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Chapter 11: The Balance of Payments and Exchange Rates. The Balance of Payments Exchange Rates Theories of Exchange Rate Determination PPP: Purchasing Power Parity UIP: Uncovered Interest Parity The Dornbusch Model of Exchange Rate Overshooting

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chapter 11 the balance of payments and exchange rates
Chapter 11: The Balance of Payments and Exchange Rates
  • The Balance of Payments
  • Exchange Rates
  • Theories of Exchange Rate Determination
  • PPP: Purchasing Power Parity
  • UIP: Uncovered Interest Parity
  • The Dornbusch Model of Exchange Rate Overshooting
  • Interaction of Exchange Rates and the Balance of Payments
learning objectives
Learning Objectives
  • Introduce the important features of the open economy
  • Construct the balance of payments
  • Define and describe exchange rates
  • Two main theories of exchange rate determination are introduced: Purchasing Power Parity (PPP) and Uncovered Interest Parity (UIP)
  • The Dornbusch Model of Exchange Rate Overshooting is also examined.
  • Analyse important interactions between the exchange rate and the balance of payments
the open economy
The Open Economy
  • Two main features:
  • Balance of Payments: one nation’s trade with the rest of the world, including imports and exports of goods and services, but also in capital goods and increasingly so in financial assets.
  • Exchange rate: the rate at which one currency can be converted into another. It affects both the competitiveness of exports and imports, and also the returns on different financial assets. Also, the demand for different currencies and hence the exchange rate is determined by international trade flows.
incorporating the open economy
Incorporating the Open Economy
  • Exports and imports feed directly into the circular flow as injections and leakages, respectively.
  • Capital goods are important for the productive capacity of the economy. Trade in financial assets will have a large bearing on the price and availability of finance in the domestic economy, which will then have implications for domestic consumption and investment.
  • Policy making must be aware of this as developments in the rest of the world can be transmitted into the domestic economy. Also, the effectiveness of domestic policy will depend on the actions and reactions of other economies.
the balance of payments
The Balance of Payments
  • The balance of payments is simply one nation’s accounts with the rest of the world.
  • Sales of goods, services, physical capital and financial assets from domestic to overseas residents are credits on the balance of payments.
  • The reverse, purchases by domestic residents from those overseas, are recorded as debits.
  • The overall position of the balance of payments is simply the netting out of these credits and debits.
  • However, the balance of payments is constructed so that it always adds to zero: a position of no overall surplus or deficit.
  • This is because of the role of official financing.
the balance of payments1
The Balance of Payments
  • There are 4 parts to the BoP:
    • Current Account
    • Capital Account
    • Balancing Item
  • Adding the three previous items gives the balance of payments position.
    • Official Financing: The balance of payments must be in overall balance; this remaining balance is therefore countered by official financing. Therefore, the balance of payments will always equate to zero.
exchange rates
Exchange Rates
  • Nominal Exchange Rate: It is expressed as a ratio indicating how much of one currency can be traded for a unit of another: E = £/$.
  • The exchange rate is defined by the number of £s required to purchase $1. In this case, an appreciation in the pound means that fewer £s are required to buy $1, so E falls. A depreciation of the £ implies that more of them are now required, so that E rises.
  • Real Exchange Rate: The real exchange rate compares the price of foreign goods and services to domestic goods and services: R = (£ / $) * (PUS / PUK). This is the nominal exchange multiplied by the ratio of prices.
  • The real exchange rate tends to follow the same trends as the nominal exchange rate.
exchange rates1
Exchange Rates
  • Effective Exchange Rate: The effective exchange rate (also known as the multilateral exchange rate) is the exchange rate against a basket of various currencies. This is a weighted average of bilateral exchange rates and provides a more realistic idea of a currency’s strength. The weights attached to each bilateral exchange rate are usually taken from trade shares, as this will weight the bilateral exchange rate according to its importance to the economy.
  • Spot and Forward Exchange Rates: The exchanges rates defined above are spot rates – quite literally because these are the rates that would apply to foreign exchange transactions taken relatively immediately or on the spot. A forward exchange rate is typically offered by a market-maker, such as a bank.
theories of exchange rate determination
Theories of Exchange Rate Determination
  • The exchange rate is simply the price of one currency in terms of another. Therefore, like all prices, the rate will be determined by the relative demands and supplies of each currency.
