Transcript dollar to peso exchange rat

ADJUSTMENT IN AN OPEN
ECONOMY
Professor Robert Lawrence
8th October 2015
Agenda
• The Long Run Neutrality of Nominal
Variables. (Money, Price Levels,
Exchange Rates).
• Mechanisms of Adjustment in an Open
Economy
• Adjustment in the Face of Shocks: some
examples
Quick recap: Nominal and real variables
• Nominal variables are measured in monetary units:
• E.g.:
•
•
•
•
Nominal GDP ($ per year)
Nominal interest rate (% of $ amount, per year)
Nominal wage ($ per hour)
Nominal exchange rate ($ per Yen)
• Real variables are measured in physical units:
• E.g.:
• Real GDP (output per year)
• Real productivity (output per hour)
• Real exchange rate (units of US goods per unit of Japanese goods)
Real variables are what’s important in the long run.
Get real.
• Opportunity cost is the true cost
• For efficient resource allocation, if we choose to consume or produce a product we
need to know what it costs us – and the cost is the opportunity cost in terms of
other goods we might produce or consume.
• If pears are $1 and apples $2, each apple I buy means I give up the opportunity to
buy 2 pears. The relative price of apples is two pears, the relative price of pears is
half an apple.
• So when you draw a demand curve you are relating the quantity demanded to a
relative price.
• Thus, it is relative prices that matter
• Relative real prices matter: prices in terms of goods, not nominal or dollar prices. If
we double all prices, nothing real will change.
• That is why we generally do micro-economics without money in the model.
Efficiency: It’s all about relativity!
How does the price level change in response to changes
in the money supply?
• Start with quantity equation:
M*V=P*Y
• M = money supply
• V = velocity, or the rate at which money circulates
• P = price of output
• Y = quantity of output
• Note: P * Y = value of output (nominal GDP)
• We assume that V is constant and exogenous  With V constant, the money supply M
determines nominal GDP (P*Y)
In the Long run
• Output (Y) is determined by factor supplies and technology.
• So the change in M is mainly reflected in changes in the price level P
• And we expect changes in money supply to translate into inflation.
The short and the long run
In the long run prices are
free to adjust
In the short run prices do
not adjust fully
• E.g.: If the nominal exchange rate
• If the nominal exchange rate
changes, the real exchange rate
doesn’t change (instead, the price
level adjusts: inflation or deflation).
• We are mostly interested in the
long-run effects
• Although:
“In the long run
we are all dead”
changes, the real exchange rate
changes too.
• So, changes in the nominal
exchange rate can affect exports
and imports.
Neutrality of money – only in the long run!
• Suppose first that P and V are fixed and Y is flexible
• In the short run changes in M will have an impact on changes in Y
• With sticky prices (or contracts), expanding the money supply could increase employment.
• So short run changes in the money supply could have real effects.
• But in the long run, with the economy at full employment, Y is determined
by factor supplies and technology
• Once the economy reaches full employment, further increases in the money supply will result in
inflation.
• Thus the change in M will result in a proportional change in P in the long run
• Similarly, contracting the money supply would result in an increase in unemployment, but
eventually wages will fall, and full employment will be restored.
• In the long run therefore money is neutral, and monetary changes result in
proportional changes in price levels.
Evidence: Neutrality of money during 4 hyperinflations
Understanding the units of ε
ε 
e P
P *
(Yen per $)  ($ per unit U.S. goods)

Yen per unit Japanese goods

Yen per unit U.S. goods
Yen per unit Japanese goods

Units of Japanese goods
per unit of U.S. goods
Mankiw
Purchasing power parity (PPP)
• Theory of PPP implies that goods should cost the same in real terms in both
countries.
∆𝑷
∆𝜺 = ∆𝒆 ∗
∆𝑷∗
• This implies that the nominal exchange rate between the two countries’
currencies depends on changes in their price levels.
• Example: A sweater sells for $45 in New York and for £30 in London; the
exchange rate is £0.67/dollar, if PPP holds.
PPP predicts a pound/dollar exchange rate (E) of:
E£/$= PUK/PUS
where:
PUS = dollar price of a reference commodity basket sold in US
PUK = pound price of the same basket in UK
Source: International Economics: Theory and Policy, Sixth Edition by Paul R. Krugman and Maurice Obstfeld
Relationship between nominal exchange rate and
price level during German hyperinflation
Source: Gregory Mankiw, Principle of Macroeconomics, 5th edition, p. 294.
A Dangerous Idea!
• If you were to change the price level using monetary
policy, it should not affect employment in the long run.
