Transcript Balance of Payment and exchange rate overshooting

Balance of Payment and Exchange Rate
Overshooting
Thre approaches to the balance of payment
Keynesian or Absorption (UK Experience 1970-90)
Monetary approach (German and Japanese Experience)
Elasticity (Marshall-Lerner-Robinson conditions)
Internal and External Balance and Tinbergenian Assignment Problem
Exchanger Rate Overshooting


Balance Of Payment:  Px X  PM M   KA  0
Macroeconomic Themes:10
1
Open Economy Model: Equilibrium in Six
Different Markets
Balance of Payment analysis: Graphical approach
Labour Market
LD
LS
Goods and Money
Money market
IS
AS LM
MD MS
Wage
i
Domestic bonds
BS
BD
i
Foreign Bonds
i*
Foreign Exchange
i
Interest rt
L
Y
M/P
DB
FB
exchange rate
Output
Y
Employment
Output
P
Price
Real money balance
Macroeconomic Themes:10
Portfolio allocation
e
2
Internal and External Balance Under the Fixed
Exchange Rate Regime
analysis of internal and external stability using IS-LM and international financial integration line can be
Analysis of Internal and External Stability
Convergence process to macro equilibrium
Interest
Rate
ESM
EDG
BOP+
i  i*
BOP +
Unempl.
K inflow
BOPUnemployment
K-outflow
BOP+
Inflation/Boom
K-inflow
BOP= X-M=0
BOPBoom
K-Outflow
ESM
ESG
BOP+
ESG
EDM
BOP+
BOP=0
ESM
EDG
BOP-
EDM
EDG
BOP-
EDM
ESG
BOP-
YF
Notes: YF full employment output, BOP = Balance of Payment, K= capital, ESG =Excess supply of
goods, EDG =Excess demand for goods, ESM =excess supply of money, EDM=excess demand for
money
conducted using this diagram.
Macroeconomic Themes:10
3
Policy Spill-over Effects in Interdependent
Economies
Answer: Use a two country Mundell-Fleming Model
Expansionary fiscal policy in country 1
Impact in country 2
i2=i2*
i1=i1*
BOP
LM2’
LM2
LM1 LM2
IS2 IS2’
IS1’
O
y0
In fixed exchange rate with
IS1
y1 y2
o
Y
perfect capital mobility: g  0
Macroeconomic Themes:10
y0 y2 y1
;
Y *
0
g
R
; g  0
R *
; g  0
4
BOP: Keynesian Approach
Capital account
Exports, imports and trade balance to Income
KA+
Imports
CA
exports
trade balance
Interest rate
Income
KA-
Interest
Rate
interest rate
Interest rate
Macroeconomic Themes:10
External balance
Income
5
Monetary Approach to BOP
Money demand M d  pf Y , r 


Money supply M s  R  D
Growth rate of reserves: g r  0 y g y 1g d
Growth of income raises reserves and favourable to BOP
Has just opposite result than the Keynesian Model.
Macroeconomic Themes:10
6
BOP: Elasticity Approach
Trade balance: Px X  PM M   KA  0
Country 1
Country 2
PD
PM
A
B
C
S
E
I
J
K
O
E Export F
O
G
H Home Import
P*
L
M
P*
PP* N
O
P
R
V
W
Q
S Foreign import O
T
Macroeconomic Themes:10
U
Foreing Exoport
7
BOP: Elasticity Approach (Marshall-Lerner
Condition)

Net export function
NX  X  eM
NX  X Y * , e  eM Y , e 
For simplicity assume that NX  X  eM . Then three are three sources of changes in the
net exports:
1. Exports 2. Imports and 3. Exchange rate
NX  X  eM  Me Divide each term by X , NX  X  e M  M e
X
X
X
X
e
1
M 1
X

eM
NX

0


Now using the fact that
when the trade is balanced (
);
and
.
X M
X e
NX X M e
NX
X e M e




