slides rer demandmu2166/uim/slides_rer_demand.pdfin addition sudden stops are characterized by sharp...

Slides for Chapter 10:

Aggregate Demand Shocks and the Real Exchange Rate

International Macroeconomics

Schmitt-Grohe Uribe Woodford

Columbia University

April 17, 2018

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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford

Motivation

• The Balassa-Samuelson model emphasizes technological factors

affecting the real exchange rate. A country becomes more expensive

relative to others when it the difference in technical progress in its

traded sector relative to its nontraded sector is larger than in the

other countries. Because technological progress occurs slowly over

time, the model is best suited to understand long-run movements in

the real exchange rate.

• However, real exchange rates, also experience sizable movements

in relatively short periods of time, which are unlikely to be due to

changes in technologies.

• An example of such episodes is given by sudden stops, to which

we turn next.

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Sudden Stops

A sudden stop is a situation in which a country that is running

current account deficits, that is, is borrowing from the rest of

the world, experiences a sudden and large increase in the cost of

external borrowing. Foreign lenders either start charging a much

larger country premium or stop lending altogether. As a result,

the current account reverts quickly from deficit to surplus, as the

country is cut from international financial markets.

In addition sudden stops are characterized by sharp depreciations of

the real exchange rate (the country becomes suddenly much cheaper

relative to other countries) and by severe contractions in aggregate

activity (collapses in output, consumption, and investment).

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Case Study: The Argentine Sudden Stop of 2001

At the end of 2001, Argentina suffered a crisis that had all the signs

of a sudden stop.

In the second half of 2001, foreign lenders begin in increase the

Argentine interest rate premium to extremely high levels. In Decemer,

Argentina defaults on its foreign debt, which leads to a cutoff from

international capital markets.

The following slides look at what happened to the interest-rate

premium, the current, output, and the real exchange rate around

the Argentine Sudden Stop of 2001.∗

∗All graphs are taken from: “The IMF and Argentina, 1991-2001,” prepared by ateam headed by Shinji Takagi, Washington, D.C.: International Monetary Fund,Independent Evaluation Office, 2004.

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The Argentine Interest-Rate Premium

During the Sudden Stop of 2001

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Current Account Reversal in Argentine Sudden Stop

The next graph displays capital inflows in Argentina over the period

1991 to 2002.

Capital inflows represent the change in a countries net liability position.

In terms of the notation of the two-period model of chapter 3, capital

inflows are given by

capital inflows= −(B∗1 − B∗

0)

Now recalliing the relationship between changes in the net asset

position and the current account

CA1 = B∗1 − B∗

0

We have that the graph shows −CAt

In the graph we see:

• current account deficits until the year 2000.

• drastic current account reversal beginning in 2001 with current

account surpluses in 2001 and 2002

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7


Large Contraction in GDP During the Argentine Sudden

Stop

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Large Real Exchange Rate Depreciation in the

Argentine Sudden Stop

The next graph displays the inverse of the peso/dollar real exchange

rate:

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epeso/dollar=

PArg

Speso/dollarPUS

where PArg denotes the price level in Argentina, PUS the price level

in the United States, Speso/dollar the nominal exchange rate, defined

as the peso price of one U.S. dollar. and 1epeso/dollar is the peso/dollar

real exchange rate.

The figure shows that the real exchange rate increased (that is,

depreciated) by about 200 percent in 2002. This means that the

Argentina becomes much cheaper relative to the United States in a

very short period of time. This cannot be explained by technological

progress as suggested by the Balassa-Samuelson model. Also, Argentina

did not apply tariffs of 200 percent at that time, so it was not trade

barriers either.

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Why did the Real Exchange Rate Depreciate so Much?

Recall

epeso/dollar =Speso/dollarPUS

PArg= Speso/dollarφ(PUS

T , PUSN )

φ(PargT , P

argN )

=φ(1, Pus

N /PusT )

φ(1, PargN /P

argT )

Suppose that φ(PN , PT ) = P 1−αT Pα

N and that α = 0.75 (so that households allocate

75 percent of thier expenditute to nontradables, a plausible number). Then

epeso/dollar =

(

PusN /Pus

TParg

N /PargT

)α

Taking log differences

%∆epeso/dollar = α[

%∆(PusN /Pus

T ) −%∆(PargN /P

argT )

]

' 0% − α %∆(PargN /P

argT )

200% ' −0.75 %∆(PargN /P

argT )

So the question of why did the real exchange rate depreciate so much becomes:

Why did the relative price of nontradables fall so much during the Sudden

Stop?

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What happens in a Sudden Stop?

Narrative: Argentina had a large trade deficit before the Sudden

Stop. With the default it has no more access to international

capital markets. The CA must swing into balance, or surplus,

CA ≥ 0 and there must be a trade balance reversal from deficits

to surplus, TB => 0. With a trade balance reversal domestic

demand for traded goods falls, and absent any relative price changes

domestic demand for nontraded goods also falls. Weak domestic

demand for nontradables will lead to a decline in the relative price

of nontradables bringing about a real depreciation.

We will embed this narrative into a theoretical model next.

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The TNT Model

2 goods: QT and QN

QT = traded output

QN = nontraded output

PT = domestic currency price of traded good

PN = domestic currency price of nontraded good

Law of one price holds for traded goods: PT = SP ∗T

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Production

Production of Tradables:

QT = FT(LT ); F ′T (·) > 0; ; F ′′

T (·) < 0;

LT = labor input in the traded sector

Production of Nontradables:

QN = FN(LN); F ′N(·) > 0; ; F ′′

N(·) < 0;

LN = labor input in the nontraded sector

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Labor Supply

Fixed Labor Supply: L = LT + LN

L = total labor supply

Increase in labor input in the traded sector must be compensated

one for one by decreases in the nontraded sector

dLT = −dLN (1)

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Construct the Production Possibility Frontier

dQT = F ′T(LT )dLT (2)

dQN = F ′N(LN)dLN (3)

[insert graph]

What is the slope of the PPF?

