Transcript Macroeconomics Chamberlin and Yueh

Macroeconomics
Chamberlin and Yueh
Chapter 11
Lecture slides
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The Balance of Payments and
Exchange Rates
• The Balance of Payments
• Exchange Rates
• Theories of Exchange Rate Determination
•
PPP: Purchasing Power Parity
•
UIP: Uncovered Interest Parity
•
The Dornbusch Model of Exchange Rate
Overshooting
• Interaction of Exchange Rates and the Balance of
Payments
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Learning Objectives
•
•
•
•
Introduce the important features of the open economy
Construct the balance of payments
Define and describe exchange rates
Two main theories of exchange rate determination are
introduced: Purchasing Power Parity (PPP) and Uncovered
Interest Parity (UIP)
• The Dornbusch Model of Exchange Rate Overshooting is
also examined.
• Analyse important interactions between the exchange rate
and the balance of payments
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The Open Economy
• Two main features:
• Balance of Payments: one nation’s trade with the rest of the
world, including imports and exports of goods and services,
but also in capital goods and increasingly so in financial
assets.
• Exchange rate: the rate at which one currency can be
converted into another. It affects both the competitiveness
of exports and imports, and also the returns on different
financial assets. Also, the demand for different currencies
and hence the exchange rate is determined by international
trade flows.
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Incorporating the Open Economy
• Exports and imports feed directly into the circular flow as
injections and leakages, respectively.
• Capital goods are important for the productive capacity of
the economy. Trade in financial assets will have a large
bearing on the price and availability of finance in the
domestic economy, which will then have implications for
domestic consumption and investment.
• Policy making must be aware of this as developments in the
rest of the world can be transmitted into the domestic
economy. Also, the effectiveness of domestic policy will
depend on the actions and reactions of other economies.
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The Balance of Payments
• The balance of payments is simply one nation’s accounts
with the rest of the world.
• Sales of goods, services, physical capital and financial
assets from domestic to overseas residents are credits on the
balance of payments.
• The reverse, purchases by domestic residents from those
overseas, are recorded as debits.
• The overall position of the balance of payments is simply
the netting out of these credits and debits.
• However, the balance of payments is constructed so that it
always adds to zero: a position of no overall surplus or
deficit.
• This is because of the role of official financing.
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The Balance of Payments
• There are 4 parts to the BoP:
– Current Account
– Capital Account
– Balancing Item
• Adding the three previous items gives the balance
of payments position.
– Official Financing: The balance of payments must be in
overall balance; this remaining balance is therefore
countered by official financing. Therefore, the balance
of payments will always equate to zero.
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Exchange Rates
• Nominal Exchange Rate: It is expressed as a ratio indicating
how much of one currency can be traded for a unit of
another: E = £/$.
• The exchange rate is defined by the number of £s required
to purchase $1. In this case, an appreciation in the pound
means that fewer £s are required to buy $1, so E falls. A
depreciation of the £ implies that more of them are now
required, so that E rises.
• Real Exchange Rate: The real exchange rate compares the
price of foreign goods and services to domestic goods and
services: R = (£ / $) * (PUS / PUK). This is the nominal
exchange multiplied by the ratio of prices.
• The real exchange rate tends to follow the same trends as
the nominal exchange rate.
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Nominal and Real Exchange Rates,
UK
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Exchange Rates
• Effective Exchange Rate: The effective exchange rate (also
known as the multilateral exchange rate) is the exchange
rate against a basket of various currencies. This is a
weighted average of bilateral exchange rates and provides a
more realistic idea of a currency’s strength. The weights
attached to each bilateral exchange rate are usually taken
from trade shares, as this will weight the bilateral exchange
rate according to its importance to the economy.
• Spot and Forward Exchange Rates: The exchanges rates
defined above are spot rates – quite literally because these
are the rates that would apply to foreign exchange
transactions taken relatively immediately or on the spot. A
forward exchange rate is typically offered by a marketmaker, such as a bank.
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Theories of Exchange Rate
Determination
• The exchange rate is simply the price of one currency in
terms of another. Therefore, like all prices, the rate will be
determined by the relative demands and supplies of each
currency.
• When demand for a currency rises relative to its supply, that
currency’s value relative to others will rise – this is known
