M/P (1) r i gni ( im with multiplier feedback effects) (2) i f. S dependent on capital flow elasticity

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1 When real money supply is increased, more money is available for transactions than is needed. Individuals use some of this money to buy financial assets, and nominal interest rates fall. With no inflation, real interest rates drop also. This link is depicted, below, in line (1). M/P (1) r i gni ( im with multiplier feedback effects) (2) i f S dependent on capital flow elasticity (3) im (& 1 im ) current account S (income effect predominates) The fall in real interest rates stimulates investment and income (both directly and via the multiplier effect). The fall in real interest rates also leads to a negative change in net foreign investment flows and a decline in the value of the dollar, (2). Furthermore, increased income leads to more imports, a worsening current account balance, and another source of a declining currency value, (3). Therefore, real money supply increases cause real interest rates to fall and the domestic currency to depreciate. growth is signaled. In this case, the traded sector The two scenarios that we have analyzed highlight the linkages between government fiscal and monetary policy expansions, output, the exchange rate and real interest rates. Decreases in money supply and government spending stimulus can be analyzed similarly. Some Keynesian Analysis - 9

2 Based on these links and an assumption of relatively elastic capital flows for the United States, we have the following suggested linkages between policy initiatives and foreign currency value changes relative to the dollar: Tight M/P gni r elastic capital flows S dominate income effect Loose g r gni Loose M/P gni r raise income, while the S interest effect is mixed Loose g r gni Loose M/P gni r mixed income effect interest S rate effect will dominate Tight g r gni Tight M/P gni r mixed interest rate effect S dominant income effect Tight g r gni From 1981 to 1985, with the exception of January 1983, tight money growth and loose government spending led to high real interest rates and a high dollar value. With more money growth and large federal deficits (i.e. g, the dollar fell through In 1989, the dollar rose again. Certainly during this period of exchange rate changes, resources were reallocated between the traded and nontraded sectors. To the extent that these shifts were costly, the U.S. may have lost out from policies that didn't consider and incorporate exchange rate changs. Unless world income growth and interest rate growth differentials come more into line, real exchange rates will continue to change, and a series of resource shifts are likely to continue. Fixed Exchange Rates and France Our consideration of fixed exchange rates will center on an historical relationship between the French franc and the Deutschemark. The value of the franc was pegged to the Belgian/Luxembourg franc, Danish krone, Deutschemark, Dutch Some Keynesian Analysis - 10

3 guilder, Italian lira, Irish pound, Portuguese escudo and the Spanish peseta. This system of pegged exchange rates is known as the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS). ERM currency values were first fixed in 1979, and the parities were reset from time to time. The longest period of stability ran from This fixing of exchange rates necessitated coordination of monetary, fiscal, investment and trade policies among the countries with currencies in the ERM. Changes in the parities indicated that this coordination was not being achieved. A major revaluation occurred in 1987, and the lire was devalued in January During the period, the French franc remained fixed in value relative to the Deutschemark. This situation was caused by some basic changes in the economic policy of the Socialist government. To see what necessitated this policy, we will use the Keynesian view to depict the economic policy alternatives and their effects. The ERM was also known as "the snake", as the exchange rates between the currencies had to remain within agreed upon bounds around their assigned parities (or the inside of the snake). Importantly, the values of these currencies floated as a basket together against the dollar, and most other currencies. The ERM rates and the ranges around these rates (divergence limits) in which the currencies had to trade relative to each other were reported regularly. In 1992, the current rates and divergence limits were the following: Some Keynesian Analysis - 11

4 Currency Parities in the EMS Exchange Rate Mechanism (Financial Times, 7/31/92) One EMS Divergence unit costs Limit (±) One DM costs Belgian/Luxembourg franc % British pound sterling % Danish krone % Deutschemark % ( EMS unit = 1 DM) French franc % Dutch guilder % Irish punt % Italian lira % Portuguese Escudo % Spanish Pesata % Historically, the ERM French franc value was devalued relative to the Deutschemark. In 1982, the French government was pursuing expansionary monetary and fiscal policies, while other ERM countries were not. Furthermore, the French also restricted foreign capital flows. Symbolically, we can analyze this scenario as follows: g (1) gni im current account pressure S (relative to $) (reserve outflow in ERM) (2) r X i f tendency for S but capital flow restricted and M (3) r X if S (capital flow restricted, but some left, relative to $) (reserve outflow in ERM) (4) P current account S tendency from PPP We find that the income and price effects led to pressure on the franc to devalue, and France had to run down its reserves unless capital in-flows compensated. Instead, net capital outflows fluctuated wildly. S/T capital inflows decreased. Foreign direct and other L/T investment were negative balances, while portfolio investment was positive. The net effect was that the expansion failed to bring in foreign investment at levels sufficient to sustain the huge income- (and price-) driven current account deficits. Some Keynesian Analysis - 12