• But if prices are sticky (in the short run), until they adjust,
there will be real effects.
• Similarly, if you change the exchange rate, in short run
you could have real effects, but over long run it will be
neutral.
• Some examples: Argentina and Britain
Argentina: hyperinflation, the dollar peg
and the Argentine great depression
1970s-1980s: hyperinflation
• 1975-1990: average inflation 325% per year
Currency peg – designed to cure hyperinflation.
• Argentinian peso was pegged to US dollar in 1991
• Theory: fixing the nominal exchange rate would force domestic prices to grow
in line with US prices – i.e. would cure hyperinflation
• Inflation fell from peak of 3,000% in 1989 to 3.4% in 1994
But high adjustment costs
• Unemployment steadily rose to 15% in 2000.
• Severe recession and economic crisis 1998-2002
eventually resulted in abandonment of peg.
Protests during economic crisis 2001
Britain: Going back to Gold
• Britain was on the gold standard before WW1
• 1918 government report: "it is imperative that after the war, the conditions necessary for the
maintenance of an effective gold standard should be restored without delay.“
• 1918-1925: appreciation of exchange rate and domestic deflation in anticipation of return
to gold standard at the same rate as before the war - despite the fact that prices had
tripled in the UK (but only doubled in the US).
• 1925: Keynes estimated that sterling was 10% overvalued.
“How could [they] do such a silly thing?”
“Thus, the process of going back to gold involved, for Britain, two years of unprecedentedly
high real interest rates, the effect of which was to cripple British industry and leave as its legacy
an unemployment rate of 10 per cent which lasted until 1940.
By the time the Great deflation had ended in 1923 British wholesale prices had fallen
from their 1920 peak of 324 (1913=100) to 160 and weekly wage rates from 252 to 180 in
the same period. Unemployment had gone up from 3 per cent in 1920 to 22 per cent in
the second quarter of 1921 before falling back to 11 per cent. The sterling-dollar rate,
having sunk to 3.5 at the height of the boom, had improved to 4.50 by early 1923, but the
wholesale British/price index was still higher than America's.”
• Britain left the gold standard again in 1931
The First 100 Years: A policy that crippled: The Gold Standard debate
Robert Skidelsky Financial Times | Sunday, February 15, 1998
Agenda
• The Long Run Neutrality of Nominal
Variables. (Money, Price Levels, Exchange
Rates).
• Mechanisms of Adjustment in an Open
Economy
• Adjustment in the Face of Shocks: some
examples
Large Current Account imbalances have
developed over the last decade
Source: Feenstra and Taylor: International Economics, Second Edition
Copyright © 2012 by Worth Publishers
Source: Feenstra and Taylor: International Economics
Review: In a Closed Economy:
National Savings equals National Investment (S = I)
1.
Y = C+I+G
National Income =
Consumption (C) + Investment (I) + Government Spending (G)
2.
Y–C–G=I
3.
Define National Saving (S) = Y – C – G
S= I
National Savings = National Investment
In a closed economy: what is not consumed (i.e. what is saved) is
invested.
Closed Economy: all goods and services
are produced and consumed domestically
Production
Producer Income
Spending and
Saving
Consumer Spending
and Saving
Closed Economy: What is not Consumed
(i.e. Saving) is Invested
Investment
National Savings
=
National Investment
Saving
Production
Spending and
Saving
Sales
Consumption
Producer Income
Consumer Spending
and Saving
Open Economy:
Trade Surplus is Income that is not Spent
Net Exports = X – M
Trade Surplus
Exports
Imports
Domestic Sales
of Domestic
Products
Income
Domestic
Purchases of
Domestic
Products
Expenditure
Income exceeds Expenditure by the Current Account Surplus = Net Foreign Lending
Open Economy: Can borrow from/lend to rest of world.
Trade Balance = National Income – National Spending
National Income = Y = C + I + G + X – M
X – M = Trade Balance in Goods and Services
= Current Account
“Strictly, Current Account includes factor incomes and
transfers but we will mean X - M”
National Expenditure (Spending) = E = C + I + G
National Income – National Expenditure = X – M
Difference between National Income and
Expenditure change in Net Foreign Assets
• Country with a deficit is spending more than its income by
either increasing its net foreign debt or reducing its net
foreign assets.
• Country with a trade surplus is either reducing its net
foreign debt or increasing its net foreign assets.
Trade Balance = Saving - Investment
Y=C+I+G+X–M
Y–C–I–G =X–M
(Y – C – G) – I = X – M
Define national saving S = Y – C – G
S–I=X–M
National Saving – National Investment = Trade Balance
S = Sp + Sg
National Saving = Private plus Government Saving
Summary of definitions: X-M is...
