Macroeconomic Theory and Policy

Transcription

1 ECO 209 Macroeconomc Theory and Polcy Lecture 7: The Open Economy wth Fxed Exchange Rates Gustavo Indart Slde 1

2 Open Economy under Fxed Exchange Rates Let s consder an open economy wth no captal moblty Therefore the balance of payments s equal to the balance n the current account BP = NX Let s assume the followng expressons for exports (X) and mports (Q) X = X + x (ep f /P) Q = Q + m s (ep f /P) NX = X Q + (x + s) (ep f /P) m For nstance, an ncrease n the RER ncreases NX snce Canadan goods become relatvely less expensve and thus more compettve n the nternatonal market Gustavo Indart Slde 2

3 The Balance of Payment Equlbrum Snce CF = 0, the balance of payment s n equlbrum when the current account s n equlbrum,.e., when NX = 0: NX = X Q + (x + s)(ep f /P) m = 0 Therefore, the current account s n equlbrum at a unque level of ncome: 0 = [X Q + (x + s)(ep f /P)] / m However, snce we are assumng a fxed exchange rate, the balance of payments need not be n equlbrum at the economy s equlbrum ncome (*) Indeed, at the economy s equlbrum ncome, the balance of payments could show a defct or a surplus A defct s fnanced by the Bank of Canada runnng down ts reserves of foregn exchange, and a surplus s fnanced by the Bank of Canada buldng up reserves Gustavo Indart Slde 3

4 The Balance of Trade Equlbrum X Q Surplus Defct X = X + x (ep f /P) Q = Q s (ep f /P) + m Q NX < 0 X + x(ep f /P) X NX > 0 Q s(ep f /P) Gustavo Indart Slde 4

5 The Economy and the Balance of Trade Equlbrum Surplus BP=0 Defct LM * X Q NX > 0 * IS 0 Q X The balance of trade s runnng a surplus at the equlbrum level of ncome *. Therefore, the Bank of Canada s accumulatng foregn reserves. * 0 Gustavo Indart Slde 5

6 Internal and External Balance We have seen that the economy could be n equlbrum (*) whle the external sector would be n dsequlbrum At the same tme, we have also seen that the equlbrum level of output could be below or above the fullemployment level ( fe ) When the equlbrum level of output s at the fullemployment level we say that there s nternal balance When the foregn sector s n equlbrum, that s, when BP = 0, we say that there s external balance Gustavo Indart Slde 6

7 Internal and External Balance It seems desrable to try to acheve nternal and external balance The benefts of achevng an nternal balance are rather obvous But why s external balance desrable? On the one hand, a country can t run a balance of payments defct ndefntely snce t wll eventually run out of foregn currency reserves On the other hand, a country should not run a balance of payments surplus ndefntely (and accumulate foregn currency reserves) because ths would reduce consumpton possbltes (and the standard of lvng) Gustavo Indart Slde 7

8 Internal and External Balance Suppose that external balance occurs at a lower level of output than nternal balance BP=0 fe Equlbrum output could occur n three dfferent areas: 1) at a level below the external balance level 2) at a level between the nternal and the external balance levels 3) at a level above the nternal balance level I Recesson Surplus 0 II Recesson Defct fe III Boom Defct Gustavo Indart Slde 8

9 Polcy Optons n Area I If equlbrum output falls wthn Area I, the economy s experencng a recessonary gap and a trade surplus BP=0 fe Here, the government should mplement expansonary fscal or monetary polcy to reduce the recessonary gap and the trade surplus Suppose that the government ncreases ts expendture on goods and servces LM IS IS Ths would ncrease output and decrease the trade surplus 1 0 fe Gustavo Indart Slde 9

10 Polcy Optons n Area III If equlbrum output falls wthn Area III, the economy s experencng an nflatonary gap and a trade defct BP=0 fe Here, the government should mplement contractonary fscal or monetary polcy to reduce the nflatonary gap and the trade defct LM Suppose that the government decreases ts expendture on goods and servces Ths would decrease output and decrease the trade defct 0 fe IS 1 IS Gustavo Indart Slde 10

11 Polcy Optons n Area II 1 BP=0 0 1 IS fe fe LM If equlbrum output falls wthn Area II, the economy s experencng a recessonary gap and a trade defct Here we have a polcy dlemma: Expansonary polcy wll acheve nternal balance, but the trade defct wll ncrease Contractonary polcy wll acheve external balance, but the recessonary gap wll ncrease Ths occurs because we have two ndependent targets and only one polcy nstrument (aggregate demand polces) The soluton then s to fnd another polcy nstrument that would ncrease net exports at each level of ncome We wll consder two dfferent polces: 1) tarffs and 2) devaluaton Gustavo Indart Slde 11

12 Polcy Optons n Area II BP=0 LM The balance of trade s runnng a defct at the equlbrum level of ncome *. Therefore, the Bank of Canada s loosng foregn reserves. X Q 0 * IS fe IS Q Suppose that the government frst mplements expansonary fscal polcy to acheve nternal balance, thus further ncreasng the defct n the external sector. 0 * fe X The government must now mplement a dfferent polcy to reduce the defct n the external sector. Gustavo Indart Slde 12