as an appreciation in the currency.
• Likewise, when demand falls relative to supply for a
particular currency, its value will fall – this is known as a
currency depreciation.
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Supply and demand of currency
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Increased preference for foreign
goods
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Increased preference for domestic
goods
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Theories of Exchange Rate
Determination
• The relative demands and supplies of
currencies, and therefore the exchange rates,
are trade determined.
• With this in mind, there are two main
theories of exchange rate determination.
• Purchasing Power Parity (PPP) refers to
trade in goods and services, and
• Uncovered Interest Parity (UIP) refers to
the trade in financial assets.
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PPP: Purchasing Power Parity
• This theory argues that the exchange rate will change so
that the price of a particular good or service will be the
same regardless of where you buy it. For this reason, the
theory of PPP is often known as the law of one price.
• The theory of PPP therefore argues that the nominal
exchange rate will change to offset price differences and the
real exchange rate should remain constant.
• The £-$ real exchange rate is defined as:
• R = (£ / $) * (PUS / PUK) = E * (PUS / PUK),
• where E is the nominal exchange rate.
• If U.S. prices rose relative to those in the UK, the nominal
exchange rate will appreciate (remember that this means
that E falls) to keep R constant.
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PPP: Purchasing Power Parity
• How and why do things like this happen? The answer is
simply because of an arbitrage relationship.
• Suppose U.S. prices rise, so that the ratio PUS / PUK
increases. Now that goods in the UK are relatively cheaper,
consumers in the UK will switch consumption away from
U.S. goods towards ones produced in the UK. This will
reduce the supply of £s and the demand for $s. Likewise,
U.S. consumers too will switch consumption away from
U.S. to UK produce, increasing the demand for £s and the
supply of $s.
• This will lead to an exchange rate appreciation for the £ (a
fall in E).
• Rearranging the equation for the real exchange rate gives a
simple equation that determines the nominal exchange rate:
E = PUK / PUS.
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PPP: Purchasing Power Parity
• So, the nominal £-$ exchange rate is determined by the ratio
of price levels.
• In general terms:
• P = Domestic prices in domestic currency
• P* = Foreign prices in foreign currencies
• E = Nominal exchange rate between domestic and foreign
currencies
• EP* = Foreign prices in domestic currency
• Arbitrage requires that domestic and foreign goods prices
are equalised in terms of domestic currency: P = EP*, which
can be re-arranged to give: E = P / P*.
• A rise (fall) in domestic relative to foreign prices will
induce a nominal exchange rate depreciation (appreciation).
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PPP: Purchasing Power Parity
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Relative PPP
• The PPP equation is a levels equation, where the exchange rate is
simply the ratio of domestic and foreign prices.
• Relative PPP expresses this equation in terms of differences, relating
the change in the nominal exchange rate to the changes in relative
prices: %E  %P  %P 
• If the overseas price level is taken to be constant, , then the relative PPP
equation can be simplified to: %E  %P
• The change in the nominal exchange rate is directly proportional to the
change in the price level.
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The Monetary Theory of the
Exchange Rate
• PPP suggests that the nominal exchange rate is
mainly determined by factors that influence the
domestic price level.
• Previously, we have seen that the money supply
might be an important determinant of the price
level, and therefore could be an indirect factor in
influencing the exchange rate.
• The monetary theory of the exchange rate is really
an open economy extension to the simple quantity
theory of money.
• In this way, the exchange rate is determined by the
actions of the domestic monetary authority.
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The Monetary Theory of the
Exchange Rate
•
•
•
•
•
•
•
The well-known Quantity Theory of Money equation is:
Mv = PY,
where
M = Money stock
v = Velocity of circulation
P = Price level
Y = Full employment output
• As v and Y are constants, this can be rearranged to give:
• P = 1/v (M/Y).
• Therefore: % M  % P
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The Monetary Theory of the
Exchange Rate
• If relative prices are determined by different monetary
regimes, then it is easy to make the additional step to see
how the nominal exchange rate is determined.
• Using the relative PPP equation, the change in domestic
prices can then feed directly and proportionately into the
exchange rate:
%M  %P  %E
• For example, a 10% increase in the money supply will lead
to a 10% increase in prices, and a 10% depreciation in the
exchange rate.
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Judging PPP
• The simple intuition behind the theory of Purchasing Power Parity is
that international differences in prices cannot persist. Consumers will
