A Monetary Model of Exchange Rate and Balance of Payments Adjustment

Transcription

1 Economic Iue, Vol. 10, Part 1, March 2005 A Monetary Model of Exchange Rate and Balance of Payment Adjutment Anthony J Makin 1 ABSTRACT Thi article propoe an alternative monetary model for examining the effect of dometic monetary hock on the exchange rate and the balance of payment. Uing an output-expenditure framework, it how that dometic monetary hock can drive a wedge between national expenditure and production and generate incipient current account imbalance with exchange rate and balance of payment implication. Contrary to previou monetary approache, the model ugget a new chain of cauality that run from dometic money to the exchange rate to the price level, rather than from money to the price level to the exchange rate. It alo how that under fixed rate external adjutment i conitent with money market equilibrium and price level tability. 1. INTRODUCTION THE TRADITIONAL MONETARY APPROACH to the balance of payment (MABP) and the monetary approach to the exchange rate (MAER) developed by numerou author decade ago (Polak 1957, Frenkel 1976, Johnon 1977, Branon and Henderon 1985, Frenkel and Mua 1985) propoed that the dometic money market hould be at the centre of balance of payment and exchange rate analyi, an idea originally epoued by the claical economit David Hume (1752). The MABP aumed national output wa autonomou and uggeted that balance of payment adjutment under a fixed exchange rate reflected temporary diequilibria between dometic money demand and upply. The MAER alo preumed an invariant level of national income, focuing on money role in determining nominal exchange rate rather than change in the central bank reerve. However, by taking national income a given, the MAER neglected the ignificance of the current account a an output-expen

2 A J Makin diture imbalance and the poibility of monetary hock contributing to temporary variation in national income. The till popular Mundell-Fleming (MF) model explicitly addree exchange rate and national income variation in the open economy, but a an aggregate demand-ide model, it ignore national price level dynamic and ha aggregate upply adjuting endogenouly to total pending. (See Mundell 1963, Fleming 1962 and Frenkel and Razin 1992). Though other author have tried to remedy thi by poiting an upward loping aggregate upply function (Argy and Salop 1979, Bruce and Purvi 1985), all variant of the MF model rely on an ad hoc pecification of the external account that i unrelated to total pending and production. Thi model alo neglect that current account imbalance ignify international borrowing and lending and the intertemporal ue of foreign aving in the economy (Makin 2002, Frenkel and Razin 1992 and Sach 1982). More recently, the new open economy macroeconomic (Obtfeld and Rogoff 1995, 1996) ha provided an alternative intertemporal paradigm, characterized by explicit microfoundation, nominal rigiditie and imperfect competition. Unfortunately model developed within thi paradigm (alo ee Chari, Kehoe and McGrattan 2000 and Coretti and Peenti 2001) are highly enitive to the pecification of the microfoundation themelve, uch a the nature of utility function and the ource of price tickine (Sarno and Taylor 2003). Methodologically, thi paper i at odd with recent theorizing in the field founded on microeconomic principle and optimiing repreentative agent. Nonethele, it i conitent with Krugman (1995) call for workable guide to anwer unreolved quetion in the field and Romer' (2000) defene of traditional approache in macroeconomic on the ground that they are no le realitic than more complicated optimiing approache developed from microeconomic foundation. Thi paper preent an alternative monetary model of the exchange rate and balance of payment conitent with the precept of international finance. The framework to be outlined in what follow yield everal new reult. For intance, inter alia, it how that contrary to the MABP, international adjutment under fixed rate i conitent with money market equilibrium, not diequilibrium. Under floating rate, it permit temporary variation in output, expenditure and employment, contrary to the MAER. It alo ugget a new chain of cauality that run from dometic money market to exchange rate to price level, rather than from money market to price level to exchange rate. At the ame time, unlike the MF model, it put the output-expenditure relationhip at the forefront and explicitly trace out the impact of monetary hock on national expenditure, output, the exchange rate and price level. Moreover, unlike the new open economy macroeconomic, the current account imbalance i treated throughout a an output-expenditure rather than aving-invetment phenomenon. The next ection of the paper develop the baic linkage and framework to be ued to model dometic monetary

