ECO 209Y MACROECONOMIC THEORY AND POLICY LECTURE 8: THE OPEN ECONOMY WITH FIXED EXCHANGE RATES

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1 ECO 209 MACROECONOMIC THEOR AND POLIC LECTURE 8: THE OPEN ECONOM WITH FIXED EXCHANGE RATES Gustavo Indart Slde 1

2 OPEN ECONOM UNDER FIXED EXCHANGE RATES Let s consder an open economy wth no captal moblty Therefore the balance of payments s equal to the balance n the current account BP = NX Let s assume the followng functons for exports (X) and mports (Q) X = X + x (ep f /P) Q = Q + m s (ep f /P) NX = X Q + (x + s) (ep f /P) m For nstance, an ncrease n the RER ncreases NX snce Canadan goods become relatvely less expensve and thus more compettve n the nternatonal market Gustavo Indart Slde 2

3 THE BALANCE OF PAMENT EQUILIBRIUM Snce CF = 0, the balance of payment s n equlbrum when the current account s n equlbrum,.e., when NX = 0: NX = X Q + (x + s)(ep f /P) m = 0 Therefore, the current account s n equlbrum at a unque level of ncome: 0 = [X Q + (x + s)(ep f /P)] / m Gustavo Indart Slde 3

4 THE BALANCE OF PAMENT EQUILIBRIUM (CONT D) However, snce we are assumng a fxed exchange rate, BP may not be n equlbrum when the economy s n equlbrum (.e., BP 0 at = *) Indeed, at *, the balance of payments could show a defct (BP < 0) or a surplus (BP > 0) If the balance of payments s n dsequlbrum, then the exchange market s also n dsequlbrum If BP < 0, then there s an excess demand (defct) n the exchange market and the central bank sells foregn currency If BP > 0, then there s an excess supply (surplus) n the exchange market and the central bank buys foregn currency Gustavo Indart Slde 4

5 THE BALANCE OF TRADE EQUILIBRIUM X Q Surplus Defct X = X + x (ep f /P) Q = Q s (ep f /P) + m X + x(ep f /P) NX < 0 Q X X > Q at 1 and thus the central bank s accumulatng foregn reserves. Q s(ep f /P) NX > 0 X < Q at 2 and thus the central bank s reducng ts foregn reserves Gustavo Indart Slde 5

6 THE ECONOM AND THE BALANCE OF TRADE EQUILIBRIUM Surplus BP=0 Defct LM * X Q NX > 0 * IS 0 Q X The balance of trade s runnng a surplus at the equlbrum level of ncome *. Therefore, the Bank of Canada s accumulatng foregn reserves. * 0 Gustavo Indart Slde 6

7 THE EFFECT OF AN INCREASE IN AE Surplus BP=0 Defct 2 1 LM IS IS The ncrease n AE causes the IS curve to shft to the rght by α AE AE. X Q NX > Q X The ncrease n equlbrum ncome s equal to β FP AE. As ncome ncreases, the surplus n the external sector decreases as Q rses whle X remans constant. Gustavo Indart Slde 7

8 INTERNAL AND EXTERNAL BALANCE We have seen that the economy could be n equlbrum (*) whle the external sector would be n dsequlbrum At the same tme, we have also seen that the equlbrum level of output could be below or above the full-employment level ( fe ) When the equlbrum level of output s at the fullemployment level we say that there s nternal balance When the foregn sector s n equlbrum, that s, when BP = 0, we say that there s external balance Gustavo Indart Slde 8

9 INTERNAL AND EXTERNAL BALANCE (CONT D) It seems desrable to try to acheve nternal and external balance The benefts of achevng an nternal balance are rather obvous But why s external balance desrable? On the one hand, a country can t run a balance of payments defct ndefntely snce t wll eventually run out of foregn currency reserves On the other hand, a country should not run a balance of payments surplus ndefntely (and accumulate foregn currency reserves) because ths would reduce consumpton possbltes (and the standard of lvng) Gustavo Indart Slde 9

10 INTERNAL AND EXTERNAL BALANCE Suppose that external balance occurs at a lower level of output than nternal balance BP=0 fe Equlbrum output could occur n three dfferent areas: 1) at a level below the external balance level 2) at a level between the nternal and the external balance levels 3) at a level above the nternal balance level I Recesson Surplus 0 II Recesson Defct fe III Boom Defct Gustavo Indart Slde 10

11 POLIC OPTIONS IN AREA I If equlbrum output falls wthn Area I, the economy s experencng a recessonary gap and a trade surplus BP=0 fe Here, the government should mplement expansonary fscal or monetary polcy to reduce the recessonary gap and the trade surplus Suppose that the government ncreases ts expendture on goods and servces Ths would ncrease and decrease the trade surplus and the recessonary gap 1 0 LM IS IS fe Gustavo Indart Slde 11

