Lectures µy, ε,weseethata

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1 Lectures <5> The effect of changes in foreign demand on output and net exports Suppose that foreign income is increased by 4Y. For simplicity, assume that Y = Y TB. Figure 12-4 A rise in foreign income Y has two effects (4Z D = 4NX = 4 Y X for any given Y ): causing both the NX and the ZZ to shift up by the change in X. Theresultsare: A rise in foreign income leads to an increase in domestic output and to an improvement in the trade balance in equilibrium Imports rise with the increased equil income, but not enough to offset the initial rise in exports so that the trade balance must improve. The waiting game played by countries with an incentive to cheat. A rise in domestic demand leads to a smaller increase in output (than in a closed economy) but to a trade deficit, while a rise in foreign demand leads to an increase in our output and to a trade surplus. Therefore, countries prefer increases in foreign demand to increases in domestic demand. In international coordination, a country is likely to promise an increase in its own demand, and then not to deliver on that promise while waiting for its foreign trading partners to increase their demand. <6> The effect of changes in the real exchange rate on output and net exports From the trade balance NX (Y ; Y, ε) =X µy, ε εq µy, ε,weseethata + real depreciation (i.e., ε ) affects NX via 3 channels: Domestic goods are relatively cheaper: X NX ; Foreign goods are relatively more expensive: Q NX ; The same quantity of imports now costs more to buy: ε NX. The Marshall-Lerner condition means that the first two (quantity) effects outweigh the third one (price effect) so that a depreciation causes NX to rise. Look back at Ex (??) for the indication of the net effect of ε on NX Under this condition, ε will cause both NX and ZZ to shift up by 4 ε NX Figure : similar to Figure 12-4 The result: A depreciation and a foreign income rise have the same effect on output and the trade balance: Y and NX. <7> The effect of changes in the combination of fiscal and real-exchangerate policies Suppose that a government wants to reduce the trade deficit without changing output. It can choose a right combination of a real depreciation (ε ) andfiscal contraction (G or T ). Figure 12-5 ε causes both NX and ZZ to shift up by 4 ε NX.Then,G causes ZZ 0 to shift down back to ZZ, without causing NX to shift. Derive the adjustment to fiscal policy from real exchange rate policy based on 4G = 4 ε NX for a given 4ε. 1

2 <8> The J-curve The Marshall-Lerner condition does not hold initially because a depreciation may have a relatively greater effect on the price of imports than on the quantities of imports and exports. In this stage, the price effect dominates its quantity effect. Thus, the depreciation initially causes NX to fall and has a negative impact on domestic output. Over time, however, the quantities of X and Q will respond to the change in ε in a favorable way. The quantity effect of ε is becoming to overcome its price effect. That is, the Marshall-Lerner condition will apply eventually, and this depreciation will lead the trade balance to improve. The graphical presentation of this adjustment is called J-curve. See figure 12-6 <9> The relationship between saving, investment and the trade balance (1) In a closed economy, the equil condition for the goods market can be written as I = S T, where total saving S T is private saving S (= Y T C) plus public saving S public (= T G). (2) In an open economy, the equil condition for the goods market can be written as S T I = NX. Proof: Start with Y = C + I + G + NX, subtract C + T from both sides, and use the defn of S. YouhaveS = I + G T + NX.UsethedefnsofS T and S public.we obtain S T = I + NX. Intuitions of this condition are: If NX > 0, thens T >I. A trade surplus corresponds to the excess of (total) saving over investment, which is used to lend to foreigners and reflected as a capital account deficit. If NX < 0, thens T <I.Atradedeficit, equal to the excess of investment over (total) saving, is borrowed from abroad and reflected by a capital account surplus. If NX =0,thenS T = I. Trade is balanced and the net capital inflow is zero so that domestic investment is financed by domestic saving. Thus, there is net lending to the rest of the world if a country saves more than it invests; there is net borrowing from the rest of the world if a country invests more than it saves. From the above, G T = S I +( NX), one sees that a rise in budget deficit is reflected in a rise in private saving, a fall in investment, or a rise in trade deficit. What follows covers Chapter 13 and part of Chapter 14. We will use the openeconomy IS LM model and the interest parity condition to discuss the simultaneous equilibrium in both the goods market and financial markets, including the foreignexchange market. The model in Chapter 13 characterizes the joint movements of output, the interest rate, and the exchange rate in an open economy. We will explain the effects of fiscal and monetary policy under flexible exchange rates, examine the effects of fiscal policy under fixed exchange rates, and analyze how changes in capital mobility alter the ability of monetary policy to affect domestic output under fixed exchange rates. Chapter 13 2

