textbooks.elsevier.com · Web viewUsing the trade flow model to explain the devaluation Assume that the U.K. taste for U.S. goods rises. The pound should depreciate. The Bank of England

Melvin and NorrbinInstructor’s Manual

International Money and Finance

Chapter 12: Determinants of the Balance of Trade

Outline of this Chapter The chapter tries to explain why the domestic currency devaluation does not

necessarily improve the balance of trade. Elasticities Approach

o J-Curveo Currency Contract Periodo Pass-Through Analysiso The Marshall-Lerner Condition

Absorption Approach

Explaining the Balance of Trade with Theories The balance of trade records a country’s trade in goods and services with the rest of

the world. Why do some countries run a balance of trade surplus, while others run deficits? We try to explain this question using 2 approaches.

Elasticity Approach Absorption Approach

Trade and foreign exchangeo When a country imports, it supplies foreign exchange as payment.o When a country exports, it demands foreign exchange as payment.o An excess supply of foreign exchange is equivalent to a balance of trade

deficit.o An excess demand for foreign exchange is equivalent to a balance of trade

surplus. The balance of trade is in balance when the quantity of foreign exchange supplied and

quantity demanded are equal.

Using the trade flow model to explain the devaluation Assume that the U.K. taste for U.S. goods rises.

$/₤ S1 (UK importers) S2 2.00 D intervention Q ₤

Q1₤ QS

₤

The pound should depreciate.

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The Bank of England can peg the exchange rate at $2.00/pound by selling $ and buying pound by the amount QS

£ - Q1£.

U.K. balance of trade: o Exports → same as beforeo Imports → increase

Thus, U.K will have a trade deficit at a pegged exchange rate. How to eliminate trade deficit?

o The Bank of England could devalue the exchange rate from $2/pound to $1/pound.

o This would make the U.S. goods become more expensive for the British. o So it should slow down the imports from the U.S. and improve trade balance

again.

Puzzle: sometimes trade deficits become worsen after the devaluationo A devaluation of domestic currency

↓ price of domestic exports → export more ↑ price of foreign imports → import less Trade deficit should improve.

o However, it doesn’t always work like this in the real world. In many case, trade deficits become worse after the devaluation.

o Why?

Elasticities Approach to the Balance of Trade The Elasticities Approach is concerned with how change in relative prices of

domestic and foreign goods will change the quantities traded. Relative price – the price of one good relative to another. Relative prices change as relative demand and supply for individual goods change

(caused by changes in taste, production technology, or government taxes/subsidies, etc.)

o Ex: Some medical research has found that eating chocolate everyday could reduce the risk of heart attacks. This event would increase the demand for chocolate and raise the price of chocolate. Holding other things constant, now the chocolate is relatively more expensive.

A change in the exchange rate could change the price of foreign goods in terms of domestic currency.

o Example: Suppose that a tuxedo costs $100 in the U.S. and €100 in Italy. If the exchange rate is €1 = $1, then the tux costs the same in each

country. If the exchange rate changes to €2 = $1, then

o For Americans: the tux in the U.S. is still $100, but the tux in Italy is now only $50 (half-off).

o For Italians: the tux in Italy is still €100, but the tux in the U.S. is now $200 (twice more).

o When $ appreciates (€ depreciates): Americans find the Italian goods relatively cheaper. Italians find the American goods relatively more expensive.

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o Would it mean that the U.S. will have the balance of trade deficit and Italy will have the balance of trade surplus?

How much would the devaluation of the euro affect the U.S. quantity demanded for Italian goods depending on the elasticities of demand and supply.

Elasticity – the responsiveness of quantity to changes in price.o Inelastic: the quantity is relatively less responsive to price changes.o Elastic: a small change in price causes a large change in the quantity.

The elasticity of demand:

ε d=%∆ Q%∆ P

The percentage change in quantity demanded divided by the percentage change in price.

Note that we only consider the absolute value of this coefficient. If the price increase 5% and the quantity demanded fall by 5%, the elasticity of

demand is 1.o If ε d is greater than 1, the demand is elastic.o If ε d is less than 1, the demand is inelastic.

Just as we compute for ε dwe can use the same formula to compute the elasticity of supply, ε s

If the price increase 5% and the quantity supplied increase by 5%, ε s= 1.o If ε sis greater than 1, the supply is elastic.o If ε s is less than 1, the supply is inelastic.

When price falls:o A perfectly elastic demand, there is no change in the quantity.o An elastic demand (flat), larger increase in Q.o A inelastic demand (steep), smaller increase in Q.

Elasticity of Demand and RevenuesTotal revenue = price x quantity

o When the demand is elastic, an increase in price will decrease the total revenue.

o When the demand is inelastic, an increase in price will increase the total revenue.

The devaluation and the J-curve After the devaluation, it is often observed that the trade balance initially deteriorates

for a while before getting improved. The pattern of the BOT after the devaluation creates a J-curve.

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Current Account J-Curve

0 _ Time devalue

Why do we have a J-curve? J-curve effect – following devaluation, trade balance is initially worsened before

improving later. Two reasons to explain the downward part of the J-curve:

o The currency contracting period Immediately after the devaluation, trade and payments contracts have

already been negotiated prior to the change in exchange rate become revalued.

o The pass-through period After the devaluation, import prices and export prices do not adjust as

expected due to inelastic demand and/or supply curves.

Currency Contracting Period Contracts are usually set up for 30, 60, and 90 day payments and delivery. Immediately after a devaluation, contracts negotiated prior the exchange rate change

become due

Contracts Currency Payments signed devaluation due t1 t2 t3 time

Contracts are signed at t1.A currency devaluation at t2.Payments have to be made at t3.

In this case, the buyers and sellers have little ability to respond to the devaluation (inelastic).

No change in quantity after the devaluation. Example: Currency Contracting Effect

o Suppose that we import a BMW and agree to make a payment in 90 days for €20,000.

o Assume that S$/€ = 1.0

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o We are expecting to pay $20,000 for this imported car.o Now, suppose that the dollar is devalued: S$/€ = 2.0o The effect of the devaluation depends on whether you agree on the contract to

pay in dollars or in euros.o If we agree to pay in euro, now the import cost goes up to $40,000.o However, if we agree to pay in dollar in the contract, then the import cost

remains the same at $20,000. When dollar devalues: from S$/€ = 1.0 to S$/€ = 2.0

o Import contract written in dollar: U.S. import values – unaffected.

o Import contract written in euro: U.S. import values – increase.

o Export contract written in dollar: U.S. export values – unaffected

o Export contract written in euro U.S. export value – increase.

The effects on U.S. trade balance, after a dollar devaluation U.S. Import Contracts Written in

Dollar Euro U.S. Export Contracts Written in

Euro U.S. exports ↑ U.S. import same Trade balance ↑

U.S. exports ↑ U.S. imports ↑ Trade balance ?

Dollar U.S. exports same U.S. imports same Trade balance same

U.S. exports same U.S. imports ↑ Trade balance ↓

Only the quadrant 4 results in a deterioration of trade balance as depicted in the J-Curve.

When import contracts are written in foreign currencies and the export contracts are written in the domestic currency, a domestic currency devaluation can lead to a trade deficit.