always seek to buy goods and services where they are cheapest. If the
same goods cost different amounts in different parts of the world, profits
could be made by buying the goods where they are cheapest and selling
them where they are most expensive. As a consequence of this
arbitrage behaviour, the exchange rate will adjust so that the law of one
price holds.
• Global Applications 11.4 The Big Mac Index
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Judging PPP
• PPP may not hold because:
• Transport Costs
• For arbitrage to always reinstate the law of one price it must
be able to operate without any costs or friction. Transport
costs can refer to both the costs of moving goods around the
world or any costs that arise due to the delay in their
deliveries.
• Adding transport costs to the price of foreign goods changes
the PPP relationship in the following way:
P  EP  TC
• TC are transport costs which drive a wedge between the
effective actual and listed prices of foreign goods.
• Including transport costs certainly implies that PPP may not
hold in its levels form. However, the relative version of
PPP would continue to hold.
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Judging PPP
• Search Costs: On a similar note, for arbitrage to work
effectively, consumers must have a large amount of
information available to them. In fact, it is perhaps one of
the reasons why PPP is regarded as a long run theory of the
exchange rate. It simply takes time for people to gather the
required information in order to act upon international price
differences.
• Imperfect Competition: The law of one price is grounded in
the world of perfect competition. When firms produce
differentiated goods, then consumers no longer purchase on
the basis of price but also in terms of specifications and
quality.
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Judging PPP
• Non-Traded Goods
• Arbitrage in international goods prices can only be expected
in goods that are traded. Therefore, we wouldn’t expect PPP
to hold outside of the goods sector and for the whole
economy.
• This is most apparent in developing nations, where the price
levels are much lower than in the developed world.
However, this has not been associated with a rapid
appreciation in their currency. Average price levels are low,
but there is no pressure on the exchange rate to adjust
accordingly. One explanation of why this happens is known
as the Balassa-Samuelson effect.
• Global Applications 11.5 Balassa-Samuelson: Evidence
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Quarterly percentage changes in nominal
exchange rates and relative prices, UK
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Judging PPP
• All in all there appears to be evidence – both empirical and theoretical –
to justify a departure from strict PPP theory.
• The conventional wisdom is that as a theory, PPP is most useful and
realistic in the longer term.
• In the short run, the nominal exchange rate is much more volatile than
the theory of PPP would imply. This can be taken as an indication that
there may be other factors which drive the nominal exchange rate. The
theory of Purchasing Power Parity predominately relates to the trade in
physical goods and services, but these current account trades only make
up a small part of the overall balance of payments.
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UIP: Uncovered Interest Parity
• Given that much of the capital account constitutes shortterm financial flows, it may also account for the observed
volatility in short term exchange rates.
• Whereas PPP determines the exchange rate to arbitrage
prices in the goods market, Uncovered Interest Parity
(UIP) does a similar thing in the financial assets market.
• Since the 1980s, liberalisation in the world’s financial
markets means that currency transactions related to the
trade in financial assets outweighs that in goods and
services by as much as 100:1 in value terms.
• Much of this is very liquid and can move around the world
at great speeds in search of the best returns.
• Uncovered Interest Parity (UIP) models the exchange rate
through relative asset returns.
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UIP: Uncovered Interest Parity
• The two key assumptions in this model are that assets are
perfectly substitutable, and there is perfect international
capital mobility. As a result, arbitrage means that the
exchange rate will change so that the returns on all financial
assets should be equalised.
• When you purchase a foreign asset, there are two things that
determine the returns that are derived from it:
• The overseas interest rate is defined by r*.
• Exchange rate movements, E.
• The first of these is clear. The second refers to having
purchased a foreign asset, the returns are only realised once
they have been converted back into domestic currency. If,
however, the exchange rate changes, the rate at which this
conversion takes place will also change.
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UIP: Uncovered Interest Parity
• The overall returns from investing overseas will be equal to both the
foreign interest rate and also the interim percentage change in the
exchange rate: r   %E
• The theory of UIP is based on the idea that the expected returns from
investing in domestic and foreign assets should be equalised.
E e
r = r* + %E, r  r 
E