  • When demand for a currency rises relative to its supply, that currency’s value relative to others will rise – this is known as an appreciation in the currency.
  • Likewise, when demand falls relative to supply for a particular currency, its value will fall – this is known as a currency depreciation.
theories of exchange rate determination1
Theories of Exchange Rate Determination
  • The relative demands and supplies of currencies, and therefore the exchange rates, are trade determined.
  • With this in mind, there are two main theories of exchange rate determination.
  • Purchasing Power Parity (PPP) refers to trade in goods and services, and
  • Uncovered Interest Parity (UIP) refers to the trade in financial assets.
ppp purchasing power parity
PPP: Purchasing Power Parity
  • This theory argues that the exchange rate will change so that the price of a particular good or service will be the same regardless of where you buy it. For this reason, the theory of PPP is often known as the law of one price.
  • The theory of PPP therefore argues that the nominal exchange rate will change to offset price differences and the real exchange rate should remain constant.
  • The £-$ real exchange rate is defined as:
  • R = (£ / $) * (PUS / PUK) = E * (PUS / PUK),
  • where E is the nominal exchange rate.
  • If U.S. prices rose relative to those in the UK, the nominal exchange rate will appreciate (remember that this means that E falls) to keep R constant.
ppp purchasing power parity1
PPP: Purchasing Power Parity
  • How and why do things like this happen? The answer is simply because of an arbitrage relationship.
  • Suppose U.S. prices rise, so that the ratio PUS / PUK increases. Now that goods in the UK are relatively cheaper, consumers in the UK will switch consumption away from U.S. goods towards ones produced in the UK. This will reduce the supply of £s and the demand for $s. Likewise, U.S. consumers too will switch consumption away from U.S. to UK produce, increasing the demand for £s and the supply of $s.
  • This will lead to an exchange rate appreciation for the £ (a fall in E).
  • Rearranging the equation for the real exchange rate gives a simple equation that determines the nominal exchange rate: E = PUK / PUS.
ppp purchasing power parity2
PPP: Purchasing Power Parity
  • So, the nominal £-$ exchange rate is determined by the ratio of price levels.
  • In general terms:
  • P = Domestic prices in domestic currency
  • P* = Foreign prices in foreign currencies
  • E = Nominal exchange rate between domestic and foreign currencies
  • EP* = Foreign prices in domestic currency
  • Arbitrage requires that domestic and foreign goods prices are equalised in terms of domestic currency: P = EP*, which can be re-arranged to give: E = P / P*.
  • A rise (fall) in domestic relative to foreign prices will induce a nominal exchange rate depreciation (appreciation).
relative ppp
Relative PPP
  • The PPP equation is a levels equation, where the exchange rate is simply the ratio of domestic and foreign prices.
  • Relative PPP expresses this equation in terms of differences, relating the change in the nominal exchange rate to the changes in relative prices:
  • If the overseas price level is taken to be constant, , then the relative PPP equation can be simplified to:
  • The change in the nominal exchange rate is directly proportional to the change in the price level.
the monetary theory of the exchange rate
The Monetary Theory of the Exchange Rate
  • PPP suggests that the nominal exchange rate is mainly determined by factors that influence the domestic price level.
  • Previously, we have seen that the money supply might be an important determinant of the price level, and therefore could be an indirect factor in influencing the exchange rate.
  • The monetary theory of the exchange rate is really an open economy extension to the simple quantity theory of money.
  • In this way, the exchange rate is determined by the actions of the domestic monetary authority.
the monetary theory of the exchange rate1
The Monetary Theory of the Exchange Rate
  • The well-known Quantity Theory of Money equation is:
  • Mv = PY,
  • where
  • M = Money stock
  • v = Velocity of circulation
  • P = Price level
  • Y = Full employment output
  • As v and Y are constants, this can be rearranged to give:
  • P = 1/v (M/Y).