Pass-Through Analysis The contracting explanation applied for the duration of the negotiation period (i.e. 30,

60, or 90 days). What happens after that? After the contract expires, the quantity adjustment might still be minimal, if the good

is inelastic or if suppliers cannot change the quantity supplied. Pass-through analysis considers the elasticity of demand and supply resulting in an

inability for people to adjust in the short run.

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What happens if:o Elasticity of demand for or supply of exports is inelastic.o Elasticity of demand for or supply of imports is inelastic.

Example: suppose that dollar devalues by 10%.

Case A: U.S. demand for imports is perfectly inelastic.

A devaluation will increase the prices of imports in dollar. If imported goods are inelastic (e.g. hard to find a close substitute of French wine),

U.S. importers will continue to buy at Q1. The supply curve shifts to the left. Foreign exporters want to charge a higher dollar

price, because dollar is worth less. American buyers pay 10% more. Foreign exporters get the same in their currency. Import values: Original: P1 x Q1 New: P2 x Q1 Total import value ↑

Case B: Foreigners’ demand for U.S. exports is perfectly inelastic.

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After the devaluation, the supply curve (by U.S. exporters) shifts to the right. U.S. exporters are willing to sell goods at lower price in foreign currency, because the

foreign currency is now worth more. With the perfectly inelastic demand curve: The U.S. exports the same quantity American exporters charge lower price in foreign currency, but the value of exports in

dollars remains the same. Total export value constant.

Case C: supply of foreign production is inelastic.

The supply can be inelastic because the productions are constrained by labor/resources contracts, such that plants cannot expand or decrease the amount produced.

Since dollar is weaken, foreign goods become relatively more expensive. The demand curve shifts to the left.

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The foreign currency price of imports falls by the amount of devaluation. Thus, there is no pass-through in this case (the price to foreigners does not change). The value of imports in dollars constant.

Case D: Supply of U.S. exports is perfectly inelastic

A weaken dollar would increase the demand for U.S. exports. With the perfectly inelastic supply curve, the dollar price of exports rises by the full

amount of the devaluation. As the price in dollar increases, the value of U.S. exports increases. Total export value increases.

U.S. Trade Balance Effects During Pass-Through Period (after the devaluation)

Box 4 is the case where the U.S. trade balance get worsen, when both demands for U.S. imports and exports are perfectly inelastic.

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Marshall – Lerner Condition Two economists have proven how high the elasticity has to be before a devaluation

leads to an improvement of the balance of trade. Marshall – Lerner condition – the necessary condition of international demand

elasticities that will ensure an improvement in the trade balance after a devaluation.

| elasticitiesof the demand for imports+elasticitiesof the demand for exports|>1

Thus, the downward part of the J-curve represents the case that the sum of elasticities of demands for both imports and exports is less than 1. The Marshall-Lerner condition is not met.

In the long run, we expect elasticities to increase. Therefore, the current account eventually improves.

Marshall-Lerner condition and the J-curve

MLC: If the sum of elasticities of demand for imports and demand for exports is greater than 1, then trade balance will improve.

J-curve indicates that when devaluation increases the price of foreign goods to the home country and decreases the price of domestic goods to foreign buyers, there is a short-run period during which trade balance falls.

Absorption Approach The elasticity approach shows that it is possible for a country to improve its trade

balance by a devaluation. The devaluation will eventually reduce imports and increase exports, stimulating

production of goods and services. What if a country is at its full-employment level of production before the

devaluation, can it still improve trade balance? Sometimes the actual response of the trade balance to a devaluation seems slower

than the elasticities approach would argue.

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Therefore, a different theory was developed that emphasized the aggregate output effect.

Absorption approach to the balance of trade – a theory based on the relationship of domestic spending for domestic goods (absorption) relative to domestic output.

From Macroeconomics, an economy’s total output (Y) is:

Y = C + I + G + (X – M)

C is consumption, I is investment, G is government spending, X is exports, and M is imports.

Let us call (C + I + G) “Absorption (A)”:

Y = C + I + G + (X – M)

Domestic Net ExportsAbsorption (A)

The absorption term represents the domestic spending by households, businesses, and government.

Absorption: A = C + I + G

Y = A + X – M Y – A = X – M

o If Y > A → X – M > 0 (trade surplus)o If Y < A → X – M < 0 (trade deficit)

Suppose that U.S. total output is $12 trillion and the absorption is $12.7 trillion.o Y – A = 12 – 12.7 = - 0.7 trilliono So, U.S. trade deficit would be 700 billion.

How can we improve this trade deficit situation?o Either ↑Y or ↓Ao A devaluation should improve balance of trade if we allow A or Y to adjust

appropriately.

The effects of a devaluationCase 1: Y is below the full-employment level

o Y < YF

o So, an economy still has some unemployed resources to be used in production.o Thus, Y has room to increase.o A devaluation leads to an increase in demand for the domestic goods and

services, leading to an increase in the domestic production. o Thus, the country can increase production without adjusting A.o (Y – A) ↑ = (X – M) ↑

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o Trade balance will improve, following a devaluation (after the elasticity period has gone by).

Case 2: Y is at the full-employment levelo Y = YF

o Then, we can no longer increase Y.o Thus, A has to fall.o How to decrease the absorption?

A = C + I + G

↓C: by a consumption tax, by raising real interest rate, or by slowing down real wage growth.

↓I: it is not a good idea to slow investment, as the long run growth of a country depends on investment, but need to make sure that there is not the short run bubbles (e.g. dot-com markets in the 1990’s).

↓G: this is the favorite place for a reduction. The IMF often recommends reductions here, e.g. Social Security Reform in Turkey to reduce the transfer payments by the government. Cutting farm and other firm subsidies is also a common target.

IMF and the Absorption Approach IMF provides financial assistance to a crisis-ridden country with some conditions to

ensure debt repayment. (known as IMF conditionality). IMF usually requires the borrowing country to cut its absorption term. The conditions were aimed to promote the country’s long-run growth. However, they

may have short-run costs to the borrowing country. Some economists criticize the conditions to cut the domestic absorption to do more

harms than good and would send the country in a recession to more severe recession. There are still debates whether IMF conditionality is good or bad for countries.

Summary This chapter discussed why the domestic currency devaluation does not necessarily

improve the balance of trade, especially in the short run. The elasticities approach to the balance of trade explains how various degrees of

elasticities of demand and supply of imported goods could affect the balance of trade. A devaluation of the domestic currency raises the price of foreign goods relative to

the domestic goods. As prices of imports increasing, the total payments to importers could rise or fall depending on the elasticities of demand for imports.

The J-curve describes the pattern of the balance of trade after the currency devaluation such that the trade balance falls in the beginning and then rises later.

The J-curve effect could be a result of currency contract period and pass-through price adjustment.

Since some of international exchange contracts are signed before and the payments are collected after the currency devaluation, the devaluation could worsen the balance

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of trade when the export contracts are written in domestic currency and the import contracts are written in foreign currency.

The balance of trade will worsen from a currency devaluation, if there is a full pass-through, resulting in higher import prices and lower export prices.

The Marshall-Lerner condition indicates that if the sum of absolute values of the elasticities of demand for imports and demand for exports is greater than one, a currency devaluation could improve the balance of trade.

