Open economy macroeconomics and exchange rates Part I

Transcription

1 Understanding the World Economy Master in Economics and Business Open economy macroeconomics and exchange rates Part I Lecture 10 Nicolas Coeurdacier nicolas.coeurdacier@sciencespo.fr

2 Lecture 10 : Open economy macroeconomics and exchange rates Part I 1. Balance of payments (BOP) 2.Exchangerateinthelongrun:PPP 3. BOP Theory of Exchange Rates

3 Open economy national income identities National Accounting Y= C + I + G + EX -IM Y: GDP C: Consumption I: Investment G: public spending EX: Exports of goods and services IM: Imports Current account (sometimes net exports): CA= EX-IM

4 The Fundamental Balance of Payments Identity National Revenue = National Output National output (Y) is: Y I + C + G + [EX IM] with EX IMP = CA = Current Account Balance The use of national revenues : Y C + S P + T Then: (I S P ) + (G T) + (EX IMP) 0 Introducing Public Savings (Fiscal Surplus): S G =T-G CA S P + S G - I S-I

5 The Fundamental Balance of Payments Identity CA S P + S G - I S-I Accounting identity (no behaviour, no explanation, no theory here) A country whose savings exceed national investment tends to run a current account surplus : the country is lending to the rest oftheworld A current account deficit can reflect: - Small saving rate (high consumption) (US from 2000) - High investment(us ) - Budget deficit(us since 2001)

6 A bit more of accounting Balance of Payments (BOP) - Registers all transactions with foreign economic agents - 3 main sorts of transactions: - exports and imports of goods and services current account (CA) -sale and purchase of financial assets financial account (FA) - certain transfers of wealth (small) capital account (KA)

7 The Balance of Payments The Balance of Payments (BOP) = Current Account + Financial Account + Capital Account The Balance of Payments has to balance: BOP = 0 (abstracting from errors and omissions)

8 Why does the balance of payments have to balance? Essentially an accounting trick - every credit needs to be matched by a debit: double entry book keeping principle! The current account shows overall situation in transactions of goods and services. The capital and financial account shows how this is financed. Consider the case of the U.K running a current account deficit, in otherwordstheu.kcannotpayitsimportbillfromexportsalone. One solution is for the U.K to sell any overseas assets and use the money to pay the import bill. Another option would be to sell some U.K companies which would count as Inward Direct Investment. This would create a financial account surplus equal to the current account deficit.

9 The Current Account Trade Balance= Exports of Goods and Services -Imports of Goods and Services = (X-M) Current Account=Balance on Goods and Services + Net Foreign Workers Remittances + Net International Aid+ Net Royalties + Net Investment Income = (X-M+NFI)

10 The Financial & Capital Accounts Financial account (FA): records flow of financial assets. These are Foreign Direct Investment, Net Portfolio Flows and Net Other(mainly bank loans and trade credits) Capital account (KA): records flow of non-financial assets between countries debt forgiveness, purchase of royalty rights However because of measurement error also a category called errors and omissions

11 French Balance of Payments (EUR, millions, 2013) Current Account Balance of Trade Balance of Services Capital Account Financial Account Net FDI Net Portfolio Primary & secondary income bal Net Other (incl. derivatives) Errors and Omissions

12 China Balance of Payments ($bn H1 2009) Balance of Trade 118 Net FDI, Private and Official Assets Balance of Services -19 Reserves -186 NFI 31 Statistical Discrepancies Current Account 130 Financial Account -129 Capital Account -1 Total Balance (CA+FA+KA) 0

13 Lecture 10 : Open economy macroeconomics and exchange rates Part I 1. Balance of payments(bop) 2. Exchange rate in the long run: PPP 3. BOP Theory of Exchange Rates

14 The nominal exchange rate Two types of quotation: E is the exchange rate of the euro/dollar: price of the foreign currency (dollar) in units of the domestic currency (euro) 1 $ = E E increases means euro depreciates (it takes more euros to buy one dollar) E is the price of the domestic currency (euro) in units of the foreign currency (dollar) 1 = E $ In the following, we use the first(more standard, although not most intuitive) convention: E increases means the euro depreciates

15 Price conversion P i $ : price of good iin dollar E is the exchange rate (nbof euros to make one $) P i price of good iconverted in euro P i = E. P i $ Remark: A depreciation of the euro (E ) increases the price in euro of an American good (if the producer price P i $ does not react). Decreases the price in $ of a European good (if the producer price in euro does not change).