12 POLIC OPTIONS IN AREA III If equlbrum output falls wthn Area III, the economy s experencng an nflatonary gap and a trade defct BP=0 fe Here, the government should mplement contractonary fscal or monetary polcy to reduce the nflatonary gap and the trade defct LM Suppose that the government decreases ts expendture on goods and servces Ths would decrease and decrease the trade defct and the nflatonary gap 0 fe IS 1 IS Gustavo Indart Slde 12

13 POLIC OPTIONS IN AREA II 1 BP=0 0 1 IS fe fe LM If equlbrum output falls wthn Area II, the economy s experencng a recessonary gap and a trade defct Here we have a polcy dlemma: Expansonary polcy wll acheve nternal balance, but the trade defct wll ncrease Contractonary polcy wll acheve external balance, but the recessonary gap wll ncrease Ths occurs because we have two ndependent targets and only one polcy nstrument (aggregate demand polces) The soluton then s to fnd another polcy nstrument that would ncrease net exports at each level of ncome We wll consder two dfferent polces: 1) tarffs and 2) devaluaton Gustavo Indart Slde 13

14 POLIC OPTIONS IN AREA II BP=0 LM The balance of trade s runnng a defct at the equlbrum level of ncome *. Therefore, the Bank of Canada s loosng foregn reserves. X Q 0 * IS fe IS Q Suppose that the government frst mplements expansonary fscal polcy to acheve nternal balance, thus further ncreasng the defct n the external sector. 0 * fe X The government must now mplement a dfferent polcy to elmnate the defct n the external sector. Gustavo Indart Slde 14

15 POLIC OPTIONS IN AREA II: IMPACT OF A TARIFF BP=0 BP =0 LM The economy has acheved nternal balance but there s a defct n the balance of trade. X Q 0 0 fe fe IS IS Q Q X The ntroducton of a tarff reduces mports at each level of ncome, that s, causes the Q curve to shft down to the rght. The ncrease n NX has an mpact on AE, and thus the IS curve shfts out to the rght. Therefore, the government should use contractonary polcy at the same tme that t ntroduces the tarff. Gustavo Indart Slde 15

16 POLIC OPTIONS IN AREA II: IMPACT OF A DEVALUATION BP=0 LM The economy has acheved nternal balance but there s a defct n the balance of trade. X Q 0 0 fe fe IS IS Q Q X X The devaluaton of the Canadan dollar reduces Q and ncreases X at each level of, that s, t causes the X curve to shft up and the Q curve to shft down. The ncrease n NX has an mpact on AE, and thus the IS curve shfts to the rght. Therefore, the government should use contractonary polcy at the same tme that t devalues the currency. Gustavo Indart Slde 16

17 CAPITAL FLOWS We wll assume that the foregn rate of nterest (*) s gven, and that Captal wll flow nto Canada whenever > * Captal wll flow out of Canada whenever < * When = *, captal flow s zero (or rather, an nvestor would be ndfferent between nvestng at home or abroad) Under these assumptons, the balance n the captal account s gven by the equaton: CF = a ( *) or = * + (1/a) CF where a measures the senstvty of captal flows to the nterest rate dfferental or the degree of captal moblty Gustavo Indart Slde 17

18 CAPITAL FLOWS CF = a ( *) = * + (1/a) CF 1 CF * Slope = 1/a 2 ( ) CF CF 2 CF 1 CF (+) Gustavo Indart Slde 18

19 THE BALANCE OF PAMENTS AND CAPITAL FLOWS The overall balance of payments (BP) now becomes: BP = NX + CF = X Q m + (x + s)(ep f /P) + a( *) = [X Q + (x + s)(ep f /P) a*] m + a = BP m + a where BP = X Q + (x + s)(ep f /P) a* If we set BP = 0, we obtan the combnatons of nterest rate () and ncome () for whch there s balance of payments equlbrum: BP = BP m + a = 0 Gustavo Indart Slde 19

20 THE BALANCE OF PAMENTS As we have seen, equlbrum n the external sector means that: BP = BP m + a = 0 where BP = X Q + (x + s)(ep f /P) a* Therefore, we obtan a relatonshp between and showng external balance (the BP curve): = BP/a + (m/a) Gustavo Indart Slde 20

21 THE BP CURVE Slope = m/a BP = BP/a + (m/a) BP = X Q + (x + s)(ep f /P) a* BP/a Note that changes n any of the determnants of BP wll cause the BP curve to shft. Gustavo Indart Slde 21

22 PERFECT CAPITAL MOBILIT (a = ) AND THE BP CURVE = BP/a + (m/a) Snce BP = X Q + (x + s)(ep f /P) a* BP/a = X/a + Q/a [(x + s)/a] (ep f /P) + * and f a =, then BP/a = * and m/a = 0 * BP = * Gustavo Indart Slde 22

