Transcript L14-15

(V) SMALL OPEN ECONOMIES
LECTURES 14 & 15
Definition of Small Open Economies:
The prices of all tradable goods
are determined exogenously on world markets –
not just importables but exportables as well.
• Devaluation in
small open economies
• The Salter-Swan (NTGs) model
LECTURE 14: DEVALUATION
IN SMALL OPEN ECONOMIES
Key Question:
If a country is too small to affect its terms of trade
(i.e., it must take prices of its X & M as given on world markets),
does that mean E has no effect on TB or BP?
Answer: No. Two channels -(1) Contractionary effects of devaluation reduce spending.
(2) Output can shift from non-traded sector to traded.
After big devaluations in Mexico in 1994 and Korea in 1997
trade balances “improved” quickly. Can our model explain it?
Prices of their exports are mostly set on world markets and income fell.
Maybe we need another model.
The real balance effect can reduce spending.
Assume P flexible; perhaps PPP even holds.
1.Devaluation: E ↑ => P ↑ => M/P ↓
=> “ED for M”
=> e.g., A↓ (via i ↑) => BP↑.
Devaluation can also have other contractionary effects,
besides real balance effect, as we will see. (Appendix II.)
Two more experiments, with E fixed,
in the version of MABP that assumes
P perfectly flexible so Y = 𝑌.
2. Monetary expansion: NDA↑ => M/P ↑
(=> “Excess Supply of M”) => e.g., A↑ (via i ↓) => BP↓.
𝑌↑ => L(Y)↑ =>
(=> “Excess Demand for M”)
=> BP↑.
3. Supply-side growth:
Recall that in the MABP, we assume that forex reserve flows are not sterilized;
thus the BP becomes the channel via which a country’s M is brought into line.
INTRODUCTION TO SALTER-SWAN MODEL
Key Assumptions:
•
All Traded Goods (TGs) are aggregated together.
=> TB becomes: output of TGs minus consumption of TGs.
•
There is also a 2nd market,
in NonTraded Goods (NTGs).
Key results:
(1) Devaluation works also by changing relative price of NTGs.
(2) To attain both internal and external balance
(e.g., Y= 𝑌 & CA=0), you need both expenditure-switching
and expenditure-reducing policies.
Two alternative definitions of the real exchange rate
Q≡
(I) Two-good model:
𝐸𝑃∗
𝑃
.
(II) Small open economy model,
a.k.a. dependent-economy, Salter (1959) - Swan (1963),
Australian, or NonTraded Goods model:
𝐸 𝑃𝑇𝐺 ∗
“real exchange rate” ≡
𝑃𝑁𝑇𝐺
or, instead, the reciprocal:
where PTG* is exogenous.
𝑃𝑁𝑇𝐺
“relative P of NTGs” ≡
𝐸 𝑃𝑇𝐺 ∗
≡ PN .
housing
&
haircuts
Salter diagram
Salter (1959)
Start in a TB=0 equilibrium.
Production in each sector,
coincides with respective
consumption quantities
XTG = CTG & XNTG = CNTG
if:
● the price mechanism is
used to allocate resources,
● markets clear, and
● total consumer spending
= total income.
●
food
&
clothing
Experiment: Increase spending, A
What happens in the TG market?
 Excess Demand for TG: CTG > XTG ,
i.e., trade deficit
(at point F).
 Would require a fall in PN
if Excess Demand for TG is to be eliminated:
{
output of TG↑
<= via
CTG ↓ (probably)
}
=> (XTG - CTG )↑ .
(at point B).
Rise in A => TD at F;
must be accompanied
by a fall in PN
if the Trade Balance is
to be kept unchanged.
=> XTG ↑
CTG ↓
We have now derived
the downward-sloping
BB relationship.
Experiment: Increase spending, A
What happens in the NTG market?
Excess Demand for NTG (overheating) at point F.
 Would require a rise in PN
to eliminate Excess Demand for NTG at G.
<= via
{
output of NTG ↑
CNTG ↓
}
=> (XNTG-CNTG )↑
A rise in A must
be accompanied
by a rise in PN
if internal
balance is to be
kept unchanged.
XNTG↑ CNTG ↓
We have now
derived the
upward-sloping
NN relationship.
The Swan
Diagram
The external balance line,BB,
& internal balance line, NN,
divide the A-E space
into 4 zones of macroeconomic “illness.”
Swan (1963)
Swan Diagram, continued
The Tinbergen-Meade principle of targets & instruments
To attain two goals -- internal and external balance -you need two independent policy instruments:
expenditure-switching policies
(exchange rate)
and expenditure-reducing policies
(fiscal or monetary contraction).
China’s position in the Swan Diagram in 2008 called
for real appreciation. In 2009, also demand expansion...
ES & TD
Relative Price of NTGs
𝑃𝑁𝑇𝐺
𝐸 𝑃𝑇𝐺 ∗
YY:
Internal balance
Y=𝑌
ES & TB>0
ED & TD
China
2009
China
2002
China
2008
BB:
External balance
CA=0
ED & TB>0
Spending A
15
Two policy experiments
•
(1) Fall in Demand: A
•
=> recession at point H
in fig. 20.6.
If PN is sticky & exchange rate fixed, downward
adjustment to point E may be slow & painful.
At point H,
economy is in recession.
Eventually prices may fall
enough to clear markets.
But with sticky prices,
devaluation can speed up
adjustment.
Second policy experiment
(2) Devaluation: E
Improves TB in two ways:
(i) Real balance effect, reduces spending.
(ii) Fall in PNTG /PTG , switches spending out of TG,
& switches supply into TG (at E).
Appendix I: Rudiger Dornbusch, AER (1973)
“Devaluation, Money & Nontraded Goods”
Combines NTG model
,
with MABP
Two automatic mechanisms of adjustment:
(i) PNTG flexible => always on NN;
PN rises instantly in response to ED.
(ii) reserve flows not sterilized;
Money adjusts in response to TD.
E.g., two experiments
1. NDA => jump to point G. (Fig. 20.5)
2. E  => jump to point E. (Fig. 20.6)
In each case, over time, reserve flows gradually bring
the economy back to S (following the sequence of arrows).
Appendix II: CONTRACTIONARY
EFFECTS OF DEVALUATION
Why were the real effects
of the 1997-98 East Asia currency crisis so severe?
Two prominent explanations:
• High interest rates raise default probability.
The IMF may not have sufficiently realized this –
according to Furman & Stiglitz; and Radelet & Sachs; both in BPEA (1998).
• Devaluation is contractionary: many possible channels,
including real balance effect & balance-sheet effect.
Possible Contractionary Effects of Devaluation
Some negative effects on AD:
•
High import bill and low elasticities
•
Real balance effect (MABP)
•
Distribution effect: Diaz-Alejandro (1963)
MPC urban workers > MPC rich landowners
•
Balance sheet effect: difficulty servicing $-denominated debts
2 negative effects on AS:
•
Rise in P imported inputs , e.g., oil
•
Rise in W, e.g., where indexed to CPI.
TO BE CONTINUED IN LECTURE ON CRISES IN EMERGING MARKETS
The balance
sheet effect
In currency crises
such as late-90s’,
loss in output
depends on foreigndenominated debt
times real
devaluation.
API-120 - Prof. J.Frankel