Balance of Payments and Exchange Rates. Balance of Payments and Exchange Rates Alternative Exchange...

Balance of PaymentsBalance of Paymentsand Exchange Ratesand Exchange Rates

Balance of Payments and Exchange RatesBalance of Payments and Exchange Rates

Alternative Exchange Rate Regimes

ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE EXCHANGE RATE REGIMES

• Internal and external policy objectives– internal balance

– external balance• narrow sense: current account balance

• broad sense: total currency flow balance

National income

(a) Internal balance

Internal and external balanceInternal and external balance

Quantity of £s

S1 by UK

D by overseasresidents

(b) External balance

Fixedexchange rate

– possible conflicts between internal and external objectives

National income

Assume that initially thereis internal imbalance: at Ye2

National income

Assume that the governmentincreases aggregate demandto achieve internal balance.

Quantity of £s

S1 by UK

r1 Fixedexchange rate

S2 by UK

This createsexternal imbalance:

i.e. currency flow deficit

Quantity of £s

S1 by UK

S2 by UK

Or an imbalance in the narrow sense (a current account deficit) under a

floating exchange rate

Recession Boom

Current account surplus

Current account deficit

Exchange rate depreciationForeign boom

Exchange rate appreciationForeign recession

Contractionary fiscal policyLower consumption

Expansionary fiscal policyHigher consumption

Internal balance

Effects on internal and (narrow) external balanceEffects on internal and (narrow) external balance

UK balance of payments as % of GDP, 1970–2007UK balance of payments as % of GDP, 1970–2007

Source: Financial Statement and Budget Report (H M Treasury, 2005)

• Nominal and real exchange rates

• Nominal and real exchange rates– real exchange rate index

• RERI = NERI × PX / PM

• Nominal and real exchange rates– real exchange rate index

• RERI = NERI × PX / PM

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Sterling nominal and real exchange rate indices(1990 = 100)

Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Nominal exchange rate

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Realexchange rate

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Realexchange rate

• Alternative exchange rate regimes

– completely fixed

Quantity of £s

S by UK

D from abroad

Fixed rateb a

(a) Total currency flow deficit(a) Total currency flow deficit

Quantity of £s

S by UK

D from abroad

Fixed rated c

(b) Total currency flow surplus (b) Total currency flow surplus

– freely floating

– intermediate

– freely floating

– intermediate

• Fixed exchange rates

– foreign exchange intervention

• effects on the money supply

• sterilisation

– correcting a disequilibrium

• expenditure reducing

• expenditure switching

• Fixed exchange rates

– foreign exchange intervention

• effects on the money supply

• sterilisation

– correcting a disequilibrium

• expenditure reducing

• expenditure switching

• Free-floating exchange rates

– automatic correction

Adjustment of the exchange rate to a shift in demand and supplyAdjustment of the exchange rate to a shift in demand and supply

Quantity of £s

Depreciation

Quantity of £s

Appreciation

Adjustment of the exchange rate to a shift in demand and supplyAdjustment of the exchange rate to a shift in demand and supply

– expenditure switching (the substitution effect)

• the process of adjustment

• elasticities of currency demand and supply

Supply of pounds and the elasticity of demand for importsSupply of pounds and the elasticity of demand for imports

Quantity of £s

Elastic demandfor imports

Quantity of £s

Inelastic demandfor imports

Supply of pounds and the elasticity of demand for importsSupply of pounds and the elasticity of demand for imports

Quantity of £s

Unstable equilibriumUnstable equilibrium

Quantity of £s

Unstable equilibriumUnstable equilibrium

• the Marshall–Lerner condition

– expenditure changing (the income effect)

• a rise in income

(X – M)1

Current accountdeficit of a – b

The income effect (stable prices)The income effect (stable prices)

(X – M)1

Exchange rate

depreciates

(X – M)1

Exports rise;

imports fall

(X – M)1

Expenditure

(X – M)1

Income effectExports fall back somewhat;

imports rise back somewhat

(X – M)1

Eventual equilibrium (Y2)Positive substitution effect: c – b

Negative income effect: c – a

Net balance of payments effect: a – b

(X – M)2

• a rise in prices

• Intermediate exchange rate regimes

– adjustable peg

– dirty floating

– crawling peg

– adjustable peg

– dirty floating

– crawling peg

The crawling peg within exchange rate bandsThe crawling peg within exchange rate bands

