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
Lecture 10 : Open economy macroeconomics and exchange rates Part I 1. Balance of payments (BOP) 2.Exchangerateinthelongrun:PPP 3. BOP Theory of Exchange Rates
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
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
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 1995-2000) - Budget deficit (US since 2001)
2 0 0 7 (S P I)and (S G ) in the US 6,0 4,0 2,0 0,0-2,0-4,0-6,0-8,0 2 0 0 5 2 0 0 3 2 0 0 1 1 9 9 9 1 9 9 7 1 9 9 5 1 9 9 3 1 9 9 1 1 9 8 9 1 9 8 7 1 9 8 5 1 9 8 3 1 9 8 1 1 9 7 9 1 9 7 7 1 9 7 5 1 9 7 3 1 9 7 1 US Private Savings Investment Gap (% of GDP) US Fiscal Surplus (% of GDP)
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)
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)
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.
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)
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
French Balance of Payments (EUR, millions, 2013) Current Account Balance of Trade Balance of Services Capital Account 1 813-30 277 Financial Account 14 185-42 516 Net FDI 5136 18 267 Net Portfolio 69834 Primary & secondary income bal. -6 027 Net Other (incl. derivatives) Errors and Omissions -60 784 14278
China Balance of Payments ($billion 2014) Balance of Trade 476 Net FDI, Private and Official Assets 38.2 Balance of Services -192 Reserves -117.8 NFI -64.3 Statistical Discrepancies -140 Current Account 219.7 Financial Account + Errors -219.7 Capital Account 0 Total Balance (CA+FA+KA) 0
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
The nominal exchange rate Nominal exchange rate = rate at which a currency trades for another 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 $ Mostly use the first convention (more standard, although not most intuitive): E increases means the euro depreciates
Floating and fixed exchange rate regimes Floating The exchange rate is determined on foreign 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.
The Yen and Euro Nominal Exchange Rate Nominal Exchange Rate = number of yen or euros that could be purchased with one dollar
31/01/1992 31/05/1992 30/09/1992 31/01/1993 31/05/1993 30/09/1993 31/01/1994 31/05/1994 30/09/1994 31/01/1995 31/05/1995 30/09/1995 31/01/1996 31/05/1996 30/09/1996 31/01/1997 31/05/1997 30/09/1997 31/01/1998 31/05/1998 30/09/1998 31/01/1999 31/05/1999 30/09/1999 31/01/2000 31/05/2000 30/09/2000 31/01/2001 31/05/2001 30/09/2001 31/01/2002 31/05/2002 30/09/2002 31/01/2003 31/05/2003 30/09/2003 31/01/2004 31/05/2004 4 3 2 1 0 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 Peso
Price conversion $ =priceofusgoodsindollar Eistheexchangerate(numberofeurostobuyone$) ( ) = priceofusgoodsconvertedineuro ( ) = E $ Remark: A depreciation of the euro(e ) Increases the price in euro of US goods (if the producer price doesnotchange). Decreases the price in $ of European goods (if the producer price in euro does not change).
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) Consider a good (i) with price P i, (euros) in the eurozone andp i,$ (USD)intheUS. LawofonePrice=longtermarbitragemechanism P i, = E. P i,$ IfP i >E.P i$ :buytheusproducedgood,sellitineurope; increase demand in US, increase supply in Europe. Price converge.
The Law of One Price for Burgers Source: www.economist.com/content/big-mac-index (February 27, 2013).
Price differentials in Europe for identical car models (excl. taxes); 2009 France Germany UK Lowest VW Passat 115% 124% 82% UK Renault Clio 3 NISSAN Micra 130% 131% 98% Hungary 93% 113% 110% 77% Poland 71% FIAT Panda 116% 126% 94% Hungary 92% Source: EU commission
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.
Purchasing power parity (PPP) Idea developed initially by Ricardo (1772 1823)= LOP for consumption basket. 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 eurozoneand US. 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 $
The PPP exchange rate: E PPP ( /$) = P / P $ P / P $ $ undervalued, overvalued $ overvalued, undervalued 45 Nominal Exchange rate ( /$)
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 $t : inflation in zone and US π t = (P t P t-1 )/ P t-1
Empirical validity of PPP Studies overwhelmingly reject PPP as a short-run relationship. Works much better in the long term. The variance of floating nominal exchange rates is an order of magnitude greater than the variance of relative price indices. The failure of short-run PPP can be partly attributed to the stickiness in nominal prices (short run).
