Chapter 7

1. Chapter 7 International Trade, ExchangeRates, and Macroeconomic Policy

2. The International Trilemma The international “trilemma” is the impossibility of any nation to simultaneously maintain all of the following: Independent control of domestic monetary policy Fixed exchange rates Free flows of capital with other nations The EU’s common currency (the Euro) and free flows of capital between countries prevent individual EU countries from pursuing independent monetary policies The US has flexible exchange rates and free flows of capital, so it can run an independent monetary policy But countries like Japan and China can buy USD to keep their own currencies undervalued to promote their exports

3. We learned that an economy with positive NX must lend to foreigners (lending or foreign investment), while an economy with negative NX must borrow from foreigners. • We also learned that government budget deficit can be financed partially or totally by foreign borrowing depending on the size of the economy. • A small open economy can borrow the entire deficit without crowding out, while a large economy influences world interest rates and thus crowd out private investment.

4. The trilemma • Is the impossibility to maintain simultaneously : • Independent control of domestic monetary policy • Fixed exchange rates • Free flows of capital with other nations. • The current account and the balance of payments (BOP) • Current account equals NX of goods and services, plus two additional components (are not part of GDP); • net income from abroad and • net unilateral transfers.

5. Net flow of international investment income, these do not represent production in the domestic economy. They are added to the Gross National product not GDP. • Net international transfers, e.g., remittances, they are also excluded from GDP. • The current account and the capital account • BOP is divided into two parts. • The current account, which records all types of flows for current income and output.

6. The capital account, records purchases and sales of foreign assets by citizens and purchases and sales of foreign assets by foreigners. • BOP outcome • When total credits are greater than debits, the country is said to run a BOP surplus, i.e., it will receive more foreign money for credits than domestic money it pays for debits. The opposite is called a BOP deficit. • The overall BOP surplus or deficit is the sum of the current account and capital account. Current account balance + capital account balance = BOP outcome.

7. The Current Account and National Saving National Saving is the sum of private and government saving: NS= S + (T – G) Recall the Magic Equation: T – G = (I + NX) – S Rearranging yields  S + (T – G) = I + NX  NS = I + NX **OR** -NX = I – NS (1) Recall that a current account deficit  NX < 0 Amount borrowed from foreigners = foreign borrowing = -NX Equation (1)  foreign borrowing rises because: Investment increases National savings falls

8. Why is U.S. Income From Abroad Positive? You would expect that the large negative U.S. international investment position would make net income more and more negative, but it is not (see Table 7-1) Reason: The U.S. must earn a much higher rate of return on the assets that U.S. residents own abroad than foreigners earn on their assets owned in the U.S. Half of the negative U.S. international investment position comes from foreign holdings of international reserves USD holdings often invested in short-term, low interest Treasuries U.S. has, in contrast, virtually no foreign currency holdings U.S. investors in foreign countries often buy factories or companies yielding higher returns

9. Foreign borrowing and international indebtedness • A current account deficit must be financed either by borrowing from foreign firms, households and governments. IT must increase its indebtedness. • A current account surplus implies a reduction in indebtedness or an increase in the countries net investment surplus. Change in international investment position = current account balance + net revaluations

10. Table 7-1 The U.S. Balance of Payments, as a Percent of GDP, Selected Years

11. Figure 7-1 The U.S. Current Account Balance and Its Net International Investment Position, 1975-2010

12. Exchange rates • The price of one currency in terms of another is called the foreign exchange rate. It can be shown in two ways, • Convention: The foreign exchange rate of the dollar is usually quoted as units of foreign currency per dollar. • Example: e´ = 106.00 ¥ / $ = Value of the Dollar • Exception: The Euro-USD and the pound-USD exchange rates are quoted as dollars per Euro and dollars per pound. • Example: $1.41 / € = Value of the Euro

13. Note: the two rates are equivalent (1/106 = .009437) • But it is conventional (in USA) to express the foreign exchange rate as the foreign currency per dollar, i.e., Yen 106.00 per $. Except for the British pound and the euro. Changes in exchange rates • The USD is said to appreciate (depreciate) if the value of the dollar rises (falls) relative to another currency. • A higher number means that the dollar experiences and • A lower number indicates a depreciation. ¥/$ decreases from 106.25 to 1.06 and the €/$ rate declines from .7798 to .7769, indicating a depreciation of the dollar against the euro. • Sometimes the depreciation is high over time, e.g., the €/$ rate.

