Week 10: Exchange Rates and the Balance of Payments

Transcription

1 Week 10: Exchange Rates and the Balance of Payments Until last week, we took up specific aspects of economic globalization, such as trade, feign direct investment and migration, and discussed these phenomena independently. In the remainder of this course, we will broaden our perspective and consider how the economy of a country as a whole interacts with those of other countries. A branch of economics that studies the behavi of the entire economy of a country is called macroeconomics. A sub-discipline of macroeconomics, which focuses on interaction among national economies, is called openeconomy macroeconomics. 1 A key variable in open-economy macroeconomics is the exchange rate, which we define as the price of a unit of feign currency measured in domestic currencies. The relationship between national economies and exchange rates is a little complicated. This is because what happens in individual countries influences exchange rates while fluctuations in exchange rates may also impact the way national economies behave. This week, we first review the concept of gross domestic product and derive an equation that describes the relationship between the internal and external balances of a national economy. This relationship will then be used to analyze how the trade balance of a country evolves over time and how the government s economic policy affects the trade balance and exchange rates. Open-Economy Macroeconomic Accounts As you (must have) learned in high school, gross domestic product (DP) refers to the sum of value added created in a country during a certain period of time. Let us consider what this means in terms of Figure 1. Figure 1. ross domestic product and international trade Steel 200 Automobiles 300 Iron e Impts Automobiles Expts 50 Investment 150 Home country Consumption (Note) All values refer to the cumulative sum during a specific period of time, such as one year. The areas marked with blue col represent the home country s value added. 1 An open-economy is an antonym of a closed economy, which is a country in autarky. 1

2 In this figure, the home country impts iron e and processes it into steel and then into automobiles, the only final good produced in this country. Some of the automobiles manufactured in this country is sold to feign countries but the rest are sold at home. Those which are purchased within the country can be classified into consumption and investment. In general, consumption refers to spending by households on goods and services that are purchased f their own sake. In contrast, investment is expenditure by firms and the government on goods and services that will become part of their capital stocks and will be utilized in the future. 2 In Figure 1, the steel company pays f iron e and sells steel f 200. The auto firm purchases steel f 200 f steel and sells automobiles f 300. Since the steel and auto companies generate value added of each, this country s DP is = 200. This country s DP can also be calculated by deducting the value of impts from the total value of final products ( 300- = 200). The total output of final products equals the sum of consumption, investment and expts. In equation fms, these relationships can be described as Impts ( M) DP ( Y) = Output ( O) (1) Output ( O) = Consumption ( C) Investment ( I) Expts ( X). (2) Substituting the first equation into the second equation, we find Impts ( M) DP ( Y) = Consumption ( C) Investment ( I) Expts ( X) (3) writing in terms of symbols only, M Y = C I X. (4) Let us move impts (M) to the right-hand side of equation. Then we have Y = C I X M (5) Y = C I TB (6) in which TB = X-Y represents the trade balance net expts of the country. Nmally, people spend part of their income on daily consumption and save the remainder f future expenditure. At the national level, income is represented by DP, 3 and the difference between DP and consumption (Y C) constitutes national savings (S). Therefe, equation (6) can be written alternatively as S = I TB (7) S I = X M. (8) The left-hand side of equation (8) represents the internal balance of the country in the sense that when S = I, the country has enough (but not excessive) savings to meet domestic investment needs. On the other hand, the right- hand side of the equation net expts can be described as the external balance of the country. As will be discussed below, this last equation has a number of imptant implications f a country s trade balance. 2 Among household expenditures, purchase of housing is considered investment. 3 To be me precise, when a country has an additional income from ( payments to) feign countries, national income may exceed fall sht of DP (remittances discussed in Week 8 are an example of such international income transfers). The difference between DP and national income cresponds to the difference between the trade balance and the current account balance. Although this note does not distinguish the trade and current account balances to keep our analysis simple, this distinction can be imptant in practice. 2