The Yen/$ exchange rate and the relative priceratio over the long term
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
Long Run PPP: $/ real exchange rate (in logs) 0.5 The mean reversion of real exchange rates 0.4 0.3 0.2 overvalued relative to PPP 0.1 0-0.1-0.2-0.3-0.4 undervalued relative to PPP -0.5 1791 1803 1815 1827 1839 1851 1863 1875 1887 1899 1911 1923 1935 1947 1959 1971 1983 1995 Note: Higher values means a (real) dollar depreciation (or a appreciation)
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: i / us i us S 2001 P 2001 P 2001 log log log + / = α + β ε i us i us t + S 1960 P 1960 P 1960 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). 1
Relative PPP prevails in the very long-run but fails in the short-run %Depreciation 6 0 1 Year Window 4 3 2 7 1 0-7 -2 3 %Depreciation 30 23 17-4 0-4 0-20 I n fl a ti o n d iffe r e n tia l 0 2 0 40 6 0 %Depreciation 12 9 6 3 0-3 -6 Infla tion Diffe re ntia l -10-5 0 5 10 15 10 3-3 -10-20 -10 0 10 20 30 Inflation Differential 20 Year Window Remember relative PPP: (E t E t-1 )/E t-1 = π t -π $t 5 Year Window
Why are prices higher in rich countries? Same question as: why E x P rich > P poor? Obvious deviation from PPP. Related question: why does the real exchange rate of countries that grow relative to rest of world appreciate?(q=exp world /P ) Examples: Japan, South Korea, Ireland, today China? One theory relies on the presence of non-traded goods together with productivity differences between rich and poor in the traded(manufacturing) sector = Balassa Samuelson effect
Balassa-Samuelson effect Key distinction: Tradable goods (manufactured goods) and non tradable(services) Around 75% of the consumption basket in industrialized countries is non tradable (health, education, most services ) even if definition of a tradable good/service becomes blurred (internet) Productivity differences between rich and poor countries is much larger for tradables than for non tradables: it is very large for example in manufacturing (of an order of 10 or more), but much smaller in services (think of haircuts: technology is not hugely different across countries).
Understanding the Balassa-Samuelson effect Workers can be hairdressers (non-traded) or work in the textile industry (traded). Workers can produce haircuts or T-shirts. T-shirts sold 1$ in international markets. US worker produces 50 T-shirts/hour, Indian worker only 10. Both US and Indian hairdressers make 5 haircuts/hour. Question:whatisthepriceofanhaircutinIndiaandin the US? Implications?
Income convergence and exchange rate appreciation (here appreciation is up!) Source: Reisen, 2009
Lecture 10 : Open economy macroeconomics and exchange rates Part I 1. Balance of payments(bop) 2.Exchangerateinthelongrun:PPP 3. BOP Theory of Exchange Rates
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.
The Current Account 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.
The Current Account and Real Exchange Rates Two country world = Europe-US. NetexportsNXoftheeurozonedependontherealexchangerate CA () = EX -IM in euros = Net exports ( ) =E P $ /P =relativepriceofusgoodswithrespecttoeuropeangoods A real depreciation of the euro ( ) increases competitiveness of European goods. More exports and less imports from US (substitution). Net exports But if slow response of volumes (empirically 6 months-1 year) value of imports. Net exports In the short-term, net exports deteriorate when real depreciation but in the medium-term, net exports improve. This is the J-curve.
The J-Curve volume effect dominates value effect Immediate effect of real depreciation on the CA J-curve: value effect dominates volume effect
The Current Account and Real Exchange Rates We assume from now on: nominal or real deprecia]on (E or q ) generates an in demand via an in net exports : CA (q)= (EX - IM ) +
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
BOP Theory of Exchange Rates q S-I CA=Net Exports Real Exchange Rate determined by equality of net savings with net exports
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.
Increase in fiscal deficits (fall in public savings) q S-I CA=Net Exports Appreciation of the currency and deterioration of the current account
Reagan and Bush I Deficits 6 5 4 % of GDP 3 2 1 0-1 1981 1982 1983 1984 1985 1986 1987 1988 5 Current Account deficit Fiscal deficit 4 % of GDP 3 2 1 0-1 1989 1990 1991 1992 Source : Bureau of Economic Analysis
Drop in investment q S-I CA=Net Exports Depreciation of the currency and improvement of the current account
2007 2006 2005 Argentina 2001-2002 Financial Crisis 25 20 15 10 5 0-5 -10 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 Current Account (% of GDP) Investment rate % of GDP Real GDP Growth
Increase in demand for European goods q S-I CA=Net Exports
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.