16 Floating and fixed exchange rate regimes Floating: The exchange rate is determined on exchange rate markets without interventions of central banks(euro/dollar) Fixed : Central banks intervene on markets to maintain the exchange rate at an announced level or around such a level (Gold standard at the end of 19th century, FF/DM, Bretton Woods system until 1971, certain developing and emerging countries) Many intermediate situations Mostly focus on floating for now.

17 The Yen and Euro Nominal Exchange Rate Nominal Exchange Rate = number of yen or euros that could be purchased with one dollar

18 31/01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ The Argentine Peso Nominal Exchange Rate Devaluation of the Peso Fixed Exchange rate Regime: 1 peso =1 $ An example of fixed exchange-rate: the Currency Board in Argentina in the nineties

19 The law of one price (LOP) Long term perspective on exchange rates = when prices are flexible On competitive markets, in absence of transport costs and tariffs twoidenticalgoodsmustbesoldatthesameprice (expressed in the same currency) Consideragoodindexedbyi. LawofonePrice=longtermarbitragemechanism P i = E. P i $ IfP i >E.P i$ :buytheusproducedgood,sellitineurope; increase demand in US, increase supply in Europe: price converge

20 Purchasing power parity (PPP) Idea developed initially by Ricardo ( ) The price levels of different countries are equalized when measured in the same currency: P = E x P $ where P and P $ are price indices of US and euro zone. E = P / P $ : Absolute version of PPP An increase in the general level of prices reduces purchasing power of domestic currency and leads to a depreciation. PPP (nominal) exchange rate: E PPP = P / P $

21 The PPP exchange rate: E PPP ( /$) = P / P $ P / P $ $ undervalued, overvalued $overvalued, undervalued 45 Nominal Exchange rate ( /$)

22 Relative PPP The variation of the exchange rate is equal to the difference in the variation in prices, the difference in inflation rates (approximation) E t = P t / P $t (E t E t-1 )/E t-1 π t -π $t π t and π $t : inflation in zone and US π t = (P t P t-1 )/ P t-1

23 Empirical validity of the LOP LOP fails in short run : not puzzling for non traded goods (haircuts); but also for traded goods. Transport costs, trade barriers (tariffs and regulations): make arbitrage more difficult. Imperfect competition: firms segment markets (to have high prices where price elasticity of demand is low) : pricing to market. Branding. Many goods considered to be highly traded contain nontraded components. Retail and wholesale costs (distribution costs) account for around 50% of final consumer price.

24 Empirical validity of PPP Studies overwhelmingly reject PPP as a short-run relationship, better as long term. The variance of floating nominal exchange rates is an order of magnitude greater than the variance of relative price indices. The failure of short-run PPP can be attributed partly to the stickiness in nominal prices(short run). Worksmuchbetterinthelongterm.

25 What is the exchange rate of country i consistent with LOP for the Big Mac? Required appreciation or depreciation to satisfy LOP? E Big Mac = P US /P i The Economist - Oct. 2010

26 Long term real exchange rate Real exchange rate (RER) defined as the relative price index of goods and services between two countries: q = E x P $ / P A real depreciation of vis-à-vis the $ (q )can come from nominal depreciation (E ), an increase in P $ or a fall in P Relative PPP RER is constant! PPP: (E t E t-1 )/E t-1 = π t -π $t (q t q t-1 )/q t-1 = (E t E t-1 )/E t-1 + π $t -π t = 0

27 Long Run PPP: $/ real exchange rate (in logs) 0.5 The mean reversion of real exchange rates overvalued relative to PPP undervalued relative to PPP Note: Higher values means a (real) dollar depreciation (or a appreciation)

28 The Yen/$ exchange rate and the relative priceratio over the long term

29 Empiricaltest of relative PPP in the long-run Looking across countries over a long time period [1960;2001], run the following regression where(i) is a country: log S S i/ us 2001 i/ us 1960 log P P i 2001 i 1960 log P P us 2001 us 1960 t 1 RelativePPPassumption:βisexpecttobe=1(andα=zero). Can inflation differentials over 41 years explain exchange rate variations over the same period? βisfairlyclosetooneforthissampleofcountries. Convergence towards PPP: slow reversion towards PPP(from 3 to 5yearstoeliminatehalfofthegap).