Nointervention

Central bankbuys domestic

currency

Nointervention

Central banksells domestic

currency

Nointervention

– adjustable peg

– dirty floating

– crawling peg

– joint float

– adjustable peg

– dirty floating

– crawling peg

– joint float

– adjustable peg

– dirty floating

– crawling peg

– joint float

– exchange rate bands

– adjustable peg

– dirty floating

– crawling peg

– joint float

– adjustable peg

– dirty floating

– crawling peg

– joint float

• exchange rate bands under the old ERM

– adjustable peg

– dirty floating

– crawling peg

– joint float

• exchange rate bands under the old ERM

Fixed Exchange RatesFixed Exchange Rates

FIXED EXCHANGE RATESFIXED EXCHANGE RATES

• Response to contractionary internal shock

– short-run effect

• assumption: relatively inflexible wages & prices

• effects of reduced aggregate demand– current account surplus

– reduced interest rates financial account deficit

• financial account effect likely to be the bigger

• to prevent exchange rate falling, the interest rate must thus not be allowed to fall so far

– money supply must be allowed to contract to match the fall in demand for money

– internal imbalance will persist

• assumption: relatively inflexible wages & prices

• effects of reduced aggregate demand– current account surplus

– reduced interest rates financial account deficit

• financial account effect likely to be the bigger

• to prevent exchange rate falling, the interest rate must thus not be allowed to fall so far

– money supply must be allowed to contract to match the fall in demand for money

– internal imbalance will persist

– long-run effect

• assume: greater flexibility of wages & prices

– this allows internal balance to be restored

• external effects of reduced AD

– large current account surplus from fall in real exchange rate

– reduced somewhat by the rise again in aggregate demand from higher exports and lower imports

• overall external balance restored

• current account surplus may persist

– long-run effect

• assume: greater flexibility of wages & prices

– this allows internal balance to be restored

• external effects of reduced AD

– large current account surplus from fall in real exchange rate

– reduced somewhat by the rise again in aggregate demand from higher exports and lower imports

• overall external balance restored

• current account surplus may persist

• Response to contractionary external shock

• assumption: fall in exports

• current account deficit

– fall in X fall in AD fall in M

• financial account

– fall in AD fall in r

– if r is allowed to fall financial account deficit

– money supply must be reduced to prevent this happening this allows r to rise

• rise in r makes recession worse

• current account deficit

– fall in X fall in AD fall in M

• financial account

– fall in AD fall in r

– if r is allowed to fall financial account deficit

– money supply must be reduced to prevent this happening this allows r to rise

• rise in r makes recession worse

– long-run effect

• reduction in AD reduces inflation

• this reduces real exchange rate

• current account deficit is eliminated

• flexible prices restore internal balance too

• but the ‘long term’ may be very long in coming!

– long-run effect

• reduction in AD reduces inflation

• this reduces real exchange rate

• current account deficit is eliminated

• flexible prices restore internal balance too

• but the ‘long term’ may be very long in coming!

• Effectiveness of government policies– monetary policy

• relatively ineffective

– fiscal policy• relatively effective

• Causes of balance of payments problems under fixed rates– different rates of inflation– different rates of growth– income elasticities of demand for imports

higher than for exports– long-term structural changes

• Effectiveness of government policies– monetary policy

– fiscal policy• relatively effective

• Causes of balance of payments problems under fixed rates– different rates of inflation– different rates of growth– income elasticities of demand for imports

higher than for exports– long-term structural changes

• Advantages of fixed exchange rates

– certainty

– no speculation (if rate is absolutely fixed)

– automatic correction of monetary errors

– prevents ‘irresponsible’ government policies

• Advantages of fixed exchange rates

– certainty

– no speculation (if rate is absolutely fixed)