According to the absorption approach, the effects of the currency devaluation on trade balance depend not only on whether an economy is operating at its full-employment, but also whether the domestic absorption changes during the devaluation. At the full-employment level, if the domestic absorption remains constant, the currency devaluation will not change the balance of trade.

Exercises1. Suppose that the U.S. is considering devaluing its dollar against a foreign currency to

improve the trade balance. What type of currency contracting would have a negative effect on the trade balance?

2. Suppose that the U.S. is considering devaluing its dollar against a foreign currency to improve the trade balance. What type of pass-through effects would lead to a positive effect on the trade balance?

3. Suppose that the U.S. is considering devaluing its dollar against a foreign currency to improve the trade balance. Use the absorption approach to explain how the U.S. can improve its trade balance from the currency devaluation, if the country is currently operating in the full-employment level of output.

4. Give examples policies that a country could implement to reduce its absorption.5. What is the J-curve? Explain.6. How can we use the Marshall-Lerner condition to explain the J-curve effect?

Answer1. When the U.S. import contracts are written in foreign currency (imports will increase

after the devaluation) and the U.S. export contracts written in dollar (exports remain constant). Thus, devaluation will cause trade balance to be more deficits.

2. When the U.S. imports have inelastic supply (import will remain constant) and the U.S. exports have inelastic supply (exports will increase). Thus, the devaluation will improve trade balance.

3. At the full-employment level of output, output reaches its maximum level so that output no longer can increase. To reduce the trade deficits, the U.S. will have to cut the domestic absorption (by decreasing C, I, and G)

4. Examples: raise taxes, cut government spending, raise interest rate, decrease money supply.

5. The J-curve describes the pattern of the balance of trade after the currency devaluation such that the trade balance falls in the beginning and then rises later.

6. In the short run, both demands for exports and imports are inelastic. Hence, the sum of the two elasticities of demand is less than one. A currency devaluation will worsen the trade balance. With a passage of time, the elasticities of demands for exports and imports

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will increase, and thus the sum of the two elasticities will be greater than one. The devaluation will improve trade balance.

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Chapter 13: the IS-LM-BP Approach

Outline of This Chapter Macroeconomic Equilibrium: three markets

o Building the IS curveo Building the LM curveo Building the BP curve

The IS-LM-BP model Policy Analysis: fiscal vs. monetary Under fixed exchange rates, Under floating exchange rates, International Policy Coordination

Economic Goals of an Open Economy To reach internal balance and external balance. Internal balance – a steady growth of the economy (low unemployment rate, markets

are in equilibrium, resources are efficiently used). External balance – achieve a desired trade balance or desired international capital

flows. Three equilibrium conditions

o Goods market equilibrium The quantity of goods and services supplied is equal to the quantity

demanded. This is the IS curve

o Money market equilibrium The willingness to hold money is equal to the quantity of money

supply. This is the LM curve.

o Balance of payments equilibrium The current account deficit is equal to the capital account surplus, so

that the official settlements equals to zero. This is the BP curve.

Deriving the IS curve Income leakages = domestic spending injections

S + T + IM = I + G + X (1)

S = domestic savingT = taxesIM = importsI = investment spending (ex. new plants)G = government spending

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X = exports

When the leakages equal to the injections, then the value of income received from producing goods and services will equal to total spending.

We assume:o S depends on income

Higher income, people tend to save more.o T is arbitrarily set by the government.o IM depends on income

Higher income, people buy more goods and imported goods.o I depends on interest rate

Higher interest rate, higher the costs of borrowing and hence decrease the willingness to invest.

o G is arbitrarily set by the government.o X depends on foreign income

If people in trading partner countries are wealthier, they will buy more from us.

IS curve – the various combinations of i and Y that satisfy the equality in the equation (1).

o Every point on the IS curve represents an equilibrium in the goods market.o IS curve is downward slopingo If interest rate falls, investment projects become more profitable. So,

investment increases. More investment spending will create more production and generate more income. Thus, income rises.

↓ i → ↑Y ↑ i → ↓ Y

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Deriving the LM curveMoney supply = Money demand

M S=M d(i ,Y )

MS money supply is fixed (by the Fed)o The money supply curve is vertical.

Md money demand is a function of income (Y) and interest rate (i).o Higher income: people will hold more cash as the amount of transactions

increases with their income. Positive relationship

o Higher interest rate: the opportunity cost of holding cash increases, people are less likely to hold cash than before.

Inverse relationshipo Money demand is a downward-sloping curve.

An increase in interest rate decreases the quantity demanded for money.

An increase in income will shift the entire demand for money curve to the right.

Suppose that the market is initially in an equilibrium, an increase in income will increase the demand for money. But, since the amount of money supplied is fixed, it would cause an excess demand for money at the same interest rate. Thus, interest rate must rise to discourage cash holding and bring the market to a new equilibrium

LM curve – the combinations of i and Y that bring the money market into equilibrium.

Ever point on the LM curve brings the demand for money to equal to the supply of money.

LM curve is upward sloping curve.

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The BP Curve BP curve – the combinations of I and Y that yield balance of payments equilibrium. The BOP equilibrium occurs when: The current account surplus = the capital account deficit

o CS = CDo So, the official settlement = 0

Higher interest rate at home attracts foreign investors → current account is able to sustain higher deficit.

Different shapes of the BP curve:o If capital is perfectly mobile, the BP curve is horizontal.o If capital is not perfectly mobile, then the BP curve is upward sloping.o If the capital is perfectly immobile (due to restrictions), then the BP curve is

vertical.

Shifting the curves

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Equilibrium in three markets Interest rate (i) LM BP i* e IS Y* Income,

Output (Y) When three curves cross at the same point, the equilibrium interest rate i* clears all

three markets simultaneously.

Two Policy Types Policy aims to promote the full-employment production and stable price levels.

Fiscal Policy: G and To When G > T, the government runs budget deficit.

This is also called “expansionary fiscal policy.”o When G < T, the government runs budget surplus.

This is “restrictive fiscal policy.”o Fiscal policy will shift the IS curve

Monetary Policy: Ms

o Increase money supply = expansionary monetary policyo Decrease money supply = restrictive monetary policyo Monetary policy will shift the LM curve

Policy Analysis:Monetary Policy under Fixed Exchange Rates

Assume perfect capital mobility Suppose the central bank increases the money supply.

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LM shifts to the right. At e’, the good market and the money market are in equilibrium. Interest rate falls and income rises. Large capital outflow Large official settlements deficit Pressure the domestic currency to depreciate. To peg, the central bank has to buy domestic currency and sell foreign currency. Buying domestic currency will decrease the money supply. Move the LM back to its original location. Monetary policy is ineffective under fixed exchange rates.

Fiscal Policy under Fixed Exchange Rates Assume a perfect capital mobility. Suppose that government uses an expansionary fiscal policy.

IS curve shifts to the right. Income rises and interest rate rises (at e’) Large capital account surplus (because of higher i) Official settlements become a surplus. Pressure the domestic currency to appreciate. To peg, the central bank has to buy foreign currency and sell domestic currency. Increase the money supply. LM shifts to the right. Fiscal policy increases income in a country with a fixed exchange rate.