•
E e
Rearranging,
= r – r*
E
• This is the UIP condition: the expected change in the exchange rate is
equal to the differential between domestic and foreign interest rates.
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UIP: Uncovered Interest Parity
• Under rational expectations, people on
average form correct expectations of the
change in the exchange rate so:
E e E

E
E
E
 r  r
E
• If the domestic interest rate rises above (falls
below) the foreign rate, then there will be an
expectation of a depreciation (an
appreciation) in the exchange rate.
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UIP: Uncovered Interest Parity
• The best approach to explaining how UIP works is through
a very simple example.
• Suppose that initially the domestic and foreign interest rates
were equal. In this case, international investors are
indifferent between the domestic and foreign assets, and
there is no expected change in the exchange rate.
• However, the domestic interest rate then rises by 2% for one
period, after which it returns to its original level.
• Now that domestic assets offer higher returns, the demand
for foreign currency will fall as domestic investors
substitute out of foreign and into domestic assets. The
supply of foreign currency will also increase as foreign
investors do the same.
• Consequently, the domestic exchange will appreciate from
E1 to E2.
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Rise in domestic interest rate
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UIP: Uncovered Interest Parity
• However, once that interest differential disappears,
what should happen to the exchange rate?
• As domestic assets are no longer offering higher
returns than on foreign assets, there is no reason for
the demand and supply curves to stay at D2 and S2,
respectively. Both will return to their initial levels
and the exchange rate will return to E1.
• The initial appreciation in the exchange rate will
only last as long as the interest differential is
expected to persist.
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UIP: Uncovered Interest Parity
• However, by how much will the domestic exchange rate appreciate (E1
to E2)?
• Well, according to the UIP condition, this will be by 2%. We know that
once the interest rate falls back to its initial value, the exchange rate
must return to its initial value. Therefore, this immediate appreciation
must be stimulating expectations of a depreciation, and from UIP, this
expected depreciation will be 2%.
• So, in order to depreciate 2% back to its initial value, the exchange rate
must first of all appreciate by the same – exactly 2%. This is shown in
the next figure.
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Rise in domestic interest rate
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UIP: Uncovered Interest Parity
• The movements in the exchange rate act to equalise the
returns on domestic and foreign assets, just as UIP predicts.
Although domestic assets offer 2% more than those abroad,
this is countered by the expected 2% depreciation in the
currency.
• What if the exchange rate were to initially appreciate by
less than 2%? In this case, the interest differential would be
2%, but the expected depreciation would be less than 2%.
Domestic assets would offer higher returns than those
overseas, encouraging further purchases of domestic assets
would then appreciate the exchange rate further until the
appreciation had reached 2%.
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UIP: Uncovered Interest Parity
• The UIP relationship is effectively maintained by
international investors who seek to achieve the highest
returns possible. Arbitrage is much stronger here than in
the goods market due to the relative ease at moving large
sums of finance around the world and due to competition
among different investors. If international investors have
billions of Pounds at their disposal, then very small interest
differentials will lead to significant differences in returns.
• This will also explain why exchange rate movements are
very fast. In the above figure, the exchange rate effectively
jumps as soon as the interest differential appears. This is
because any investor who can purchase the domestic assets
before the exchange rate has fully appreciated will make
additional returns.
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UIP: Uncovered Interest Parity
• The size of exchange rate changes following interest rate
movements depends on both the size and the persistence of
interest rate differentials. An one period interest differential
is 4%. This would then generate an initial appreciation of
the same amount, with of course an expected depreciation
of also 4% over the period.
• If the interest differential were 2% but was maintained for
two periods, then the initial appreciation in the exchange
rate would once again be approximately 4%. As the
differential is 2% in each period, from the UIP relationship,
the expected depreciation in each would also be 2%,
justifying the initial appreciation of about 4%.
• This is shown in the following figures.
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1-period interest rate differential of 4%
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2-period interest rate differential of 2%
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UIP: Uncovered Interest Parity
• As a theory accounting for short-term movements in the
exchange rate, UIP is important. The following figure plots
evidence for the UK-U.S. nominal exchange rate. There is
cursory evidence to suggest that an appreciation in the
exchange rate is associated with a positive interest
differential.
• There are though two extensions to the theory of UIP, which
might break the relationship between short-term exchange
rate movements and the interest differential.
• The first is the idea that there are different risks in investing
in different assets. Secondly, interest-bearing assets are not
the only financial assets; there are also equities and the
currencies themselves. Accepting a wider definition of
what constitutes a financial asset might explain exchange
rate movements.
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UK-U.S. nominal exchange rate and
interest differential
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Risk Premia
• Therefore, the UIP condition may work better if it is adapted to include
e