– automatic correction of monetary errors

– prevents ‘irresponsible’ government policies

• Disadvantages of fixed exchange rates– new classical view

• make monetary policy ineffective

• anti free market

– Keynesian view• balance of payments deficits can lead to

recession

• possibility of competitive deflation

• problems of international liquidity

• inability to adjust to shocks

• speculation

• Disadvantages of fixed exchange rates– new classical view

• make monetary policy ineffective

• anti free market

– Keynesian view• balance of payments deficits can lead to

recession

• possibility of competitive deflation

• problems of international liquidity

• inability to adjust to shocks

• speculation

Free-floating Exchange Rates

FREE-FLOATING RATESFREE-FLOATING RATES

• Response to shocks

– internal shocks

• purchasing-power parity theory

• limitations of theory in short run

– changes in interest rates affect financial account

– this affects current account in opposite direction

– external shocks

• changes in exchange rate help to insulate domestic economy from such shocks

– the path to long-run equilibrium

• Response to shocks

– internal shocks

• purchasing-power parity theory

• limitations of theory in short run

– changes in interest rates affect financial account

– this affects current account in opposite direction

– external shocks

• changes in exchange rate help to insulate domestic economy from such shocks

– the path to long-run equilibrium

Exchangerate path

Exchange rate path to long-run equilibriumafter a shock at time t1

Exchangerate path

Exchange rate path to long-run equilibriumafter a shock at time t1

• Speculation

– stabilising speculation

• Speculation

Quantity of £s

Stabilising speculationStabilising speculation

People believe that exchange rate change

is only temporary.

• Speculation

– destabilising speculation

• Speculation

Quantity of £s

Destabilising speculationDestabilising speculation

People believe that exchange rate change

indicates a trend.

• Speculation

• overshooting

• Speculation

• overshooting

• Effectiveness of government policy

– monetary policy

• relatively effective

– direct effect on aggregate demand

– reinforced by a change in the exchange rate

• effect of speculation

– fiscal policy

– offset by effect on interest rates & exchange rate

• Effectiveness of government policy

– monetary policy

• relatively effective

– reinforced by a change in the exchange rate

• effect of speculation

– fiscal policy

– offset by effect on interest rates & exchange rate

• Advantages of free-floating rates– automatic correction

• no problem of international liquidity and reserves

– insulation from external events

– governments free to pursue domestic policy

• Disadvantages of free-floating rates– unstable exchange rates

Fluctuations between the euro and the dollarFluctuations between the euro and the dollar

US interest rate

ECBinterest rate

US interest rate

ECBinterest rate

$ / €US interest

ECBinterest rate

– speculation

– uncertainty for business

– speculation

– lack of discipline on economy

– speculation

– lack of discipline on economy

Exchange Rate Systems in Practice

EXCHANGE RATE SYSTEMS IN PRACTICEEXCHANGE RATE SYSTEMS IN PRACTICE

• The Bretton Woods system (1943–73)

– the system

• role of the IMF

• correction through deflation or reflation

• correction through devaluation or revaluation

– Problems of adjustment

• disruption of devaluations

• J-curve effect of devaluation

– the system

• role of the IMF

Surplus

Deficit

Devaluation takesplace at t1

The J-curve effectThe J-curve effect

– the system

• role of the IMF

• stop–go policies

– the system

• role of the IMF

– the system

• role of the IMF

• speculation

– the system

• role of the IMF

• speculation

• The Bretton Woods system (cont.)

– problems of international liquidity

• over-reliance on US dollar

• problem of US deficits and excess liquidity

– decline in confidence in the system

– the collapse of the system

• The Bretton Woods system (cont.)