0


1
=>
X
X
M
e
X
X
e
M
e
 
Macroeconomic Themes:10
8
Exchange Rate Overshooting
Goods and Money market equilibrium and the exchange rate
Price
Level
Exchange Rate Overshooting
Goods market
Goods market eq.
Price
c
  0
a
e e 
1
b
 p  p

money market eq.
Exchange Rate
Macroeconomic Themes:10
Exchange Rate
9
Internal and External Balance and Tibergenian TargetInstrument Assignment Problem
Fiscal and Monetary Policies for Stability
Budget
Surplus
Budget
surplus
Excess
demand
Boom
Inflation
Excess supply
Recession
BOP surplus
BOP
deficit
Internal balance
External balance
Interest rate
Interest rate
Budget
Surplus
Deflation and BOP surplus
Fiscal Policy
Inflation and BOPdeficit
EB
Interest rate
monetary
policy
Macroeconomic Themes:10
IB
10
Assignment Problem in the Mundel-Fleming Model
Assuring Internal and external stability using the fiscal and monetary policies
Under imperfect Capital Mobility Scenario
LM2
LM1
Interest rate
b
a
BOP
IS2
IS1
Y*
Income
Originally the internal equilibrium is at point a where both goods and money
market are in equilibrium but the external account is imbalance by amount
ab. Money supply is reduced to raise the interest by shifting LM1 to LM2.
However, this policy action will create an internal imbalance and
unemployment will result because economy is operating under full capacity
at point c. Accommodating fiscal policy can shift IS1 to IS2 at point b where
both internal and external account are balances and stability is achieved.
How does this curve look like under a perfect capital mobility condition?
Macroeconomic Themes:10
11
Exchange Rate in the Long Run
Purchasing power parity:
p  EP*
Money demand at home
M  KY 
p
Money demand abroad:
M *  K *Y *  E  p
p*
P*
*Y *
M
K
E 
KY
M*





 
 





*
*
*
Long run exchange rate e  m  m    k  k    y y 


Macroeconomic Themes:10



12
J-curve hypothesis:
 devaluation of a currency deteriorates the trade
balance condition in the short run because
imports can not decrease and export cannot
increase immediately.
 However over time adjustments will take place
so that exports increase and imports can decrease
Impact of devaluation on net exports
Net Exports
Time
Macroeconomic Themes:10
13
A Small open economy model of trade
Preference (CD orCES): U  U ( D, M )
expenditure: PY  PD D  PM M
Transformation function (CET) :
T  T ( E , D)
PY  P D  P E
Total Income:
D
E
(1) Total
(2)
(3)
(4)
D = domestically produced and consumed good
M= imports
E = exports
From optimizing behaviour on the demand side,
U
P
T
P
D
D
E
 Themes:10 ;
 E
Real exchange rate: Macroeconomic
U
T
P
M PM (1 t ) D
D
14
Economy wide Income and Trade Balance in
a Small Open Economy
Economy wide income, I, trade balance and market
clearing conditions:
Domestic sales exports and Tariff:
I P DP ER
(6)
D
E
Trade Balance condition:
P M P EB
(7)
M
E
Demand and supply of domestic goods:
DD  DS
(8)
P and P world prices of imports and exports.
E
M
Domestic economy is too small to change the world price.
Macroeconomic Themes:10
15
Global Trade model
Production :
 INT
j,i,r

Yi,r  min 
 ai, j,r

  1 
,  Ki,rr Li,r r



 


(1)
Domestic Supply and exports:

1
 i,r
i,r
i,r 
Yi,r    i,rYDi,r  (1   i,r ) X i,r 


Armington:
 i,r

Ai,r   i,rYDi,r
Transportation:

1
 i,r
 i,r 
 (1  i,r ) M i,r 
(3)