14. Table 7-2 Daily Quotations of Foreign Exchange Rates, January 12, 2011

15. The Market for Foreign Exchange Why do people (foreigners) hold U.S. dollars? To buy American goods and services  U.S. exports lead to D$↑ To buy USD-denominated financial assets  capital inflows lead to D$↑ For the convenience and/or safety of holding USD  D$↑ Why do people (Americans) sell U.S. dollars? To buy foreign currencies to buy foreign goods U.S. imports lead to S$↑ To buy foreign currencies to buy foreign $-denominated financial assets  capital outflows lead to S$↑

16. Figure 7-2 Foreign Exchange Rates of the Dollar Against Four Major Currencies, Monthly, 1970-2010

17. The market for foreign exchange • Touristswhen they travel to any country they need to exchange their currency into that country’s currency • Banksthat have too much of too little of foreign money can trade for what they need in the foreign exchange market. • The results of trading in foreign exchange are illustrated for four foreign nations. • The factors that determine the foreign exchange rate and influences its fluctuations can be summarized on the a demand supply diagram like those used in figure 6-3

18. Why people hold dollars and Swiss Francs • People in many countries may find dollars or Swiss Francs more convenient or safer than their own currencies. Sellers in these countries also accept dollars and Swiss Francs. • A change in preferences of people will shift the demand curve for dollars and thus exchange rates. • Demand for currencies is driven from the demand for its imports and capital outflows. It also has a supply driven from the demand of its exports and capital inflows.

19. Figure 7-3 Determination of the Price in Euros of the Dollar

20. What explains the slopes of the demand and supply curves for dollars in figure 6-3. D0 will be vertical if the price elasticity for Swiss demand for US imports is zero. • If price elasticity is negative the demand curve will be negatively slopped. Look at figure 6-3 • The analysis for S0 is different. S0 will be vertical if the price elasticity of the US demand for Swiss imports is -1 (since revenues in foreign exchange will be the same with changes in exchange rate). only if the price elasticity is greater than unity (in absolute terms) S0 will be positively slopped. • How governments can influence foreign exchange rates. • If exchange rate of the dollar is higher than market equilibrium, people must accept a lower rate for it to induce foreigners to accept it.

21. But some countries may prevent the depreciation of the dollar, because it will make their exports expensive to sell. • How they do that? Look at figure 6-3, the Switzerland government can purchase the distance AB to maintain the dollar appreciated at a rate of CHF 2.00/$. • Real exchange rates and purchasing power parity • The real exchange rate (e) is equal to the nominal rate (e’) adjusted for differences in inflation rates between the two countries. e = e’ × p/pf • Suppose that in 2010 e and e’ for the Mexican peso is 10/$, the price level in the two countries is 100 10 pesos/$ = 10 pesos × 100/100

22. Assume that in 2011 pf is 200 while the US price remains fixed at 100 5 pesos/$ = 10 pesos × 100/200 • The dollar experienced a real depreciation against the peso. If the opposite is true the dollar would experience a real appreciation. • Countries experience high inflation, find their nominal exchange rate depreciates, while their real exchange rate remains roughly unchanged. • Suppose that e jumps from 10 to 20 pesos/$ (nominal depreciation), hence; 10 = 20 × 100/200 no real depreciation • Countries with rapid inflation usually witness nominal depreciation without any major change in real exchange rate.

23. We care about e more than e’, because it is a major determinant of NX. When e appreciates M become cheaper an X become expensive, business profits go down and unemployment increases and vice versa. • The theory of purchasing power parity • PPP states that in open economies prices of traded goods should be the same everywhere, therefore e should be constant (1); 1 = e’ × p/pf • Swapping the left hand side and solve for e’ e’ = pf/p

24. PPP and inflation differentials ∆e’/e’ = pf _ p • Growth rate of e’ = growth rate of pf – p. the term ∆e’/e’ is positive when there is an appreciation of a currency. The term pf – p is the inflation differential between foreign and domestic inflation. • Why PPP breaks down • New inventions • Discovery of new deposits of raw materials • Higher demand for a currency e.g., to deposit in banks. • Non-traded goods • Government policy e.g., subsidization.

