Transcript Fixed Exchange Rates

Chapter 7
International
Trade, Exchange
Rates, and
Macroeconomic
Policy
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The International Trilemma
• The international “trilemma” is the impossibility of any nation
to simultaneously maintain all of the following:
– Independent control of domestic monetary policy
– Fixed exchange rates
– Free flows of capital with other nations
• The EU’s common currency (the Euro) and free flows of capital
between countries prevent individual EU countries from
pursuing independent monetary policies
• The US has flexible exchange rates and free flows of capital, so
it can run an independent monetary policy
– But countries like Japan and China can buy USD to keep their own
currencies undervalued to promote their exports
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7-2
•
•
•
We learned that 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.
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7-3
The trilemma
•
Is the impossibility to maintain simultaneously :
1. Independent control of domestic monetary policy
2. Fixed exchange rates
3. Free flows of capital with other nations.
•
•
The current account and the balance of payments (BOP)
Current account equals NX of goods and services, plus two
additional components (are not part of GDP);
net income from abroad and
net unilateral transfers.
•
•
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• 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.
1. The current account, which records all types of flows for
current income and output.
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7-5
2. 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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The Current Account and National
Saving
• National Saving is the sum of private and government
saving: NS = S + (T – G)
• Recall the Magic Equation:
T – G = (I + NX) – S
Rearranging yields  S + (T – G) = I + NX
 NS = I + NX **OR** -NX = I – NS
(1)
• Recall that a current account deficit  NX < 0
– Amount borrowed from foreigners = foreign borrowing = -NX
• Equation (1)  foreign borrowing rises because:
– Investment increases
– National savings falls
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Why is U.S. Income From Abroad
Positive?
• You would expect that the large negative U.S. international investment position
would make net income more and more negative, but it is not (see Table 7-1)
• Reason: The U.S. must earn a much higher rate of return on the assets that U.S.
residents own abroad than foreigners earn on their assets owned in the U.S.
– Half of the negative U.S. international investment position comes from
foreign holdings of international reserves
• USD holdings often invested in short-term, low interest Treasuries
– U.S. has, in contrast, virtually no foreign currency holdings
– U.S. investors in foreign countries often buy factories or companies yielding
higher returns
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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 + net revaluations
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Table 7-1 The U.S. Balance of Payments, as a
Percent of GDP, Selected Years
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Figure 7-1 The U.S. Current Account Balance
and Its Net International Investment Position,
1975-2010
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7-11
•
•
Exchange rates
The price of one currency in terms of another is called the
foreign exchange rate. It can be shown in two ways,
– Convention: The foreign exchange rate of the dollar is
usually quoted as units of foreign currency per dollar.
• Example: e´ = 106.00 ¥ / $ = Value of the Dollar
– Exception: The Euro-USD and the pound-USD exchange
rates are quoted as dollars per Euro and dollars per pound.
• Example: $1.41 / € = Value of the Euro
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•
•
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 $. Except for the British pound and the euro.
Changes in exchange rates
• The USD is said to appreciate (depreciate) if the value of the
dollar rises (falls) relative to another currency.
• A higher number means that the dollar experiences
appreciation and a lower number indicates a depreciation.
• ¥/$ decreases from 106.25 to 1.06 and the €/$ rate declines
from .7798 to .7769, indicating a depreciation of the dollar
against the euro. Sometimes the depreciation is high over time,
e.g., the €/$ rate.
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7-13
Table 7-2 Daily Quotations of Foreign
Exchange Rates, January 12, 2011
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The Market for Foreign Exchange
• Why do people (foreigners) hold U.S. dollars?
– To buy American goods and services  U.S. exports lead
to D$ ↑
– To buy USD-denominated financial assets  capital
inflows lead to D$ ↑
– For the convenience and/or safety of holding USD  D$↑
• Why do people (Americans) sell U.S. dollars?
– To buy foreign currencies to buy foreign goods
 U.S. imports lead to S$↑
– To buy foreign currencies to buy foreign $-denominated
financial assets
 capital outflows lead to S$↑
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Figure 7-2 Foreign Exchange Rates of the
Dollar Against Four Major Currencies, Monthly,
1970-2010
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• The market for foreign exchange
• Tourists when they travel to any country they need to exchange
their currency into that country’s 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.
• 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
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• 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 7-3 Determination of the Price in
Euros 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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7-20
• 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/$.