  • Therefore:
the monetary theory of the exchange rate2
The Monetary Theory of the Exchange Rate
  • If relative prices are determined by different monetary regimes, then it is easy to make the additional step to see how the nominal exchange rate is determined.
  • Using the relative PPP equation, the change in domestic prices can then feed directly and proportionately into the exchange rate:
  • For example, a 10% increase in the money supply will lead to a 10% increase in prices, and a 10% depreciation in the exchange rate.
judging ppp
Judging PPP
  • The simple intuition behind the theory of Purchasing Power Parity is that international differences in prices cannot persist. Consumers will always seek to buy goods and services where they are cheapest. If the same goods cost different amounts in different parts of the world, profits could be made by buying the goods where they are cheapest and selling them where they are most expensive. As a consequence of this arbitrage behaviour, the exchange rate will adjust so that the law of one price holds.
  • Global Applications 11.4 The Big Mac Index
judging ppp1
Judging PPP
  • PPP may not hold because:
  • Transport Costs
  • For arbitrage to always reinstate the law of one price it must be able to operate without any costs or friction. Transport costs can refer to both the costs of moving goods around the world or any costs that arise due to the delay in their deliveries.
  • Adding transport costs to the price of foreign goods changes the PPP relationship in the following way:
  • TC are transport costs which drive a wedge between the effective actual and listed prices of foreign goods.
  • Including transport costs certainly implies that PPP may not hold in its levels form. However, the relative version of PPP would continue to hold.
judging ppp2
Judging PPP
  • Search Costs: On a similar note, for arbitrage to work effectively, consumers must have a large amount of information available to them. In fact, it is perhaps one of the reasons why PPP is regarded as a long run theory of the exchange rate. It simply takes time for people to gather the required information in order to act upon international price differences.
  • Imperfect Competition: The law of one price is grounded in the world of perfect competition. When firms produce differentiated goods, then consumers no longer purchase on the basis of price but also in terms of specifications and quality.
judging ppp3
Judging PPP
  • Non-Traded Goods
  • Arbitrage in international goods prices can only be expected in goods that are traded. Therefore, we wouldn’t expect PPP to hold outside of the goods sector and for the whole economy.
  • This is most apparent in developing nations, where the price levels are much lower than in the developed world. However, this has not been associated with a rapid appreciation in their currency. Average price levels are low, but there is no pressure on the exchange rate to adjust accordingly. One explanation of why this happens is known as the Balassa-Samuelson effect.
  • Global Applications 11.5 Balassa-Samuelson: Evidence
judging ppp4
Judging PPP
  • All in all there appears to be evidence – both empirical and theoretical – to justify a departure from strict PPP theory.
  • The conventional wisdom is that as a theory, PPP is most useful and realistic in the longer term.
  • In the short run, the nominal exchange rate is much more volatile than the theory of PPP would imply. This can be taken as an indication that there may be other factors which drive the nominal exchange rate. The theory of Purchasing Power Parity predominately relates to the trade in physical goods and services, but these current account trades only make up a small part of the overall balance of payments.
uip uncovered interest parity
UIP: Uncovered Interest Parity
  • Given that much of the capital account constitutes short-term financial flows, it may also account for the observed volatility in short term exchange rates.
  • Whereas PPP determines the exchange rate to arbitrage prices in the goods market, Uncovered Interest Parity (UIP) does a similar thing in the financial assets market.
  • Since the 1980s, liberalisation in the world’s financial markets means that currency transactions related to the trade in financial assets outweighs that in goods and services by as much as 100:1 in value terms.
  • Much of this is very liquid and can move around the world at great speeds in search of the best returns.
  • Uncovered Interest Parity (UIP) models the exchange rate through relative asset returns.
uip uncovered interest parity1
UIP: Uncovered Interest Parity
  • The two key assumptions in this model are that assets are perfectly substitutable, and there is perfect international capital mobility. As a result, arbitrage means that the exchange rate will change so that the returns on all financial assets should be equalised.
  • When you purchase a foreign asset, there are two things that determine the returns that are derived from it:
  • The overseas interest rate is defined by r*.
  • Exchange rate movements, E.