a risk premium:
E  r     r
• where μ is the relative risk premium on domestic assets.
• A positive interest differential can no longer be taken as an indicator
that the currency will appreciate (generating the expectation of a
depreciation).
• If the risk premium is relatively large, then the risk adjusted interest
differential may in fact be negative – leading to a depreciating exchange
rate (an expectation of an appreciation).
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UIP Condition with Risk Premium
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Stock Markets and the Exchange Rate
• In reality, investing overseas does not always need to be in
the form of interest bearing assets, such as bonds or bank
accounts. Equity investments normally take the form of
assets such as stocks and shares.
• It should certainly be apparent from the next figure that in a
short horizon exchange rates are very volatile and displays
the same type of random walk process that describes
financial markets.
• As financial asset prices are based on expected future
profits, prices will jump every time new information is
revealed to the market. As information is always arriving at
markets, share prices will be volatile and this is reflected in
currency markets.
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Percentage daily change in the £-$
nominal exchange rate
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Stock Markets and the Exchange Rate
• There is a strong linkage between stock and currency
markets. For example, suppose new information comes to
light predicting a downturn in the U.S. economy. The
expectation of lower future profits will place downward
pressure on equity prices and investors will sell, perhaps
transferring funds into Japanese or European assets. The
$US will subsequently depreciate.
• Longer-term volatility relationships can also be accounted
for, e.g., the sharp appreciation in the $US during the late
1990s and the U.S. asset bubble in U.S.
• The relationship between stock markets and currencies can
also cloud the UIP relationship. Increases in interest rates
need not always lead to an appreciation in the exchange
rate. In fact, a rise in interest rates would be expected to
lead to a fall in stock market prices and may therefore lead
to a depreciation in the exchange rate.
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Currency Trading
• Explaining exchange rate volatility is even easier once we
allow for the fact that the exchange rate itself can be viewed
as the price of a financial asset. This is because currency
traders aim to make money by predicting the movements in
the exchange rate.
• For example, at one moment in time, a trader could
purchase on the spot market. If the domestic currency then
depreciates, the domestic currency can then be repurchased
and a profit made.
• When currencies themselves are viewed as financial assets,
it means that they too can be subject to the same volatility
as other financial assets. This is certainly true in the short
run, but may also manifest itself in long-term volatility,
such as bubbles. The long appreciation in the $US at the
beginning of the 1980s is certainly an example.
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The Dornbusch Model of Exchange
Rate Overshooting
• The two most common theories accounting for exchange
rate movements have just been introduced.
• One of the most common observations regarding the
exchange rate is its relative volatility in the short run, where
movements in the nominal exchange rate are large
compared to those in relative prices. Explaining this short
run volatility is a challenge for the traditional models.
• The Dornbusch overshooting model is one answer. It
simply looks at how the PPP and UIP conditions interact,
and predicts that the exchange rate might be quite volatile to
changes in monetary policy.
• As will be seen, the important factor generating the
exchange rate overshooting result is price rigidity.
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The Dornbusch Model of Exchange
Rate Overshooting
• To see why, consider what happens when prices adjust
quickly to changes in the money supply.
• The next figure represents equilibrium in the money market.
An increase in the money supply from M1 to M2 shifts the
money supply curve to the right.
• However, because there are no price rigidities, the
predictions of the quantity theory of money will conclude
that prices will rise proportionately, P1 to P2, so that
%M=%P.
• As a result, there will be no overall effect on the real money
supply, which will leave the interest rate unchanged at r1.
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The Dornbusch Model of Exchange
Rate Overshooting
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The Dornbusch Model of Exchange
Rate Overshooting
• In the absence of price rigidities, this happens quickly.
• As interest rates do not change, the theory of UIP will not
offer any prediction here as to how the exchange rate will
change.
• Instead, movements in the exchange rate will be completely
described by the monetary theory of the exchange rate, or
PPP.
• This is shown in the next figure.
• The exchange rate will only move proportionately with the
initial change in the money supply and prices (E1 to E2 in
panel (d)). This is certainly at odds with the empirical
evidence, which would indicate a more than proportional
reaction of the exchange rate to fit in with empirical
observation.
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The Dornbusch Model of Exchange
Rate Overshooting
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The Dornbusch Model of Exchange
Rate Overshooting
• Suppose now there are price rigidities.
• The same increase in the money supply will not be offset by
a proportional rise in prices. This is shown in panel (b) of
the next figure, where it now takes time for prices to rise.
• In the long run, the predictions of the quantity theory of
money still apply, but price changes are not instantaneous
and in the short run prices will rise proportionately less than
the change in the money supply.
• In this case, the real money supply is affected in the short
run, which places downward pressure on the interest rate.
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The Dornbusch Model of Exchange
Rate Overshooting
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The Dornbusch Model of Exchange
Rate Overshooting
• According to the theory of UIP, this will lead to the
expectation of an appreciation. However, in the long run,
the predictions of PPP must still apply – which suggest a
proportional depreciation in the currency.
• Therefore, in the long run, the exchange rate must
depreciate, but in the short run there is an expectation of
appreciation.
• The only way for these two things to coexist is if the
exchange rate over depreciates in the short run.
• Hence, the initial depreciation of the exchange rate must be
proportionately larger than the initial increase in the money
supply. This is shown in panel (d) where the exchange rate
overshoots in the short run from E1 to E0 before settling at
its long run equilibrium value of E2.
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Interaction of Exchange Rates and
the Balance of Payments
• The exchange rate is most likely to have an impact on the
current account part of the balance of payments.
• This in turn is made up of two parts.
• The first is the trade balance, which is the difference in the
exports and imports of goods and services.
• The second part consists of net income flows, which are
largely made up by the net factor incomes of foreign
directly invested firms.
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Interaction of Exchange Rates and
the Balance of Payments
• Although the exchange rate will affect the size of these
flows, the conventional approach is to assume that the
exchange rate has the most significant effect on the trade
balance.
• The position of the trade balance is determined by the net
value of exports and imports, with the value being
determined by price and volume.
• Movements in the exchange rate can be expected to have
two opposing effects on trade.
– Competitiveness
– Terms of Trade
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Competitiveness and the trade balance
• The price of exports in terms of the domestic currency is
given by the domestic price level: PX=P.
• The price of foreign goods is given by the overseas price

