the balance of payments and the exchange rate imports, exports savings and investment in an open...

The balance of payments and the

exchange rate

Imports, exportsSavings and investment in an

open economyExchange rate regimes

Balance of payments and exchange rate

Up until now, we have worked only in the case of closed economies No trade considerations were present

However, we know that in fact trade is important in understanding macroeconomics, particularly so with globalisation. As for previous models, this means we have to

introduce corrections to the model to obtain a better understanding of what trade does to the economy


Imports, exports and exchange rates

Current account, capital account and balance of payments

Exchange rate regimes


The first element to take into account in an open economy is the presence of imports M and exports X in aggregate demand

These represent another possible leakage from the circular flow of income In particular, agents will have a propensity

to import which will have to be taken into account when calculating multipliers

*, ,X YY C Y T I i G e M Y e


Second problem: in terms of national accounting, exports / imports are not measured in the same units: We need to convert imports paid in foreign

currency into national currency Exports towards other countries are also

affected by the value of the currency This is where the exchange rate comes in

*, ,X YY C Y T I i G e M Y e


The exchange rate (e) is the price of one currency in terms of another currency

Note of caution ! There are 2 ways of working it out: The amount of $ you can buy with 1€ :

1€ = 1.35$ The amount of € required to buy 1$ :

1$ = 0.75€

These two measures are equivalent, but be careful, the second one (often used in models) is not intuitive : If e falls, less € are needed to purchase 1$, so the euro

has appreciated (it is worth more in $ terms) If e increases, more € are needed to purchase 1$, so the

euro has depreciated (it is worth less in $ terms)


e=price of the currency (dollars/euro)

Quantity

Equilibrium exchange rate e*

Supply of euros

Purchase of dollar-denominated assets, imports

Purchase of euro-denominated assets, exports

Demand for euros

The exchange rate is a price


The exchange rate is in nominal terms It is possible to define a real exchange rate

which accounts for the price levels in the two currency areas

The real exchange rate gives a relative price It expresses the relative value of a

representative basket in the euro zone to the same basket in the USA.

$

€€/$€/$ P

Peereal


This allows us to define the purchasing power parity (PPP) exchange rate. The PPP exchange rate is the nominal exchange rate

that occurs when the real exchange rate is 1.

The PPP exchange rate is often considered to be the long run equilibrium exchange rate It is also used to compare economic variables across

countries, particularly measures related to standards of living or welfare

$

€€/$€/$ P

Peereal

€

$€/$ P

PePPP

Current account and capital account

The current account is not the only element of international trade.

The balance of payments composed of:The current account CA:

Tracks outflows minus inflows of goods and services It corresponds to the Exports – Imports component.

The capital account KA: Tracks inflows minus outflows of capital of a country Either as direct investment (building factories, etc) Or purchases/sales of assets


The current account was explained in the previous section as the ‘net exports’ added to C + I + G. What role does the capital account play ?

To understand their relation, let’s derive the savings/investment balance for an open economy

Setting Z = Y :

MTSCY

XGICZ

XGIMTS


This gives us the equilibrium condition in terms of investment and savings:

XI T MS G Simplifying assumption: the government budget is in

equilibrium (G-T = 0) If there is a CA deficit (X-M < 0), there are not enough

savings (agents are spending too much). Some of the financing of investment (I) must come from abroad.

If there is a CA surplus (X-M > 0), there is excess savings (agents are not spending enough). The excess saving are used to fund foreign investment.

The adjustment to the current account balance occurs through an inflow or outflow of savings: This is the capital account.


The BoP is in equilibrium when CA+KA = 0 The current account

and capital imbalances add to 0

As seen in the previous slide, this is equivalent to saying that S = I in an open economy


Source: BIS,2007 World Report


The USA have been net importers and net borrowers since the 1980’s. The US current account deficit in 2006 was 6,6% of its GDP.

Europe has recently seen positive balances on its current account, which reflects a relatively low level of growth.