  • The first of these is clear. The second refers to having purchased a foreign asset, the returns are only realised once they have been converted back into domestic currency. If, however, the exchange rate changes, the rate at which this conversion takes place will also change.
uip uncovered interest parity2
UIP: Uncovered Interest Parity
  • The overall returns from investing overseas will be equal to both the foreign interest rate and also the interim percentage change in the exchange rate:
  • The theory of UIP is based on the idea that the expected returns from investing in domestic and foreign assets should be equalised. r = r* + %E,
  • Rearranging, = r – r*
  • This is the UIP condition: the expected change in the exchange rate is equal to the differential between domestic and foreign interest rates.
uip uncovered interest parity3
UIP: Uncovered Interest Parity
  • Under rational expectations, people on average form correct expectations of the change in the exchange rate so:
  • If the domestic interest rate rises above (falls below) the foreign rate, then there will be an expectation of a depreciation (an appreciation) in the exchange rate.
uip uncovered interest parity4
UIP: Uncovered Interest Parity
  • The best approach to explaining how UIP works is through a very simple example.
  • Suppose that initially the domestic and foreign interest rates were equal. In this case, international investors are indifferent between the domestic and foreign assets, and there is no expected change in the exchange rate.
  • However, the domestic interest rate then rises by 2% for one period, after which it returns to its original level.
  • Now that domestic assets offer higher returns, the demand for foreign currency will fall as domestic investors substitute out of foreign and into domestic assets. The supply of foreign currency will also increase as foreign investors do the same.
  • Consequently, the domestic exchange will appreciate from E1 to E2.
uip uncovered interest parity5
UIP: Uncovered Interest Parity
  • However, once that interest differential disappears, what should happen to the exchange rate?
  • As domestic assets are no longer offering higher returns than on foreign assets, there is no reason for the demand and supply curves to stay at D2 and S2, respectively. Both will return to their initial levels and the exchange rate will return to E1.
  • The initial appreciation in the exchange rate will only last as long as the interest differential is expected to persist.
uip uncovered interest parity6
UIP: Uncovered Interest Parity
  • However, by how much will the domestic exchange rate appreciate (E1 to E2)?
  • Well, according to the UIP condition, this will be by 2%. We know that once the interest rate falls back to its initial value, the exchange rate must return to its initial value. Therefore, this immediate appreciation must be stimulating expectations of a depreciation, and from UIP, this expected depreciation will be 2%.
  • So, in order to depreciate 2% back to its initial value, the exchange rate must first of all appreciate by the same – exactly 2%. This is shown in the next figure.
uip uncovered interest parity7
UIP: Uncovered Interest Parity
  • The movements in the exchange rate act to equalise the returns on domestic and foreign assets, just as UIP predicts. Although domestic assets offer 2% more than those abroad, this is countered by the expected 2% depreciation in the currency.
  • What if the exchange rate were to initially appreciate by less than 2%? In this case, the interest differential would be 2%, but the expected depreciation would be less than 2%. Domestic assets would offer higher returns than those overseas, encouraging further purchases of domestic assets would then appreciate the exchange rate further until the appreciation had reached 2%.
uip uncovered interest parity8
UIP: Uncovered Interest Parity
  • The UIP relationship is effectively maintained by international investors who seek to achieve the highest returns possible. Arbitrage is much stronger here than in the goods market due to the relative ease at moving large sums of finance around the world and due to competition among different investors. If international investors have billions of Pounds at their disposal, then very small interest differentials will lead to significant differences in returns.
  • This will also explain why exchange rate movements are very fast. In the above figure, the exchange rate effectively jumps as soon as the interest differential appears. This is because any investor who can purchase the domestic assets before the exchange rate has fully appreciated will make additional returns.
uip uncovered interest parity9
UIP: Uncovered Interest Parity
  • The size of exchange rate changes following interest rate movements depends on both the size and the persistence of interest rate differentials. An one period interest differential is 4%. This would then generate an initial appreciation of the same amount, with of course an expected depreciation of also 4% over the period.
  • If the interest differential were 2% but was maintained for two periods, then the initial appreciation in the exchange rate would once again be approximately 4%. As the differential is 2% in each period, from the UIP relationship, the expected depreciation in each would also be 2%, justifying the initial appreciation of about 4%.
