Msc Macro: Exchange Rate Economics
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1 Msc Macro: Exchange Rate Economics Philip R. Lane, TCD Spring 2014 Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
2 Introduction Medium-term behaviour of real exchange rates Invariant to exchange rate regime Relation to macroeconomic fundamentals Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
3 Balassa-Samuelson Model Small open economy Two sectors: traded and nontraded International capital mobility Intersectoral labour mobility Real exchange rate driven by productivity di erential Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
4 Model Speci cation Production technologies in traded and nontraded sectors Labour market Unique wage w Exogenous interest rate r Relative price of nontradables p Y T = A T F (K T, L T ) Y N = A N G (K N, L N ) L = L T + L N Nontraded good: consumption; Traded good: consumption and investment Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
5 Pro t Maximisation by Firms Traded-sector rms maximise 1 s t [A TsF (K Ts, L Ts ) w s L Ts K Ts+1] 1 + r Nontraded-sector rms maximise 1 s t [p s A NsG (K Ns, L Ns ) w s L Ns K Ns+1] 1 + r Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
6 Pro t Maximisation by Firms Denote capital-labour ratio K /L = k and output-labour ratio Y /L = y Per-worker production functions y T = A T F (k T ), y N = A N G (k N ) First-Order Conditions 1 MP KT = r ) A T f 0 (k T ) = r 2 MP LT = w ) A T [f (k T ) f 0 (k T )k T ] = w 3 VMP KN = r ) pa N g 0 (k N ) = r 4 VMP LN = w ) pa N [g(k N ) g 0 (k N )k N ] = w Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
7 Recursive Solution k T = k T (A T, r) w = w(k T ) = w(a T, r) Equations (3)-(4) jointly determine p, k N Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
8 B-S Graph I I graph 1.pdf Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
9 B-S Graph: II Increase in A T graph 2.pdf Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
10 B-S Graph: III Increase in A N graph 3.pdf Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
11 General Solution µ = labour share ˆp = µ L N µ LT  T  N General Productivity Increase  T =  N =  ˆp = [ µ L N µ LT 1] Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
12 Limits to Balassa-Samuelson Incomplete explanation, especially within advanced-country group Demand-side factors if diminishing returns to scale in nontraded sector (e.g. role of a xed factor) Role of aggregate labour supply if diminishing returns to scale in nontraded sector Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
13 More Limits to Balassa-Samuelson product variety and product quality Price discrimination in traded goods prices High-productivity enclaves within traded sector Limited inter-sectoral labour mobility Shifts in sectoral expenditure shares Prices in regulated sector Taxes Housing sector Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
14 Consumption Dynamics, the Price Level and the Real Interest Rate Can smooth tradables consumption through imports/exports Nontradables consumption limited by output of nontradables U t = β s t u(c s ) s=t C = Ω(C T, C N ) = θ > 0, γ 2 (0, 1) γ 1 θ C θ θ 1 T + (1 γ) 1 θ 1 θ C θ N De ne relative price of nontradables as p De ne price level P as minimum expenditure such that C = Ω(C T, C N ) = 1, given p P = hγ + (1 γ)p 1 θi 1 1 θ θ θ 1 Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
15 Intra-Temporal Optimisation Maximise u(c ) subject to Z = C T + pc N C N C T = C T = C N = (1 γ) p θ γ γ (γ + (1 γ)p 1 θ ) p θ (1 γ) (γ + (1 γ)p 1 θ ) 1 Z = γ P Z = (1 γ) θ C p P θ C (Z = PC) Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
16 Inter-Temporal Optimisation Maximise U t subject to 1 s t (P s C s ) = (1 + r)b t r s=t Can write U t = Optimality requires β s s=t (1 + t r)bs u u 0 (C s ) P s = β(1 + r) u0 (C s+1 ) P s+1 P s s=t 1 s t (Y s ) 1 + r B s+1 + Y s u 0 (C s ) = β (1 + r)p s P s+1 u 0 (C s+1 ) = β(1 + r c s+1)u 0 (C s+1 ) (1 + r c s+1) = (1 + r)p s P s+1 r c : consumption-based real interest rate Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
17 Resource Constraints GDP Y s = Y T,s + py N,s Y N,s = C N,s 1 s t (C T,s ) = (1 + r)b t + s=t 1 + r s=t 1 s t (Y T,s ) 1 + r u 0 (C s ) = β(1 + r) u0 (C s+1 ) P s P s+1 (1 + σ r)ps C s+1 = β σ C s C T,s+1 = Ps P s+1 P s+1 σ θ (1 + r) σ β σ C T,s Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
18 Resource Constraints C T,s+1 = σ = θ σ > θ σ < θ Ps P s+1 σ θ (1 + r) σ β σ C T,s CA t = B t+1 B t = rb t + Y T,t + p t Y N,t C T,t p t C N,t = rb t + Y T,t C T,t Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
19 Distribution Sector Pure tradables very limited part of consumption Retail prices of tradables have large non-traded component P C T = P P T + ψp N where PT C is consumer price of tradable good, PP T tradable good and ψp N is distribution cost is producer price of Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
20 Productivity and the Terms of Trade Terms of trade decline may o set BS e ect Depends on nature of trade expansion: intensive margin versus extensive margin Distribution sector: terms of trade may improve in short run Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
21 Government Spending and the Long-Run Real Exchange Rate IMF: higher government consumption associated with substantial real appreciation Impact of government investment more ambiguous The Composition of Government Spending and the Real Exchange Rate (Galstyan and Lane, JMCB, 2009) Philip R. Lane, TCD () Msc Macro: Exchange Rate Economics Spring / 21
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