3 Economic Iue, Vol. 10, Part 1, March 2005 hock in ection 3. The final ection conclude by highlighting the contribution of the model. 2. MONETARY FOUNDATIONS When modelling aggregate demand, extant open economy macroeconomic approache, including the MF model, typically define aggregate demand a the um of dometic pending on an economy' good and ervice, net of import, plu foreign demand for it good and ervice, meaured a export. That i, ( C + I M ) + X = Y (1) where C i conumption including government pending, I i dometic invetment, M i import, X export and Y output. The left ide how dometic demand for home production, the bracketed term, plu foreign demand for dometic product. Defined thi way, aggregate demand alway equal aggregate upply. Alternatively, following Alexander (1952) and Makin (2004), thi paper define aggregate demand a total pending by reident entitie on good and ervice, incluive of import, that i C + I = E = AD (2) and E i total expenditure or aggregate demand, AD, meaured in real flow term. At the ame time, it interpret aggregate upply a the total quantity of good and ervice provided for ale at home and abroad, recogniing that part of aggregate upply i produced to atify export demand. Since Y - E = X - M, it follow that, AD = AS only when export equal import. Or in other word, only when the current account i balanced and there i no net international flow of fund, o the economy i neither incrementally borrowing nor lending abroad. Ex pot, under a fixed exchange rate with limited capital mobility, the current account balance, CA, mut alo equal the central bank change in reerve, dr. Yet, under a floating rate with capital mobility, a AD > AS foreign invetor either acquire home currency denominated bond, to the extent of the private capital inflow FI, or a AD<AS, reident acquire foreign bond and there i capital outflow. In ummary, AD AS = CA = dr or FI (3) For (3) to hold, increaed net demand for foreign currency ariing from a pending-output difference mut be matched by a net upply of foreign currency made available from the central bank reerve, or through private capital inflow. Otherwie, the exchange rate adjut. All good and ervice are potentially tradable and in final equilibrium the dometic price level i imply the product of the exogenou world price (P*)

4 A J Makin and nominal effective exchange rate (), defined a the trade weighted price of foreign exchange, P=P*. By etting the foreign price level at unity throughout, the dometic price level become P = (4) The dometic money tock M S i determined by the home economy central bank. Money market equilibrium prevail when reident real demand for cah balance, (L), which i negatively related to the dometic interet rate (r) and poitively related to output (Y), the level of real wealth (K ), equal the real upply of money. That i, M L L = L( r, Y, K); < 0 > 0 (5) r K Figure 1: Dometic money market equilibrium M 0 0 M 0 1 * r = r 0 r 1 L L L, M Equation (4) and (5) ugget that the tronger the exchange rate, the lower i the price level, the larger i the real money tock and, for given money demand and nominal money upply, the lower i the real interet rate. Conumption and invetment pending by reident i negatively related to the exchange rate, the price level and the real interet rate. Hence AD = AD( r(, P); M, L) (6)

5 Economic Iue, Vol. 10, Part 1, March 2005 AD AD AD < 0, < 0, < 0 r P AD M AD > 0, < 0 L Equation (6) provide the bai for an AD chedule in exchange rate - expenditure and income pace, a hown in Figure 2. Figure 2: An international monetary framework, P L AS AS S AS S = = P P AD AD Y Y,E Y, E It i downward loping becaue, other thing being equal, a tronger exchange rate (lower price level) raie the real money upply, which lower the real dometic interet rate, thereby inducing higher dometic expenditure. The negative lope of thi chedule can alo be jutified on the bai that a lower price level increae the economy real wealth level, which induce higher expenditure for given real income. Money upply or money demand hock hift the AD chedule becaue it i drawn for a given nominal money upply and real money demand. Figure 2 alo depict hort and long run aggregate upply function. Long run AS L depend on the ize of the labour force, W, the economy capital tock, K, which determine real wealth, and multifactor productivity, ϕ. Hence, AS L f f f (7) = f ( W, K, ϕ) = Y > 0 > 0 > 0 W K ϕ