Monetary Policy under Floating Exchange Rate Assume perfect capital mobility. Suppose the central bank increases money supply. LM shifts to the right. Income rises and interest rate falls (at e’). Large current account deficit Official settlements deficit Domestic currency depreciates.

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Currency depreciation makes domestic exports become relatively cheaper. An increase in exports shifts the IS curve to the right. New equilibrium (e”): income rises and i = iF. Monetary policy increases the domestic income under floating exchange rates.

Fiscal Policy under Floating Exchange Rates Assume a perfect capital mobility. Suppose that the government uses an expansionary fiscal policy.

IS curve shifts to the right. Income rises and interest rate rises (at e’). Capital account surplus (because domestic i > iF). Official settlements surplus The domestic currency appreciates. An appreciation of the domestic currency shifts the IS curve to the left. Return to the original equilibrium point. With floating exchange rates, fiscal policy is ineffective.

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Applying the IS-LM-BP model: Asian Financial Crisis In 1997, investors perceived that assets in Thailand were riskier than other countries. To defend the fixed exchange rate, the Bank of Thailand had to buy Thai baht and sell

dollar reserves. This would reduce the money supply, shifting LM to the left.

Domestic interest rate rose sharply → discourage investment → income falls Thailand went into a deep recession In July 1997, Thai government decided to allow the exchange rate to float. The sharp depreciation of Thai baht improved the country’s competitiveness in

exporting goods. The IS curve shifts to the right.

The recovery began. Income and employment started to rise.

International Policy Coordination Motivation: with high degree of capital mobility, fiscal policy in each country could

cause divergence of interest rates, and thus lead to exchange rate adjustments. If all countries can synchronize their fiscal actions, it could minimize such exchange rate volatility.

Benefits: stable exchange rates, stable trade, no sharp movements of capital flows, and crisis deterrence.

This topic is still widely debated.

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It is not an easy task to design a set of “rules of the game” within which countries can pursue their own national objectives and yet which still leads to some form of global coordination of macroeconomic policies.

Summary The desired economic outcome in an open economy is to achieve both internal

balance and external balance at the same time. Internal balance refers to a domestic equilibrium condition such that good market and

money market are in equilibrium and unemployment is at its natural level. External balance requires the balance of payments to be in equilibrium. The condition

implies zero balance on the official settlement – the current account surplus must be equal to the capital account deficit.

The IS curve represents the combinations of income and interest rate levels that bring the good market to equilibrium (i.e. leakages equals to injections).

The LM curve represents the combinations of income and interest rate levels that bring the money market to equilibrium (i.e. money demand equals to money supply).

The BP curve represents the combinations of income and interest rate levels that bring the balance of payments to equilibrium (i.e. current account surplus equals to capital account deficit).

The internal and external equilibriums occur when three curves intersect at one point. The factors that shift the IS curve are a change in domestic price level, a change in

exchange rate, and a change in fiscal policy variable. The factor that shifts the LM curve is a change in money supply. The factor that shifts the BP curve is a change in perception of asset substitutability. With perfect substitutability and perfect capital mobility, the domestic interest rate is

equal to the foreign interest rate. With fixed exchange rates, a country cannot conduct an independent monetary policy

to change domestic income. Only fiscal policy is effective in changing equilibrium income.

With floating exchange rates, monetary policy is effective in changing domestic income. However, fiscal policy has no effect on income because of a complete crowding-out effect from the balance of payments adjustment.

International policy coordination is an idea that aims to stabilize the exchange rates by coordinating each country’s fiscal and monetary policies to achieve the best international outcome.

Exercises1. Explain the difference between a closed economy and an open economy. Explain also

how the pursuit of internal equilibrium will be different between two types of the economies.

2. Consider the IS-LM-BP model of an open economy with a constant price level, perfect asset substitutability, and perfect capital mobility. The economy is initially in both internal and external equilibrium.

a. Explain why the BP curve is a horizontal line at i = iF, where i is the domestic nominal interest rate and iF is the foreign nominal interest rate.

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b. Define the internal equilibrium and external equilibrium of the economy, respectively.

3. From question 2, suppose now that the domestic economy decides to reduce its money supply.

a. What are the initial effects of this monetary policy on the goods market, the money market, the foreign exchange market, and the balance of payments of the domestic economy? Which curve(s) will shift?

b. What is the adjustment mechanism under a fixed exchange rate regime? Illustrate and explain which curve(s) will shift during the adjustment, and then compare the new equilibrium with the initial equilibrium.

c. What is the adjustment mechanism under a flexible exchange rate regime? Illustrate and explain which curve(s) will shift during the adjustment, and then compare the new equilibrium with the initial equilibrium.

4. From question 2, suppose now that the domestic government decides to increase the government spending.

a. What are the initial effects of this fiscal policy on the goods market, the money market, the foreign exchange market, and the balance of payments of the domestic economy? Which curve(s) will shift?

b. What is the adjustment mechanism under a fixed exchange rate regime? Illustrate and explain which curve(s) will shift during the adjustment, and then compare the new equilibrium with the initial equilibrium.

c. What is the adjustment mechanism under a flexible exchange rate regime? Illustrate and explain which curve(s) will shift during the adjustment, and then compare the new equilibrium with the initial equilibrium.

5. If a country has a surplus balance of payments, what will be the appropriate government policy to restore the balance of payments back to equilibrium? What effects might this have on the country’s income?

6. What is the international policy coordination? Explain why it is difficult to adopt the international policy coordination in practice.

Answer1. A close economy assumes no international trade, so the net exports (NX) will be dropped

from the national income identity (Y = C + I + G). There is no concern about the role of exchange rate in the IS curve, no foreign reserves in the money supply equation, and no BP curve. The internal balance is just to clear the good market (domestic spending = domestic output) and clear the money market (money creation = money being held). An open economy adds the international trade and capital flow aspects into the model. By allowing the exchange rate, foreign reserves, and capital flows, the market-clearing condition in the goods market changes. The equilibrium in the goods market becomes S + T + IM = I + G + X.

2. a. The BP curve is a horizontal line at i = iF because of the perfect mobility of capital flows and perfect substitution between assets (home and abroad). When interest rates between home and foreign country are equalized, there is no different between two countries’ assets. If the interest rate at home is higher than foreign country, the infinite amount of capital will flow into home country. However, if foreign interest rate is higher than home rate, no investor would invest at home.

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b. For perfect asset substitutability and perfect capital mobility, the internal equilibrium conditions are S + T + IM = I + G + X in the goods market and money supply equals to money demand in the money market. The external equilibrium conditions are the current account surplus = the capital account deficit and official settlement equals to zero.