25. The big Mac index • If PPP worked perfectly, good would cost the same in all countries after conversion into a common currency. • The economist magazine constructed a PPP test using the “BIG MAC” cost in different countries in the world. • based on the prices of the sandwich, a PPP exchange rate would be computed. • This is compared with the actual exchange rate. • Degree of appreciation and depreciation would be calculated.

26. International Perspective Big Mac Meets PPP

27. Exchange rate systems • Flexible exchange rate system • Exchange rate is free to change • Changes in exchange rate: • Depreciation • Appreciation • BOP deficit can be corrected by a depreciation • An appreciation would correct the surplus of BOP. • The system can be: • Clean or pure, without any interventions by central banks • Dirty or managed, with frequent interventions by central banks.

28. Exchange rate systems • Fixed exchange rate system • The exchange rate is fixed for a long period of time. • The central bank agreed to finance any surplus or deficit in BOP. • To do so CB maintains foreign exchange reserves and stands ready to buy or sell dollars as needed to maintain the foreign exchange rate of its currency.

29. Exchange rate systems • Changes of foreign exchange rates • Devaluation: reduces the value of the currency in terms of foreign currencies. • Revaluation: increases the value of the currency in terms of foreign currencies. • Note: foreign exchange reserves are central bank holdings of foreign money to respond to changes in exchange rates by supplying of buying foreign money.

30. Determinants of net exports • Net exports and the foreign exchange rate • Effect of real income. NX = NXa – nxY • NXa is the autonomous component of net exports (determined mainly by foreign income). • nx is the fraction of real income spent on imports. During expansions imports would be high (NX will be low) while during recessions imports will be low (NX will be high).

31. Effect of the foreign exchange rate • When exchange rate appreciates X tends to decline and M tend to increase, NX go down. To reflect this negative relationship NX = NXa – nxY – ue. e.g., NX = 1000 - .1Y – 2e • Suppose that Y = 8000, e=100 NX would be zero. An appreciation in e to 150 would reduce NX to -100. • The real exchange rate and interest rate • The demand for dollars and the fundamentals • The demand for dollars is to buy American products or assets. Why the outside world hold dollars, The fundamentals include changes in the world wide to buy American goods, e.g., an invention of new products in USA (+ve), or outside USA (-ve),

32. But fundamentals change slowly, therefore they are not responsible for volatile changes in e. • Sharp ups and downs in e are due to the desire of foreigners to buy American securities. If American securities are attractive (+ve effect), or foreign securities became more attractive (-ve effect). Relative attractiveness depends on (average) interest rate differentials. • (r-rf), if r > rfUS securities would be more attractive, and vice versa. a rise in US interest should thus cause an appreciation and vice versa.

33. Interest rates and capital mobility • Interest rates affect e through capital mobility. • Perfect capital mobility if residents of one country can buy any desired assets with very low commissions and fees, interest rates would be tightly linked. If rf increases, the demand for foreign securities increases, which raises r relative to rf. • Any event a country tends to change r relative to rf will generate a huge capital movement that will soon eliminate the (r-rf), e.g., capital expansion lowers r and causes capital outflows which bring r back to its original level.

34. The two adjustment mechanisms: fixed and flexible rates • Perfect capital mobility implies that fiscal and monetary policies do not affect domestic interest rates r. • With fixed e, a stimulative monetary policy will not reduce domestic r but instead will lead the country to a loss of international reserves as the capital account causes a BOP deficit. • In a pure flexible e, monetary policy stimulus generates excess supply of money and lowers e till supply and demand are in balance again. • In short under perfect capital mobility both monetary and fiscal policy lose control over r. under fixed e monetary stimulus causes a loss of reserves, and fiscal stimulus causes reserves to increase. • Under flexible e monetary stimulus causes depreciation and fiscal stimulus causes an appreciation, and vice versa.

35. The IS-LM model in a small open economy • The assumption of perfect capital mobility introduces a new assumption in the IS-LM that • Any small change in r caused by shifts in monetary and fiscal policy will generate capital flows that will quickly bring the domestic interest rate into line with the unchanged foreign interest rate. • The BP schedule • Under perfect capital mobility BOP can be in equilibrium only at a single r equal to rf. Any higher interest rate will lead to unlimited capital inflows causing a huge BOP surplus. Any lower r will lead to unlimited capital outflows causing a huge BOP deficit. The BOP is in equilibrium only along the BP line, capital and current accounts are in equilibrium.