• Difference between exports and imports
• Difference between income and spending
• Change in net foreign assets
• Difference between national saving and investment
• Where national saving = private plus government saving
Are trade deficits good or bad?
Was Polonius right?
“Neither a borrower nor
a lender be,
For loan oft loses both
itself and friend,
And borrowing dulls the
edge of husbandry.”
Hamlet Act 1, scene 3,
Economists: it all depends why
• Borrowing may be good, if you are investing in something
that will allow you to pay back the money.
• Borrowing may be bad if you consume it, and leave
yourself in debt.
• Examples:
• Student Loans to go to Harvard
• Life Cycle Spending. Young, middle age, retirement
Some implications of the definitions
• Do deficits reflect higher investment or lower saving?
• Is it lower private saving or lower public saving?
• Is it higher investment in housing or in plant and equipment?
A good deficit: Norway oil boom
When Norway discovered oil, it invested in oil-related infrastructure – investing for
Feenstra and Taylor: International Economics, Second Edition
future growth in wealth.
Copyright © 2012 by Worth Publishers
US current account deficit: savings bust
Saving, Investment and the Current Account Balance (as a share of GDP)
In the US deficits are growing but they’re funding the fall in saving, not investment.
After depreciation: nothing left
Share of GDP
USA: Gross and Net National Saving
The US is wearing out its capital equipment. Net Saving = Gross Saving minus
depreciation = almost zero!
Who is not saving? Households or Government
Share of GDP
US Net Saving by Sector
In the US, saving by firms was relatively constant until the 2008 financial crisis.
Household saving has fallen from 8% to 2%, rising since the crisis. Government
spending reflects different fiscal policy regimes (Reagan, Clinton, Bush, Obama).
China: Saving Boom!
China’s savings rate is very high (close to 50% of GDP)! China responded to the
financial crisis by building new infrastructure (investment). S and I, not just X and M,
are key drivers of the Chinese surplus.
Are these deficits good or bad?
• One View: Nothing wrong as long as the borrowers are
able to repay, and the lenders are content with lending.
• Another View: These imbalances are too large. Chinese
are poor, they should be spending more. Americans are
rich, they should be saving more.
At all times X – M = S - I
• Typically to explain X – M people think about what is
happening in the goods markets. But unless they can
change S – I, developments in the goods markets will
not affect the trade balance.
• Similarly if S – I changes, and the country as a whole
changes its net international lending or borrowing, this will
lead to changes in the goods markets.
How does the adjustment happen?
• Savings, investment, exports, imports – are all determined by the
decentralized behavior of many individuals.
• How does adjustment happen to keep X-M = S-I?
• Example: What happens if a country starts saving more?
• If a country increases its S relative to I, (or equivalently reduces its
spending relative to its production) there will be an excess supply
of its goods and services.
• This excess supply on the world market pushes down the price of
those goods and services in real terms (i.e. the real exchange rate)
• As a result, more of them are purchased: exports rise relative to
imports. So, X-M increases and balance is restored.
Adjustment: must be Expenditure Changes
and Expenditure Switching
S – I View: Expenditure Changes
• Expenditure must be adjusted: to reduce deficit must reduce
Spending relative to Income (raise S relative to I).
• If there were only one product in the world, (or products
very close substitutes) this would be sufficient.
X – M View: Expenditure Switching
• To reduce deficit when products are different, spending
should also be switched.
• At home: away from imports towards domestic goods and
services. Abroad: towards our exports.
How X – M (NX) depends on ε
ε 
U.S. goods become more expensive relative to
foreign goods

X, M

NX
Source: Mankiw
The relation between the trade balance and the
real exchange rate
Real Dollar
Exchange Rate
Slope of the line
reflects the
response of trade
to the dollar.
High Real dollar leads to
deficits
Trade Deficit
Trade Surplus
Low Real dollar generates
surpluses
US non-oil trade balance and real exchange rate
Non-oil Trade Balance and Real Exchange Rate
1973 to 2008
4.700
Real Exchange
Rate 4.650
4.600
4.550
4.500
4.450
4.400
4.350
-0.04
-0.03
-0.02
-0.01
0
0.01
0.02
0.03
Non-oil trade balance in goods and services
Simplifying assumption
• Assume Saving is Fixed at
S1
• (In reality could depend in incomes, fiscal policy,
demographics, wealth)
• Assume Investment is Fixed at
I1
• (In reality could depend on interest rates, incomes,
taxes, ..etc)
How ε is determined
Neither S nor I
depend on ε,
so the net capital
outflow curve is
vertical.