3. a. A decrease in money supply will shift the LM curve to the left. An excess demand for money will drive the interest rate upward to restore the money market equilibrium. Higher interest rate will discourage investment spending in the domestic country and lead to lower income. Since i > iF, there will be large capital inflow to the domestic country. This leads to official settlement surplus and pressures the domestic currency to appreciate. i LM2 LM1 inew B A i=iF BP IS Y2 Y1 Income (Y) b. Under a fixed exchange rate, the central bank will have to sell domestic currency and buy foreign currency to peg the exchange rate. This would cause an increase in domestic money supply and shift the LM curve back to its original location (LM2 to LM1). The economy will move back to point A. i LM2 LM1 inew B A i=iF BP IS Y2 Y1 Income (Y)

c. Under flexible exchange rate, when the money supply decreases, the LM curve shifts to the left and pushes interest rate upward. This leads to capital inflows and official settlement surplus. The domestic currency will appreciate. The currency appreciation will make domestic exports become relatively more expensive to foreigners, lowering demand

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for domestic exports. A decrease in exports shifts the IS curve to the left (to IS2). The economy moves from point A to point C. The domestic output falls to Y3. i LM2 LM1 inew B C A i=iF BP IS1 IS2 Y3 Y2 Y1 Income (Y)

4. a. An increase in government spending will shift the IS curve to the right. Income and interest rate rise. Since i > iF, there will be large capital inflows and official settlement surplus. The domestic currency faces a pressure to appreciate. i LM1 inew B A i=iF BP IS2 IS1 Y1 Y2 Income (Y) b. Under the fixed exchange rate, the central bank will have to buy foreign currency and sell domestic currency to peg the exchange rate. By selling domestic currency, the money supply will increase. Thus, the LM curve will shift to the right and bring the interest rate back to i=iF level. The economy will move to point C, resulting in higher income.

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i LM1 LM2 inew B A i=iF BP IS2 IS1 Y1 Y2 Y3 Income (Y) c. Under flexible exchange rate, an increase in government spending will cause the IS curve to shift to the right. Higher interest rate will bring in capital flows and cause an appreciation of domestic currency. As the currency appreciates, domestic exports become relatively more expensive to foreigners, resulting in a decrease in demand for domestic exports. The IS curve will shift to the left, returning to its initial location at IS1. The fiscal policy is ineffective under flexible exchange rate. i LM1 inew B A i=iF BP IS2 IS1 Y1 Y2 Income (Y)

5. In the case of a positive official settlements balance, there will be pressure on the domestic currency to appreciate. To remove that pressure the government has two options either to shift out the monetary policy or shift in the fiscal policy. If the government chooses the monetary option, the central bank must buy foreign currency and inject additional domestic currency in the economy. In the case of fiscal policy, the government can reduce fiscal spending and/or raise taxes, contracting the IS-curve.

6. International policy coordination refers to the issue of having a high variability in the exchange rate due to shifting fiscal and monetary policies. Thus, countries have to coordinate fiscal and monetary policies to avoid sharp currency fluctuations. This is already done in G-7 meetings where the major economies get together to discuss the

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future plans for monetary and fiscal polices. The difficulty is to have countries follow the plans, as domestic pressures usually supersede the international coordination.

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Chapter 14: the Monetary Approach

Outline of This Chapter Specie Flow Mechanism The Background of the Monetary Approach The Monetary Approach to the Balance of Payments The Monetary Approach to the Exchange Rate Managed Float Sterilization

What is the Monetary Approach? Monetary Approach – any balance of payments disequilibrium or exchange rate

movements is based on a monetary disequilibrium. The monetary approach focuses on the factors that affect the money demand and

money supply. Two approaches to link the money market disequilibrium to international trade flow

and exchange rates are:o For the fixed exchange rate – Monetary Approach to Balance of Payments

(MABP)o For the flexible exchange rate – Monetary Approach to Exchange Rate

(MAER)

Specie Flow Mechanism (Hume, 1752) Hume’s analysis is a strict monetary approach to prices and the balance of payments. Basically, the exchange rate is the relative price of the money supply (gold) in

different countries. When a country has a trade surplus, gold would flow into the country in the amount

that the value of exports exceeds the value of imports. Conversely, when such a country has a trade deficit, gold would flow out of the

country in the amount that the value of imports exceeds the value of exports. Consequently, the money supply would rise in a country with a positive balance of

trade and fall in a country with a negative balance of trade. Price will rise in the surplus country and fall in the deficit country. After that the

system is back in equilibrium. Gold supply = Money supply

o Let’s consider the Gold Standard. o Suppose that 1French franc = 1 ounce of gold and 1 British pound = 1/2 ounce

of gold.o Thus, the exchange rate for one British pound is SFFr/£ = 0.5o The two countries would be linked by the absolute PPP, so that

SFFr/£ = PFrance /Pengland

o Now suppose that there is a 10% increase in gold supply in England.o ↑Gold in England → ↑Ms in England→↑PEngland

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o Since the exchange rate is fixed, the PPP condition fails temporarily.SFFr/£ = PFrance /↑Pengland

o Goods in England become more expensive → buy more from France and pay France with gold. This outflow of gold toward France will increase France’s money supply and drive up prices in France as well.

o Trade deficit happens temporarily until prices in two countries converge to their PPP condition of a fixed exchange rate.

Review: basic concepts about money What is money?

o Currency plus bank deposits at the central bank.o This is called base money.o Base money multiplies into money supply, e.g.o M1 = Cash + checking accounts + traveler’s checks.

The Supply of Moneyo The Fed controls the amount of base money to change the money supply.o How can the Fed control the amount of money?

Change reserve requirement Change the discount rate Use open market operations (buying/selling bonds) Buy or sell foreign exchanges

o Note that currencies today are not pegged to gold. The money itself has no intrinsic value (just a bunch of numbers on checking account, or a piece of paper), but we have confidence in it.

Expanding the money supply to allow for international effect

M S=(R+D)

o Note that here the money multiplier is assumed to be 1, for simplicity.o The money base can be divided into two parts:o Domestic money creation (D)

The Fed usually uses the open market operations to increase or decrease money supply.

When they buy U.S. Treasury securities, they inject more money into the circulation → ↑D

When they sell U.S. Treasury securities, they take money out of the circulation → ↓D

o International reserves (R) Money that is used to settle international debts, primarily foreign

exchange. An excess supply of money → reserves outflow → ↓R An excess demand for money → reserves inflow →↑R

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The Demand for Moneyo When we talk about the demand for money, we are not saying that we want

more and more money. o On the contrary, we say, for a fixed amount of wealth, why would people hold

their wealth in money (cash) form? o Why not put some of their wealth in other interest-earning assets, like stocks

and bonds?o Every minute you hold cash in your wallet, you give up the opportunity to

earn interest payments. o So, why do we hold cash?

Because we need to make transactions. Cash is the most liquid asset.

The Cambridge Approach to Money Demando The demand for money is:

M d=kPY

o P is the price level, Y is the real income, and k is a fraction of cash holding.o This equation says the willingness to hold cash is equal to a proportion of

nominal income.o Think about this: suppose you have $1,000 allowance each month and you

normally spend $600 in food, clothing, and gas. You would only need to hold 60% of your allowance in cash (k = 0.6) and put the rest of your allowance in stocks to earn interests.

o Thus, the demand for money depends on prices and incomes. Higher income → buy more → need to hold more cash Higher prices → more money is needed to buy the same amount of

goods.

Equilibrium: Ms = Md

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o When the Fed increases the money supply, interest rate falls.o In the real world, the Fed does this by targeting a federal funds rate (inter-

bank overnight lending interest rate).o If the Fed decides to “cut rate,” then they will buy bonds to inject more money

into the economy.