23 POINTS OFF THE BP CURVE BP = NX + CF = BP/a + (m/a) Surplus BP BP/a 2 1 B A Defct If the rate of nterest ncreases whle the level of ncome remans unchanged, the balance n the captal account mproves whle the balance n the current account remans unchanged. Therefore, the balance of payment shows a surplus at pont B. 1 Gustavo Indart Slde 23

24 EQUILIBRIUM INCOME AND THE BALANCE OF PAMENTS LM For smplcty, we wll usually assume that the BP curve s flatter than the LM curve,.e., that the degree of captal moblty s relatvely large. Surplus BP Defct IS 1 Gustavo Indart Slde 24

25 THE LINK BETWEEN THE BALANCE OF PAMENTS AND THE MONE SUPPL Under a fxed exchange rate system, the central bank ntervenes n the foregn exchange market to elmnate any excess demand or supply of foregn currency There s a lnk between the central bank s purchase and sale of foregn currency and the supply of money When there s a surplus (.e., BP > 0), the central bank buys foregn currency and pays wth domestc currency The central bank pays wth domestc currency and n ths way njects money nto the economy When there s a defct (.e., BP < 0), the central bank sells foregn currency and t s payed wth domestc currency The central bank receves domestc currency n payment and n ths way wthdraws money from the economy Gustavo Indart Slde 25

26 THE IMPACT OF EXPANSIONAR FISCAL POLIC Surplus As and start to ncrease along the LM curve, a surplus emerges n the balance of payments. The Bank of Canada purchases the excess supply of foregn currency and the money supply ncreases. E E LM BP LM IS ΔG > 0 Δ > 0 Δ > 0 ΔI < 0 ΔNX < 0 ΔX = 0 ΔQ > 0 ΔCF > 0 Δ IS Defct 1 2 Gustavo Indart Slde 26

27 THE IMPACT OF EXPANSIONAR MONETAR POLIC Surplus E LM LM BP As decreases, a defct emerges n the balance of payments. The Bank of Canada sells foregn currency to elmnate the excess demand and the money supply decreases. IS Defct 1 Gustavo Indart Slde 27

28 STERILIZATION POLICIES The Bank of Canada can offset the effect of foregn exchange transactons usng sterlzaton polces For nstance, when the Bank of Canada buys foregn currency t can smultaneously decrease the money supply through an open market operaton Sterlzaton polces are not possble f there s a relatvely hgh degree of captal moblty Sterlzaton polces wll work only f there s some degree of control on captal movements Gustavo Indart Slde 28

29 ARGUMENTS FOR CAPITAL ACCOUNT REGULATIONS: THE TRILEMMA It s dffcult for a country to mantan the followng three goals smultaneously: Free captal moblty Fxed exchange rates An autonomous monetary polcy The Trlemma : Countres can acheve at most only two of these three goals smultaneously Therefore, f a country wants to have an ndependent monetary polcy whle keepng a stable and compettve exchange rate, then t must control captal moblty Gustavo Indart Slde 29

30 APPENDIX I: EXPANSIONAR FISCAL POLIC WITH NO CAPITAL MOBILIT Δ = 0 Δ > 0 ΔI < 0 ΔNX = 0 ΔX = 0 ΔQ = X Q BP=0 1 1 LM IS LM IS Gustavo Indart Slde 30 Q X At the ntal equlbrum ncome the economy s n external balance. An ncrease n G causes the IS curve to shft up to the rght and a stuaton of excess demand arses n the goods market. As ncreases, Q rses and a defct arses n the external sector. The central bank sells foregn currency to elmnate the excess demand and the money supply decreases, causng the LM curve to shft up to the left.

31 APPENDIX II: EXPANSIONAR MONETAR POLIC WITH NO CAPITAL MOBILIT Δ = 0 Δ = 0 ΔI = 0 ΔNX = 0 ΔX = 0 ΔQ = X Q BP=0 1 1 LM IS LM Gustavo Indart Slde 31 Q X At the ntal equlbrum ncome the economy s n external balance. An ncrease n the M S causes the LM curve to shft down to the rght. The rate of nterest falls and an excess demand arses n the goods market. As ncreases, Q rses and a defct arses n the external sector. The central bank sells foregn currency to elmnate the excess demand and the money supply decreases, causng the LM curve to shft up to the left.

32 APPENDIX III: INCREASE IN AUTONOMOUS EXPORTS AND IMPERFECT CAPITAL MOBILIT 1 2 Δ A LM C LM BP LM BP Δ > 0 Δ < 0 ΔI > 0 ΔNX > 0 ΔX > 0 ΔQ > 0 ΔCF < 0 1 ' B IS IS Δ 1 2 Gustavo Indart Slde 32