Transcript Exchange rate - Imperial College London

Economic
Environment
Lecture 8
Joint Honours 2003/4
Professor Stephen Hall
The Business School
Imperial College London
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© Stephen Hall, Imperial College London
Revision
A Note on the Natural Rate Hypothesis
• Graphically, the natural rate of output can be seen as
that associated with the intersections of constantly rising
aggregate supply and demand curves.
S1
P
S0
D1
D0
Natural Rate of output
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The short-run aggregate supply schedule
P0
Suppose the economy is initially at Yp in fullemployment equilibrium at A, with price P0
SAS In response to a fall in
aggregate demand,
A
SAS1 firms in the short run
B
vary labour input, thus
moving along SAS to B.
SAS2
P2
A2
Yp
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Output
In time, the firm is able to
negotiate lower wages,
and the SAS shifts to
SAS1 and then to SAS2,
until equilibrium is
restored at A2.
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A fall in nominal money supply
AS
SAS
P
P'
P''
P3
E
E'
E3
MDS'
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Starting from long-run
equilibrium at E:
a fall in nominal money
supply shifts MDS to MDS'
SAS'
Given wage levels, firms
SAS3 adjust to E' in the short run
With price at P' but wages
unchanged, the real wage
rises bringing involuntary
MDS unemployment.
As the labour market (wage)
adjusts SAS shifts e.g. to SAS'
Yp
Output
Equilibrium is eventually reached at E3, back at Yp.
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An adverse supply shock:
e.g. an increase in the price of oil
Higher oil prices force
SAS' firms to charge more
for their output, so SAS
SAS shifts to SAS'
P
equilibrium from E to E'
E'
P'
P
E
MDS
Y'
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Yp'
Output
Higher prices cause a
move along MDS, and
output falls to Y'
In time, unemployment
reduces wages and SAS
gradually shifts back to
SAS, so Yp is restored.
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Trade and Exchange
rates
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Open economy macroeconomics
• … is the study of economies in which
international transactions play a significant role
– international considerations are especially important for open
economies like the UK, Germany or the Netherlands
• Domestic macroeconomic policy in such
countries cannot ignore the influence of the rest
of the world
– especially via the exchange rate.
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Trade and the International environment
• Globalisation
• Growing trading blocks
• Trade disputes tariffs and protectionism
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Exports as % of GDP
80
1967
1998
60
% 40
20
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Ja
pa
n
U
SA
ly
Ita
U
K
Fr
an
ce
Be
l
gi
um
N
' la
nd
s
0
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Destination of world exports, 1996
North
America
17%
Africa Other
2% 7%
EU
38%
Latin
America
5%
Middle East
3%
Asia
28%
Source: Direction of Trade Statistics
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The composition of world exports
100%
80%
60%
40%
20%
0%
1955
Food, ag
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Fuels
1995
Other primary
Manufactures
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Comparative advantage
• Trade offers benefits when there are international
differences in the opportunity cost of goods.
• Opportunity cost of a good
– the quantity of other goods sacrificed to make one
more unit of that good
• The law of comparative advantage
– states that countries should specialize in
producing and exporting the goods that they
produce at a lower relative cost than other
countries.
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The source of comparative advantage
• An important difference between countries is in factor
endowments
• which will be reflected in different relative factor prices
– e.g. if the UK has relatively abundant capital but relatively
scarce labour as compared with India,
– then the UK would tend to specialize in capital-intensive
goods,
– and India would tend to specialize in labour-intensive
products
• Comparative advantage may also reflect a relative advantage
in technology
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Gainers and losers
• Countries may gain from specialization and
trade
– but not all countries may gain equally
• Commercial policy
– is government policy that influences
international trade through taxes or
subsidies
• e.g. tariffs
– or through direct restrictions on imports
and exports.
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The effect of a tariff
SS
DD and SS show the domestic
demand and supply for a good.
If the world price is Pw,
and there is free trade,
domestic firms supply Qs
Pw + T
domestic demand is Qd
Pw
and the difference is imported.
DD A tariff can stimulate domestic
supply and restrict imports
Qs Qs '
Qd' Qd Quantity
At a domestic price Pw + T,
where T is the size of the tariff
Domestic demand falls to Qd', domestic supply rises to Qs'
and imports fall.
