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# Basic Theories of the Balance of Payments - PowerPoint PPT Presentation

Basic Theories of the Balance of Payments. Three Approaches. Three Approaches. The Elasticities Approach to the Balance of Trade The Absorption Approach to the Balance of Trade The Monetary Approach to the Balance of Payment ( MABOP ). The Elasticities Approach to BOT.

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### Basic Theories of the Balance of Payments

Three Approaches

• The Elasticities Approach to the Balance of Trade

• The Absorption Approach to the Balance of Trade

• The Monetary Approach to the Balance of Payment (MABOP)

• d = elasticity of demand

= the responsiveness of quantity

demanded to changes in price

d= (%Qd)/(%P)

which is usually negative

• | d| > 1  the demand is elastic

• | d | < 1  the demand is inelastic

• If the demand is elastic, the 1% rise in price leads to more than 1% decline in quantity demanded.

• If the demand is inelastic, the 1% rise in price leads to less than 1% decline in quantity demanded.

• Does the devaluation of a currency improve the country’s balance of trade?

• Consider EPs/\$ = the Mexican peso price of the dollar

• (1) If the demand curve for the dollar slopes downward and the supply curve of the dollar slopes upward, then the devaluation of the peso leads to an excess supply of the dollar, which causes the Mexican trade deficit to decrease.

• (2) If the demand curve for the dollar is steep and the supply curve of the dollar is negatively sloped, then the devaluation of the peso leads to an excess demand for the dollar, which causes the Mexican trade deficit to increase.

• (1): stable FX market equilibrium

• (2): unstable FX market equilibrium

• The case (2) could occur when Mexican demand for US imports and US demand for Mexican exports are both very inelastic.

• The greater the elasticities of both country’s demand for the other country’s goods, the greater the improvement in Mexico trade balance after a peso devaluation.

• The condition that guarantees the case (1) is called Marshall-Lerner Condition.

• After the devaluation, it is often observed that the trade balance initially deteriorates for a while before getting improved.

• Why do we have a J-Curve?

• The initial demands tend to be inelastic.

• Suppose Mexico imports good X from the US and exports good Y to the US.

• Devaluation  Eps/\$ 

 PXPs  & PY\$ 

 QXd  & QYd 

• But if Mexican demand for X is inelastic, the % decrease in QXd would be smaller than the % increase in PXPs so that Imports = PXPs QXd would increase.

• Further, if US demand for Y is inelastic, the % increase in QYd would be smaller than the % decline in PY\$ so that Exports = PY\$ QYd would fall.

• Devaluation Import prices  in the home country and export prices  in foreign countries.

But prices do not adjust instantaneously.

• Persistent BOP deficit  devaluation

 Home demand for imports  and foreign demand for exports 

 an improvement in BOP in the L-R

• How do prices adjust to exchange rate changes in the S-R?

• Differences in the pass-through effect across countries  Producers adjust profit margins

• Example: When the yen appreciated against the dollar substantially during late 1980s, Japanese auto-makers limited the pass-through of higher prices by reducing the profit margins on their products.

• In general,

• Depreciation of the dollar  Foreign sellers cut their profit margins

• Appreciation of the dollar  Foreign sellers increase their profit margins

• Recall the national income identity:

Y = C + I + G + (X – M)

So

Y – A = X – M

where A = C + I + G is the total domestic spending or absorption.

• If Y > A, then X – M > 0 or BOT > 0.

If Y < A, then X – M < 0 or BOT < 0.

• Does devaluation always improve BOT?

• Recall: If Y = Y*  Full employment level of output, then all resources are already employed and hence, X – M  needs A .

• If Y < Y*, then X – M  obtains through increasing Y with A unchanged, i.e. by producing more to sell to foreigners.

• So, when Y < Y*, devaluation would improve BOT.

• But when Y > Y*, devaluation would increase X – M but create inflation.

• Recall

Current account

Non-reserve capital account

--------------------------------------

Official reserve account  money

supply

• AssetsLiabilities

 Domestic Credit Currency

(Treasury securities, (Fed reserve notes

Discount loans, etc ) outstanding)

 International  Bank reserves

reserves

(Gold, SDR, other foreign

currencies denominated

deposits and bonds)

• DC + IR = CU + R MB (1)

where DC = domestic credit

IR = international reserves

CU = currency

R = bank reserves

MB = monetary base

• Suppose the Fed sells \$1 billion of its foreign assets in exchange for \$1 billion of US currency.

Fed’s balance sheet

AssetsLiabilities

Foreign assets-\$1 billion Currency -\$1 billion

So, MB  by \$1 billion.

• Recall: MS = m•MB (2)

where m = money multiplier

• M = CU + D

where D = deposits

MB = CU + R

So, M/MB = (CU + D)/(CU + R)

= (1 + c)/(c + r)  m

where c = currency-deposit ratio

r = reserve ratio

• Substituting (2) in (1), we obtain

MS = m (DC + IR) (3)

• Consider Money demand function:

Md = k•P•L (4)

where P = price level at home and L is the liquidity preference function, which depends on income and the interest rate. k is a constant.

• Now assume PPP

P = E•P* (5)

where E = home currency price of the

foreign currency

P* = price level in the foreign country

• Substituting (5) into (4), we have

Md = k•E•P*•L (6)

• In equilibrium, Md = MS.

• So, from (3) and (6), we have

k•E•P*•L= m (DC + IR)

• In terms of “% changes” (or growth rates),

E^ + P*^ + L^ = w•DC^ + (1-w)•IR^

where k^ = m^ =0 because they are constants. w = DC/(DC + IR).

• Rearranging, we obtain

(1-w)• IR^ - E^ = P*^ + L^ - w•DC^ (7)

• With a fixed exchange rate (E^ = 0),

BOP^ = IR^ = [1/(1-w)]•(P*^ + L^)

- [w/(1-w)]•DC^ (8)

• Fed increases MS(Excess money supply)

 DC   IR   BOP 

• Fed decreases MS

 DC  IR  BOP

• With a flexible exchange rate (BOP=0),

-E^ = P*^ + L^ - w•DC^ (9)

• Fed increases MS

 DC  E (depreciation)

• Fed decreases MS

 DC  E (appreciation)

• Although exchange rates are market determined in principle, central banks intervene at times to peg the rates at some desired level.

• When MS or Md changes, the central bank can choose either E^ or IR^ to adjust.

• Recall PPP again: P = EP*.

• With a fixed ex rate, E^ = 0, so

P^ = P*^

In other words, when the foreign price level is increasing rapidly, then the home price must follow if we are to maintain the fixed E.  Imported Inflation

• With flexible rates, E is free to vary so that even when P*^ > 0, P^ can be zero by letting E^ = - P*^, or letting the home currency to appreciate by the same amount as the foreign inflation rate.

• BOP disequilibria are essentially monetary phenomena.

• Devaluation is a substitute for reducing the growth of domestic credit.

• Appreciation is a substitute for increasing domestic credit growth.