  • This is shown in the following figures.
uip uncovered interest parity10
UIP: Uncovered Interest Parity
  • As a theory accounting for short-term movements in the exchange rate, UIP is important. The following figure plots evidence for the UK-U.S. nominal exchange rate. There is cursory evidence to suggest that an appreciation in the exchange rate is associated with a positive interest differential.
  • There are though two extensions to the theory of UIP, which might break the relationship between short-term exchange rate movements and the interest differential.
  • The first is the idea that there are different risks in investing in different assets. Secondly, interest-bearing assets are not the only financial assets; there are also equities and the currencies themselves. Accepting a wider definition of what constitutes a financial asset might explain exchange rate movements.
risk premia
Risk Premia
  • Therefore, the UIP condition may work better if it is adapted to include a risk premium:
  • where μ is the relative risk premium on domestic assets.
  • A positive interest differential can no longer be taken as an indicator that the currency will appreciate (generating the expectation of a depreciation).
  • If the risk premium is relatively large, then the risk adjusted interest differential may in fact be negative – leading to a depreciating exchange rate (an expectation of an appreciation).
stock markets and the exchange rate
Stock Markets and the Exchange Rate
  • In reality, investing overseas does not always need to be in the form of interest bearing assets, such as bonds or bank accounts. Equity investments normally take the form of assets such as stocks and shares.
  • It should certainly be apparent from the next figure that in a short horizon exchange rates are very volatile and displays the same type of random walk process that describes financial markets.
  • As financial asset prices are based on expected future profits, prices will jump every time new information is revealed to the market. As information is always arriving at markets, share prices will be volatile and this is reflected in currency markets.
stock markets and the exchange rate1
Stock Markets and the Exchange Rate
  • There is a strong linkage between stock and currency markets. For example, suppose new information comes to light predicting a downturn in the U.S. economy. The expectation of lower future profits will place downward pressure on equity prices and investors will sell, perhaps transferring funds into Japanese or European assets. The $US will subsequently depreciate.
  • Longer-term volatility relationships can also be accounted for, e.g., the sharp appreciation in the $US during the late 1990s and the U.S. asset bubble in U.S.
  • The relationship between stock markets and currencies can also cloud the UIP relationship. Increases in interest rates need not always lead to an appreciation in the exchange rate. In fact, a rise in interest rates would be expected to lead to a fall in stock market prices and may therefore lead to a depreciation in the exchange rate.
currency trading
Currency Trading
  • Explaining exchange rate volatility is even easier once we allow for the fact that the exchange rate itself can be viewed as the price of a financial asset. This is because currency traders aim to make money by predicting the movements in the exchange rate.
  • For example, at one moment in time, a trader could purchase on the spot market. If the domestic currency then depreciates, the domestic currency can then be repurchased and a profit made.
  • When currencies themselves are viewed as financial assets, it means that they too can be subject to the same volatility as other financial assets. This is certainly true in the short run, but may also manifest itself in long-term volatility, such as bubbles. The long appreciation in the $US at the beginning of the 1980s is certainly an example.
the dornbusch model of exchange rate overshooting
The Dornbusch Model of Exchange Rate Overshooting
  • The two most common theories accounting for exchange rate movements have just been introduced.
  • One of the most common observations regarding the exchange rate is its relative volatility in the short run, where movements in the nominal exchange rate are large compared to those in relative prices. Explaining this short run volatility is a challenge for the traditional models.
  • The Dornbusch overshooting model is one answer. It simply looks at how the PPP and UIP conditions interact, and predicts that the exchange rate might be quite volatile to changes in monetary policy.
  • As will be seen, the important factor generating the exchange rate overshooting result is price rigidity.
the dornbusch model of exchange rate overshooting1
The Dornbusch Model of Exchange Rate Overshooting
  • To see why, consider what happens when prices adjust quickly to changes in the money supply.
  • The next figure represents equilibrium in the money market. An increase in the money supply from M1 to M2 shifts the money supply curve to the right.
  • However, because there are no price rigidities, the predictions of the quantity theory of money will conclude that prices will rise proportionately, P1 to P2, so that %M=%P.
