Transcript Diapositive 1

The balance of payments
and the exchange rate
Imports, exports
Savings and investment in an
open economy
Exchange rate regimes
Balance of payments and exchange rate

Up until now, we have worked only in the case
of closed economies
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
No trade considerations were present
However, we know that in fact trade is
important in understanding macroeconomics,
particularly so with globalisation.

As for previous models, this means we have to
introduce corrections to the model to obtain a
better understanding of what trade does to the
economy
Balance of payments and exchange rate
Imports, exports and exchange rates
Current account, capital account and
balance of payments
Exchange rate regimes
Imports, exports and exchange rates

The first element to take into account in an
open economy is the presence of imports M
and exports X in aggregate demand
   
Y  C Y  T   I  i   G  X Y * , e  M Y , e
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
 
These represent another possible leakage
from the circular flow of income

In particular, agents will have a propensity to
import which will have to be taken into
account when calculating multipliers
Imports, exports and exchange rates
   
Y  C Y  T   I  i   G  X Y * , e  M Y , e

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 
Second problem: in terms of national
accounting, exports / imports are not
measured in the same units:
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
We need to convert imports paid in foreign
currency into national currency
Exports towards other countries are also affected
by the value of the currency
This is where the exchange rate comes in
Imports, exports and exchange rates
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The exchange rate (e) is the price of one currency in
terms of another currency
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Note of caution ! There are 2 ways of working it out:
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The amount of $ you can buy with 1€ :
 1€ = 1.35$
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The amount of € required to buy 1$ :
 1$ = 0.75€
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These two measures are equivalent, but be careful, the
second one (often used in models) is not intuitive :
 If e falls, less € are needed to purchase 1$, so the euro

has appreciated (it is worth more in $ terms)
If e increases, more € are needed to purchase 1$, so the
euro has depreciated (it is worth less in $ terms)
Imports, exports and exchange rates
The exchange rate is a price
e=price of the currency
(dollars/euro)
Supply of euros
Purchase of dollardenominated assets,
imports
Equilibrium
exchange rate e*
Purchase of eurodenominated assets,
exports
Demand for euros
Quantity
Imports, exports and exchange rates
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The exchange rate is in nominal terms
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It is possible to define a real exchange rate
which accounts for the price levels in the two
currency areas
real
$/ €
e
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 e$ / €
P€
P$
The real exchange rate gives a relative price
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It expresses the relative value of a
representative basket in the euro zone to the
same basket in the USA.
Imports, exports and exchange rates
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This allows us to define the purchasing power parity
(PPP) exchange rate.
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The PPP exchange rate is the nominal exchange rate that
occurs when the real exchange rate is 1.
real
$/ €
e

 e$ / €
P€
P$
PPP
$/ €
e
P$

P€
The PPP exchange rate is often considered to be the
long run equilibrium exchange rate
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It is also used to compare economic variables across
countries, particularly measures related to standards of
living or welfare
Balance of payments and exchange rate
Imports, exports and exchange rates
Current account, capital account and
balance of payments
Exchange rate regimes
Current account and capital account
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The current account is not the only element
of international trade.
The balance of payments composed of:
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The current account CA:
 Tracks outflows minus inflows of goods and services
 It corresponds to the Exports – Imports component.
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The capital account KA:
 Tracks inflows minus outflows of capital of a country
 Either as direct investment (building factories, etc)
 Or purchases/sales of assets
Current account and capital account
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The current account was explained in the previous
section as the ‘net exports’ added to C + I + G.
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What role does the capital account play ?
To understand their relation, let’s derive the
savings/investment balance for an open economy
Z  C  I  G  X