6 A J Makin It i aumed that W, K and ϕ are contant over the time frame of the following analyi. All dometic price including wage are preumed fully flexible over the time frame in quetion, enabling the good and ervice market to clear and for the unemployment rate to tabilize at it natural rate. Hence, the longer term aggregate upply chedule rie vertically at Y. Nominal exchange rate depreciation make home produced good and ervice cheaper from foreigner perpective ince dometic output i priced in the home currency. Thi create additional demand for the home country output, a determined in elaticitie approach parlance by the elaticity of the ret of the world demand for it export, M*. At the ame time, production of additional output by home firm, or the elaticity of the upply of the home economy' export, i contrained by dometic cot, including wage. For given wage, the riing AS S chedule will therefore reflect diminihing marginal capital productivity and riing marginal cot under competitive condition. Hence, dm * = Y Y = dx (8) Production in the hort run therefore behave a depicted by the AS S chedule in Figure 2 where real appreciation (depreciation) temporarily lower (raie) output above it normal level. Eventually nominal wage will adjut a w worker bargain to retore real wage, 0 w = 2. Alternatively, nominal wage 0 2 adjutment i conitent with the equation w =σ ( Y Y ) (9) where σ i an adjutment parameter. A become apparent, the degree of wage tickine i irrelevant to the international adjutment proce under fixed exchange rate. The economy i in initial general equilibrium in thi framework where the AD and AS chedule interect. At thi point, money demand equal money upply, national expenditure equal production, export equal import, the dometic interet rate equal the foreign interet rate and there i no net external financing requirement. 3. MONETARY SHOCKS: FLOATING VERSUS FIXED EXCHANGE RATES We now conider dometic and international adjutment in repone to monetary hock under fixed and floating exchange rate. The reult for monetary contraction and expanion are ymmetrical in thi model. However, for variety, a monetary contraction i illutrated under floating rate and a monetary expanion under fixed rate

7 Economic Iue, Vol. 10, Part 1, March 2005 Monetary contraction under a floating rate Conider firt a monetary contraction under a floating exchange rate brought about by dometic bond ale by the central bank. Under thee circumtance, the home economy interet rate rie and reduce dometic pending. The AD chedule therefore hift to the left, appreciating the nominal exchange rate ince the incipient current account urplu create an exce upply of foreign exchange. On the aggregate upply ide of the economy, the appreciation decreae foreign demand cauing dometic production to fall a export fall and production move down along the hort run aggregate upply chedule. Meanwhile, the currency appreciation lower the price level through it impact on the expenditure ide, temporarily raiing the real wage. Yet, a wage contract are renegotiated, the equilibrium real wage i retored in the ube w quent period 0 w = 2. Thi hift the hort run upply chedule down 0 2 throughout the econd period until eventual equilibrium i reached at Y 2. Figure 3: Monetary contraction under a floating exchange rate, P L AS AS S S 1 AS 1 AS S 2 AS AD 0 AD 0 AD 1 AD 1 Y 1 Y 0, Y, E