3 <1> The simplifying assumptions Assume that the domestic and foreign price levels are given. Thus, There is no inflation, actual or expected, so that the nominal and real interest rates are the same. Replace r by i in the model The nominal and real exchange rates move together. Suppose further that P /P =1so that both rates are the same. Replace ε by E in the model Assume that the Marshall-Lerner condition holds so that NX rises with a depreciation (i.e., a higher E) Assume the expected future exchange rate (E e )isgiven,equaltoe e <2> A review of all markets Goods market Ariseini causes a fall in I, in demand and in output. A rise in E (depreciation) causes a rise in NX, in demand and in output. The IS (equil condition) is: Ex (13.2) Y = C µy, T + I µy, i + G + NX + + µ Y,Y +, E + Financial markets: money vs bonds Foreigners may have a demand for our bonds to earn interest income but do not need our currency for transactions in their countries, so the demand for domestic money comes only from domestic residents AriseinY shifts M d to the right while a fall in M shifts M s to the left, either causing a rise in i. TheLM (equil condition) is: Ex (13.3) M/P = Y L (i) Foreign exchange markets: domestic vs foreign bonds The choice between domestic and foreign bonds can be characterized by the interest parity (IP) condition in equil: Ex (13.5) E = E e 1+i i This displays a negative relation between the current exchange rate E and the domestic interest rate i for given (E e,i ). Thus, a rise in the domestic interest rate leads to a fall in the exchange rate (an appreciation) ³ {Omitted: Differencing Ex (11.4) (in the text) yields: 4i = 4i + Ee 4E e. 4E E E e E If the expectation remains unchanged such that E e E e and 4E e = 0, then ³ 4E E. If i = i initially such that E e = E andifthereisno 4i = 4i + Ee E change in foreign interest rates such that 4i =0,then4i = 4E E so that a rise in i leads to a fall in E, i.e., a (current rather than expected future) appreciation.} Figure 13-1 <3> Simultaneous equilibrium Substituting Ex (13.5) into Ex (13.2), along with Ex (13.3), yields a set of two equations with two unknowns (Y,i): Ã! IS : Y = C (Y,T)+I (Y,i)+G + NX Y,Y E, e 1+i i 3

4 LM : M P = Y L (i) (1) The parameters for the IS relation include (T,G,Y,i, E e ). Note that (Y,i), as the variables for the IS, are negatively related to each other since: A rise in i reduces I, demand and output A rise in i reduces E, NX, demand and output The multiplier is smaller in an open economy than in a closed economy because part of the domestic demand falls on imported goods. This suggests that the IS may be steeper in an open economy than in a closed economy {in some circumstances that NX is more sensitive to Y but less sensitive to E or i (i.e., the BP curve is steeper, to be discussed), and I is very sensitive to i}, and that open-economy output is less responsive to changes in the interest rate, making it difficult for the central bank to affect income through monetary policy or interest rate adjustments Figure 13a-1 Use this figure to show how a flatter ZZ relation leads to a steeper IS relation Did you notice that both openness and expectations cause the IS to become steeper? The LM relation is the same as in the closed economy with M/P as the parameter The IP relation depicts a negative dependence of E on i. A rise (fall) in i means a reduction (increase) in E, as reflected by movements along the IP curve Figure 13-2 After equil (Y,i ) has been obtained, we can derive from it the equil exchange rate E that could be lower or higher than E e. If E < (>) E e, investors expect a depreciation (appreciation) <4> The effects of policy under flexible exchange rates (1) Fiscal policy AriseinG causes a rise in demand and a rightward shift in the IS while the LM remains the same as before, thus increasing the equil interest rate and income. As the interest rate rises, Canadian bonds are more attractive, and investors switch from foreign bonds to Canadian bonds, causing an appreciation of C$ and hence a reduction in NX. Figure 13-3 Result: following a rise in G, ( Y,i) riseande falls in equil Implications: Under fiscal expansion, the resulting appreciation decreases exports and increases imports, and the resulting rise in income increases imports further, both making the trade balance deteriorate. If this fiscal expansion is financed by a budget deficit and the trade is initially balanced, then the budget deficit leads to a trade deficit, a situation of twin deficits. (2) Monetary policy AfallinM causes the LM to shift up, leading to a higher interest rate and lower income in equil. As the interest rate rises, investment falls and an appreciation of C$ 4

