macro lecture 12

8/21/2019 Macro Lecture 12

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MacroLecture12 International Linkages

Lecture Highlights

All countries are linked internationally through trade in goods andthrough financial markets. The exchange rate (ER) is the price ofa foreign currency in terms of domestic currency (ringgit). A highexchange ratea week ringgitreduces imports and increasesexports, stimulating AD.

Under fixed exchange rates, CB buys and sells foreign currencyto fix the exchange rate. Under floating exchange rates, themarket determines the value of one currency in terms of another.

If a country wishes to maintain a fixed ER in the presence of a BPdeficit, the CB must buy back domestic currency, using itsreserves of foreign currency and gold or borrowing reserves from

abroad. In the LR, ER adjust so as to equalize the real cost of goods

across countries.

With perfect capital mobility and fixed ER, fiscal policy iseffective. With perfect capital mobility and floating ER, monetarypolicy is effective.


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International Linkages

Any economy is linked to the rest of

the world through two broad channels:

(i) Trade (in goods & services)

(ii) Finance

The trade linkage means that some of a countrys production isexported to foreign countries, whole some goods that areconsumed/ invested at home are produced abroad andimported.

The basic IS-LM model of income determination must be amended

to include international effects.


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Contd.

The prices of Malaysian goods relative to those of ourcompetitors have direct impacts on demand, outputand employment.

A decline in the ringgit prices of our competitors,relative to the prices at which Malaysian firms sell,shifts demand away from Malaysian goods towardgoods produced abroad.

e.g. exchange rate from US$1 = RM3 to US$1 =

RM2 Our imports

Our exports


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International links in the area of

financeMalaysian citizens whether households, banks, or

corporations, can hold Malaysian assets such asTreasury bills or corporate bonds or they can hold

assets in foreign countries.International investors shift their assets around theworld, they link asset markets here and abroad affect income, exchange rates, and the ability of

monetary policy to influence interest rates.


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The balance of payments and

exchange ratesThe balance of payments (BP) is the record of the

transactions of the residents of a country with therest of the world.

2 main accounts in BP:

(i) The current account- Records trade in goods and services, as well as

transfer payments. Services include freight,royalty payments, and interest payments. Transferpayments consist of remittances, gifts, and grants.

trade balance records trade in goods + trade inservices and net transfers current accountbalance


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Contd.

(ii) The capital account records purchases and sales of assets, suchas stocks, bonds, and property.

net capital inflow capital account surplus.

External accounts must balance

if a country runs a deficit in its current a/c the deficit needs to befinanced by selling assets or by borrowing abroad. These salesof assets or borrowingthe country is running a capital a/csurplus.

Current a/c deficit + net capital inflow = 0

Capital a/c has 2 components:(i) The transactions of the countrys private sector

(ii) Official reserve transactionsthe CBs activities


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Contd.

A current a/c deficit can be financed by private residents sellingoff assets abroad or borrowing abroad or

Current a/c deficit can be financed by the government, whichruns down its reserves of foreign exchange, selling foreigncurrency in the foreign exchange market.

The increase in official reserves the overall BP surplus

BP surplus = increase in official exchange reserves = current a/csurplus + private net capital inflow


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Exchange rates and the market for foreign

exchangeDemand for foreign currencies by domestic residentsDD for foreign exchange

Foreign exchange market- The market in which national currencies are traded

for one another.The link between the BP a/c and transactions in the

foreign exchange market.- All expenditures by all Malaysian on foreign goods,

services or assets represent DD for foreigncurrencies.


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Contd.

- Malaysian buying a computer from US pays itin ringgit, but the American exporter willexpect to be paid in dollar. So ringgit must be

exchanged for dollar in the foreign exchangemarket.

- Malaysian exporters will expect to be paid inringgit, and to buy our goods, foreigners must

sell their currency and buy ringgit.


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DD & SS in the Foreign Exchange

Market (FOREX)We assume that CBs do not intervene in the FOREX market. We

relax this assumption later.We assume that there are only 2 countriesMalaysia and the USA.MalaysiaringgitUSAdollar

The exchange ratethe relative price of the two currencies.We express as the price of the dollar in terms of ringgit.e.g. if the price of the dollar isUS$1 = RM3.50 OR RM1 = US$0.28


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Contd.