3 The Saving-Investment Balance and the Balance of Trade Large surpluses and deficits in a country s trade balance often become a source of bitter international disputes. F example, the USA has been incurring persistent trade deficits with China, Japan, ermany and other countries, which President Donald Trump criticizes of engaging in unfair trade practices. Accding to equation (8), however, a country s trade balance is equal to S I, its internal balance. S represents the sum of all savings by residents in that country, including not only households but also firms and the government. I represents all capital investment conducted within the country, including expenditures on equipment and structures by companies, infrastructure investment by the government, and expenditures on housing by the households. When individuals and firms decide how much to spend and save out of their income, they are unlikely to think about the national balance of trade. Then how do the left- and right-hand sides of equation (8) become equalized? The sht answer is that exchange rates adjust in a way that equates both sides of the equation. As we learned in Week 3, whether a country expts impts a certain good depends on the exchange rate. When we write the yen-dollar exchange rate (the price of one dollar in yen) as e, an increase in e will make American goods expensive in comparison to Japanese goods. Therefe, when equation (8) describes Japan s internal and external balances, a rise in e should be associated with an increase in X and a decrease in M. One way of making these relations explicit in equation (8) is to rewrite this equation as follows: ( ) ( ). S I = X e M e (9) In equation (9), the sign indicates that there is a positive relationship between X and e, while the sign indicates that the relationship between M and e is negative. Since a country s trade balance is its expts minus impts, equation (9) can also be written as ( ) S I = TB e. (10) As an example, let us suppose that Japan has experienced a sudden investment boom. In equations (9) and (10), this is represented by an increase in I. If the amount of saving S remains the same, S I declines, and so must TB(e). Since TB and e are related to each other positively, a fall in TB requires a fall in e, which is an appreciation of the yen. Indeed, a country s investment boom (and me generally, an economic boom) is often accompanied by an appreciation of that country s currency vis-à-vis feign currencies. Economic Development and the Trade Balance In the course of a country s economic development, the relative size of national saving and investment often undergoes notable changes. Figure 2 illustrates typical trajecties of S and I (measured as proption of DP) in the process of economic development and how this adjustment is reflected in the trade balance. Po countries can ill affd to make saving but need to invest in social infrastructure and production facilities in der to strengthen their ability to produce goods and services. Accdingly, these countries often brow money from abroad and conduct me investment than can be financed with domestic savings alone, which implies a negative balance of trade. Nevertheless, once industrialization gathers pace and people become moderately well-off, national saving starts to increase. Sooner later saving exceeds domestic investment needs, at which point the country s trade balance turns positive. By the time the country joins the rank of highincome countries, population aging sets in. Since elderly people tend to dissave rather than save, 4 the amount 4 Dissaving means negative saving. Retired people have no income (other than pensions) and suppt their life by drawing down what they have saved in the past; this is negative saving. 3

4 Trade balance as % of DP(%) of national saving decreases in an aging country. When national saving falls below national investment needs, the country s trade balance turns negative again. S I Figure 2. Economic growth and the Savings and Investment balance I S DP per capita S- I X- M 0 Trade surplus Trade deficit S- I= X- M Low-income countries Middle-income countries High-income countries The process described above is consistent with changes in the sectal composition of a country s production discussed in Week 7. A country s economic development and an increase in its income level are often accompanied by a rise and a fall of manufacturing industries: the secondary sect (manufacturing and construction) expands when a po country grows into a middle-income economy but starts shrinking as it becomes a mature, high-income economy. Since substantial ptions of international trade concern manufactured goods, countries with a large manufacturing sect tend to run a large trade surplus. 30 Figure 3. Income level and the balance of trade as % of DP ( average) India China ermany ,000 10,000 Japan 100, USA -20 Kea PPP DP per capita (2000 constant U$) (Notes) The relative size of the bubbles represents the relative size of population. PPP (purchasing power parity) DP refer to real DP adjusted f international prices and measured in terms of US dollars as of (Source) Wld Bank, Wld development Indicats. 4

5 Figure 3 plots data on DP per capita and the trade balance as percentage of DP f a large number of countries. Data in this graph seems to be consistent with the relationship between the national income level and the trade balance illustrated in Figure 2. Advanced countries, including Japan, are on the right-hand side of this hump-shaped relationship. F these countries, gradual deteriations in net expts are a natural outcome of economic development and should not be considered a matter f concern. Separating Private and Public Savings and Investment What we discussed above concerns adjustment of the trade balance over several decades me. Over shter periods of a few several years, the variables in equation (8) are heavily influenced by the government s fiscal policy. When analyzing the trade balance over relatively sht periods of time, it is useful to rewrite these equations in a way that highlights the government s fiscal position. Since the government conducts little no international trade, this means rewriting the variables on the left-hand side of the equation. Let us write the amount of saving by the private sect (households and firms) with symbol S P and express the saving by the government as S. Similarly, we write the amounts of investment by the private sect and the government as I P and I, respectively. Then we can rewrite equations (9) and (10) as ( S S ) ( I I ) X ( e) M ( e) = (11) P P ( S I ) ( S I ) TB ( e). = (12) P P The government s income is its tax receipts (T). Its total expenditure () is the sum of public consumption (C ) and public investment (I ). 5 Therefe, S equals T C while I equals C. Using these relationships, we can rewrite S I as ( ) ( ). S I = T C I = T C I = T (13) Substituting this expression into equation (12), we find the following relationship: ( S I ) ( T ) TB ( e). P = (14) P In wds, equation (14) tells us the following: a country s trade balance is equal to the sum of the savingsinvestment balance of the private sect and the fiscal balance of the government. T 0 implies that the government runs a fiscal surplus, whereas T 0 means that its incurs a fiscal deficit. In equation (14), T and are the government s control variables in the sense that the government can at least in principle decide their values at its discretion. Since equation (14) is an identity that always holds, it follows that the government s fiscal policy can influence the exchange rate even if it does not explicitly target the exchange rate. 6 In the accompanying pre-class assignment, you will be asked to exple implications of this statement. Further Readings: Reinert, Chap.13; Sawyer & Sprinkle, Chap.13 & Public investment is expenditure by the government on public infrastructure such as roads, sewage and school buildings. Public consumption is all non-investment government expenditures, such as salaries paid to public officials. 6 Countries that adopt the fixed exchange rate regime adjust T and so as to keep the value of e stable. The choice between fixed and floating exchange rates will be discussed in Week 12. 5