• Real exchange rates and purchasing power parity
• The real exchange rate (e) is equal to the nominal rate (e’) adjusted
for differences in inflation rates between the two countries.
e = e’ × p/pf
• Suppose that in 2010 e and e’ for the Mexican peso is 10/$, the price
level in the two countries is 100
10 pesos/$ = 10 pesos × 100/100
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• Assume that in 2011 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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7-23
•
•
•
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
1. New inventions
2. Discovery of new deposits of raw materials
3. Higher demand for a currency e.g., to deposit in banks.
4. Non-traded goods
5. Government policy e.g., subsidization.
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7-24
The big Mac index
• If PPP worked perfectly, good would cost the same in all
countries after conversion into a common currency.
• The economist magazine constructed a PPP test using the “BIG
MAC” cost in different countries in the world.
 based on the prices of the sandwich, a PPP exchange rate would
be computed.
 This is compared with the actual exchange rate.
 Degree of appreciation and depreciation would be calculated.
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International
Perspective
Big Mac Meets
PPP
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Exchange rate systems
• Flexible exchange rate system
• Exchange rate is free to change
• Changes in exchange rate:
o Depreciation
o Appreciation
• BOP deficit can be corrected by a depreciation
• An appreciation would correct the surplus of BOP.
• The system can be:
• Clean or pure, without any interventions by central banks
• Dirty or managed, with frequent interventions by central banks.
•
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Exchange rate systems
• Fixed exchange rate system
• The exchange rate is fixed for a long period of time.
• 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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Exchange rate systems
• Changes of foreign exchange rates
• Devaluation: reduces the value of the currency in terms of
foreign currencies.
• Revaluation: increases the value of the currency in terms of
foreign currencies.
• Note: foreign exchange reserves are central bank holdings of
foreign money to respond to changes in exchange rates by
supplying of buying foreign money.
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7-29
• 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).
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7-30
• 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
• Suppose that Y = 8000, e=100 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),
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7-31
• 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.
• (r-rf), if r > rf US securities would be more attractive, and vice
versa. a rise in US interest should thus cause an appreciation and
vice versa.
•
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• 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 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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7-33
• The two 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 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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7-34
• The IS-LM model in a small open economy
• The assumption of perfect capital mobility introduces a new
assumption in the IS-LM that
• 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.
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• 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.
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7-36
• 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
7-37
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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7-38
• 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 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.
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7-39
Figure 6-9 Effect of a Fiscal Policy Stimulus with Fixed
Exchange Rates
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7-40
• 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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7-41
• 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
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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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7-43
• 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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7-44
• 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 7-45
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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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7-46
• 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. See7-47
the following summary.
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Summary of Monetary and Fiscal
Policy Effects in Open Economics
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7-48
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7-49
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7-50
How Governments Can Affect
Exchange Rates?
• To prevent its currency from being too strong, or
equivalently, to make its currency more competitive, a
country’s central bank can sell the home currency (and
simultaneously buy foreign $)
– This would encourage the country’s exports
– A central bank has the ability to create an unlimited amount of
its home currency  no limit to this FX intervention
– Example: China and Japan have bought massive quantities of
USD to keep their currencies from appreciating
• To prevent its currency from falling in value, or equivalently,
to protect its currency, a country’s central bank can would
buy the home currency (and simultaneously sell foreign $)
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7-51
The Real Exchange Rate
• The real exchange rate (e) is equal to the average nominal
exchange rate (e ‫ )׳‬between a country and its trading partners,
with an adjustment for the difference in inflation rates between that
country and its partners
• Algebraically, the real exchange rate is defined below:
where P = home price level and Pf = foreign price level
• Example: Suppose e = e ‫ =׳‬10 pesos/$ and P = Pf = 100
– Now suppose that Mexican inflation causes Pf↑ to Pf = 200
• Assume e ‫ ׳‬and P are unchanged
– Result: e = (10 pesos/$)x(100/200) = 5 pesos/$  real depreciation of
$!
– Note: Usually when countries experience rapid inflation, the real
exchange rate does not change. Then e ‫ ↑׳‬ nominal appreciation of $!