30

31 Relative PPP prevails in the very long-run but fails in the short-run %Depreciation 60 1 Year Window %Depreciation Inflation differential %Depreciation Inflation Differential Inflation Differential 20 Year Window Remember relative PPP: (E t E t-1 )/E t-1 = π t -π $t 5 Year Window

32 Why are prices higher in rich countries? Same question as: why E x P rich > P poor? Obvious deviation from PPP. Relatedquestion:whydoes the realexchange rate of countries that grow relative to rest of world appreciate?(q=exp world /P ) Examples: Japan, South Korea, Ireland, today China? One theory relies on the presence of non-traded goods together with productivity differences between rich and poor in the traded(manufacturing) sector = Balassa Samuelson effect

33

34 Balassa-Samuelson effect Key distinction: Tradable goods (manufactured goods) and non tradable(services) Around 75% of the consumption basket in industrialized countries is non tradable (health, education, most services ) even if definition of a tradable good/service becomes blurred (internet) Productivity differences between rich and poor countries is much larger for tradables than for non tradables: it is very large for example in manufacturing (of an order of 10 or more), but much smaller in services (think of haircuts: technology is not hugely different across countries).

35 Understanding the Balassa-Samuelson effect Workers can be hairdressers (non-traded) or work in the textile industry (traded). Workers can produce haircuts or T-shirts. T-shirts sold 1$ in international markets. US worker produces 50 T-shirts/hour, Indian worker only 10. Both US and Indian hairdressers make 5 haircuts/ hour. Question: what is the price of an haircut in India and in the US? Implications?

36 Income convergence and exchange rate appreciation(here appreciation is up!) Source: Reisen, 2009

37 Lecture 10 : Open economy macroeconomics and exchange rates Part I 1. Balance of payments(bop) 2.Exchangerateinthelongrun:PPP 3. BOP Theory of Exchange Rates

38 BOP theory of exchange rates Develop a simple framework to examine how the current account and exchange rate of a country is affected by various macroeconomic events to explain some of the medium term deviations from PPP documented in the section.

39 The role of exchange rate But while the National Accounts show that: How does this happen? CA = S-I Variations in the real exchange rate ensure that current account equals net savings.

40 The Current Account Focus on flexible exchange rates Two country model: Europe-US. CA = CA(q, Y d, Y $d ) q = E P $ /P : real exchange rate; relative priceof US goods with respect to European goods q : real depreciationof euro

41 The Current Account CA = EX -IM in euros = Net exports in euros Suppose E (or equivalently q ): How do exports (foreign demand for European goods) and imports (European demand for foreign goods) react? Depends on two main factors: 1) In which currency exporters fix their prices? How much pass-through of exchange rates to consumer prices? 2) How large is the elasticity of substitution between domestic and foreign goods?

42 The Current Account If q volume of imports, exports : substitution But if slow response of volumes(empirically 6 months-1 year): valueofimports volume versus value effect. In short term, the value effect can dominate NeteffectontheCAofq? J-curve--- in the short-term, a real exchange rate depreciation worsens the current account but in the medium-term (under some conditions), the substitution effect dominates and the current account improves.

43 The J-Curve volume effect dominates value effect Immediate effect of real depreciation on the CA J-curve: value effect dominates volume effect

44 The Current Account We assume from now on: nominal or real depreciabon (E or q ) generates an in demand via an in net exports : CA (q)= (EX -IM ) +

45 The Current Account q High real exchange rate means European goods cheaper so Europe export more and import less -net exports increases with q 0 CA=Net Exports

46 BOP Theory of Exchange Rates q S-I CA=Net Exports Real Exchange Rate determined by equality of net savings with net exports

47 BOP Theory of Exchange Rates A depreciation of real exchange rate means domestic goods are more competitive on international markets. Real exchange rate adjusts to ensure net exports equals net savings. If net savings > net exports, then real exchange rate depreciates which decreases imports and boosts exports. Eventually net exports equal net savings.

48 Increase in fiscal deficits (fall in public savings) q S-I CA=Net Exports Appreciation of the currency and deterioration of the current account

49 Reagan and Bush I Deficits 6 5 % of GDP Current Account deficit Fiscal deficit 5 % of GDP Source : Bureau of Economic Analysis

50 Drop in investment q S-I CA=Net Exports Depreciation of the currency and improvement of the current account

51 Argentina Financial Crisis Current Account (% of GDP) Investment rate % of GDP Real GDP Growth

52 Increase in demand for European goods q S-I CA=Net Exports

53 Summary In the long-term, changes in nominal exchange rates reflect differences in inflation as predicted by relative purchasing power parity. Failures of PPP are due to price rigidities, barriers to international trade, pricingto-market. Due to the Balassa Samuelson effect, poor countries have lower prices and face appreciating real exchange rates when catching-up in terms of productivity. In the medium to long-term, the real exchange rate will adjust to a level where the current account surplus/deficit matches longer term capital flows.