Transcript Asset Approach to Balance of Payments

International Economics
Portfolio Balance Models
1
Asset Market Approach to
Exchange Rates
2
Asset Markets Approach
• Asset Markets or Portfolio Balance approach
focuses on capital flows due to changes in assets
held by residents
– assumes that financial markets to keep international
demand for stocks of national assets equal to their supply.
• Foreign & domestic bonds are imperfect substitutes.
• Characterize asset-holdings of residents as:
– Domestic money, implicit cost of interest rate i.
– Domestic government bonds yielding interest rate i.
– Foreign government bonds yielding i* + xa where xa is
the expected % change in the exchange rate (UIPC).
3
Domestic Money Market
1. Domestic Money Market
• Money Demand
- + +
L = m( i, i*+xa, Y, P)W
– m( ) is the percent of Wealth, W, held as domestic money.
– Signs of i and i*+xa reflect opp. cost of holding money.
• Money Supply
Ms = M0
– Assuming money stock set by domestic central bank.
• Equilibrium
M0= m(i, i*+xa, Y, P)W= L
– Assuming only domestic residents hold domestic money.
4
Domestic Bond Market
2. Domestic Bond Market
• Bond Demand
+ - Bd = b( i, i*+xa, Y, P)W
– b( ) is the percent of Wealth, W, held as domestic bonds.
– Signs of Y and P reflect transaction demand for money.
• Bond Supply
Bs = B0
– Assuming bond stock set by domestic government.
• Equilibrium
B0= b(i, i*+xa, Y, P)W= Bd
5
Foreign Bond Market
3. Foreign Bond Market
• Bond Demand
- +
- B*d = b*( i, i*+xa, Y, P)W
– b*( ) is the percent of Wealth, W, held as foreign bonds.
• Bond Supply
B*s = eB*0
– Assuming bond stock set by foreign government.
– Must multiply B* by e to convert into domestic currency.
• Equilibrium
eB*0= b*(i, i*+xa, Y, P)W= B*d
– Assuming domestic residents do not hold foreign money.
6
Overall Asset Markets Model
Domestic Money, (MM Curve)
M0= m(i, i*+xa, Y, P)W
Domestic Bonds, (BB Curve)
B0= b(i, i*+xa, Y, P)W
Foreign Bonds, (FF Curve)
eB*0= b*(i, i*+xa, Y, P)W
Wealth Identities
W = M + B + eB*0 and m() + b() + b*() = 1
7
Asset Markets Approach
• Features of the Model
– Wealth identity ensures that equilibrium in two of the
markets implies third market is also in equilibrium.
– Wealth share identity means that changes in desire to hold
one asset imply adjustments in one or both of the others.
• Asset Markets Approach Diagrams
– Begin by looking at interactions between the three markets
induced by policy events.
– Then derive single diagram that summarizes the three
markets equilibrium. Relate shifts in individual markets to
shifts in market curves (MM, BB, FF) on this single
diagram.
8
Increase in Domestic
Bond Supply
9
Increase in Domestic Bonds
i
Ms
PB =
1/i
0
B s1
B s0
i1
i0
Md1
Md0
Domestic Money Market
P*B =
1/(i*+xa)
Bd
M
Domestic Bond Market
B
Increase in Domestic Bonds
Direct Effects (Curve Shifts)
B*s
1. Supply of Domestic Bonds rises, PB falls.
Wealth increases by amount of new bonds
Indirect Effects (Adjustments)
2. Rise in W raises Md. Domestic i rises.
?
B*d0
Foreign Bond Market
B*
3. Rise in W raises B*d, capital outflows but
rise in i lowers B*d. Effect on e uncertain.
4. Rise in W raises Bd partly offsets 1.
10
Deriving Portfolio Balance Diagram
•
Working with the three markets directly is cumbersome and hides the
dependence of the markets through the Wealth identity.
• Portfolio Balance Diagram (Axes are e and i)
– Derive relationship between e and i in each market.
o
Note that as e rises, eB* rises, and so wealth, W, rises.
– Money Market, MM Curve
o
Rise in e, leads to rise in W, which raises Md. To keep Ms = Md requires rise
in i. MM curve is upward-sloping in e-i diagram.
– Domestic Bond Market, BB Curve
o
o
B0= b(i, i*+xa, Y, P)W
Rise in e, leads to rise in W, which raises Bd. To keep Bs = Bd requires rise
in PB i.e. i falls. BB curve is downward-sloping in e-i diagram.
– Foreign Bond Market, FF Curve
o
M0= m(i, i*+xa, Y, P)W
eB*0= b*(i, i*+xa, Y, P)W
Fall in i, leads to rise in B*d. To keep B*s = B*d requires rise e. FF curve is
downward-sloping in e-i diagram.