8 A J Makin Note however, that while the nominal exchange rate appreciate throughout the firt and econd period, the real money upply i alo falling. M 0 M 2 Eventually, the real money upply chedule return to it initial level = 0 2 uch that the real interet rate again equal it initial equilibrium value and real interet parity prevail. At the ame time, the economy nominal interet rate would have fallen to the extent of the nominal appreciation. In the oppoite cae of monetary expanion, the model predict that the exchange rate would immediately depreciate a expenditure rie above output, eventually curbing exce expenditure but puhing up nominal wage and eventually raiing the dometic price level with no lating effect on output. In um, contractionary or expanionary monetary policy only temporarily influence expenditure and output in thi model through it effect on the real interet rate and competitivene but affect nominal variable in the long run, conitent with the neutrality of money propoition. Monetary expanion under fixed rate Conider next the economy-wide impact of a monetary expanion under a fixed exchange rate that reult from a central bank purchae of bond from reident. An exogenou rie in the nominal money upply initially lower the dometic interet rate, thereby inducing greater conumption and invetment expenditure by reident houehold and firm, hifting the AD curve rightward a hown in Figure 4. Since the dometic real interet rate temporarily fall relative to the foreign interet rate, foreigner would be unwilling to finance any current account deficit ariing from dometic pending over output at exchange rate 0. To maintain the exchange rate at, the monetary authoritie mut purchae dometic currency in the foreign exchange market by depleting foreign currency reerve. Thi manifet a a temporary balance of payment deficit equivalent to the current account deficit. If left unterilized, thi foreign exchange market intervention necearily offet the original money upply decreae. Accordingly, the dometic interet rate revert to it original level and the curve return to it tarting point in Figure 4. Hence monetary expanion i impoible given the exchange rate contraint, though it doe alter the compoition of the central bank balance heet ex pot. If the monetary hock i a fall in reident demand for money, then the dometic interet rate would actually fall, hifting the AD curve rightward, thereby creating exce demand for good, ervice and foreign currency. Under thee circumtance, the central bank then ha to reduce the dometic money upply to the ame extent a the fall in money demand to maintain the exchange rate at

9 Economic Iue, Vol. 10, Part 1, March 2005 Figure 4 - Monetary expanion under fixed exchange rate,p L AS AS = 0,1,2 P0,1,2 AD 1 CAD 1 = BOP 1 AD 0,2 Y 0,1,2 E 1 Y, E Y, E It alo follow here that terilized foreign exchange market intervention by the central bank after expanionary open market operation would not tem exchange rate depreciation a it would not revere the initial money upply increae and conequent fall in dometic interet rate and extra dometic expenditure. 4. CONCLUSION Exiting international monetary model provide an incomplete picture of the monetary tranmiion mechanim in open economie a they fail to explicitly trace out exchange rate and balance of payment adjutment with reference to the macroeconomic fundamental of pending and production. In particular, tandard approache neglect the central role of the current account a an output-expenditure rather than a aving-invetment phenomenon. Moreover, other model do not allow the exchange rate to be a major ource of inflationary preure for increaingly open economie. By bringing dicrepant output-expenditure behaviour to the forefront, the monetary model outlined above provide an alternative mean of under

10 A J Makin tanding the tranmiion of monetary hock to dometic and international macroeconomic variable. Unlike the MABP, it treat international adjutment a a dynamic proce conitent with continuou equality between reident demand for the home money upply. Moreover, under floating exchange rate, yet contrary to the MAER, it afford a major role to output-expenditure imbalance in determining the exchange rate. In o doing, it how how cauation run from money through expenditure to the exchange rate to price level preure, rather than from money to the price level to the exchange rate, even with purchaing power parity impoed a a long run condition. The importance of economy-wide factor a an influence on exchange rate ha generated coniderable empirical teting and debate (Flood and Roe 1999, MacDonald 1999, Rogoff 1999). However, mot econometric pecification have been baed on the original MAER, wherea thi paper relate monetary foundation to the exchange rate and balance of payment directly through national expenditure and production aggregate. It would be ueful to tet empirically the alternative cauality chain propoed by thi model. Thi could entail examining for a cro ection of countrie whether epiode of currency depreciation that are aociated with exceive dometic money upply growth and high national expenditure actually precede inflationary urge, a the model propoe, or whether inflationary urge in fact precede bout of depreciation, a the original MAER implie. The approach i alo pertinent to the perennial policy debate about the choice of exchange rate regime. In thi approach, a fixed exchange rate regime effectively neutralie the impact of a monetary hock on real output and employment, with the current account and overall balance of payment becoming the hock aborber. It alo ugget, contrary to the MF model, that exchange rate choice i not central to the iue of the effectivene of monetary policy a an income tabiliation intrument over the medium term. Latly, the model implie that, other thing being equal, economie uceptible to high inflation hould adopt fixed, rather than a floating, exchange rate, given low and table inflation in their main trading partner. Accepted for publication: 10th December 2004 ENDNOTE 1. Griffith Buine School, Griffith Univerity, Gold Coat, Autralia. t.makin@griffith.edu.au

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