Balance of Payments and Exchange Rates

1. Balance of Payments and Exchange Rates

2. Balance of Payments and Exchange Rates Alternative Exchange Rate Regimes

3. ALTERNATIVE EXCHANGE RATE REGIMES • Internal and external policy objectives • internal balance • external balance • narrow sense: current account balance • broad sense: total currency flow balance

4. W1 J1 Internal and external balance W, J (a) Internal balance O YF Ye1 National income

5. S1by UK D by overseas residents Internal and external balance (b) External balance r1 Exchange rate Fixed exchange rate O Quantity of £s

6. ALTERNATIVE EXCHANGE RATE REGIMES • Internal and external policy objectives • internal balance • external balance • narrow sense: current account balance • broad sense: total currency flow balance • possible conflicts between internal and external objectives

7. Internal and external balance W, J Assume that initially there is internal imbalance: at Ye2 W2 W1 J1 J2 O Ye2 YF Ye1 National income

8. Assume that the government increases aggregate demand to achieve internal balance. Internal and external balance W, J W2 W1 J1 J2 O Ye2 YF Ye1 National income

9. This creates external imbalance: i.e. currency flow deficit S2by UK Internal and external balance S1by UK r1 Exchange rate Fixed exchange rate D by overseas residents O Quantity of £s

10. S2by UK r2 Internal and external balance S1by UK Exchange rate r1 Or an imbalance in the narrow sense (a current account deficit) under a floating exchange rate D by overseas residents O Quantity of £s

11. Effects on internal and (narrow) external balance Current account surplus 2 1 Contractionary fiscal policy Lower consumption Exchange rate depreciation Foreign boom Internal balance External balance Recession Boom Exchange rate appreciation Foreign recession Expansionary fiscal policy Higher consumption 4 3 Current account deficit

12. UK balance of payments as % of GDP, 1970–2007 Source: Financial Statement and Budget Report (H M Treasury, 2005)

13. ALTERNATIVE EXCHANGE RATE REGIMES • Internal and external policy objectives • internal balance • external balance • narrow sense: current account balance • broad sense: total currency flow balance • possible conflicts between internal and external objectives • Nominal and real exchange rates

14. ALTERNATIVE EXCHANGE RATE REGIMES • Internal and external policy objectives • internal balance • external balance • narrow sense: current account balance • broad sense: total currency flow balance • possible conflicts between internal and external objectives • Nominal and real exchange rates • real exchange rate index • RERI = NERI × PX/PM

15. Sterling nominal and real exchange rate indices (1990 = 100) Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)

16. Sterling nominal and real exchange rate indices (1990 = 100) Nominal exchange rate Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)

17. Sterling nominal and real exchange rate indices (1990 = 100) Nominal exchange rate Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)

18. Sterling nominal and real exchange rate indices (1990 = 100) Real exchange rate Nominal exchange rate Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)

19. Sterling nominal and real exchange rate indices (1990 = 100) Real exchange rate Nominal exchange rate Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)

20. ALTERNATIVE EXCHANGE RATE REGIMES • Alternative exchange rate regimes • completely fixed

21. Sby UK a b Fixed rate D from abroad (a) Total currency flow deficit Exchange rate O Quantity of £s

22. c d (b) Total currency flow surplus Sby UK Exchange rate Fixed rate D from abroad O Quantity of £s

23. ALTERNATIVE EXCHANGE RATE REGIMES • Alternative exchange rate regimes • completely fixed • freely floating

24. ALTERNATIVE EXCHANGE RATE REGIMES • Alternative exchange rate regimes • completely fixed • freely floating • intermediate

25. ALTERNATIVE EXCHANGE RATE REGIMES • Fixed exchange rates • foreign exchange intervention • effects on the money supply • sterilisation • correcting a disequilibrium • expenditure reducing • expenditure switching

26. ALTERNATIVE EXCHANGE RATE REGIMES • Free-floating exchange rates • automatic correction

27. S2 Depreciation er2 D2 Adjustment of the exchange rate to a shift in demand and supply S1 er1 Exchange rate D1 O Quantity of £s