5 Due to the reality of exchange restrictions, less net foreign investment occurred. Without this effect, link (2) above, this potential franc demand failed to buoy the currency s value. The fact that exchange restrictions limited the foreign net investment response to real interest rate changes is indicated by the X breaking the link. Net capital inflows did not occur, and the franc was overvalued. As a result, the Central Banks of the other countries in the ERM were required to buy French francs. When these reserve flows grew too large, the ERM revalued the DM and Dutch guilder and devalued the other currencies. (Revaluation is increasing a fixed currency s relative value, the opposite of devalue.) Under fixed exchange rates, foreign exchange reserves are a measure of the likelihood of devaluations. Furthermore, when exchange rate changes do come between two "fixed" or pegged currencies, a jump in the relative values of the currencies occurs. With the rundown in French reserves and run up in German and Dutch reserves, the franc was devalued in March Over the 1990s, the need for such adjustments diminished, and 11 European Union countries decided to adopt a common currency on January 1, The adopting countries and associated valuations are listed in bold in Table 1 below: Some Keynesian Analysis - 13

6 Table 1 Countries Adopting the Euro Currency Exchange Currency Date of Rate Rate Currency Name Abbreviation Country Establishment 1 EUR = Austrian schilling ATS Austria 31 December Belgian franc BEF Belgium 31 December Danish krone 3 DKK Denmark 31 December Deutsche mark DEM Germany 31 December Finnish mark FIM Finland 31 December French franc FRF France 31 December 1998 Monégasque franc MCF Monaco Irish pound IEP Ireland 31 December Italian lira ITL Italy 31 December 1998 Sammarinese lira SML San Marino Vatican lira VAL Vatican City Luxembourg franc LUF Luxembourg 31 December Dutch guilder NLG Netherlands 31 December Portuguese escudo PTE Portugal 31 December Spanish peseta ESP Spain 31 December Greek drachma GRD Greece 19 June Estonian kroon 3 EEK Estonia 27 June Lithuanian lita 3 LTL Lithuania 27 June Slovenian tolar SIT Slovenia 27 June Cypriot pound CYP Cyprus 29 April Latvian lat 3 LVL Latvia 29 April Maltese lira MTL Malta 29 April Slovak koruna SKK Slovakia 25 November 2005 Countries in bold are the original 11 members on January 1, Subsequently, Greece (2001), Slovenia (2007), Cyprus (2008), Malta (2008), Slovakia (2009), Estonia (2011), Latvia (2014) adopted the Euro, and Lithuania is scheduled for adoption in Denmark and the U.K. are exempted from adopting the Euro under the Maastricht Treaty of 1992, though Denmark still maintains its ERM parity. All other countries must meet the ERM parity conditions for twoyears prior to adopting the Euro. 1. Before 17 March 2007, the exchange rate was 1 EUR = SKK. 2. Before 8 July 2008, the exchange rate was 1 EUR = SKK. 3. Euro adoption has not yet taken place for Denmark, Estonia, Latvia and Lithuania. The experience of the countries using the Euro as their currency has been mixed. Trade, labor mobility, and cross-country investment and wealth have flourished. However, production has tended to center in areas that were most productive prior to the common currency. Furthermore, a well-worn path of adjustment for poorer nations has been precluded. Some Keynesian Analysis - 14

7 Nations using the Euro can no longer allow their home currency to depreciate to improve the competitiveness of their local production for export. At the same time, this depreciation makes imports more expensive. Both of these changes improve the trade balance, and return domestic production competitiveness, albeit at a lower profit level. The massive credit default of the PIGS (Portugal, Italy, Greece, Spain) might not have occurred or at least have been less violent if the floating exchange rate buffer had remained. The 50% write down of Greek debt was a defacto devaluation of the Euro for the purpose of repaying Greek debt. Of course, the heavy-handed debt renegoation wasn t called a selective Euro devaluation. Despite the difficulties of some countries that have adopted the Euro, more countries seek to adopt the currency. The J-Curve Pattern of Current Account Exchange Rate Adjustment By assuming that a depreciating domestic currency value corrects a balance of payments deficit (and appreciation corrects surplus), we have assumed that immediate substitutes are available for traded goods and services. Lower export prices may not lead to significant export growth or import reduction. A measure of this trade characteristic is known as the Marshall-Lerner condition (which is named after its developers). This condition is based on the sensitivity of export and import demands to exchange rate changes. These sensitivities are measured as the export and import elasticities with respect to exchange rate changes. When the absolute value of the sum of the export and import exchange rate demand elasticities of a country is less than one, then a domestic currency depreciation will worsen, not improve, the trade balance. When this absolute value is greater than one, then a depreciation should improve the trade balance. The condition, in which elastic demand responses to a depreciation improve the trade Some Keynesian Analysis - 15