Deriving the Monetary Approach We need 3 conditions:

(1) M d=kPY(2) M S=R+D

From the absolute PPP: S$ / FC=PUS/PFC,we can rewrite into(3) PUS=S$ /FC ∙ PFC (FC stands for Foreign Country)

M d=M S

k PUS Y US=R+Dk (S¿¿$ / FC ∙ PFC)Y US=R+D ¿

The unit of each variable is in levels ($billion). Since we are more interested in the percentage change, we will apply some mathematical magic (that you do not have to worry about) to convert levels into percentage changes.

We will put a dot on top of each variable to represent the percentage change unit. Now, we will have:

S$ / FC+ PFC+Y US=R+ D

o Note: k was dropped from the equation because it is a constant. The multiply becomes a plus sign (this is because we take logarithm

on multiplicative terms).

Group international variables on the left-handed side of the equation, we will get:

R−S$ /FC=PFC+Y US−D

This is also called Asset Market Approach to Exchange Rates.

The Monetary Approach to the Balance of Payment (MABP) From R−S$ /FC=PFC+Y US−D, assume that the countries are in the fixed exchange

rate arrangement (e.g. in the Bretton Woods system). Because of the fixed exchange rate, the S$ /FC term is now dropped from this equation. The monetary approach becomes:

R=PFC+Y US−D This is the MABP.

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Example of the MABP: Case 1 Suppose the Fed increases the U.S. money supply by an open market operation. ↑D by 10% There has to be changes in the other variables to offset the 10% change in D.

Recall: in the Bretton Woods system, the U.S. agreed not to intervene, so foreign central banks would have to intervene.

Foreign central bank: o Buys $ and sell its currency (so, the reserves will flow out from the U.S.)o Causes foreign money supply goes upo Increases foreign inflation rate (PFC rises)

↓ R5 %=↑ PFC 5 %+Y US−↑D10 %

The fixed exchange rate causes countries to be dependent on each other.

Example of the MABP: Case 2 Suppose there is a 100% increase in foreign inflation (↑PFC 100%). Foreigners will buy U.S. goods, causing an increase in the demand for dollar. To peg the exchange rate with $ (in the Bretton Woods system), foreign central bank

has to sell $ and buy its currency.o Foreign sells $ → ↑Ro Foreign buys its currency→↓ M S→ ↓ PFC

A possible adjustment in the MABP:

↑ R=↑↓ PFC+ Y US−D

Example of the MABP: Case 3 Suppose that the U.S. output (income) grows 3% (↑Y US3%). Since income increases, the money demand will increase. If the money supply remains constant, interest rate would rise, making the U.S. assets

more attractive to invest. Foreigners will buy U.S. assets, causing an increase in the demand for dollar. To peg the exchange rate with $ (in the Bretton Woods system), foreign central bank

has to sell $ and buy its currency. Foreign sells $ → ↑R

Foreign buys its currency →↓ M S→ ↓ PFC

A possible adjustment in the MABP:

↑ R=↓ PFC+↑ Y US−D

Policy implications of the MABP The effects of an expansionary monetary policy

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o There are no effects on output in either the short run or the long run.o In the short run, the policy leads to an excess supply of money, induces an

increase in expenditure and moves the BOP into deficit.o In the long run, Foreign exchange reserves fall by the extent of the expansion

in domestic credit. The BOP deficit returns the money supply to original level. o The effects of monetary policy in one country will be transmitted to other

countries. One would expect the phenomenon of “inflation export.”

The Monetary Approach to the Exchange Rate (MAER) Now, we consider the world with flexible exchange rates. When the exchange rates are fixed, money flows between countries to adjust to any

disequilibrium. When the exchange rates are flexible, the exchange rates will fluctuate to adjust to

disequilibrium. From


In this case, no central bank intervention takes place, so we can drop R term. But, we need to keep the exchange rate term.

We will have:

− S$/FC=PFC+Y US−D

Example of the MAER: Case 1 Suppose the Fed increases the money supply by 10%. ↑D by 10% → ↑PUS by 10%

If ↑PUS by 10%, then ↑ S$ /FC=↑ PUS

PFC by 10%.

The full effect of the monetary policy is felt on the exchange rate.

↑− S$ / FC=PFC+Y US−↑D

The foreign currency value goes up 10% (or dollar depreciates by 10%) Monetary policy from one country does not affect another country.

Example of the MAER: Case 2 Assume that the foreign inflation rises 100%.

If ↑PFC by 100%, then ↓ S$ /FC=PUS

↑PFC by 100%.

The full effect of the monetary policy is felt on the exchange rate.

↓− S$ / FC=↑PFC+Y US−D The foreign currency value depreciates100% (or dollar appreciates by 100%)

Example of the MAER: Case 3

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Suppose that the U.S. output grows 2% (↑Y US2%). Since income increases, the money demand will increase. Stronger demand for dollar → $ appreciates.

↓− S$ /FC=PFC+↑ Y US−D

Monetary Approach for a Managed Float A managed float – exchange rates are determined by market forces of demand and

supply (flexible), but central banks intervene at times to peg the rates at some desired levels.

In this case, our monetary approach retains all variables and the equation remains:


Managed Float: Case 1 The Fed increases the money supply by 10%. ↑D by 10% → ↑PUS by 10%

If ↑PUS by 10%, then ↑ S$ /FC=↑ PUS

PFC by 10%.

However, if the foreign central bank resists the appreciation of the foreign currency, they can:

Buys $ → ↓R Sell its currency → foreign money supply goes up → ↑PFC

↓ R−↑ S$ /FC=↑ PFC+Y US−↑D The exact division of the 10% into other variables depends on how much foreign

central bank wants to intervene.Sterilized Intervention

The central bank can choose to let S$ /FCto adjust to the free-market level; or, holding S$ /FCat some level and allowing Rto adjust.

Sterilization – the offsetting of international reserve flows by central banks that wish to follow an independent monetary policy.

o Use open-market operations to offset the effect of a foreign exchange intervention on the domestic money supply.

o This involves two transactions in one. Example: Sterilized Intervention

o Suppose there is a pressure on Japanese yen to appreciate. If the Bank of Japan wants to intervene to prevent the yen appreciation, it can

Buy $ Sell ¥

o Now, it has increased the $ reserves in the vault and increased the ¥ supply in its economy. This could lead to inflation.

o To offset this effect, the Bank of Japan can Sell Japanese government bonds and Buy ¥ (through the open-

market operations)

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Summary The basic premise of the monetary approach is that any balance of payments

disequilibrium is based on a monetary disequilibrium. Specie-flow mechanism explains the adjustments to a change in money supply in one

country under the fixed exchange rate environment through price movements and international trade flows.

According to the specie-flow mechanism, an increase in money supply in Country A will cause a balance of trade deficit in Country A, and a balance of trade surplus in Country B in the short run. In the long run, with the flow of gold from the trade deficit country to the trade surplus country, prices in two countries will adjust to bring both countries back in equilibrium again.

Two applications of the monetary approach are: (i) the monetary approach to the balance of payment (MABP), and (ii) the monetary approach to the exchange rate (MAER).

The MABP emphasizes money demand and money supply as determinants of the balance of payments under the fixed exchange rate.

The MAER emphasizes money demand and money supply as determinants of exchange rate movements.

The money supply is composed of domestic credit and international reserves. The money demand is derived from people’s willingness to hold money, which is a

constant proportion of their nominal income. The MABP implies that the change in international reserves equals to the foreign

inflation rate plus the growth rate of domestic output minus the change in domestic money creation.