36. The BP schedule • Under perfect capital mobility BOP can be in equilibrium only at a single r equal to rf. Any higher interest rate will lead to unlimited capital inflows causing a huge BOP surplus. Any lower r will lead to unlimited capital outflows causing a huge BOP deficit. The BOP is in equilibrium only along the BP line, capital and current accounts are in equilibrium.

37. The analysis of fixed exchange rates • We will examine the effects of monetary and the fiscal expansion. We will assume that price level is fixed. • Monetary expansion • Figure 6-8, if real money supply increases LM shifts to the RHS, while IS is assumed to be unchanged, r will go down to r1. This generates huge capital outflows and loss of international reserves. To prevent such movements, the CB must boast interest rate back to r by reversing the monetary stimulus. LM shifts back to LM0 and the economy returns back to E0. Monetary policy is impotent. • Fiscal expansion • With fixed exchange rates, the only way domestic policy makers can alter the real income is to use fiscal policy

38. Figure 6-8 Effect of an Increase in the Money Supply with Fixed Exchange Rates

39. A fiscal expansion shifts IS to the RHS which moves the economy to E2, r increases to r2, leading to huge capital inflows. International reserves increase and since e is fixed, CB must increase MS until r returns to its initial level. • In a closed economy without capital inflows, the economy would move to point E3. • Perfect capital mobility with fixed r makes fiscal policy very effective.

40. Figure 6-9 Effect of a Fiscal Policy Stimulus with Fixed Exchange Rates

41. Analysis with flexible exchange rates • The CB does nothing to prevent an appreciation or depreciation. Monetary policy becomes very effective while fiscal policy becomes ineffective.

42. Figure 6-10. Note that the currency depreciates whenever the economy moves below the BP (increases NX and shifts IS to the RHS) and appreciates whenever it moves above the BP line (reduces NX and shifts IS to the LHS). • Monetary expansion • Shifts the LM to the RHS, capital outflows lead to a depreciation and NX increase such that IS shifts to IS1, till the economy arrives to E3, where the economy and BOP are in equilibrium at higher Y. • Fiscal expansion • Shifts IS to the RHS, capital inflows lead to an appreciation and NX decreases. IS falls back to its initial position E0.

43. Figure 6-10 Effect of a Monetary and Fiscal Policy Stimulus with Flexible Exchange Rates

44. LM does not shift and domestic crowding out is replaced by international crowding out which is complete in this case. The twin deficits are identical; trade deficit is the fiscal deficit. • Notes: • With fixed exchange rates, fiscal policy is highly effective and CB is forced to accommodate fiscal policy actions. Monetary policy is impotent. • With flexible exchange rates, monetary policy is highly effective, CB can stimulate the economy by causing the exchange rate to depreciate. Fiscal policy is impotent and international crowding out is complete.

45. Capital mobility and exchange rates in a large open economy • How a large economy differs from a small open economy • A large economy has a substantial control over its r, capital flows are not substantial to change r to equate rf. Capital mobility is imperfect to eliminate (r-rf). • Figure 6-11, for a small open economy BP is horizontal. In a large economy capital account surplus occurs with r is high, and a deficit occurs when r is low. • For a BOP balance any surplus in capital account must be offset by a deficit in current account which requires a high level of income, e.g., at point C. • For a BOP balance any deficit in capital account must also be offset by a surplus in current account caused by lower income e.g., at point A. BP slopes up for a large economy because capital mobility is positively related to r.

46. Figure 6-11 The BP Line in a Small and Large Open Economy Capital account surplus Must be with a C. account Deficit (needs large income Capital account deficit Must be with a C. account surplus (needs small income

47. Monetary and fiscal policy with fixed and flexible exchange rates • With fixed e monetary policy is impotent in a large economy, while fiscal policy is highly effective, but some what less than the case of a small open economy, since its stimulus is divided between an increase in real income and domestic r instead of being entirely directed toward an increase in real income. • With flexible e fiscal policy is impotent in a large economy, while monetary policy is highly effective, but since higher income must be accompanied by higher r (BP is upward slopping), there is some crowding out of domestic expenditures, and this must be offset by a larger stimulus to NX than in a small open economy requiring an even larger depreciation. See the following summary.

48. Summary of Monetary and Fiscal Policy Effects in Open Economics