Divide (3) by (2) and use (1) to obtain:

dQN

dQT= −

F ′N(LN)

F ′T(LT )

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This equations says that the slope of the PPF is equal to the

marginal rate of transformation between traded and nontraded goods.

Suppose we move down the PPF, producing more tradables. Then

LT must rise and LN must fall. This raises the marginal product

of labor in the nontraded sector, F ′N(LN), and lowers the marginal

product of labor in the traded sector, F ′T(LT ). This is so because

we are assuming that the production functions display decreasing

returns to scale, which is to say we assume that the marginal product

of labor is decreasing with labor.

This assumption then implies that the PPF becomes steeper as QT

rises. It follows that the PPF is concave towards the origin,

Our argument is that a Sudden Stop moves the economy down

its PPF, reallocating production from the nontraded sector to the

nontraded sector. The above relation says that the sudden stop

causes the economy to produce at a point where the PPF is steeper.

But we want to link the Sudden Stop to a real exchange depreciations.

Is there a link between the slope of the PPF and the relative price

of nontradables in terms of tradables? We will show that link in the

next slide.


Traded Goods Sector

Firms choose QT and LT to maximize profits

profits = PTQT − WLT .

subject to

QT = FT(LT ).

Eliminate QT

profits = PTFT(LT ) − WLT

Choose LT to maximize profits

∂profits

∂LT= 0 ⇒ PTF ′

T(LT ) = W (*)

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Nontraded Goods Sector

Firms choose QN and LN to maximize profits

profits = PNQN − WLN .

subject to

QN = FN(LN).

Eliminate QN

profits = PNFN(LN)− WLN

Choose LN to maximize profits

∂profits

∂LN= 0 ⇒ PNF ′

N(LN) = W (**)

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Combining (*) with (**) yields

PT

PN=

F ′N(LN)

F ′T(LT )

(4)

As we move down the PPF its slope becomes steeper and steeper

implying that the relative price of nontradables relative to tradables

falls.

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A Sudden Stop is a situation in which the production of nontradables

must fall and the production of tradables must rise. That is a move

down the production possibility frontier. What will induce firms to

shift production out of the nontraded sector and into the traded

sector? The relative price of nontraded goods must fall.

Hence a Sudden Stop leads to a real exchange rate depreciation.

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In 2008 Iceland experienced a Sudden Stop

1. Interest rates spike

2. Large trade balance reversal

3. Output suddenly stops growing

and ...

as in the case of Argentina in 2001, the sudden stop is associated

with a large real exchange depreciation

Let’s look at the data for Iceland

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Interest rates spike

Here we look at Credit Default Swap (CDC) rates.

What is a Credit Default Swap.

Suppose the government of Iceland issues a 10-year bond for $100

with an annual coupon rate of 5 percent. This means that Iceland

must make a payment to the lender of $5 every year and in year 10

must also pay the principal of $100.

In a CDS contract the seller of that contract offers insurance against

default by the debtor (= Iceland). This insurance contract (the

CDS contract) works as follows. Every year that the debtor does

not default the creditor pay the CDS rate, denoted c, to the insurer,

that is, every year the creditor pays c×100. Now suppose the debtor

defaults. Then the insurer buys from the creditor the defaulted debt

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at face value, that is, in our example the insurer buys the defaulted

debt from the lender for $100.

CDS rates are often used to measure how borrowing costs increase

for a given country because they are easily available.

The next graph shows Iceland’s CDS spreads between September 1

2008 and October 29, 2008. The units of the vertical axis are basis

points. The horizontal axis measures time. The graph shows that

betwen Sept 1, 2008 and October 11, 2008 the Icelandic CDS spread

increased from 2 percent (200 basis points) to over 14 percent (1400

basis points). This large increase in CDS spreads indicates that

interest rates at which Iceland would have been able to borrow must

have increased significantly.


The interest rate increase is accompanied by a dramatic trade balance

reversal

The units on the vertical axis are percent of GDP.

The trade balance goes from a deficit of 15 percent of GDP in 2006

to a surplus of 10 percent of GDP in 2010.

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... and output stops growing

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... And what happens to the real exchange rate? The real exchange

rate depreciates!

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To sum up, Iceland in 2008 represents another example in which a

sudden stop lead to a large real exchange rate depreciation in the

short run.

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Third Example of observing a large Real Exchange

Rate depreciation after a Sudden Stop

Case Study: Chile 1979-1985

In 1982 (after the default of Mexico in August) credit dries up for

highly indebted developing countries, particularly in Latin America.

These countries were running large current account deficits. The

Sudden Stop forces them to run TB surpluses to service their existing

debts.

What is the required external adjustment?

QT ↑ and QN ↓

This adjustment caused a large real exchange rate depreciation (and

with it costly reallocations of production away from the nontraded

sector towards the traded sector)

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Chile, Real Exchange Rate Depreciation and Trade Balance

Reversal, 1979-1985

∆e TBGDP

Year % %

1979 -1.71980 -2.81981 -8.21982 20.6 0.31983 27.5 5.01984 5.1 1.91985 32.6 5.3

cumulative RER depreciation of close to 90 percent.

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Add other examples of sudden stops...

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