level and the nominal exchange rate: PM  EP
• Competitiveness is the ratio of export and import prices or
alternatively the real exchange rate. This can also be
thought of the inverse of the terms of trade:
EP 

P
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Competitiveness and the trade balance
• The demand for exports (X) is a positive function
of the level of competitiveness and overseas
income: X  xY  Y , xY    0



• Overseas income is represented by Y*. The
coefficient, xY  , is the proportion of total foreign
income that is spent on domestic goods. As the
exchange rate depreciates (θ rises), domestic goods
become cheaper, which encourages substitution
towards them, so xY   rises.


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Competitiveness and the trade balance
• The demand for imports is a negative function of
competitiveness and a positive function of domestic
income: M  mY  Y mY    0

• As income rises, households tend to consume more – a
proportion of which will go on imported goods, so there is a
positive relationship between imports and income. This
proportion is governed by the marginal propensity to
import: mY   . This will negatively related to the real
exchange rate, as a depreciation will make domestic goods
relatively cheaper encouraging substitution towards them.
So, as θ rises (falls), mY   falls (rises).
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Competitiveness and the trade balance
• The trade balance is the value of exports minus the value of imports. In
terms of domestic currency, this is:
BT  PxY   Y   EP mY  Y
• The real value of the trade balance can be calculated by dividing
EP
through by the domestic price level: BT