A higher exchange rate means that the price ofFOREX has risen.

When ex.rate foreign currency has

appreciated or

the ringgit has depreciated.

ex.rate the price of FOREX has declined.

The dollar has depreciated while ringgit hasappreciated.


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DD & SS of FOREX

Sfe

Dfe

eo

Forex rate

SS & DD for FOREX


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Contd.

Malaysian imports are DD for FOREX.

DD for FOREX vary with the price of FOREX.

Dfe downward-sloping

as the price of FOREX Dfe

FOREX the cost in terms of ringgit(import prices become more expensive)

Imports

Less FOREX will be demanded


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Contd.

e.g. Suppose that you are considering the purchase ofan American computer that costs US$1,000.

If the ex.rate US$1 = RM3.50

The computer will cost RM3,500If the ex.rate US$1 = RM4.00

The computer will cost RM4,000

The higher the exchange rate, the higher the ringgitcost of imported goods DD for FOREX


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Contd.

The SS schedule for foreign exchange is drawn with a positiveslope.

The SS of FOREX as ex. Rate

As the ex.rate Malaysian goods become less expensive toAmericans.

Holding all other prices, including the ringgit price of Malaysianexports fixed.

e.g. Malaysian product that sell for RM100 would cost US$28 at anex.rate US$1 = RM3.50 or RM1 = $US0.28

But the product would cost US$25 at ex.rate US$ = RM4.00 or RM1= US$0.25

DD for Malaysian exports as the ex.rate as the ex.rate


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Flexible Exchange Rate (floating rate)

In a flexible exchange rate system, the central banks allow theexchange rate to adjust to equate the SS and DD for foreigncurrency.

If the ex.rate were US$1 = RM3.50 and American exports toMalaysia

DD for dollars by Malaysians.

Central banks stand aside completely and allow ex.rates to be freelydetermined in the FOREX markets.

In the above example, the ex.rate could move from RM3.50 perdollar to RM3.55 per dollar

Making American goods more expensive in terms of ringgit.

DD for American goods by Malaysians.


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Effect in the FOREX market of an

increase in the DD for imports

Sfe

Dfe

eo

ex

rate

SS & DD for FOREX

Dfe

e

An autonomous increase inimport DD shifts the DD for

FOREX from Dfe to Dfe.

At the initial equilibriumexchange rate (eo)excess DD FOREX.

The exchange rate to e to

re-equilibrate SS and DD inthe FOREX.


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Fixed exchange rates/ pegging the

exchange rate

In a fixed exchange rate system, foreign central banksstand ready to buy and sell their currencies at afixed price in terms of other currency.

Assume that the central bank of Malaysia (BankNegara) wishes the exchange rate for the ringgit:US$1 = RM3.50 (RM1= US$0.28)

The official fixed exchange rate US$1 = RM3.50 is

below the equilibrium exchange rate.(see next slide)


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DD & SS of FOREX

Sfe

Dfe

3.60

ex

rate

SS & DD for FOREX

3.50

XDfe

At US$1 = RM3.50Ringgit overvalued

Dollar undervalued


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Contd.

The fixed exchange rate US$1 = RM3.50 is below themarket equilibrium rate US$1 = RM3.60 excessDD (XD) for FOREX.

To keep the exchange rate at US1 = RM3.50 Bank

Negara will buy dollars for RM3.50, the exchangerate cannot fall below that point.To keep the exchange rate from rising, Bank Negara

must supply FOREXit must exchange dollars forringgit.

Alternatively, the CB of the USA i.e the FederalReserve would SS dollars (sell dollars and buyringgit) to satisfy the excess demand.


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Real exchange rate

The price of the foreign currency in terms of the ringgit e.g. US$1 =RM3.50

Bilateral nominal exchange rate

Multilateral or effective exchange rate

- The price of a representative basket of foreign currencies, eachweighted by its importance to Malaysia in international trade.

Real exchange rate R = ePf/P

e = nominal exchange rate

Pf = foreign prices

P = domestic pricesR or real depreciation goods abroad more expensive relative to

goods at home.