5 obtains (causing NX to fall), both leading to a fall in demand and Y. Figure 13-4 Result: following a fall in M, Y falls, i rises and E falls in equil (3) A policy mix A fiscal contraction coupled with a monetary expansion leads to a drop in the interest and exchange rates in equil while income could be kept unchanged Figure 13a-2 <5> The effects of policy under fixed exchange rates (1) Various schemes of fixed exchange rates in practice Some countries Peg their currency to US$ or to French franc or to a basket of currencies based on the trading composition. Crawling peg by some countries. They set a pre-determined rate of nominal depreciation against US$ to avoid the real appreciation pressure caused by their higher inflation than in US Bands and EMS: see the text devaluation and revaluation under fixed rates, compared with depreciation and appreciation under flexible rates (2) Monetary policy Still assume that foreign and domestic prices are equal and that there is no inflation in the world. Also, assume that there is perfect capital mobility around the world, and that financial (and foreign exchange) markets believe that the government will make commitments to maintaining a fixed exchange rate Under fixed exchange rate, E e = E = E and substituting this into the IP condition yields i = i. The equality of domestic and foreign interest rates is ensured by internationally perfect capital mobility. So, Under a fixed exchange rate and perfect capital mobility, the domestic and foreign interest rates must be the same Then, Ex (1) IS : Y = C (Y,T)+I (Y,i )+G + NX ³ Y,Y, E M LM : P = Y L (i ) (2) Think of this set as having two equations with two unknowns (Y,M). That is, M is not treated as a parameter but as a variable. Thus, M now becomes endogenous, and monetary policy is only a passive tool needed to accommodate changes in fiscal policy or foreign factors. From the IS,onecansolveY = Y ³ T,G,Y,i, E. From Y and the LM, you can solve M = M (Y,P,i )=M ³ T,G,Y,i, E,P. Monetary policy is not independent of fiscal policy but submissive to the latter. Result: Under fixed exchange rates, the central bank gives up monetary policy as a policy instrument since the money supply must adjust so as to maintain the domestic interest rate equal to the foreign interest rate 5