• As
EP

P
P

 xY   Y 
P
mY  Y
BT
 xY   Y   mY  Y
P
• When trade is balanced, BT=0, this can be rearranged to give:
xY   Y   mY  Y
or X=M.
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Competitiveness and the trade balance
• This equation aptly describes the effect of exchange rate
movements on the trade balance. A depreciation in the
currency will increase the volume of exports and reduce the
volume of imports. However, it will also increase the price
of imports, so the competitiveness and the terms of trade
effects are working in opposite directions. The overall
impact on the trade balance will depend on which effect is
the greater.
• An appreciating exchange rate has the opposite effect. The
volume of exports will fall, and the volume of imports will
rise. However, the price of imports will also fall. Although
net exports have fallen in volume, the terms of trade has
moved to counter this. Again, the overall impact will
depend on which effect dominates.
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Marshall-Lerner Condition
• For a depreciation to improve the trade balance, a necessary
condition is that the competitiveness effect outweighs the
terms of trade effect.
• For this to happen, the substitution towards domestic goods
must be sufficiently strong which will depend on the price
elasticity of demand.
• The price elasticity of demand is simply the % change in
quantity demanded following a 1% change in its price. If
this elasticity is between zero and one, then demand is
inelastic so price changes do not generate much of a
substitution effect. However, if this elasticity is in excess of
one, price changes generate a large substitution effect.
• The concept of elasticity is at the heart of the MarshallLerner condition.
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Marshall-Lerner Condition
• Following an exchange rate depreciation, the
balance of payments will:
– Improve if the sum of the price elasticity of
demand for exports and imports exceeds 1.
– Remain unchanged if the sum of the price
elasticity of demand for exports and imports
equals 1.
– Deteriorate if the sum of the price elasticity of
demand for exports and imports is less than 1.
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The J-Curve
• The conventional wisdom is that export and import prices
elasticities are much greater in the longer rather than the
shorter run. This is logical as it takes a while for consumers
to discover and then adjust to new prices.
• Due to this time pattern of elasticities, many prescribe to the
idea that the balance of payments follows a J type
movement to depreciations.
• In the short run, elasticities are low, the Marshall-Lerner
condition is violated and the terms of trade effect of
depreciations dominate.
• In the longer run, though, elasticities are greater so the
depreciation improves the balance of payments.
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The J-Curve
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U.S. trade balance as a proportion of the GDP and the $
nominal effective exchange rate during the 1980s
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Sufficient conditions
• The Marshall-Lerner condition is a necessary
condition for a depreciating exchange rate to
improve the trade balance.
• However, there are a number of further or
sufficient conditions which are required for this
result.
– Absorption effects
– Real Wage Resistance
– Pricing to market
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Absorption effects
• Following a depreciation in the exchange rate, it is expected
that net exports will improve.
• However, this is an injection into the circular flow of
income, so income would be expected to increase:
Y  k X  M 
• Imports are a function of income, where m is the marginal
propensity to import.
• Hence, it must be the case that:
M  mk  X  M 
• This is the absorption effect on the balance of payments.
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Absorption effects
• Taken together, the total change in the trade
balance will be:
 X  M   mk X  M 
 1  mk X  M 
• The trade balance will only improve if 1>mk.
• If m and k are sufficiently large, then an initial
improvement in the trade balance will generate a
large increase in income, of which a large
proportion will be spent on imports.
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Real Wage Resistance
• Competitiveness is given by the real exchange rate:
EP 

P
• It is clear that a depreciation will lead to a rise in
both E and θ.
• The consumer price index (CPI) represents the cost
of living. Some of the goods and services that
make up household consumption will come from
overseas; therefore, a depreciation will lead to an
increase in the cost of living:
CPI  P  1   EP
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Real Wage Resistance
• The value of wages is determined in part by the cost of
living. This is the nominal wage divided by the CPI.
• Hence, an exchange rate depreciation through the cost of
imports, and then the overall price level, will lead to a fall
in the real wage. In order to restore the value of the real
wage, organised labour groups such as trade unions may
push for a higher nominal wage (W).
• However, if domestic prices are simply a mark up over
costs, then this will lead to an increase in domestic prices.
This will begin to reduce competitiveness.
• It will also lead to a further increase in the cost of living
leading to a wage-price spiral. In seeking to maintain the
value of real wages (real wage resistance), the
competitiveness effects of a depreciation may be reversed.
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Pricing to market
• In a competitive industry, prices are set equal to marginal
costs and normal profits are made.
• In an imperfectly competitive industry, firms have some
market power and prices are a mark up on marginal costs:
P  1   MC