We are assuming expected future spot exchange rate is constant throughout.
11
Portfolio Balance Diagram
1. Increase in relative Ms shifts
MM back as i falls to raise Md.
Exchange Rate, e
MM
2. Increase in relative Bs shifts
BB out as i rises to raise Bd.
3. Increase in relative B*s shifts
FF down as e falls to raise xa,
and so B*d.
e0
FF
BB
i0
Domestic Interest Rate, i
12
Increase in Domestic Bonds
1. Increase in domestic Bs shifts BB out..
Exchange
Rate, e
2. Rise in Wealth shifts MM out & i up
to keep MD equal to unchanged MS.
3. FF shifts out as wealth up but i up
may bring offsetting shift back.
4. Rise in wealth also partially offsets
original shift in BB (not shown).
MM0
MM1
e0
FF1
FF0
5. Results? Domestic i rises with
certainty but effect on spot e not
certain depends on shifts in FF.
Likely FF shift is small so e falls
BB1
BB0
i0
i1
Domestic Interest Rate, i
13
Open Market Operations
14
Open Market Operations
Ms1
i
Ms0
PB =
1/i
B s0
B s1
i1
i0
Md
Bd
Domestic Money Market
P*B =
1/(i*+xa)
M
Domestic Bond Market
B
Open Market Sale of Gov’t Bonds
Direct Effects (Curve Shifts)
B*s
1. Supply of Domestic Bonds rises, PB falls.
2. Domestic Money Supply falls, i rises.
B*d(i0)
B*d(i1)
Foreign Bond Market
B*
Indirect Effects (Adjustments)
3. Rise in i lowers B*d. Capital inflows.
4. Domestic currency appreciates, spot e
falls, raising xa and return on foreign bonds.
15
Open Market Operations
1. Central bank does Open Market Sale
of government bonds. Reduces MS.
Exchange Rate, e
2. MM shifts out as i rises to keep
MM0
MD equal to lower MS.
MM1 3. BB shifts out as bonds supply
increases, bond price (1/i) falls.
4. No change in foreign BS or FF.
e0
e1
FF
BB0
i0
i1
5. Lower i leads to capital outflows.
Result: e down, (foreign currency
depreciates). Assumed i* fixed but
outflows may cause i* to fall also.
BB1
Domestic Interest Rate, i
16
Short Run vs. Long Run Exchange Rate Overshooting
17
Exchange Rate Overshooting
• Feature of FX markets is that exchange rates “overshoot” new
equilibrium positions during adjustment to a market shock.
• Assume Home country is “small” relative to Rest of World and
that capital is perfectly mobile.
– UIPC holds, foreign & domestic assets are perfect substitutes.
– Asset markets adjust more rapidly to external shocks than goods markets.
• Equilibrium involves both Asset market equilibrium and Goods
market equilibrium simultaneously.
• Goods Market Equilibrium (e = P/P* i.e. Relative PPP holds)
– Higher P implies rise in e (depreciation) to keep Absolute PPP.
• Asset Market Equilibrium (i = i* + xa i.e. UIPC holds)
– Higher P, implies higher Md, which implies higher i, so i > i* + xa.
– Capital flows in, strengthens e which raises xa leads to i = i* + xa.
18
Overshooting in Monetary Model
Perfect Capital Mobility
Domestic Money Market
Interest rates
RF1
M/P0
M/PLR
M/PSR
RF0
Rise in future price
level, leads to expected
future dep’n of
currency. Shifts RF
outwards in SR & LR.
RD0
i0
RD1
i1
eSR
Spot Rate, e
eLR
e0
L( i, Y0)
Domestic MS
19
Dornbusch Overshooting Model
Domestic
Price level, P
Absolute PPP
e = P/P*
Higher P leads to higher Md
which raises i > i* + xa. Must
have fall in e (xa up) for UIPC.
P0
e0
UIPC
i = i* + xa
Spot EXR, e
20
SR Overshooting of EXR
Domestic
Price level, P
1. Increase in Domestic Ms, lowers i,
shifts out UIPC. (xa falls for UIPC)
2. Asset markets adjust quickly, P
sticky. In SR, EXR rises to eSR.
Absolute PPP
e = P/P*
UIPC0
LR
P1
P0
e0
Exchange Rate Overshooting!!!
SR
eLR eSR
3. Goods markets adjust
slowly, P rises. Real Ms
falls, i rises in LR, EXR
falls back to eLR.
UIPC1
Spot EXR, e
21
Short Run vs. Long Run Asset Market Model
22
Real Side of the Economy
• So far have examined only asset market conditions.
– All these quantities are in nominal terms, i.e. W = M + BD + eBF
• Focus now on real side of the economy, i.e. production and
demand of goods & services in the economy.