  • As a result, there will be no overall effect on the real money supply, which will leave the interest rate unchanged at r1.
the dornbusch model of exchange rate overshooting3
The Dornbusch Model of Exchange Rate Overshooting
  • In the absence of price rigidities, this happens quickly.
  • As interest rates do not change, the theory of UIP will not offer any prediction here as to how the exchange rate will change.
  • Instead, movements in the exchange rate will be completely described by the monetary theory of the exchange rate, or PPP.
  • This is shown in the next figure.
  • The exchange rate will only move proportionately with the initial change in the money supply and prices (E1 to E2 in panel (d)). This is certainly at odds with the empirical evidence, which would indicate a more than proportional reaction of the exchange rate to fit in with empirical observation.
the dornbusch model of exchange rate overshooting5
The Dornbusch Model of Exchange Rate Overshooting
  • Suppose now there are price rigidities.
  • The same increase in the money supply will not be offset by a proportional rise in prices. This is shown in panel (b) of the next figure, where it now takes time for prices to rise.
  • In the long run, the predictions of the quantity theory of money still apply, but price changes are not instantaneous and in the short run prices will rise proportionately less than the change in the money supply.
  • In this case, the real money supply is affected in the short run, which places downward pressure on the interest rate.
the dornbusch model of exchange rate overshooting7
The Dornbusch Model of Exchange Rate Overshooting
  • According to the theory of UIP, this will lead to the expectation of an appreciation. However, in the long run, the predictions of PPP must still apply – which suggest a proportional depreciation in the currency.
  • Therefore, in the long run, the exchange rate must depreciate, but in the short run there is an expectation of appreciation.
  • The only way for these two things to coexist is if the exchange rate over depreciates in the short run.
  • Hence, the initial depreciation of the exchange rate must be proportionately larger than the initial increase in the money supply. This is shown in panel (d) where the exchange rate overshoots in the short run from E1 to E0 before settling at its long run equilibrium value of E2.
interaction of exchange rates and the balance of payments
Interaction of Exchange Rates and the Balance of Payments
  • The exchange rate is most likely to have an impact on the current account part of the balance of payments.
  • This in turn is made up of two parts.
  • The first is the trade balance, which is the difference in the exports and imports of goods and services.
  • The second part consists of net income flows, which are largely made up by the net factor incomes of foreign directly invested firms.
interaction of exchange rates and the balance of payments1
Interaction of Exchange Rates and the Balance of Payments
  • Although the exchange rate will affect the size of these flows, the conventional approach is to assume that the exchange rate has the most significant effect on the trade balance.
  • The position of the trade balance is determined by the net value of exports and imports, with the value being determined by price and volume.
  • Movements in the exchange rate can be expected to have two opposing effects on trade.
    • Competitiveness
    • Terms of Trade
competitiveness and the trade balance
Competitiveness and the trade balance
  • The price of exports in terms of the domestic currency is given by the domestic price level: PX=P.
  • The price of foreign goods is given by the overseas price level and the nominal exchange rate:
  • Competitiveness is the ratio of export and import prices or alternatively the real exchange rate. This can also be thought of the inverse of the terms of trade:
competitiveness and the trade balance1
Competitiveness and the trade balance
  • The demand for exports (X) is a positive function of the level of competitiveness and overseas income: ,
  • Overseas income is represented by Y*. The coefficient, , is the proportion of total foreign income that is spent on domestic goods. As the exchange rate depreciates (θ rises), domestic goods become cheaper, which encourages substitution towards them, so rises.
competitiveness and the trade balance2
Competitiveness and the trade balance
  • The demand for imports is a negative function of competitiveness and a positive function of domestic income:
  • As income rises, households tend to consume more – a proportion of which will go on imported goods, so there is a positive relationship between imports and income. This proportion is governed by the marginal propensity to import: . This will negatively related to the real exchange rate, as a depreciation will make domestic goods relatively cheaper encouraging substitution towards them. So, as θ rises (falls), falls (rises).
competitiveness and the trade balance3
Competitiveness and the trade balance
  • The trade balance is the value of exports minus the value of imports. In terms of domestic currency, this is:
  • The real value of the trade balance can be calculated by dividing through by the domestic price level:
  • As
  • When trade is balanced, BT=0, this can be rearranged to give: or X=M.
competitiveness and the trade balance4
Competitiveness and the trade balance
  • This equation aptly describes the effect of exchange rate movements on the trade balance. A depreciation in the currency will increase the volume of exports and reduce the volume of imports. However, it will also increase the price of imports, so the competitiveness and the terms of trade effects are working in opposite directions. The overall impact on the trade balance will depend on which effect is the greater.