P   1    MC 
• In this case, competitiveness is given by:


E 1    P

1   P
• It is perfectly conceivable that changes in the mark up may
cancel out any movements in the exchange rate, leaving the
trade balance unchanged.
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Effective depreciation
• If there is a depreciation (E rises), the effect on
competition will be neutralised if:
– Domestic firms increase their mark ups, using the
exchange rate depreciation as an opportunity to increase
margins.
– Foreign firms reduce their mark ups. Perhaps they are
concerned about losing market share and therefore are
prepared to sacrifice some margin in order to maintain
competitiveness.
– A combination of the two.
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Current Account Deficits and
Surpluses: do they matter?
• Why might large imbalances in the current account be of
concern to policy makers?
• After all, we have already seen that the current account is
offset by the capital account in the balance of payments.
• Deficits: This implies that exports exceed imports. From
the national income identity:
Y C  I G X M
• which can be rearranged to give:
X M Y C  I G
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Current Account Deficits and
Surpluses: do they matter?
• Therefore, a deficit indicates that the citizens of a country
are consuming more than they are producing.
• This results in one of two things.
– Foreign currency reserves are being run down to fund
the deficit. This, though, cannot be done forever due to
the finiteness of reserves.
– If foreign reserves are exhausted, the deficit can be
funded by borrowing from overseas. However, large
and sustained deficits result in larger and larger foreign
liabilities and higher interest rates. Foreign indebtedness
means that a large future constraint may be placed on the
economy, which has to divert resources to meeting its
debt requirements.
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Current Account Deficits and
Surpluses: do they matter?
• Surpluses
• When an economy is in equilibrium, it is the case that
injections are equal to leakages:
I G  X  S T  M
which can be re-arranged to give:
 X  M   S  I   T  G
• Running a surplus means that the economy is a net lender to
the rest of the world. However, what is apparent is that
these funds could be allocated to domestic usages, either in
private investment or government spending. The question
here is whether it is better for domestic residents to save in
domestic or foreign assets.
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Correcting a Trade Deficit
• If a country is running a persistent deficit on the trade
balance, there are generally two policy options that can be
used to correct it.
• Exchange rates: Providing the Marshall-Lerner condition
holds, a depreciation in the exchange rate will lead to an
improvement in the trade balance. In this respect, trade
deficits may be self correcting. For example, suppose there
is a large increase in imports which leads to a deterioration
in the trade balance. However, this also increases the
demand for foreign currency, and reduces the demand for
domestic currency, so the exchange rate will depreciate any
way. Therefore, automatic correction should result.
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Correcting a Trade Deficit
• Absorption approach: From the national income identity,
the trade balance is simply: X  M  Y  C  I  G
• For a given level of output, the trade balance can be
improved by simply reducing domestic absorption:
(C+I+G). These are components of aggregate demand. If
these exceed the level of domestically produced output
(C+I+G>Y), then the demand for goods and services can
only be met by imports.
• Likewise, if domestic absorption is less than domestic
output (C+I+G<Y), there is no need to import goods and
the excess production can be exported.
• Any policy which controls the absorption factors –
consumption, investment and government spending – will
influence the trade balance.
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Global Applications 11.11
• Do reductions in the government deficit
increase the current account surplus?
• Consider: (G – T) = (S – I) + (M – X)
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Summary
• This objective of this chapter was to introduce the important
features of the open economy.
• Firstly it is explained how the balance of payments are
constructed.
• Next, attention is turned to defining and describing
exchange rates.
• Two main theories of exchange rate determination are
introduced; these are Purchasing Power Parity (PPP) and
Uncovered Interest Parity (UIP). The Dornbusch model of
exchange rate overshooting is also examined.
• Finally, the important interactions between the exchange
rate and the balance of payments are analysed.
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