Under the fixed exchange rate, inflation from one country can be transmitted to the other country.

The MAER implies that, under the free floating exchange rate system, a change in monetary policy in one country will not affect the other country’s money supply, only causing an adjustment of the exchange rate.

The monetary approach in the case of a managed floating exchange rate has attributes of both the MAER and MABP approach.

Sterilized intervention is the action by a central bank to offset the effect of a foreign exchange intervention, on the domestic money supply, by using the open-market operations.

Exercises1. “Monetary disequilibrium leads to balance of payments problems under fixed

exchange rates, and a currency problem under floating exchange rates." Discuss this statement with reference to the monetary approach.

2. What are the assumptions underlying the monetary approach to the balance of payments? Explain.

3. According to the monetary approach to the balance of payments, what type of economic policies would help a country to resolve a balance of trade deficit?

4. Using the monetary approach to the balance of payment to explain how the Bretton Woods system could break down after the U.S. increasing its money supply too fast.

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5. In a perfectly floating exchange rate regime, use the monetary approach to the exchange rate to explain the effect on the dollar price of a Swiss franc ($/SFr) of the following scenarios:

a. The output in the U.S. decreases by 3%.b. The price level in Switzerland decreases by 2%.

6. Assume that Mexico and the U.S. are in a fixed exchange rate agreement. Suppose that the Fed increases the money supply by 40%. What would happen to the international reserve position for the U.S.? Assume that the U.S. has to intervene to peg the exchange rate, how could they accomplish the intervention?

Answer1. The monetary approach is built on the idea that money demand and supply will be

reflected in the official settlements balance and/or the foreign exchange rate. A shock to money supply would lead to an imbalance that has to be resolved either through the balance of payments or a change in the currency value.

2. The assumption is that the money demand and money supply of two countries would be linked through the purchasing power parity. Movements in money demand and money supply would cause the balance of payments or the currency value to adjust.

3. A trade deficit is a reflection of a monetary policy that is too loose. Reducing the monetary growth would resolve the trade deficit.

4. In the Bretton Woods system other central banks were committed to resolve any pressures on the dollar value. Therefore an increase in the U.S. domestic money growth (D) had to be offset by an equal change in (-R).

R=PFC+Y US−D

To accomplish a change in the net reserves, the foreign central banks had to buy dollars and sell their own currencies. Doing that led to a massive dollar glut in foreign central banks, combined with a higher than desired foreign inflation. In 1971 foreign central banks had enough and asked for gold, and the Bretton Woods system collapsed.

5. a) Y decreases by 3%− S$/FC=PFC+Y US−D

then $/SFr has to increase, or there is a depreciation of the dollar (appreciation of the SFr)b) Foreign price level decreases by 2% (foreign deflation)

− S$/FC=PFC+Y US−D

Again the $/SFr has to increase or there is a depreciation of the dollar (appreciation of the SFr)

6. U.S. increases its D by 40%. According to the MABP the R has to decrease by 40%:

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R=PFC+Y US−D

To do that the Federal Reserve has to buy dollars and sell Pesos out of its currency vaults.

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Chapter 15: Extensions to the Monetary Approach of Exchange Rate Determination

Outline of This Chapter This chapter tries to explain the short-run volatility of exchange rates through

financial asset markets. Five extensions to the MAER approaches

o “News” approacho Portfolio-balance approacho Overshooting approacho Currency substitution approacho Open-Economy Macro approach

Goods Prices vs. Exchange Rates In Chapter 14, we discuss how exchange rates adjust to bring the international

trade of goods into balance.

Note that goods prices adjust much slower than exchange rates. The volatility of exchange rates is about 4-8 times the volatility of prices. So, the basic Monetary Approach to Exchange Rate (MAER) may not capture

much of short-run volatility of exchange rate.

News Approach News – unexpected events, shocks, or surprises. Several economic variables are affected by “news” such as prices, interest rates,

and exchange rates. Example: if there is an announcement that the Fed considers to increases money

supply, the exchange rate will be affected immediately from this announcement. Since “news” catches everyone off-guard, this makes it very difficult to forecast

the future exchange rates. Volatile exchange rates reflect turbulent times with series of unpredictable shocks.

The Portfolio-Balance Approach If domestic and foreign bonds are NOT perfect substitutes, we need to modify the

MAER from the last chapter.

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The Portfolio-Balance Approach assumes that assets are imperfect substitutes internationally because investors perceive foreign exchange risk to be attached to foreign assets.

With imperfect substitutability, investors will hold more foreign assets only if they are compensated for risks.

From the basic MAER:

− S$/FC=−D+ PFC+Y US

In this equation, the change in exchange rate is a function of money supply (D) and money demand (PFC, Y US).

If domestic and foreign bands are not perfectly substituted, we need to modify the basic MAER.

− S$/FC=−D+BFC−B+ PFC+Y US

We include the percentage change of supply of foreign bonds (BFC) relative to the percentage change of supply of domestic bonds (B).

In addition to the demand and supply of money, the choice of portfolio assets can affect the exchange rate movements.

An increase in the supply of foreign bonds causes domestic currency to appreciate faster.

An increase in the supply of domestic bonds causes domestic currency to depreciate faster.

Trade Balance Approach Changes in expectations about future trade flow can affect the current exchange

rate. Example: suppose an international oil cartel develops. Because of anticipation of

higher oil price, an oil-importing country expects to have a large trade deficit in the future.

How would the expected future trade deficit affect the exchange rate now?o People anticipate:

Trade deficit → ↓foreign reserves → domestic currency depreciates (foreign currency appreciate).

o Once people expect domestic currency to depreciate in the future, they will shift from domestic to foreign money immediately

o Many people will try to exchange domestic currency to foreign currency now → foreign currency to appreciate right away (before a trade deficit ever happens).

Path of exchange rate after a new event causing trade deficits

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o Initial exchange rate is at E0.o At time t0, the oil cartel is formed.o With the deficit and the consequent outflow of

money from home to abroad, the domestic currency will depreciate.

o Eventually, as a new long-run equilibrium is reached at E1, the trade balance is restored.

o At t0 , there is an instantaneous jump in the exchange rate even before any trade deficits are realized, because individuals try to exchange domestic money for foreign in anticipation of the domestic currency depreciation

Overshooting Approach (Dornbusch) Theory of Exchange Rate Overshooting – explains high exchange rate volatility

by assuming that PPP does not hold in the short run, but CIRP does. When there is a shock, the assets markets adjust instantaneously, so the covered

interest parity holds. However, prices of goods and services adjust slowly to their new levels, so

purchasing power parity does not hold in the short run. Since exchange rates and interest rates adjust quickly, while traded goods prices

are sluggish, the exchange rates tend to “overshoot” or adjust too much. Time paths of exchange rate, domestic price level, and interest rate after an

increase in domestic money supply Overshooting Theory

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When the money supply increases at time t0, the domestic interest rate falls, and the spot and forward exchange rates increase (the domestic currency depreciates, while the price level remains fixed.

The eventual equilibrium price and exchange rate will rise in proportion to the increase in the money supply.