  • An appreciating exchange rate has the opposite effect. The volume of exports will fall, and the volume of imports will rise. However, the price of imports will also fall. Although net exports have fallen in volume, the terms of trade has moved to counter this. Again, the overall impact will depend on which effect dominates.
marshall lerner condition
Marshall-Lerner Condition
  • For a depreciation to improve the trade balance, a necessary condition is that the competitiveness effect outweighs the terms of trade effect.
  • For this to happen, the substitution towards domestic goods must be sufficiently strong which will depend on the price elasticity of demand.
  • The price elasticity of demand is simply the % change in quantity demanded following a 1% change in its price. If this elasticity is between zero and one, then demand is inelastic so price changes do not generate much of a substitution effect. However, if this elasticity is in excess of one, price changes generate a large substitution effect.
  • The concept of elasticity is at the heart of the Marshall-Lerner condition.
marshall lerner condition1
Marshall-Lerner Condition
  • Following an exchange rate depreciation, the balance of payments will:
    • Improve if the sum of the price elasticity of demand for exports and imports exceeds 1.
    • Remain unchanged if the sum of the price elasticity of demand for exports and imports equals 1.
    • Deteriorate if the sum of the price elasticity of demand for exports and imports is less than 1.
the j curve
The J-Curve
  • The conventional wisdom is that export and import prices elasticities are much greater in the longer rather than the shorter run. This is logical as it takes a while for consumers to discover and then adjust to new prices.
  • Due to this time pattern of elasticities, many prescribe to the idea that the balance of payments follows a J type movement to depreciations.
  • In the short run, elasticities are low, the Marshall-Lerner condition is violated and the terms of trade effect of depreciations dominate.
  • In the longer run, though, elasticities are greater so the depreciation improves the balance of payments.
slide70
U.S. trade balance as a proportion of the GDP and the $ nominal effective exchange rate during the 1980s
sufficient conditions
Sufficient conditions
  • The Marshall-Lerner condition is a necessary condition for a depreciating exchange rate to improve the trade balance.
  • However, there are a number of further or sufficient conditions which are required for this result.
    • Absorption effects
    • Real Wage Resistance
    • Pricing to market
absorption effects
Absorption effects
  • Following a depreciation in the exchange rate, it is expected that net exports will improve.
  • However, this is an injection into the circular flow of income, so income would be expected to increase:
  • Imports are a function of income, , where m is the marginal propensity to import.
  • Hence, it must be the case that:
  • This is the absorption effect on the balance of payments.
absorption effects1
Absorption effects
  • Taken together, the total change in the trade balance will be:
  • The trade balance will only improve if 1>mk.
  • If m and k are sufficiently large, then an initial improvement in the trade balance will generate a large increase in income, of which a large proportion will be spent on imports.
real wage resistance
Real Wage Resistance
  • Competitiveness is given by the real exchange rate:
  • It is clear that a depreciation will lead to a rise in both E and θ.
  • The consumer price index (CPI) represents the cost of living. Some of the goods and services that make up household consumption will come from overseas; therefore, a depreciation will lead to an increase in the cost of living:
real wage resistance1
Real Wage Resistance
  • The value of wages is determined in part by the cost of living. This is the nominal wage divided by the CPI.
  • Hence, an exchange rate depreciation through the cost of imports, and then the overall price level, will lead to a fall in the real wage. In order to restore the value of the real wage, organised labour groups such as trade unions may push for a higher nominal wage (W).
  • However, if domestic prices are simply a mark up over costs, then this will lead to an increase in domestic prices. This will begin to reduce competitiveness.