– Assume full domestic employment in prod’n of two types of goods.
o Non-traded Goods, YN(q): produced & consumed in domestic economy.
o Traded Goods, YT(q): produced domestically but consumed both
domestically and abroad. YTq > 0, YNq < 0
– Relative Price of Traded vs. Non-traded goods: q = e/PN
• Price of Non-tradables = PN Price of tradables = PT = e
– Overall Price Level: P = PNae1-a
– Demand for goods by consumers
o
o
Non-traded goods, CN = CN(q, w) with CNq > 0, CNw > 0
Traded goods, CT = CT(q, w) with CTq > 0, CTw > 0
– Real Wealth = W/P = (M + B + eB*)/P
– Macro Identities
o
C = CN + CT
YD = YN + YT + (i*+ xa)eB*
23
Deriving Real Side Diagram
• Real side of model has two equilibrium conditions:
– Equilibrium in Production: How much of total prod’n goes to tradable good?
– Equilibrium in Consumption: How much of total consump. is tradable good?
• Real Side Diagram (Axes are e and YT, CT)
– Derive relationship between e and YT or CT.
– Production Equilibrium, YY Curve
o
o
Rise in e (currency depreciates), leads to rise in value of Tradable good,
prod’n switches to YT. YY curve slopes up.
YY curve shifts with changes in full employment GDP and PN
– Consumption Equilibrium, CC Curve
o
o
Rise in e (currency depreciates), leads to rise in value of Tradable good,
consumption switches away from YT. CC curve slopes down.
CC curve shifts with changes in real wealth, w = W/P
– Increase in real wealth shifts CC curve away from origin
24
Real Side Diagram
Exchange Rate, e
1.
YY
1. Increase in PN, price of Non-traded
good shifts both curves.
2.
e0
1.
2. Increase in real wealth, shifts
CC curve outwards.
CC
Y T CT
YT, CT
25
Linking Real & Asset Sides
•
1.
2.
Asset markets and real economy are linked in two ways.
–
Exchange rate is determined/affects both parts of the economy
–
Level of real wealth is determined/affected by both parts also.
Interaction on exchange rate is captured by placing Asset
market and real-side diagrams back-to-back.
Interaction with real wealth is more complicated.
–
–
Clearly asset market nominal supplies affect nominal & real wealth.
Less obvious is that real-side equilibrium affects real wealth
o
o
o
Assume consumers have a target level of real wealth, w*.
Their savings behavior is based on comparison of desired level with
actual level of real wealth, S = b(w* - w), b > 0
By definition Savings equals difference between total income YD and
total consumption C. Can show using identities that:
S = (YT – CT ) + (i* + xa)eB*
–
i.e national savings equals net exports plus income on foreign
investments. Thus change in real wealth over time is related to
current account position, which affects Asset market equilibrium.
26
Linking Real & Asset Sides I
Exchange Rate, e
YY
MM
e0
FF
CC
YT, CT
BB
Y T CT
i0
Domestic
Interest Rate, i
27
Linking Real & Asset Sides
• Important to be clear about time frames in within which
interactions occur between markets in the economy.
• Impact Period (Shifts in MM-BB-FF curves):
– Instantaneous adjustment of Asset markets to shock in one or more of
the Asset markets of the economy.
• Short Run (Price Changes through e affect YY-CC curves):
– Prices change as a result of the asset market shock(s) and have effects
on real quantities in the the model. Will cause a divergence between
actual real wealth and desired real wealth, which in turn causes
changes in savings behavior and current account.
• Long Run (Current account imbalance affects w & W):
– Changes in flow of real savings cause accumulated changes in level of
real & nominal wealth in the economy over longer periods. These
flow accumulations lead the economy to new long run equilibrium in
both Asset and real markets of the economy.
28
Open Market Operation:
Impact, Short Run & Long Run
29
Open Market Operations: Impact Effects
Exchange Rate, e
YY0
BB0
BBI
CC0
Impact Current
Account Surplus
MMI
MM0
FF0
eI
e0
YT,
CT
Y0 T C0T
iI
i0
Domestic
Interest Rate, i
30
Open Market Operations: SR Effects
Short Run Current
Account Surplus
YY0
Exchange Rate, e
CC0
BB0
BB1
MM1
CCSR
MM0
FF0
e1
e0
YT,
CT
Y T SR Y0 T
C0T
CTSR
i1
i0
Domestic
Interest Rate, i
31
Open Market Operations: LR Effects
LR Current
Account
Deficit
Exchange Rate, e
CCLR
YYLR
BB0
BB1
CC0 CC
MM1
SR
YY0
MM0
FF0
eSR
eLR
e0
YT,
CT
Y T SR Y0 T
C0T
CTSR
i1
i0
Domestic
Interest Rate, i
32