8 balance, is known as the Marshall-Lerner Condition. It is stated algebraically as d x + d m > 1 and s x = s m = and d x elasticity of demand for domestic country s exports d m elasticity of demand for imports by domestic country s x elasticity of supply of domestic country s exports s m elasticity of supply of foreign country producing imports infinity If d x + d m > 1, then the depreciation of a country's currency relative to its trading partners improves the country's balance of payments. Since elasticities of demands are determined by the availability of substitutes, (the more substitutes, the more elastic is demand), the Marshall-Lerner condition is likely to hold across countries with substitutes for their import needs. 2 In the short-run, is it reasonable to assume such a relatively high price sensitivity for trade flows? Probably not. Instead, we should recognize that import substitution takes some time. Many purchases cannot be adjusted immediately following a price change. Therefore, a price increase leads, first, to an increase in seller's revenue. Overtime, substitution occurs, sales fall, and revenue falls. For countries, price may be viewed as the exchange rate deviation from purchasing power parity value, and net international revenue is the current account surplus or deficit. Analogously, limited trade substitution should imply that domestic currency appreciation is followed immediately by current account improvement. In the medium- to long-run, the current account should worsen. For domestic currency depreciations, a pattern of a rapidly falling current account, and then a significant rebound and rising current account should result. This phenomenon has been called the J-Curve. 2 Developing countries may have inelastic demands for the very commodities needed for their development (no substitutes). Therefore, a devaluation may well worsen these countries trade deficits. In these cases, managed exchange rates are all but necessary. Some Keynesian Analysis - 16

9 Specifically, the J-Curve is an empirical phenomenon, which documents how the trade balance responds to a devaluation under fixed exchange rates or a significant depreciation under flexible exchange rates. The response is hypothesized to resemble a "J" over a period of 6 months to 2 years. After a devaluation or depreciation, the trade balance worsens before finally improving. In the short run, it is harder to change buying practices than in the long run. (This is especially true internationally since order delivery and payment lags can run to a year or more.) As a result of this difficulty, substitution is much harder in the short run than in the long run. Therefore, short-run import demand elasticities are lower than long-run elasticities. Short-run demand elasticities, as reflected in the ability to substitute, are not likely to satisfy the Marshall-Lerner condition. Initially following a devaluation, the trade balance worsens until substitution can occur readily. After a period of six months to two years, the trade balance deficit will finally improve (if the longer-run import demand elasticities are great enough in absolute value to satisfy the Marshall-Lerner condition). The J-curve phenomenon is important, because it implies that a country that is devaluing its currency must have reserves available to support the resulting short-run worsening of the current account balance. Otherwise, a series of devaluations or other measures may have to be used to correct a balance of payments deficit problem. The J-curve also has implications for floating rate currencies. When a currency depreciates, increasing export demand and decreasing import demand are two things that will cushion its descent. However, the J-curve phenomenon suggests that when a currency depreciates, an increase in exports or decrease in imports will take a while to materialize. As a result, a currency is likely to overshoot its longer-run equilibrium level. Some Keynesian Analysis - 17

10 Production efficiencies, resource availability, tastes and money growth largely determine the long-run exchange rate. Overshooting the long-run exchange rate means that transitory factors have led to current account or basic balance account imbalances, which actually feed on themselves to drive the current exchange rate away from its long-run value. In a completely free market, an alternative to J-Curve-linked overshooting is an officially managed currency depreciation. Of course, this policy requires that the policy makers in the associated country's central bank have a pretty good idea about the size of the import demand and export supply elasticities and the longer-run equilibrium exchange rate. They must also be willing to subsidize speculators, who will trade against them. Needless to say, the existence of this knowledge and resources may not be the case. Incorrect intervention may only postpone a further and more dramatic currency value change with tremendous overshooting and adjustment costs. Central Bank Intervention The Keynesian view highlights a trade-off between short-run exchange rate changes and central bank intervention. If the short-run costs of flexible exchange rate-induced resource reallocation is high, then central bank intervention, which maintains the exchange rate at or near its long-run equilibrium level, can be justified. For example, net foreign investment inflows can lead to a higher domestic currency value and a current account deficit. In response to the short-run investment demand shift, the central bank of the country facing the domestic currency appreciation is likely sell the domestic currency to keeps its value near the long-run current account-determined equilibrium. The central bank will sell its currency to offset the increased investment demand. Such intervention against current market direction is known as "leaning against the wind." However, if the central bank is not right Some Keynesian Analysis - 18