Ti,r ,s   i,r ,s M i,r ,s
Preferences:
Household Income:
Public sector:
(2)
U r   Ci,r
i,r
I r   wr Li,r   rr Ki,r  RVr
r
i
Gr   GDi,r
(4)
(5)
(6)
(7)
i ,r
Revenue:
(8)
Gr   rr K r   w wr L r   i,r Pi,rYi,r  
P INT j ,i,r
N ,r i,r
k
Macroeconomic Themes:10
16
Equilibrium in the Global Trade Model
Goods Market: Yi,r   Ci,r 
r
Capital Market
Labour Market:
 ai, j,r INTi, j,r
rr , j
 K r   K r ,ri
r
i,r
LS r   LSi,r
i
(9)
(10)
(11)
Equilibrium in the global trade model:
A competitive equilibrium in this global economy is such that, given the prices of commodities
and factors, demands for good and supply of goods are equal at the regional as well as the global level;
factor market clears for each region and at the world level; consumers of each region maximise their utility
subject to their income constraints; and the government budget and trade are balanced for each region.
Macroeconomic Themes:10
17
Dornbusch (1976) Model of Exchange Rate Overshooting
Interest rate parity condition: r  r*  x
(1)
Adjustment of the interest to the deviation of the exchange rate:
x   e  e (2)


Money demand: m  p  r 
By substituting (1) and (2) in (3)
y
(3)
m  p  r*     e  e   y


 p  m  r*     e  e   





y (4)
e e  0  p  m  r*  y
 

Using this in (4) p  m  p  m     e  e 
In the long run,

(5)

e  e  1  p  p   e  e  1  p  p 


(6)
Thus the current exchange rate depends on the long run exchange
rate plus the deviation of current price from its trend.
Macroeconomic Themes:10
18
Now suppose the aggregate demand function of the economy is given by an IS curve in
the open economy model
ln D  u  e  p  1 y r
(7)
Increase in the price is proportional to the excess demand


p  ln D   u  e  p  1 y r 


Y 
In
run
(8)
the
long
p  0 . u  e  p  1 y r  0 

 e  p  1  y r  u

e  p  1 1  y   u

(9)
Simplify (8) using (9)


p  ln D   u  e  p  1 y r  


Y 




p  u p   p  1 1  y r*  u     1 y r  








 








*
p   u  p  p  r  r 











Macroeconomic Themes:10
19
Using the relation from (2) and (3) r  r*   e  e and


e  e  1  p  p 

p     p  p    e  e 




p     p  p     p  p   p       p  p  








 


p  v p  p where v     
 



The







time
path
of
the
pt   p   p  p  exp  vt  .
price
level
thus
is
0 
e  e  1  p  p   e  e  1  p  p  exp(-vt)



From (6) the time path of the exchange rate is
et   e   e  e  exp  vt 
 0

Macroeconomic Themes:10
20
References
K. A.Chrystal and Simon Price (1994) Controversies in Macroeconomics, Harvester Wheatsheaf, chapter 6.
Dornbusch Rudiger (1976) Expectations and Exchange Rate, Journal of Political Economy, vol. 84, no.6,
pp. 1161-1176.
Fleming J. Marcus (1962) Domestic financial policies under fixed and under floating
exchange rates, IMF staff paper 9, November , 369-379.
Krugman Paul (1979) A Model of Balance of Payment Crisis, Journal of Money Credit and Banking, 11,
Aug.
Krugman P. and L. Taylor (1978) “Contractionary Effects of Devaluation” Journal of International
Economics, 445-56.
Miller, Marcus; Salmon, Mark When Does Coordination Pay? Journal of Economic Dynamics and Control,
July-Oct. 1990, v. 14, iss. 3-4, pp. 553-69
Mundell R. A (1962) Capital mobility and stabilisation policy under fixed and flexible exchange rates,
Canadian Journal of Economic and Political Science, 29, 475-85.
Sebastian E (1986) Are Devaluations Contractionary? Review of Economics and Statistics, vol. 68, 3, 501508.
G.K.Shaw, M. J. McCrostie and D. Greenaway (2001) Macroeconomics: Theory and Policy in the UK,
Blackwell.
Taylor Mark (1995) The Economics of Exchange Rates, Journal of Economic Literature, March, vol 33,
No. 1, pp. 13-47.
Macroeconomic Themes:10
21