Y  C  S  T  M
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Setting Z = Y :
S T  M  I G  X
Current account and capital account
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This gives us the equilibrium condition in terms of
investment and savings:
S  I  G T  X  M
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Simplifying assumption: the government budget is in
equilibrium (G-T = 0)
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If there is a CA deficit (X-M < 0), there are not enough savings
(agents are spending too much). Some of the financing of
investment (I) must come from abroad.
If there is a CA surplus (X-M > 0), there is excess savings
(agents are not spending enough). The excess saving are used
to fund foreign investment.
The adjustment to the current account balance occurs
through an inflow or outflow of savings: This is the
capital account.
Current account and capital account
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The BoP is in equilibrium
when
 CA+KA = 0
 The current account and
capital imbalances add
to 0
 As seen in the previous
slide, this is equivalent
to saying that S = I in an
open economy
Current account and capital account
Source: BIS,2007 World Report
Current account and capital account
S  I  G T  X  M
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The USA have been net importers and net borrowers
since the 1980’s. The US current account deficit in 2006
was 6,6% of its GDP.
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Europe has recently seen positive balances on its current
account, which reflects a relatively low level of growth.
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Japan has traditionally been a net exporter and a net
lender.
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The current accounts surpluses of emerging Asian
countries (particularly China) have grown during the
1990’s
Current account and capital account
S  I  G T  X  M
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The amount of savings required to finance the current
account deficit of the USA has tripled since 1997.
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On the other had, the emerging economies have become
net providers of savings flows.
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Europe and Asie (including Japan) has covered 2/3 of the
funding needs of the USA in 2002.
Current account and capital account
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The problem with current account deficits
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The central problem is that these deficits can create
speculative flows of capital, whereby agents start
betting against the currency of the country
(depreciation expectations), which creates distortions
and can lead to currency crises.
Depreciation expectations can also give incentives for
capital holders to invest abroad (strong capital
outflows).
Foreign debt creates financial burdens for the
country.
These costs can further increase the current account
deficit, leading to requiring more foreign capital,
which leads to a vicious cycle.
Current account and capital account
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How is a BoP disequilibrium corrected?
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What happens if CA + KA > 0 or < 0 ?
One needs to separate:
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What happens on the foreign exchange
market in terms of supply/demand
The effective outcome, which depends on the
exchange rate regime (which is why we see
them in the next section)
 In a fixed exchange rate regime, the BC intervenes
Current account and capital account
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When BP = CA + KA > 0
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Overall, exports and capital inflows are larger than imports
and capital outflows
There is excess demand for the home currency on the
foreign exchange market
This tends to increase the value of the home currency
When BP = CA + KA < 0
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Overall, imports and capital outflows are larger than
exports and capital inflows
There is excess supply for the home currency on the
foreign exchange market
This tends to decrease the value of the home currency
Current account and capital account
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In other words, the foreign exchange market will be at
equilibrium when the balance of payments is at
equilibrium.
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Outside of equilibrium, there will be pressures on the
exchange rate
Under flexible rates, if BoP < 0, the home currency will
depreciate relative to foreign currencies (excess supply of
home currency).
Under fixed rates, if BoP < 0, the central bank will have to
intervene on the foreign exchange market to purchase its
currency back with foreign reserves.
 From time to time, the exchange rate may be changed
(devaluation), particularly if the CB is low on foreign
reserves.
Current account and capital account
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Evolution of the current account following a
depreciation:
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The J-curve
CA
Depreciation
CA deficit worsens
0
t
CA deficit is corrected
Current account and capital account
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After a depreciation, the increase in exports and
the fall in imports is not automatic:
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The volume of exports can remain fixed in the short
run because of the rigidity of short-run contracts.
Imports can be slow to fall because foreign exporters
can initially compensate the depreciation by reducing
their margins.
The effectiveness of depreciation depends on the
price elasticity of imports and exports (the
Marshall-Lerner condition)
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The sum of the absolute values of the price elasticity
of imports and exports must be greater than 1.
Balance of payments and exchange rate
Imports, exports and exchange rates
Current account, capital account and
balance of payments
Exchange rate regimes
Exchange rate regimes
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Fixed exchange rate regime:
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Floating or flexible exchange rate regime:
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Gold standard system (Bretton woods)
Euro Zone, ‘dollarisation’
Post-Bretton Wood system
Intermediate regimes:
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Crawling peg (Tunisia, Bolivia)
Currency board (Hong Kong, Estonia, Lithuania)
Dirty float (ex: Indonesia, India, Egypt)
Exchange rate regimes
Typology of exchange rate regimes
Currency board
Monetary
Union
Dollarisation/
euroisation
Increasing flexibility
Fixed exchange
rate
Crawling peg
Fixed exchange rate with
fluctuation bands
Dirty float
Pure float
Exchange rate regimes
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Arguments in favour of flexible rates:
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The market is a more efficient regulator.
The central bank is more flexible in terms of
policy, as it does not have to worry about
monitoring the exchange rate (next week)
The Central Bank does not have to hold foreign
reserves, as it does not have to intervene
The Balance of payments automatically adjusts
to equilibrium.
Note: under floating rates, the exchange rate
appreciates or depreciates
Exchange rate regimes
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Arguments in favour of fixed rates:
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Reduces exchange rate fluctuations (volatility)
that increase uncertainty and pose a risk to trade
Reduces speculative activity, which can be
destabilising.
Is not inflationary (the way flexible exchange
rates can be).
Note: under fixed rates, changes in the exchange
rate are referred to revaluations or devaluations.