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Balance of Balance of Payments Payments
AdjustmentAdjustment
Thorvaldur Gylfason
OutlineOutline
1.1. Real versus nominal exchange Real versus nominal exchange ratesrates
2.2. Balance of payments Balance of payments adjustment and welfareadjustment and welfare
3.3. The scourge of overvaluationThe scourge of overvaluation4.4. Balance of payments Balance of payments
adjustment through economic adjustment through economic policypolicy
Real versus nominal Real versus nominal exchange ratesexchange rates11
*P
ePr
r = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad
Increase in r means real appreciation
Real versus nominal Real versus nominal exchange ratesexchange rates
*P
ePr
r = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad
Devaluation or depreciation of the currency – i.e., decrease in e – makes r also decrease unless P rises so as to leave r unchanged
Foreign exchangeForeign exchange
Real exch
an
ge r
ate
Real exch
an
ge r
ate
Imports
Exports
Balance of payments Balance of payments and welfareand welfare22
Earnings from exports of goods, services, and capital
Payments for imports of goods, services, and capital
Equilibrium
Equilibrium between demand and supply in foreign exchange market establishesEquilibrium real exchange rateEquilibrium in the balance of
paymentsBOP = X + Fx – Z – Fz
= X – Z + F = current account + capital
account = 0
Balance of payments Balance of payments and welfareand welfare
Foreign exchangeForeign exchange
Real exch
an
ge r
ate
Real exch
an
ge r
ate
Imports
Exports
Balance of payments Balance of payments adjustment and welfareadjustment and welfare
Overvaluation
Deficit
Foreign exchangeForeign exchange
Pri
ce o
f fo
reig
n e
xch
ang
ePri
ce o
f fo
reig
n e
xch
an
ge
Supply (exports)
Demand (imports)
Balance of payments Balance of payments adjustment and welfareadjustment and welfare
Overvaluation
Deficit
Overvaluation works like a price ceiling
Market equilibrium and Market equilibrium and economic welfareeconomic welfare
SupplySupply
DemandDemand
EE
ProducerProducersurplussurplus
ConsumeConsumerrsurplussurplus
Quantity
Price
AA
BB
CC
Total Total welfare gainwelfare gain associated associatedwith market equilibrium equalswith market equilibrium equalsproducer surplus (= ABE) plusproducer surplus (= ABE) plusconsumer surplus (= BCE)consumer surplus (= BCE)
SupplySupply
DemandDemand
Price ceilingPrice ceiling
EE
FF
GG
Quantity
PriceWelfareWelfarelossloss
Price ceiling imposes aPrice ceiling imposes awelfare losswelfare loss equivalent to equivalent tothe triangle the triangle EFGEFG
AA
BB
CC
Consumer surplus = AFGHConsumer surplus = AFGH
HH
JJ
Market intervention and Market intervention and economic welfareeconomic welfare
Producer surplus = CGHProducer surplus = CGH
Total surplus = AFGC
The scourge of The scourge of overvaluationovervaluation
Governments may try to keep the national currency overvaluedTo keep foreign exchange cheapTo have power to ration scarce
foreign exchangeTo make GNP look larger than it is
Other examples of price ceilingsNegative real interest ratesRent controls
33
SupplySupply
DemandDemand
Price ceilingPrice ceiling
EE
FF
GG
Quantity
PriceWelfareWelfarelossloss
Price ceiling imposes aPrice ceiling imposes awelfare losswelfare loss equivalent to equivalent tothe triangle the triangle EFGEFG
AA
BB
CC
HH
JJ
Market intervention Market intervention and economic welfare, and economic welfare,
againagain
Shortage
Inflation and Inflation and overvaluationovervaluation
Inflation can result in an overvaluation of the national currencyRemember: r = eP/P*
Suppose e adjusts to P with a lagThen r is directly proportional to
the price level PNumerical example as follows
Inflation and Inflation and overvaluationovervaluation
Time
Real exchange rate
100
110
105 Average
Suppose inflation is 10 percent per year
Devaluation
Time
100
120
Real exchange rate
110 Average
Hence, increased inflation increases the real exchange rate as long as the nominal exchange rate adjusts with a lag
Suppose inflation rises to 20 percent per year
Inflation and Inflation and overvaluationovervaluation
Devaluation
How to correct How to correct overvaluationovervaluation
Under a floating exchange rate regimeAdjustment is automatic: e moves
Under a fixed exchange rate regimeDevaluation will reduce e and
thereby also r – provided inflation is kept under control
Does devaluation improve the current account?The Marshall-Lerner condition
The Marshall-Lerner The Marshall-Lerner condition: Theorycondition: Theory
T = eX – Z = eX(e) – Z(e)Not obvious that a lower e helps TWhen we do the arithmetic, i.e.,
compute the derivative dT/de, the bottom line turns out to be:
Devaluation improves the current account as long as
1ba
Suppose prices are fixed
The Marshall-Lerner The Marshall-Lerner condition: Evidencecondition: Evidence
Econometric studies indicate that the Marshall-Lerner condition is almost invariably satisfied
Industrial countries: a = 1, b = 1Developing countries: a = 1, b =
1.5Hence,
1ba Devaluation
improves the
current account
Empirical evidence from industrial countries
Elasticity of Elasticity of exports imports
Austria 1.0 1.2Belgium 1.1 1.3Canada 0.7 1.3France 1.3 0.9Germany 1.0 0.8Italy 1.3 0.8Japan 1.4 1.0Netherlands 1.5 0.7Sweden 1.6 0.9United Kingdom 1.0 1.3United States 1.2 1.2
Average 1.2 1.1
The importance of The importance of appropriate side measuresappropriate side measures
Remember:
It is crucial to accompany devaluation by fiscal and monetary restraint in order to prevent prices from rising and thus eating up the benefits of devaluation
To work, nominal devaluation must result in real devaluation
*P
ePr
Balance of payments Balance of payments adjustment and economic adjustment and economic
policypolicyPrice level
GNP
Aggregate supply
Aggregate demand
P
Y
Equilibrium
An increase in prices inducesproducers to produce more, so that aggregate supply increases
An increase in prices inducesconsumers to buy less, so thataggregate demand decreases
44
Experiment: Export boomExperiment: Export boomPrice level
GNP
AS
AD
Price level
GNP
AS
AD
AD’
A
B
Exports increase, so that aggregate demand expands
Experiment: Export boomExperiment: Export boom
Price level
GNP
AS
AD
Excess demanddrives prices up
AD’
A
B
C
Experiment: Export boomExperiment: Export boom
Price level
GNP
AS
AD
AD’
A
BAs the price level rises, so does GNP along the upward-sloping AS curve
Experiment: Export boomExperiment: Export boom
Comments on experimentComments on experimentAn export boom stimulates aggregate
demand because Y = C + I + G + X - ZTherefore, all other comparable boosts to
aggregate demand will have same effect:Consumption C (e.g., through lower taxes) Investment I (e.g., via lower interest rates)Government spending G
GNP will rise when AD increases as long as AS curve slopes up
Economic policyEconomic policy
Economic policy instrumentsExogenous variables
Fiscal policy: Government spending, taxes Monetary policy: Money, credit, interest rates Exchange rate policy: Exchange rate (if fixed) Structural policy: Liberalization, privatization, etc.