R or real appreciation our goods relatively more expensive.


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Domestic spending and spending on

domestic goodsSpending by domestic residents

A = C + I + G

Spending on domestic goods

= A + NX

= C + I + G + NXDomestic spending depends on i and Y

A = A(Y,i)

Net exports

Net exports depend on income (Y) which affects import;

Foreign income (Yf) which affects our exports; also depend on R.

NX = X(Yf,R)M(Y,R)


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Contd.

Yf improves the home countrys tradebalanceAD

R real depreciation improves the trade

balanceAD

Y M worsen the trade balance


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Contd.

IS curve: Y = A(Y,i) + NX(Y,Yf,R)

X IS shifts to the right

X IS shifts to the left

R or real depreciation

IS shifts to the right and raises net exports

Y


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Effects of disturbance on Y and NX

________________________________________

Home spending Yf Real depreciation

________________________________________

Y + + +

NX - + +

________________________________________


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Capital mobility

One element in the international economy

High degree of linkage among financial or capitalmarkets.

In most industrial countries there are no restrictionson holding assets abroad.

Malaysians or residents in other countries can holdtheir wealth either at home or abroad.

They search around for the highest return.

In reality tax differences among countries; exchangerate can change; restrictions on capital outflows differences in interest rates among countries.


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Perfect capital mobility

Capital is perfectly mobile internationally wheninvestors can purchase assets in any country,quickly, with low transaction costs, and in unlimitedaccounts

- One countrys interest rates cannot get too far fromthe world level.

- E.g. if Malaysian yields less than Singaporean yieldscapital outflow from Malaysia

Interest rates affect capital flows & the BPMonetary & fiscal policies affect interest rates

The policies affect capital account & BP


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The Balance of Payments and Capital Flows

Balance of payments surplus, BP:

BP = NX(Y,Yf,R) + CF(iif)

CF: capital flow; if: world interest rate; i = domestic interest rate

Y worsen the trade balancei where i > if capital inflow improves the capital account

The trade deficit would be financed by a capital inflow

BP in equilibrium (BP = 0)

When BP = 0 a flat line i = if

Points above BP = 0 surplus BPPoints below BP = 0 deficit BP


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Fiscal policy with a fixed exchange rate

(Contd.)

BP

LM

LM

IS

IS

Yo Y Y1

i = if

i1


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Policy effects under fixed exchange rates

Fiscal policy with a fixed exchange rateF shifts IS to the right from IS to ISDomestic interest rate, i > if Resulting in a massive capital inflow

Central bank intervention to maintain the fixedexchange rate causes Ms

LM shifts to the right from LM to LM Domestic interest rate is brought back into equality

with if Y from Yo to Y1(see next slide)


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Monetary policy with a fixed exchange rate

Ms shifts the LM curve to the right from LM to LM.

Domestic interest rate below if

BP deficit

Massive capital outflow

Central bank intervention to maintain the fixed exchange rate byselling foreign reserve assets & buys domestic currencies

domestic Ms

Domestic interest rate is restored to equality with if

Y is back at its initial level

Monetary policy is completely ineffective(see next slide)


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Monetary policy with a fixed exchange rate

(Contd.)

BP

LM

LM

IS

Yo

i = if

i1


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Policy effects under flexible exchange ratemonetary policy with a flexible exchange rate

BP

LM

LM

IS

IS

Yo Y1

i = if

i1

Ms causes the LM shifts to the right

from Lm to LM

donestic interest rate, i fall below if

massive outflow of capital

BP deficit

the exchange rate

NX IS shifts to the right from IS toIS

domestic interest rate = ifY from Yo to Y1

monetary policy is highly effectivewith perfect capital mobility andflexible exchange rates.


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Fiscal policy with a flexible exchange rate

BP

LM

IS

IS

Yo

i = if

i1

G causes the IS shifts to the right

from IS to IS

donestic interest rate, i above if

massive capital inflow

BP surplus

the exchange rate

NX IS shifts back to the left fromIS to IS

domestic interest rate = ifY to its initial level (Yo)

fiscal policy is completelyineffective under flexible exchange rate

macro lecture 12

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