– problems of international liquidity

• over-reliance on US dollar

• problem of US deficits and excess liquidity

– decline in confidence in the system

– the collapse of the system

• Managed floating: 1972 onwards– forms of managed flexibility

• extent of intervention

• forms of intervention

– justification of managed floating• focus on long-term equilibrium exchange rate

• adjustment is less disruptive

• Problems with managed floating– predicting the long-term equilibrium rate

– speculative financial movements

– conflicts with internal policy

• Managed floating: 1972 onwards– forms of managed flexibility

• extent of intervention

• forms of intervention

– justification of managed floating• focus on long-term equilibrium exchange rate

• adjustment is less disruptive

• Problems with managed floating– predicting the long-term equilibrium rate

– speculative financial movements

– conflicts with internal policy

Exchange rate indicesaverages for each period (1995 = 100)

1970-3 1974-7 1978-81 1982-5 1986-9 1990-3 1994-6 1997-9 2000–2 2003-5

Germany

Based on data in European Economy Statistical Annex (Commission of the European Union)

• UK experience of managed floating• UK experience of managed floating

1975 1980 1985 1990 1995 2000 2005

$ / £

$ / £ exchange rate and £ exchange rate index: 1976–2005$ / £ exchange rate and £ exchange rate index: 1976–2005

1975 1980 1985 1990 1995 2000 2005

$ / £

1975 1980 1985 1990 1995 2000 2005

$ / £Index

1990=100

1975 1980 1985 1990 1995 2000 2005

$ / £Index

1990=100

• UK experience of managed floating– effects of first oil crisis: 1973–6 6

• UK experience of managed floating– effects of first oil crisis: 1973–6

– second oil crisis and the rise in monetarism

1975 1980 1985 1990 1995 2000 2005

$ / £Index

1990=100

– effects of growing US budget and trade deficits in the 1980s

– the 1985 exchange crisis

1975 1980 1985 1990 1995 2000 2005

$ / £Index

1990=100

– joining and leaving the ERM

– sterling in the mid 1990s

1975 1980 1985 1990 1995 2000 2005

$ / £Index

1990=100

– recent experience

1975 1980 1985 1990 1995 2000 2005

$ / £Index

1990=100

• problems of a high pound

• exchange rate effects of inflation targeting

• The volatility of exchange rates

– causes of volatility

• money supply and inflation targets

• growth in financial movements

• abolition of exchange controls

• growth in IT

• growth in speculative activity

• growing belief that governments are powerless to prevent speculation

• The volatility of exchange rates

– causes of volatility

• money supply and inflation targets

• growth in financial movements

• abolition of exchange controls

• growth in IT

• growth in speculative activity

• growing belief that governments are powerless to prevent speculation

The Open Economy and ISLM Analysis

THE OPEN ECONOMY AND ISLM ANALYSISTHE OPEN ECONOMY AND ISLM ANALYSIS

• The BP curve• The BP curve

SURPLUS

DEFICIT

The BP curveThe BP curve

SURPLUS

DEFICIT

Assume that nationalincome rises

Deficit if rate of interestremains at r1

Rate of interest mustrise to r2 to restore

balance of payments

• The BP curve

• Analysis under a fixed exchange rate

• The BP curve

– equilibrium in the model

• The BP curve

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

Full equilibrium in the goods, moneyFull equilibrium in the goods, moneyand foreign exchange marketsand foreign exchange markets

• The BP curve

– movement to a new equilibrium

• The BP curve

– effects of fiscal policy

• The BP curve

An expansionary fiscal policyAn expansionary fiscal policy

Balance of paymentssurplus causes money

supply to expand

Restoration of

full equilibrium

An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve

Balance of paymentsdeficit causes money

supply to contract

Restoration of

full equilibrium

• The BP curve

– effects of monetary policy

• The BP curve

An expansionary monetary policyAn expansionary monetary policy

bBalance of paymentsdeficit causes money

supply to contract again

bFull equilibrium

is restoredback at point a

• Analysis under free-floating rates

– effects of exchange rate changes on the BP curve

SURPLUS

Movements in the BP curveMovements in the BP curve

Appreciation

DEFICIT

Depreciation

Movements in the BP curveMovements in the BP curve

– achievement of equilibrium

ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates

Balance of paymentssurplus causes the

exchange rate to appreciate

The appreciationcauses the IS curve

to shift to the left

Full equilibrium isrestored at point c

Balance of paymentsdeficit causes exchange

rate to depreciate

Depreciation causesthe IS curve toshift to the right

Full equilibrium isachieved at point c

The balance of paymentsdeficit causes the BP line

to shift downward

The depreciationcauses the IS curveto shift to the right

r2 b Full equilibrium isrestored at point c

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