
20
SR Overshooting of EXR
Domestic
Price level, P
1. Increase in Domestic Ms, lowers i,
shifts out UIPC. (xa falls for UIPC)
2. Asset markets adjust quickly, P
sticky. In SR, EXR rises to eSR.
Absolute PPP
e = P/P*
UIPC0
LR
P1
P0
e0
Exchange Rate Overshooting!!!
SR
eLR eSR
3. Goods markets adjust
slowly, P rises. Real Ms
falls, i rises in LR, EXR
falls back to eLR.
UIPC1
Spot EXR, e
21
Short Run vs. Long Run Asset Market Model
22
Real Side of the Economy
• So far have examined only asset market conditions.
– All these quantities are in nominal terms, i.e. W = M + BD + eBF
• Focus now on real side of the economy, i.e. production and
demand of goods & services in the economy.
– Assume full domestic employment in prod’n of two types of goods.
o Non-traded Goods, YN(q): produced & consumed in domestic economy.
o Traded Goods, YT(q): produced domestically but consumed both
domestically and abroad. YTq > 0, YNq < 0
– Relative Price of Traded vs. Non-traded goods: q = e/PN
• Price of Non-tradables = PN Price of tradables = PT = e
– Overall Price Level: P = PNae1-a
– Demand for goods by consumers
o
o
Non-traded goods, CN = CN(q, w) with CNq > 0, CNw > 0
Traded goods, CT = CT(q, w) with CTq > 0, CTw > 0
– Real Wealth = W/P = (M + B + eB*)/P
– Macro Identities
o
C = CN + CT
YD = YN + YT + (i*+ xa)eB*
23
Deriving Real Side Diagram
• Real side of model has two equilibrium conditions:
– Equilibrium in Production: How much of total prod’n goes to tradable good?
– Equilibrium in Consumption: How much of total consump. is tradable good?
• Real Side Diagram (Axes are e and YT, CT)
– Derive relationship between e and YT or CT.
– Production Equilibrium, YY Curve
o
o
Rise in e (currency depreciates), leads to rise in value of Tradable good,
prod’n switches to YT. YY curve slopes up.
YY curve shifts with changes in full employment GDP and PN
– Consumption Equilibrium, CC Curve
o
o
Rise in e (currency depreciates), leads to rise in value of Tradable good,
consumption switches away from YT. CC curve slopes down.
CC curve shifts with changes in real wealth, w = W/P
– Increase in real wealth shifts CC curve away from origin
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Real Side Diagram
Exchange Rate, e
1.
YY
1. Increase in PN, price of Non-traded
good shifts both curves.
2.
e0
1.
2. Increase in real wealth, shifts
CC curve outwards.
CC
Y T CT
YT, CT
25
Linking Real & Asset Sides
•
1.
2.
Asset markets and real economy are linked in two ways.
–
Exchange rate is determined/affects both parts of the economy
–
Level of real wealth is determined/affected by both parts also.
Interaction on exchange rate is captured by placing Asset
market and real-side diagrams back-to-back.
Interaction with real wealth is more complicated.
–
–
Clearly asset market nominal supplies affect nominal & real wealth.
Less obvious is that real-side equilibrium affects real wealth
o
o
o
Assume consumers have a target level of real wealth, w*.
Their savings behavior is based on comparison of desired level with
actual level of real wealth, S = b(w* - w), b > 0
By definition Savings equals difference between total income YD and
total consumption C. Can show using identities that:
S = (YT – CT ) + (i* + xa)eB*
–
i.e national savings equals net exports plus income on foreign
investments. Thus change in real wealth over time is related to
current account position, which affects Asset market equilibrium.
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Linking Real & Asset Sides I
Exchange Rate, e
YY
MM
e0
FF
CC
YT, CT
BB
Y T CT
i0
Domestic
Interest Rate, i
27
Linking Real & Asset Sides
• Important to be clear about time frames in within which
interactions occur between markets in the economy.
• Impact Period (Shifts in MM-BB-FF curves):
– Instantaneous adjustment of Asset markets to shock in one or more of
the Asset markets of the economy.
• Short Run (Price Changes through e affect YY-CC curves):
– Prices change as a result of the asset market shock(s) and have effects
on real quantities in the the model. Will cause a divergence between
actual real wealth and desired real wealth, which in turn causes
changes in savings behavior and current account.
• Long Run (Current account imbalance affects w & W):
– Changes in flow of real savings cause accumulated changes in level of
real & nominal wealth in the economy over longer periods. These
flow accumulations lead the economy to new long run equilibrium in
both Asset and real markets of the economy.
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Open Market Operation:
Impact, Short Run & Long Run
29
Open Market Operations: Impact Effects
Exchange Rate, e
YY0
BB0
BBI
CC0
Impact Current
Account Surplus
MMI
MM0
FF0
eI
e0
YT,
CT
Y0 T C0T
iI
i0
Domestic
Interest Rate, i
30
Open Market Operations: SR Effects
Short Run Current
Account Surplus
YY0
Exchange Rate, e
CC0
BB0
BB1
MM1
CCSR
MM0
FF0
e1
e0
YT,
CT
Y T SR Y0 T
C0T
CTSR
i1
i0
Domestic
Interest Rate, i
31
Open Market Operations: LR Effects
LR Current
Account
Deficit
Exchange Rate, e
CCLR
YYLR
BB0
BB1
CC0 CC
MM1
SR
YY0
MM0
FF0
eSR
eLR
e0
YT,
CT
Y T SR Y0 T
C0T
CTSR
i1
i0
Domestic
Interest Rate, i
32