Transcript lecture 5.slides - Lancaster University

THE OPEN ECONOMY: INTERNATIONAL ASPECTS
OF THE MACRO-ECONOMY
1. The balance of payments
2. The foreign exchange (forex) market
3. Fixed v floating exchange rates
4. Single currency areas
5. Globalisation and macro policy
What is the balance of payments?
Why are policy makers concerned about the BP?
How can govts ‘correct’ a BP problem?
How are exchange rates determined?
How can the CB affect the exchange rate?
Is a single currency for Europe desirable?
Should the G3 (G7) co-ordinate their macro-policies?
THE BALANCE OF PAYMENTS
• records all flows of money between countries
• BP = current acc + capital acc
Current account (or financial account)
- exports minus imports of goods / services
- govt transfers (e.g. EU taxes / subsidies)
Capital account
- fixed investment (FDI)
- bonds, equities, deposits (portfolio investment)
UK Current account
Exports
Imports
Services
Net income
Net govt transfers
Balance
UK Capital account
FDI (net)
Portfolio (net)
Short-term flows (net)
Balance
Reserves
Error
Balance of payments
+165
-192
+11
+7
-4
-13
+173
-143
-23
+10
+1
-2
0
Surpluses and deficits in the BP
Surplus: BP > 0
- foreign exchange reserves increase
- accumulation of foreign assets
- exchange rate ‘too high’
Deficit: BP < 0
- foreign exchange reserves decline
- loss of foreign exchange reserves
- deficit has to be financed (borrowing)
- loss of control over domestic assets
- downward pressure on exchange rate; inflationary
Determinants of the BP
BP = exports - imports + net capital flows
• exports = f (exch rate, competitiveness, world income)
• imports = f (exch rate, competitiveness, income)
• net capital flows = f (r / world r, country risk)
Model:
BP = f ( e, w/w*, y*, y, r/r*)
e = exchange rate (£/$)
w = real wage;
w* = world real wage
y = income
y* = world income
r = interest rate
r* = world interest rate
Govt intervention to ‘correct’ the BP
• exchange rate policy: buying / selling domestic currency
• fiscal / monetary policy to control AD
- raise / lower r (capital account)
- change G or T (trade account)
• supply-side policies
- improve competitiveness via labour market flexibility
THE FOREX MARKET
The exchange rate
e = £ per $ (or s = $ per £)
Determination of e: a simple model
Demand for £s (= supply of $s)
• importers of UK goods / services
• tourists visiting UK
• foreign students in UK universities
• foreigners investing in UK
• UK citizens with foreign income
Supply of £s (= demand for $s)
• opposite to above
Model:
e = f ( x - m, r - r*)
When will exchange rate appreciate?
Current account:
• demand for exports increases
• demand for imports decreases
• competitiveness increases (w / w* increases)
Capital account:
• inflow of foreign investment (r / r* increases)
FIXED v FLOATING EXCHANGE RATES
Advantages of a fixed exchange rate
• certainty for exporters / importers/ investors
• ‘no speculators’ within single currency area
• imposes constraints on govt macro policy
- constrained by effect on BP
- constrained by effect of policies on inflation
- govt has to achieve BP equilibrium over medium term
Disadvantages of a fixed exchange rate
• economic policy will be constrained by fixed ER
- chronic BP deficit requires deflationary policy
- conflict between full employment and BP equilibrium
• sudden ‘shocks’ cannot be absorbed by ER adjustment
- shocks affect ‘real’ economy if prices are fixed
• fixed ER encourages ‘protectionism’
- due to impact of shocks on ‘real’ variables
• speculators cause financial / political crises
Advantages of floating exchange rates
• govt ignores ER; no intervention needed
• no need to worry about BP
• economy is insulated from shocks (absorbed by ER)
• govt can concentrate on internal policy objectives
(inflation, unemployment, income distribution)
Disadvantages of floating exchange rates
• exchange rate can be volatile in the short run
- causes uncertainty (harmful to investment / trade)
• capital flows can cause ER to get ‘out of line’ with its
underlying (fundamental) value
• loss of BP constraint on macro-policy may lead to
inflationary bias
- with a fixed ER, govt has to respond to BP deficits
SINGLE CURRENCY AREAS
Advantages of a single currency
• lower transactions costs (no currency conversions)
• increased price competitiveness
- transparent pricing across countries
• elimination of exchange rate uncertainty
- encourages trade
- encourages investment (inc. FDI)
• lower inflation and interest rates
- central bank independent of member govts
- member states have to keep wage increases in line
to maintain competitiveness
Disadvantages of a single currency
• surrenders economic sovereignty to supra-national
authority
- no control over monetary policy
- no control over exchange rate
• deflationary effects in countries with high wage pressures
• increase in regional disparities due to greater
factor mobility
• potential loss of control over fiscal policy
- cannot use monetary expansion to pay for increase in G
- tight control over govt borrowing (fiscal balance needed)
Why might the Euro Zone not be an optimal currency area?
• labour markets are not flexible enough
- wages may be sticky downwards
- labour is not sufficiently mobile to respond
to changes in demand
- effects of changes in euro ER will vary between
member states / regions
• But: alternative methods of dealing with adverse effects of
structural change
- structural funds for re-training
- structural funds for encouraging indigenous growth
- infrastructure policies to revive declining regions
GLOBALISATION AND MACRO POLICY
Interdependence
• world’s economies increasingly inter-dependent
• steadily increasing world trade
- dependent on each other’s demand for exports
• vast increase in financial flows due to liberalisation
of financial markets
- abolition of controls on currency movements
- financial markets affect each other (instantaneously)
- Fed has profound effect on rest of world’s economies
Co-operation between G7: policy harmonisation
• need for policy harmonisation to prevent world-wide
recession / inflation
- exchange rates should not be ‘out of line’
(need to keep current accounts in reasonable balance)
- inflationary pressures are easily transmitted to other
countries
- co-ordination of interest rates may be needed to
prevent adverse capital flows
• G7 needs to deal with the problem of developing country
debt