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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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
The Argentine Interest-Rate Premium
During the Sudden Stop of 2001
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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
Large Contraction in GDP During the Argentine Sudden
Stop
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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
Large Real Exchange Rate Depreciation in the
Argentine Sudden Stop
The next graph displays the inverse of the peso/dollar real exchange
rate:
1
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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.
International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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.
International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
... and output stops growing
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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
... And what happens to the real exchange rate? The real exchange
rate depreciates!
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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
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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International Macroeconomics, Chapter 10 Schmitt-Grohe, Uribe, Woodford
Add other examples of sudden stops...
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