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7-52
Purchasing Power Parity (PPP)
• The purchasing power parity (PPP) theory holds that the
prices of identical goods should be the same in all countries,
differing only by the cost of transport and any import duties
– Implication: The real exchange rate (e) should be constant
We can choose e = 1 
f
P
e' 
P
• The theory can also be expressed in terms of rates of growth:
e' e'  P  P
f
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7-53
Figure 7-4 Nominal and Real Effective
Exchange Rates of the Dollar, 1980-2010
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Exchange Rate Systems
•
•
In a (pure) flexible exchange rate system, the foreign exchange rate is
free to change every day in order to establish an equilibrium between QS and
QD of a nation’s currency
In a fixed exchange rate system, the foreign exchange rate is fixed for
long periods of time
– Maintained by central bank purchases and sales of the nation’s currency
•
•
If there is an excess demand of the home currency  CB sells currency / buys USD
If there is an excess supply of the home currency  CB buys currency / sells USD
– When the CB purchases (sells) foreign currency, its holdings of foreign exchange
reserves increase (decrease)
– Under a fixed exchange rate system, an increase (decrease) in the value of the
currency is known as a revaluation (devaluation)
•
The current system of exchange rates is not a pure flexible exchange rate
system because of CB intervention in FX markets
– 1986-2009: Foreign CB’s intervened by buying over $4 trillion USD
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7-55
Figure 7-5 Foreign Official Holdings of Dollar
Reserves as a Percent of U.S. GDP, 1980-2010
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Net Exports and the Foreign
Exchange Rate
• Net Exports (NX) are affected by both income (Y)
and the real foreign exchange rate (e):
– If Y  spending on imports  NX
– If e  exports are more expensive, and imports are
cheaper
 NX
• Algebraically, NX = NXa – nxY – ue
where NXa is autonomous net exports
nx and u are positive parameters
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Figure 7-6 U.S. Real Net Exports and the Real
Exchange Rate of the Dollar, 1980-2010
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The Real Exchange Rate and
Interest Rate
• Recall: D and S of FX determines the nominal exchange rate
– “Fundamentals” driving X and M change slowly over time
– Volatility of exchange rates therefore attributed to international
financial capital flows
• The relative attractiveness of U.S. and foreign securities depends on
the interest rate differential (rUS – rf), which is the average U.S.
interest rate minus the average foreign interest rate
– If (rUS – rf) ↑  U.S. financial assets more attractive  ppl buy $
 e ‫↑׳‬
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Figure 7-7 The U.S. Real Corporate Bond
Rate and the Real Exchange Rate of the Dollar,
1978-2010
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Perfect Capital Mobility (PCM)
• Perfect capital mobility (PCM) occurs when investors regard
foreign assets as a perfect substitute for domestic assets, and when
investors respond instantaneously to an interest rate differential
between domestic and foreign assets by moving sufficient assets to
eliminate that differential
• Under perfect capital mobility  no control over the interest rate
– Fixed Exchange Rates: A stimulative monetary policy (or contractionary
fiscal policy) will not reduce the domestic interest rate, but will instead
cause the country to lose foreign reserve holdings
– Flexible Exchange Rates: A stimulative monetary policy (or contractionary
fiscal policy) generates an excess supply of dollars  USD depreciates,
but i unchanged
– This assumes that the economy is a Small Open Economy (or SOE),
which is considered too small for its domestic policies to affect the world
interest rate
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SOE IS/LM Model with Fixed ER’s
• Monetary Expansion
– Fed MS↑  LM shifts right  Normally r↓ and Y↑  but PCM
implies huge financial capital outflows  pressure on e ‫↓׳‬ CB
must buy $ (MS↓) by selling holdings of foreign $ (reserve
holdings↓)
– Ultimate result: r unchanged and ineffective monetary policy
• Fiscal Expansion
– Fiscal stimulus  IS shifts right  Normally r↑ and Y↑ PCM
implies huge financial capital inflows  pressure on e ‫↑׳‬ CB
must sell $ (MS↑) by buying holdings of foreign $ (reserve
holdings↑)  LM shifts right
– Ultimate result: r unchanged, but Y↑↑
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SOE IS/LM Model with Flexible ER’s
• Monetary Expansion
– Fed MS↑  LM shifts right  Normally r↓ and Y↑  but PCM
implies huge financial capital outflows  e ‫↓׳‬ NX↑  IS shifts
right
– Ultimate result: r unchanged, but Y↑↑
• Fiscal Expansion
– Fiscal stimulus  IS shifts right  Normally r↑ and Y↑ PCM
implies huge financial capital inflows  e ‫↑׳‬ NX↓  IS shifts
left
– Ultimate result: r and Y unchanged
– Domestic crowding out is replaced by international crowding out
The twin deficits are identical!
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