Although the forward rate will move immediately to its new equilibrium, F1, the spot rate will increase above the eventual equilibrium, E1, because of the need to maintain interest parity (note i has fallen in the short run).

Over time, as prices start rising, the interest rate increases and the exchange rate converge to the new equilibrium, E1.

The initial rise in the spot rate will “overshoot” its long-run value.

The Currency Substitution Approach The independence of domestic policy under flexible exchange rates may be

reduced if there is an international demand for monies. Example: Two countries A and B. Country B residents desire to hold currency A

as part of their portfolio investment.o In a region with substitutable currencies, shifts in money demand between

currencies will add an additional element of exchange rate variability. o Thus, double effects from the MAER and the currency substitution cause

excessive volatility in exchange rates.o If the cost of holding a U.S. dollar rises relative to the cost of holding U.K.

Pounds, then demand will shift away from dollars to Pounds if they are substitutes.

o This means that people can use either the U.S. dollar or the U.K. Pound to pay their bills, and they will choose the one that has the least inflation.

o Two effects: Regular MAER effect will cause a depreciation of the currency,

and Some individuals might decide to substitute the currency and start

using another currency, this leads to money demand falling and the currency depreciates further.

How to prevent high variability of exchange rate? When a high degree of currency substitution exists To prevent currencies from becoming too variable, countries need international

coordination of monetary policy. If money demanders substitute between currencies to force each currency to

follow a similar inflation rate, then the supposed independence of monetary policy under flexible exchange rates is largely illusory.

But the high volatility can be resolved by having coordinated money supply processes between countries.

The Open-Economy Macro Model The recent trends in the open economy macroeconomics focus on two modeling

types:

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(i) The general equilibrium approach – prices, interest rates, and exchange rates adjust instantaneously to restore a microeconomic-foundation based equilibrium.

o Prices, interest rates and exchange rates are always at their market-clearing levels.

o Changes in taste or productivity drives the adjustment process of exchange rate to the new level.

o Large shifts in productivity can result in large shifts in exchange rates. (ii) The IS-LM-BP framework – which describes the sluggishness of adjustments

toward the equilibrium in the short run causing temporary disequilibrium and exchange rate variability.

o In the short run, restrictions in price movements could result in temporarily disequilibrium, causing large exchange rate volatility.

Summary The monetary approach to the exchange rate does not predict the high volatility of

exchange rates There are five approaches trying to explain excessive exchange rate variation: (i)

the news approach, (ii) the portfolio-balance approach, (iii) the trade balance approach, (iv) the overshooting approach, and (v) the currency substitution approach.

The volatility of exchange rate is affected by news – unforeseeable events or shocks. News about future policies immediately affect the exchange rate.

The portfolio-balance approach extends the MAER by including the relative supply of domestic bonds to foreign bonds into the analysis of the exchange rate determination. The domestic and foreign assets are imperfect substitutes (there is a risk premium to holding foreign asset). The changes in the demand and supply of domestic and foreign bond markets will lead to exchange rate movements.

In the trade balance approach, the future expected value of a currency can have an immediate impact on current spot rates. Any news that changes the expectations about the future directions of the balance of trade will affect the expected value of the future spot exchange rates and hence will affect the current spot rates.

The overshooting approach assumes the perfect capital mobility such that financial markets adjust immediately, but the good market adjusts slowly to shocks. As a result, when the money supply increases, the domestic currency depreciates more than the necessary long-run level because of the overreaction from financial market in the short run. As time passes, the good prices will rise in proportion to the increase in money supply. The exchange rate will return to its long-run level.

The independence of domestic monetary policy under flexible exchange rates may be reduced if there is currency substitution.

If people are willing to substitute between the domestic currency and other currencies, then demand for the domestic currency might be affected by money supply changes. As a result, substitutability between currencies constrains monetary policy action and increases exchange rate volatility.

Currency substitution is important in a regional setting and it may require international coordination of monetary policy.

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The recent trends in the open economy macroeconomics focus on two modeling types: (i) the general equilibrium approach – prices, interest rates, and exchange rates adjust instantaneously to restore an equilibrium; and (ii) the IS-LM-BP framework – which describes the sluggishness of adjustments toward the equilibrium in the short run causing temporary disequilibrium and exchange rate variability.

Exercises1. In each of the five approaches, list the underlying assumptions (e.g. what is assumed in

terms of speed of adjustment in goods markets and financial markets, expectations, asset substitutability, and currency substitutability).

2. Suppose that a central bank buys bonds on the open market and uses money to pay for them, thereby increasing the supply of money and decreasing the supply of bonds. Use the portfolio-balance approach to explain what would happen to (i) domestic interest rate, (ii) demand for foreign bonds, (iii) foreign interest rate, and (iv) the spot exchange rate.

3. Explain why a high currency substitution would cause the U.S. dollar exchange rate to depreciate more than the expected level when the Fed increases money supply in the U.S.

4. Suppose that the Fed unexpectedly decreases the money supply in the U.S. Use the overshooting approach to explain how the spot exchange rate, forward rate, domestic interest rate, and the domestic price level would change in response to the policy change. Draw graphs to illustrate the time paths of the adjustments.

5. Assume that a country increases its domestic money supply. If the “overshooting” theory is correct, how could a central bank prevent the exchange rate from depreciating too much in the short run?

6. Suppose the U.S. discovers a new technology that will improve its exports. Therefore, there are rumors that this technology will bring the U.S. trade balance from trade deficits to expected long-term surpluses. What would happen to the exchange rate value of the U.S. dollar from this news? Do you anticipate any difference in the dollar values between short run and long run?

Answer1. News approach assumes that agents are forward-looking and incorporate all future

expected events in today’s rates. The portfolio approach assumes that bonds are not perfect substitutes. The trade balance approach adds an expected exchange rate adjustment through the relative trade balances. The overshooting approach assumes a quicker adjustment in the financial markets than the goods markets, whereas the currency substitution approach allows for substitution in the use of different countries’ currencies.

2. The central bank increases money supply by buying domestic bonds, causing domestic interest rates to fall. If there is no bond substitution then the foreign interest rate and the spot rate will be unaffected. However, if there is some bond substitution then demand for foreign bonds will increase causing the exchange rate to depreciate.

3. Increasing money supply would itself cause a depreciation of the domestic currency. In addition, it will cause the demand for the currency to change if there are other substitutes available. The decrease in the money demand results in an additional depreciation of the domestic currency.

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4. The unexpected decrease in money supply results in a higher short run interest rate, while the price level stays constant initially and will not fall until the long run. Therefore the exchange rate would initially over-adjust and appreciate more than the long run requires, but would start to depreciate again as prices increase, to reach a new forward rate in the long run.

5. Central banks can impose restrictions on the exchange rate to prevent “overshooting”. An upper or lower bound can be announced and intervention could keep the rate at such bounds, or the central bank can announce some exchange rate transactions restrictions that prevent the rate from moving further.

6. The expected future trade balance effects could affect the exchange rate immediately, causing an appreciation of the dollar. Over time, as the technological advancement is realized the trade balance would improve, causing the currency to further appreciate.

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Documents

textbooks.elsevier.com · Web viewUsing the trade flow model to explain the devaluation Assume that the U.K. taste for U.S. goods rises. The pound should depreciate. The Bank of England