28. S3 er3 Appreciation D3 Adjustment of the exchange rate to a shift in demand and supply S1 er1 Exchange rate D1 O Quantity of £s

29. ALTERNATIVE EXCHANGE RATE REGIMES • Free-floating exchange rates • automatic correction • expenditure switching (the substitution effect)

30. ALTERNATIVE EXCHANGE RATE REGIMES • Free-floating exchange rates • automatic correction • expenditure switching (the substitution effect) • the process of adjustment

31. ALTERNATIVE EXCHANGE RATE REGIMES • Free-floating exchange rates • automatic correction • expenditure switching (the substitution effect) • the process of adjustment • elasticities of currency demand and supply

32. Supply of pounds and the elasticity of demand for imports S Exchange rate Elastic demand for imports O Quantity of £s

33. Supply of pounds and the elasticity of demand for imports Exchange rate Inelastic demand for imports S O Quantity of £s

34. Unstable equilibrium Exchange rate r S D O Quantity of £s

35. Unstable equilibrium Exchange rate r S D O Quantity of £s

36. ALTERNATIVE EXCHANGE RATE REGIMES • Free-floating exchange rates • automatic correction • expenditure switching (the substitution effect) • the process of adjustment • elasticities of currency demand and supply • the Marshall–Lerner condition

37. ALTERNATIVE EXCHANGE RATE REGIMES • Free-floating exchange rates • automatic correction • expenditure switching (the substitution effect) • the process of adjustment • elasticities of currency demand and supply • the Marshall–Lerner condition • expenditure changing (the income effect)

38. ALTERNATIVE EXCHANGE RATE REGIMES • Free-floating exchange rates • automatic correction • expenditure switching (the substitution effect) • the process of adjustment • elasticities of currency demand and supply • the Marshall–Lerner condition • expenditure changing (the income effect) • a rise in income

39. Current account deficit of a – b a Y1 b (X – M)1 The income effect (stable prices) Y E1 Expenditure (E), exports (X), imports (M) O Y

40. Exchange rate depreciates The income effect (stable prices) Y E1 Expenditure (E), exports (X), imports (M) a O Y1 Y b (X – M)1

41. Exports rise; imports fall The income effect (stable prices) Y E1 Expenditure (E), exports (X), imports (M) a O Y1 Y b (X – M)1

42. Expenditure rises The income effect (stable prices) Y E1 Expenditure (E), exports (X), imports (M) a O Y1 Y b (X – M)1

43. Income effect Exports fall back somewhat; imports rise back somewhat The income effect (stable prices) Y E1 Expenditure (E), exports (X), imports (M) a O Y1 Y b (X – M)1

44. Eventual equilibrium (Y2) Positive substitution effect: c –b Negative income effect: c – a Net balance of payments effect: a – b c Y2 (X–M)2 The income effect (stable prices) Y E2 E1 Expenditure (E), exports (X), imports (M) a O Y1 Y b (X – M)1

45. ALTERNATIVE EXCHANGE RATE REGIMES • Free-floating exchange rates • automatic correction • expenditure switching (the substitution effect) • the process of adjustment • elasticities of currency demand and supply • the Marshall–Lerner condition • expenditure changing (the income effect) • a rise in income • a rise in prices

46. ALTERNATIVE EXCHANGE RATE REGIMES • Intermediate exchange rate regimes • adjustable peg • dirty floating • crawling peg

47. The crawling peg within exchange rate bands $1.60 $1.40 Exchange rate O Time No intervention Central bank sells domestic currency No intervention Central bank buys domestic currency No intervention

48. ALTERNATIVE EXCHANGE RATE REGIMES • Intermediate exchange rate regimes • adjustable peg • dirty floating • crawling peg • joint float

49. ALTERNATIVE EXCHANGE RATE REGIMES • Intermediate exchange rate regimes • adjustable peg • dirty floating • crawling peg • joint float • exchange rate bands

50. ALTERNATIVE EXCHANGE RATE REGIMES • Intermediate exchange rate regimes • adjustable peg • dirty floating • crawling peg • joint float • exchange rate bands • exchange rate bands under the old ERM