6 (3) Fiscal policy AriseinG shifts the IS to the right, leading to higher income and a higher interest rate that will cause an appreciation. The central bank has to prevent the appreciation from happening by increasing M and lowering the interest rate back to its initial level i. This will cause the LM to shift down. Figure 13-5 Result: following a rise in G, Y rises in equil while i and E do not change Fiscal policy is more powerful under fixed exchange rates than under flexible exchange rates since fiscal policy is accommodated by passive monetary policy in the former case Note: what is fixed under fixed exchange rates is the nominal rather than the real exchange rate. <6> Capital mobility and fixed exchange rates The central bank s liabilities include the monetary base (domestic currency and private banks reserves) while its assets are domestic bonds and foreign exchange reserves (mainly in the form of foreign bonds) (1) Perfect capital mobility Initially, i = i under fixed exchange rates. Suppose that the Bank s purchase of domestic bonds causes a rise in M in hopes of pushing the economy out of a recession. This leads i to fall below the foreign rate i, makes domestic bonds less attractive, and increases E to have a depreciation. Given the Bank s commitment to peg E, it must intervene by buying domestic currency with its foreign bonds. This process causes a fall in M, a loss in foreign exchange reserves, and a rise in i until i = i is restored. With perfect capital mobility, the above events happen very quickly. One sees that the Bank is not able to permanently affect i and Y (2) Imperfect capital mobility Suppose again that the Bank buys domestic bonds, causing a rise in M and a fall in i below i, and making domestic bonds less attractive. With imperfect capital mobility, it takes time for investors to shift from domestic to foreign bonds, or only some of investors are able to move into foreign bonds by selling domestic currency, creating a depreciation pressure. The Bank will again intervene by buying domestic currency with its foreign bonds. This time, however, the intervention will be small, only partially offsetting the initial bond purchase due to imperfect capital mobility. Although the Bank will lose some of its foreign exchange reserves, i may remain below i for sufficient amount of time for Y to rise as I is increased by a lower i than i. (3) Result As capital becomes more mobile, the Bank s ability to affect output via openmarket operations (the trading of domestic bonds) will diminish under fixed exchange rates. Any attempt to induce i<i bythebankwillbeovercomebyamore rapid response from investors. This will require a larger intervention by the Bank and a greater loss of its foreign exchange reserves. <7> Assignments: questions 1-9 on page

7 Chapter 14 (Section 14-1) Read the following on your own <1> The real interest parity condition Let r t be one-year Canadian real interest rate, the interest rate on one-year Canadian bonds in terms of Canadian goods ε t is the real exchange rate, the relative price of US goods in terms of Canadian goods Let rt be one-year US real interest rate, the interest rate on one-year US bonds in terms of US goods Let the expected real exchange rate a year from now be ε e t+1 Suppose that you have C$3.5 which can be used to buy one unit of Canadian goods. Saying that you invest C$3.5 in Canadian bonds is equivalent to saying that you invest one unit of Canadian goods on Canadian bonds. If you invest one unit of Canadian goods in Canadian bonds, you will get (1+r t ) units of Canadian goods in one year If you instead invest one unit of Canadian goods in US bonds, you have to exchange this unit for 1 ε t units of US goods and buy US bonds. You will receive 1 ε t (1 + rt ) units of US goods in one year, and have to exchange these units back for 1 ε t (1 + rt ) εe t+1 units of Canadian goods The arbitrage relation asserts that expected returns on different financial assets in some common units (i.e., Canadian goods) should be equal in equil (i.e., no further profitable arbitrage opportunity). Thus, investing in Canadian and US bonds must yieldthesameexpectedreturnintermsofcanadiangoods: 1+r t = 1 ε t (1 + r t ) ε e t+1 or r t r t εe t+1 ε t ε t The domestic real interest rate must be (approximately) equal to the foreign real interest rate plus the expected rate of real depreciation. <2> The long-run real interest parity Let r nt be n-year Canadian real interest rate, the yearly interest rate on n-year Canadian bonds in terms of Canadian goods Let rnt be n-year US real interest rate, the yearly interest rate on n-year US bonds in terms of US goods Let the expected real exchange rate n years from now be ε e t+n If you invest one Canadian good in n-year Canadian bonds and hold them for n years, we will obtain (1 + r nt ) n units of Canadian goods in n years If you instead invest one unit of Canadian goods in n-year US bonds, you have to exchange this unit for 1 ε t units of US goods and buy n-year US bonds. You will 7

8 receive 1 ε t (1 + rnt )n units of US goods in n years, and at last have to exchange these units back for 1 ε t (1 + rnt )n ε e t+n units of Canadian goods. The arbitrage relation yields (1 + r nt ) n = 1 ε t (1 + r nt )n ε e t+n or nr nt nr nt εe t+n ε t ε t = ε t ε e t+n 1+n (r nt r nt) The real exchange rate today depends positively on the long-run real exchange rate and negatively on the difference between long-run domestic and foreign real interest rates. 8