Japan has traditionally been a net exporter and a net lender.

The current accounts surpluses of emerging Asian countries (particularly China) have grown during the 1990’s

XI T MS G


The amount of savings required to finance the current account deficit of the USA has tripled since 1997.

On the other had, the emerging economies have become net providers of savings flows.

Europe and Asie (including Japan) has covered 2/3 of the funding needs of the USA in 2002.

XI T MS G


The problem with current account deficits The central problem is that these deficits can create

speculative flows of capital, whereby agents start betting against the currency of the country (depreciation expectations), which creates distortions and can lead to currency crises.

Depreciation expectations can also give incentives for capital holders to invest abroad (strong capital outflows).

Foreign debt creates financial burdens for the country.

These costs can further increase the current account deficit, leading to requiring more foreign capital, which leads to a vicious cycle.


How is a BoP disequilibrium corrected?What happens if CA + KA > 0 or < 0 ?

One needs to separate:What happens on the foreign exchange

market in terms of supply/demandThe effective outcome, which depends on

the exchange rate regime (which is why we see them in the next section) In a fixed exchange rate regime, the BC

intervenes


When BP = CA + KA > 0 Overall, exports and capital inflows are larger than

imports and capital outflows There is excess demand for the home currency on the

foreign exchange market This tends to increase the value of the home currency

When BP = CA + KA < 0 Overall, imports and capital outflows are larger than

exports and capital inflows There is excess supply for the home currency on the

foreign exchange market This tends to decrease the value of the home currency

In other words, the foreign exchange market will be at equilibrium when the balance of payments is at equilibrium. Outside of equilibrium, there will be pressures on the

exchange rate

Under flexible rates, if BoP < 0, the home currency will depreciate relative to foreign currencies (excess supply of home currency).

Under fixed rates, if BoP < 0, the central bank will have to intervene on the foreign exchange market to purchase its currency back with foreign reserves. From time to time, the exchange rate may be changed

(devaluation), particularly if the CB is low on foreign reserves.



Evolution of the current account following a depreciation: The J-curve

t

CA

0

Depreciation

CA deficit worsens

CA deficit is corrected

After a depreciation, the increase in exports and the fall in imports is not automatic: The volume of exports can remain fixed in the short

run because of the rigidity of short-run contracts. Imports can be slow to fall because foreign exporters

can initially compensate the depreciation by reducing their margins.

The effectiveness of depreciation depends on the price elasticity of imports and exports (the Marshall-Lerner condition) The sum of the absolute values of the price elasticity

of imports and exports must be greater than 1.



Fixed exchange rate regime: Gold standard system (Bretton woods) Euro Zone, ‘dollarisation’

Floating or flexible exchange rate regime: Post-Bretton Wood system

Intermediate regimes: Crawling peg (Tunisia, Bolivia) Currency board (Hong Kong, Estonia, Lithuania) Dirty float (ex: Indonesia, India, Egypt)


Increasing flexibility

MonetaryUnion

Fixed exchange rate

Crawling peg

Fixed exchange rate with fluctuation bands Dirty float

Pure float

Dollarisation/euroisation

Currency board

Typology of exchange rate regimes


Arguments in favour of flexible rates: The market is a more efficient regulator. The central bank is more flexible in terms of

policy, as it does not have to worry about monitoring the exchange rate (next week)

The Central Bank does not have to hold foreign reserves, as it does not have to intervene

The Balance of payments automatically adjusts to equilibrium.

Note: under floating rates, the exchange rate appreciates or depreciates


Arguments in favour of fixed rates: Reduces exchange rate fluctuations (volatility)

that increase uncertainty and pose a risk to trade

Reduces speculative activity, which can be destabilising.

Is not inflationary (the way flexible exchange rates can be).

Note: under fixed rates, changes in the exchange rate are referred to revaluations or devaluations.

the balance of payments and the exchange rate imports, exports savings and investment in an open...

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