13 Polcy Optons n Area II: Impact of a Tarff BP=0 BP =0 LM The economy has acheved nternal balance but there s a defct n the balance of trade. X Q 0 0 fe fe IS IS Q Q X The ntroducton of a tarff reduces mports at each level of ncome, that s, causes the Q curve to shft down to the rght. The ncrease n NX has an mpact on AE, and thus the IS curve shfts out to the rght. Therefore, the government should use contractonary polcy at the same tme that t ntroduces the tarff. Gustavo Indart Slde 13

14 Polcy Optons n Area II: Impact of a Devaluaton BP=0 BP =0 LM The economy has acheved nternal balance but there s a defct n the balance of trade. X Q 0 0 fe fe IS IS Q Q X X The devaluaton of the Canadan dollar reduces mports and ncreases exports at each level of ncome, that s, t causes the X curve to shft up and the Q curve to shft down to the rght. The ncrease n NX has an mpact on AE, and thus the IS curve shfts out to the rght. Therefore, the government should use contractonary polcy at the same tme that t devalues the currency. Gustavo Indart Slde 14

15 Captal Flows We wll assume that the foregn rate of nterest (*) s gven, and that Captal wll flow nto Canada whenever > * Captal wll flow out of Canada whenever < * When = *, captal flow s zero (or rather, an nvestor would be ndfferent between nvestng at home or abroad) Under these assumptons, the captal account surplus s gven by the equaton: CF = a ( *) or = * + (1/a) CF where a measures the senstvty of captal flows to the nterest rate dfferental or the degree of captal moblty Gustavo Indart Slde 15

16 Captal Flows CF = a ( *) = * + (1/a) CF 1 CF * Slope = 1/a 2 ( ) CF CF 2 CF 1 CF (+) Gustavo Indart Slde 16

17 The Balance of Payments and Captal Flows The overall balance of payments (BP) now becomes: BP = NX + CF = X Q m + (x + s)(ep f /P) + a( *) If we set BP = 0, we obtan the combnatons of nterest rate () and ncome () for whch there s balance of payments equlbrum: BP = X Q m + (x + s)(ep f /P) + a( *) = 0 We can wrte ths equaton as: BP = BP m + a = 0 where BP = X Q + (x + s)(ep f /P) a* Gustavo Indart Slde 17

18 The Balance of Payments As we have seen, equlbrum n the external sector means that: BP = BP m + a = 0 where BP = X Q + (x + s)(ep f /P) a* Therefore, we obtan a relatonshp between and showng external balance (the BP curve): = BP/a + (m/a) Gustavo Indart Slde 18

19 The BP Curve BP m + a = 0 Slope = m/a = BP/a + (m/a) BP BP = X Q + (x + s)(ep f /P) a* BP/a Note that changes n any of the determnants of BP wll cause the BP curve to shft. Gustavo Indart Slde 19

20 Perfect Captal Moblty (a = ) and the BP Curve = BP/a + (m/a) Snce BP = X Q + (x + s)(ep f /P) a*, BP/a = X/a + Q/a [(x + s)/a] (ep f /P) + *, and f a =, then BP/a = * and m/a = 0 * BP = * Gustavo Indart Slde 20

21 Ponts Off the BP Curve BP = NX + CF Surplus = BP/a + (m/a) BP 2 1 BP/a B A Defct If the rate of nterest ncreases whle the level of ncome remans unchanged, the balance n the captal account mproves whle the balance n the current account remans unchanged. Therefore, the balance of payment shows a surplus at pont B. 1 Gustavo Indart Slde 21

22 Equlbrum Income and the Balance of Payments For smplcty, we wll usually assume that the BP curve s flatter than the LM curve,.e., that the degree of captal moblty s relatvely large. LM Surplus BP Defct IS 1 Gustavo Indart Slde 22

23 The Lnk between the Balance of Payments and the Money Supply Under a fxed exchange rate system, the Bank of Canada ntervenes n the foregn exchange market to elmnate any excess demand or supply of foregn currency There s a lnk between the purchase and sale of foregn currency by the Bank of Canada and the supply of money When there s a balance of payments surplus, the Bank of Canada buys foregn currency and pays wth CAD$ The Bank of Canada pays wth CAD$ and n ths way njects money nto the economy When there s a balance of payments defct, the Bank of Canada sells foregn currency out of ts reserves The Bank of Canada receves CAD$ n payment and n ths way wthdraws money from the economy Gustavo Indart Slde 23

24 The Impact of Expansonary Fscal Polcy As and start to ncrease along the LM curve, a surplus emerges n the balance of payments. The Bank of Canada purchases the excess supply of foregn currency and the money supply ncreases. Surplus E E LM BP LM IS ΔG> 0 Δ > 0 Δ > 0 ΔI < 0 ΔNX < 0 ΔX = 0 ΔQ > 0 ΔCF > 0 Δ IS Defct 1 2 Gustavo Indart Slde 24

25 The Impact of Expansonary Monetary Polcy Surplus E As decreases, a defct emerges n the balance of payments. The Bank of Canada sells foregn currency to elmnate the excess demand and the money supply decreases. LM LM BP IS Defct 1 Gustavo Indart Slde 25

26 Sterlzaton Polces The Bank of Canada can offset the effect of foregn exchange transactons usng sterlzaton polces For nstance, when the Bank of Canada buys foregn currency t can smultaneously decrease the money supply through an open market operaton Sterlzaton polces are not possble f there s a relatvely hgh degree of captal moblty Sterlzaton polces wll work only f there s some degree of control on captal movements Gustavo Indart Slde 26