  • It will also lead to a further increase in the cost of living leading to a wage-price spiral. In seeking to maintain the value of real wages (real wage resistance), the competitiveness effects of a depreciation may be reversed.
pricing to market
Pricing to market
  • In a competitive industry, prices are set equal to marginal costs and normal profits are made.
  • In an imperfectly competitive industry, firms have some market power and prices are a mark up on marginal costs:
  • In this case, competitiveness is given by:
  • It is perfectly conceivable that changes in the mark up may cancel out any movements in the exchange rate, leaving the trade balance unchanged.
effective depreciation
Effective depreciation
  • If there is a depreciation (E rises), the effect on competition will be neutralised if:
    • Domestic firms increase their mark ups, using the exchange rate depreciation as an opportunity to increase margins.
    • Foreign firms reduce their mark ups. Perhaps they are concerned about losing market share and therefore are prepared to sacrifice some margin in order to maintain competitiveness.
    • A combination of the two.
current account deficits and surpluses do they matter
Current Account Deficits and Surpluses: do they matter?
  • Why might large imbalances in the current account be of concern to policy makers?
  • After all, we have already seen that the current account is offset by the capital account in the balance of payments.
  • Deficits: This implies that exports exceed imports. From the national income identity:
  • which can be rearranged to give:
current account deficits and surpluses do they matter1
Current Account Deficits and Surpluses: do they matter?
  • Therefore, a deficit indicates that the citizens of a country are consuming more than they are producing.
  • This results in one of two things.
    • Foreign currency reserves are being run down to fund the deficit. This, though, cannot be done forever due to the finiteness of reserves.
    • If foreign reserves are exhausted, the deficit can be funded by borrowing from overseas. However, large and sustained deficits result in larger and larger foreign liabilities and higher interest rates. Foreign indebtedness means that a large future constraint may be placed on the economy, which has to divert resources to meeting its debt requirements.
current account deficits and surpluses do they matter2
Current Account Deficits and Surpluses: do they matter?
  • Surpluses
  • When an economy is in equilibrium, it is the case that injections are equal to leakages:
  • which can be re-arranged to give:
  • Running a surplus means that the economy is a net lender to the rest of the world. However, what is apparent is that these funds could be allocated to domestic usages, either in private investment or government spending. The question here is whether it is better for domestic residents to save in domestic or foreign assets.
correcting a trade deficit
Correcting a Trade Deficit
  • If a country is running a persistent deficit on the trade balance, there are generally two policy options that can be used to correct it.
  • Exchange rates: Providing the Marshall-Lerner condition holds, a depreciation in the exchange rate will lead to an improvement in the trade balance. In this respect, trade deficits may be self correcting. For example, suppose there is a large increase in imports which leads to a deterioration in the trade balance. However, this also increases the demand for foreign currency, and reduces the demand for domestic currency, so the exchange rate will depreciate any way. Therefore, automatic correction should result.
correcting a trade deficit1
Correcting a Trade Deficit
  • Absorption approach: From the national income identity, the trade balance is simply:
  • For a given level of output, the trade balance can be improved by simply reducing domestic absorption: (C+I+G). These are components of aggregate demand. If these exceed the level of domestically produced output (C+I+G>Y), then the demand for goods and services can only be met by imports.
  • Likewise, if domestic absorption is less than domestic output (C+I+G<Y), there is no need to import goods and the excess production can be exported.
  • Any policy which controls the absorption factors – consumption, investment and government spending – will influence the trade balance.
global applications 11 11
Global Applications 11.11
  • Do reductions in the government deficit increase the current account surplus?
  • Consider: (G – T) = (S – I) + (M – X)
summary
Summary
  • This objective of this chapter was to introduce the important features of the open economy.
  • Firstly it is explained how the balance of payments are constructed.
  • Next, attention is turned to defining and describing exchange rates.
  • Two main theories of exchange rate determination are introduced; these are Purchasing Power Parity (PPP) and Uncovered Interest Parity (UIP). The Dornbusch model of exchange rate overshooting is also examined.
  • Finally, the important interactions between the exchange rate and the balance of payments are analysed.