Economic objectives or targetsEndogenous variables
GNP level or growth Price level or inflation Employment, unemployment BOP, exchange rate (if flexible), external debt
Aims of economic policyAims of economic policy
Apply policy instruments to attain given economic objectives
External balanceExternal balance: conduct monetary, fiscal, and exchange rate policy so as to make the balance of payments position sustainableKey to financial programmingNot only crisis management in short run
Internal balanceInternal balance: conduct policy so as to foster rapid, sustainable economic growth with low inflation and unemploymentKey to economic and social prosperity
Aggregate demandAggregate demand
Y = C + I + G + X – ZC = c(Y-T) = (1-s)(1-t)Y
where s = saving rate and t = tax rate
I = k(M/P)through interest rates
G = exogenousX = aY* - brZ = mY + cr
where r = eP/P* (real exchange rate) andincrease in r means appreciation, as before
Aggregate demandAggregate demand
Y = (1-s)(1-t)Y + k(M/P) + G + (aY* - b(eP/P*)) – (mY + c(eP/P*))
which means:
Y = F(P; M, G, t, e; Y*, P*) - + + - - + +
Aggregate demand schedule slopes downvia real balances and the real exchange rate
... and shifts in response to changes in exogenous variables, including policy
Domestic Domestic creditcredit
AD schedule slopes down Devaluation shifts AD schedule right
Monetary expansion shifts AD schedule right
Aggregate supplyAggregate supplyY = F(N) N = N(W/P)
Labor demand varies inversely with real wages
Y = F(W/P) – or, equivalently,Y = F(P; W)
+ -
Aggregate supply slopes upthrough real wages
... and shifts in response to changes in exogenous variables, including nominal wages and other costs, e.g., price of imported oil
Macroeconomic Macroeconomic equilibriumequilibrium
Price level
GNP
AS
AD
M up; G up; t down; e down
W up
Monetary or fiscal Monetary or fiscal expansionexpansion
Price level
GNP
AS
AD
M up; G up; t down
A
B
An increase in M or G or a decrease in t increases both Y and P for given W
AD’
An increase in wagesAn increase in wagesPrice level
GNP
AS
AD
W up
AS’
A
B
An increase in W increases P, but reduces Y
An increase in the price of imported oil has the same effect: stagflation
DevaluationDevaluationPrice level
GNP
AS
AD
e down
W up
AD’
AS’
A
B
When e decreases, W often also rises, so that P increases, but Y may either rise or fall.
Even if W stays put, AS will shift to the left as devaluation raises the price of oil and other imported inputs.
Balance of paymentsBalance of paymentsB = X – Z + FX = aY* - brZ = mY + crr = eP/P*F = exogenousB = F(Y, P; e, F; Y*, P*)
- - - + + +
To reduce deficit in the balance of payments:Must apply monetary or fiscal restraint to decrease Y
or P or reduce e (devaluation) or F (capital inflow)
Price level
GNP
AS
AD
Balance of payments Balance of payments adjustmentadjustment
A
Suppose, at A, there is a deficitin the balance of payments (B 0)
Then, to reduce deficit, must reduce M or G or raise t toreduce demand (shift AD left)
M or G down, t up
e or F upEnd result is still point A, but now with balance of paymentsequilibrium (B = 0). Level of GNP is unchanged, but its composition has changed.
Can offset decreasein aggregate demand by increasing e or F
Price level
GNP
AS
AD
Macroeconomic adjustment Macroeconomic adjustment and structural reformand structural reform
A
Start, at A, with a deficit in the balance of payments (B 0)
Then, to reduce deficit, try to stimulate supply (shift AS right) in addition to reducing demand
M or G down, t up
End result is point Ewith balance of paymentsequilibrium (B = 0). Level of GNP is unchanged, but its composition has changed. Price level is lower.
Stimulate supply side by liberalization, stabilization, privatization, etc.
E
AS’
AD’
ConclusionConclusion
The EndThe End
The essence of financial programming is to find the right combination of monetary, fiscal, and structural policy measures that improve the balance of payments ...... without damaging other important
macroeconomic variables, including output and employment
Theory and experience indicate that such measures are generally good for growthgood for growth