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The welfare costs of a tariff
SS
The tariff leads both to
transfers and net social
losses.
The government raises
revenue – i.e. there is a
transfer to the government
Pw+ T
Pw
DD
Qs Qs '
and there is a transfer in
the form of extra profits to
producers
Qd' Qd Quantity
There is a social cost from production inefficiency,
given that the good could be imported at Pw.
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Hall, Imperial College London
There is also a loss of consumer
surplus.
Tariffs
• The deadweight burden of a tariff suggests
that society suffers from this method of
restricting trade.
• This is the case for free trade.
• Tariffs have fallen substantially under the
GATT
– General Agreement on Tariffs and Trade
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The case for tariffs – good arguments
• Optimal tariff
– a first-best argument
– only valid where the importing country is large
enough to affect the world price
• This policy fulfils the principle of targeting
– which says that the most efficient way to attain a
given objective is to use a policy that influences
that activity directly.
– Policies that attain the objective, but also influence
other activities are second-best, because they
distort those other activities.
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The case for tariffs – second-best arguments
• Way of life
– an attempt to preserve ‘traditional’ ways
– a production subsidy would be better
• Suppressing luxuries
– an attempt to curb consumption patterns of the rich in a poor society
– better achieved by a consumption tax
• Infant industries
– an attempt to nurture new activities via learning by doing
– a temporary production subsidy probably better
• Revenue
– tariffs raise government revenue
– but there are better ways
• Cheap foreign labour
– a non-argument – denies benefits of comparative advantage
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Other commercial policies
• Although tariff rates have fallen under GATT, there
has been a proliferation of other trade restrictions
– quotas
– non-tariff barriers
• administrative regulations that discriminate
against foreign goods
– export subsidies
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The foreign exchange market
- the international market in which one national currency can be exchanged for another.
Exchange rate ($/£)
The price at which two currencies exchange is the
exchange rate.
DD shows the demand for
Suppose 2 countries: UK & USA pounds by Americans wanting
to buy British goods/assets.
SS
SS1
e0
Equilibrium exchange rate is e0
e1
DD
Quantity
of pounds
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SS shows the supply of pounds
by UK residents wishing to buy
American goods/assets.
If UK residents want more $
at each exchange rate, the
supply of £ moves to SS1
New equilibrium at e1.
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Warning!!
• Exchange rates can be defined in two
ways
• Dollars to the pound 1.4
• Pounds to the dollar 0.71
•
•
•
•
Devaluation means the currency buys less
1.4 -> 1.3 or 0.71 -> 0.79
Revaluation means it buys more
1.4 ->1.5 or 0.71 -> 0.66
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Two Basic Exchange Rate Theories
• Purchasing Power Parity
• Uncovered Interest Parity
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Purchasing Power Parity
• Basic trade relationship
• Law of one price. If a car costs £1000 in the UK
and DM3000 in Germany then the exchange rate
should be 3DM/£.
• Qualification; Transportation costs, Tarrifs,
Taxes
• A long term relationship
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Uncovered Interest Parity
• Basic speculative model
• If interest rates in the UK are 5% and in Germany
they are 4% then an investor must expect the DM/£
rate to devalue by 1%
• Expected change in exchange rate= interest diff.
• Qualification: Risk aversion
• Dominates exchange rates in the short run
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Alternative exchange rate regimes
• In a fixed exchange rate regime
– the national governments agree to maintain the
convertibility of their currency at a fixed exchange
rate.
• In a flexible exchange rate regime
– the exchange rate is allowed to attain its free
market equilibrium level without any government
intervention using exchange reserves.
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Intervention in the forex market
e1
E
A
Suppose the government is
committed to maintaining the
SS exchange rate at e1 ...
If the demand for pounds is DD1
C
there is excess demand AC.
DD
The Bank of England must
DD1 supply AC £s in return for $,
which are added to reserves.
DD2
Quantity of £s
The reverse occurs if
demand is at DD2.
When demand is DD, no intervention is needed ...
there is a balance in transactions between the countries.