ε adjusts to
equate NX
with net capital
outflow, S - I.
ε
S1 - I 1
ε1
NX(ε )
NX 1
NX
Changing only nominal exchange rate –
real exchange rate reverts
• If Real Exchange Rate
ε =
e P
P*
ε =
e
P
P*
is an Equilibrium, i.e.
Given S and I, then
increasing nominal e
will lead prices to fall to
re-establish the
equilibrium. i.e.
deflation.
• Or decreasing nominal
e will be inflationary.
Agenda
• The Long Run Neutrality of Nominal
Variables. (Money, Price Levels, Exchange
Rates).
• Mechanisms of Adjustment in an Open
Economy
• Adjustment in the Face of Shocks: some
examples
Considering different shocks in this
framework
• What happens if you change
your exchange rate?
• What happens if you change
S and I?
• What happens if the
competitiveness of your
products changes?
• What happens to trade
• How could the US and China
balances with “unfair trade?”
reduce global imbalances?
• Does US oil self-sufficiency
reduce the trade deficit?
What happens if you change the nominal
exchange rate?
• In the long run:
the domestic price level ε
will adjust to absorb the
change
• Nothing will happen to
the real exchange
rate, or the trade
ε1
balance
The long run
S1 - I 1
NX(ε )
• In the short run:
the real exchange rate
may change
NX 1
NX
What happens if you change S-I? The current
account has to adjust
Reduced national
saving, net capital
outflow, and the
supply of dollars
in the foreign
exchange
market…
…causes the real
exchange rate to
rise and NX to fall.
ε
S 2 - I1
S1 - I 1
ε2
ε1
NX(ε )
NX 2
NX 1
NX
How could the US & China reduce global
imbalances?
• USA must raise S relative to I and have a weaker real
exchange rate.
• China must reduce S relative to I and have a stronger real
exchange rate.
• The key is changing both S – I and the real exchange
rate.
E.g. China could reduce domestic saving:
S2 < S1; NX declines and stronger currency
ε
S 2 - I1
S1 - I 1
ε2
ε1
NX(ε )
NX 2
NX 1
NX
Or US could increase domestic saving:
S2 > S1; NX increases and weaker currency
ε
ε1
ε
2
S1 - I 1
NX(ε )
NX 1 NX2
NX
But - is the imbalance caused by currency
manipulation?
• Is the yuan weak because China is saving
a lot and so exporting a lot? (i.e. = equilibrium)
• If so: efforts to appreciate the yuan would just lead
to domestic deflation
• Or is the yuan weak because Chinese
authorities are artificially depressing its
value?
• If so: over how long a time period is this possible?
• Theory would suggest that changes in nominal
exchange rate have no effect on real exchange
rate in the long run
What happens to trade balances with
“unfair trade”?
• If a US trading partner subsidizes their export industries:
• What happens to the trading partner’s saving?
• What happens to their investment?
• What happens to their trade balance?
• Does it affect the US current account?
• What happens to US saving?
• What happens to US investment?
• What happens to the US trade balance?
Trade policy to subsidize exports
At any given value of
ε, an export subsidy ε
 NX
 NX shifts to
ε2
right
S -I
ε1
Trade policy doesn’t
affect S or I , so
capital flows and the
supply of dollars
remain fixed.
NX (ε )2
NX (ε )1
NX1
NX
Trade policy to subsidize exports
Results:
ε > 0
(demand
increase)
NX = 0
(supply fixed)
IM > 0
(policy)
EX > 0
(rise in ε )
ε
S -I
ε2
ε1
NX (ε )2
NX (ε )1
NX1
NX
What effect does US oil self-sufficiency
have on the trade balance?
• 2011: US trade deficit in oil was 2.1% of GDP
US trade balance as % of GDP
More oil exports means fewer other
exports – unless S or I change too
US oil production
doesn’t affect saving or
investment (much) –
but it creates extra
supply of US net
exports.
ε
S -I
ε2
ε1
NX (ε )2
ε appreciates – making
other US exports more
expensive.
So: total NX stay the
same.
NX (ε )1
NX1
NX
Conclusions
• Unless they affect saving and investment in long run trade
policies and changes in nominal exchange rates will not
affect the trade balance.
• If US is uncompetitive, over long run, the exchange rate
adjusts not the trade deficit, unless S and I are affected.
• To change the trade balance and the real exchange rate we
need policies that change national saving and investment.