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The balance of payments
• … a systematic record of all transactions
between residents of one country and the rest of
the world
• Current account
– records international flows of goods, services, income and
transfer payments
• Capital account
– records transactions involving fixed assets
• Financial account
– records transactions in financial assets
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£ billion at current prices
The UK balance of payments, 1980-1998
25
20
15
10
5
0
-5
-10
-15
-20
-25
1980
Current
Capital
Financial
Err & om
1983
1986
1989
1992
1995
1998
Source: Economic Trends Annual Supplement
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Floating exchange rates and the balance of
payments
• If the exchange rate is free to move to its
equilibrium, there is no need for
intervention
• any current account imbalance is exactly
matched by an offsetting balance in
capital/financial accounts
• if there is intervention, it is recorded as
part of the financial account.
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International competitiveness
• The competitiveness of UK goods in
international markets depends upon:
– the nominal exchange rate
– relative inflation rates
• Overall competitiveness is measured by
the real exchange rate
– which measures the relative price of goods from
different countries when measured in a common
currency
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3
$/£
2.5
1.1
Relative price
(UK/USA)
1
0.9
2
0.8
1.5
0.7
Exchange rate ($/£)
1
0.6
0.5
0.4
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
0.5
Relative price (UK/USA)
Relative prices and the nominal exchange rate, UK & USA
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The real £/$ exchange rate
The real exchange rate is the nominal rate multiplied
by the ratio of domestic to foreign prices
2.5
£/$
2
1.5
1
0.5
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
0
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Components of the balance of payments
• The current account is influenced by:
– competitiveness
– domestic and foreign income
• The capital & financial accounts are influenced by:
– relative interest rates
• which affect international capital flows.
• Perfect capital mobility
– occurs when there are no barriers to capital flows,
and investors equate expected total returns on
assets in different countries
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Internal and external balance
• Internal balance
– a situation for a country when aggregate demand is at the
full-employment level
• External balance
– a situation for a country when the current account of the
balance of payments just balances
• The combination of internal and external balance
is the long-run equilibrium for the economy.
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Shocks may move an economy away from internal and external
balance:
Surplus
More saving,
tighter fiscal &
monetary policy
Foreign boom,
lower real
exchange rate
Slump
Boom
Less saving,
easier fiscal &
monetary policy
Foreign slump,
higher real
exchange rate
Deficit
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Macroeconomic policy under fixed exchange rates
• Under fixed exchange rates, there is a crucial link
between external imbalance and domestic money supply.
• When the government intervene to maintain the exchange
rate, there is a direct effect on money supply.
• Sterilization
– an open market operation between domestic money
and domestic bonds to neutralize the tendency of
balance of payments surpluses and deficits to change
domestic money supply.
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Monetary policy under fixed exchange rates
Assume: perfect capital mobility, sluggish prices
• An increase in nominal money supply
– tends to reduce interest rates
– leads to a capital outflow
– reducing money supply as the government seeks
to maintain the exchange rate
• so monetary policy is powerless
– the government cannot fix independent targets for
both money supply and the exchange rate
– domestic and foreign interest rates cannot diverge
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Fiscal policy under fixed exchange rates
Assume: perfect capital mobility, sluggish prices
• An increase in government expenditure;
• in the short run
– stimulates output
– but also increases interest rates
– which leads to a capital inflow
– money supply expands to maintain the exchange rate
– there is no crowding-out
– as interest rates cannot rise
• in the long run:
– wages and prices adjust, affecting competitiveness
– the economy returns to potential output.
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Monetary policy
under floating exchange rates
e
e3
e2
Suppose the economy begins in equilibrium
with the nominal exchange rate at e1.
At time t, nominal money
B
supply is halved...
C e will be the new equilibrium
2
e1
exchange rate once the
economy has adjusted
A
t
Time
But prices are sluggish, so
in the short run, real money
supply falls and domestic
interest rates rise
To maintain equilibrium in the forex market, the exchange
rate overshoots to e3 , adjusting along BC with wages & prices.
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Monetary policy
under floating exchange rates (2)
• This analysis suggests that with floating
exchange rates,
• monetary policy is highly effective in the
short run
• but the effect is only transitional
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Fiscal policy under floating exchange rates
• Following an increase in government
expenditure ...
• the crowding-out effect of higher interest
rates is enhanced by appreciation of the
exchange rate
– which dampens export demand
• so fiscal policy is less effective under
floating exchange rates.
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Conclusion
• Trade is important and growing
• Exchange rate regimes affect the working
of economic policy
• A major issue in policy is the overall way of
determining exchange rates and trade
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