8th International Conference on the Chinese Economy CERDI-IDREC, University of Auvergne, France Clermont-Ferrand, October, 2011

1 8th International Conference on the Chinese Economy CERDI-IDREC, University of Auvergne, France Clermont-Ferrand, 20-21 October, 2011 Global Imbalances and Exchange Regimes with a Four-Country Stock-Flow Consistent Model Tiou-Tagba Aliti G. and Mazier J. 1 tiou_tagba@yahoo.fr and mazier@univ-paris13.fr, CEPN-CNRS, Université Paris-Nord Abstract: We use a four-country "stock-flow consistent" model (USA, Euro zone, China, Rest of World) along the lines of Godley and Lavoie (2005, 2007), Lavoie and Zhao (2010) and Mazier and Tiou-Tagba Aliti (2010) to analyze global imbalances and how they unfold, depending on the prevailing exchange-rate regime. Each area is composed of four sectors; households, firms, government and banks (which include the Central Bank). Two assets are distinguished in each country, banking deposits and Treasury bills issued by each government and held by households as well as the banking sector of each country. Firms accumulate capital and finance their investments by profit and credit. Prices and the wage share are constant. Households consume with wealth effect and require assets with rates of return. Banks provide the credit required by firms without rationing. We distinguish two cases depending on whether the rest of the world can finance its external deficits with debts in dollars or can borrow in its own currency. The overall macroeconomic adjustments are analyzed on the basis of different exchange rate regimes with two extreme cases. One consists of all currencies floating, with the possibility of the Chinese central bank having a managed exchange-rate regime. The other case has the yuan and the currency of the rest of the world pegged to the dollar while the euro and the dollar float against each other. Between those two regimes, we consider pegs for the yuan and the currency of the rest of the world. The yuan can be anchored to the dollar and the euro, or a basket comprising the dollar, euro and currency of the rest of the world (in this case equated to the yen). Exploring a longerterm perspective, we consider the case of a tri-polar world dominated by the United States, Europe and China which we illustrate by a floating of the dollar, euro, and yuan with the rest of the world (ROW) anchored to a basket composed of the three major currencies. The results complement those obtained by Lavoie and Zhao (2010) and Mazier and Tiou-Tagba Aliti (2010) in the case of a three-country model on several points. - In the face of supply shocks eroding competitiveness, the fixed parity of the yuan and/or the currency of ROW pegged to the dollar limits the reduction of global imbalances to the benefit of China and the rest of the world at the expense of the United States and Europe. In contrast, flexible dollar-yuan and/or dollar-row exchange rates appear as an effective way to reduce global imbalances. This result confirms the one obtained in the case of the three-county model. - An intermediate exchange-rate regime, which pegs the yuan to a basket of 1 Cepn-Cnrs, Université Paris-Nord, 99, avenue Jean-baptiste-clément, 93430 Villetaneuse. Courriels : mazier@univ-paris13.fr ; tiou_tagba@yahoo.fr

2 currencies including the dollar, euro and possibly the yen (approximated by the ROW in this case), yields results between the two polar cases of pure floating and the yuandollar peg alone, but closer to the latter. In the case of supply shocks involving a loss of competitiveness the results are also close to those obtained for the yuan-dollar peg alone, but with smaller global imbalances in general and in particular a lower Chinese surplus due to the appreciation of the yuan against the dollar. If the yuan is pegged to a basket containing only the dollar and the euro, the results are very close but, logically, more favorable to China, which retains more flexibility in exchange with the rest of the world - Lastly, we examine the case of a tri-polar world, quite possible in the longer term, where the dollar, euro and yuan float freely while the ROW currency is pegged to these currencies. The results are again in an intermediate range between the two polar cases, closer to those obtained with a peg to the dollar alone. Overall, the diffusion effects are larger, global imbalances smaller, and the negative effects of a loss of competitiveness less pronounced. - We compare instances where external debt is denominated in dollar, ROW, or national currency to evaluate the relative valuation effects on assets and liabilities. Although real, these effects should not be overestimated. When the position is one of net external debtor, shocks inducing a depreciation of the dollar will translate into gains for the country (here the ROW) and positive effects on growth. Intermediate exchange-rate regimes analyzed in the above scenarios illustrate the new directions to be considered for the global economy, if China were to loosen its currently very restrictive exchange rate policy. They complete those previously demonstrated (Mazier and Tiou-Tagba Aliti, 2010). A managed dollar-yuan exchange-rate parity, where the Chinese central bank intervenes to reach a target on reserves or on current account, provides enough adjustment mechanisms similar to those of pure float. These exchange-rate regimes do not guarantee, however, that the currency prices thereby achieved would correspond to the equilibrium exchange rate needed to prevent internal and external imbalances. This raises the question of reconciliation with the analysis in terms of equilibrium exchange rate (FEER). The system of managed exchange where the central bank intervenes to achieve a target current account balance would be more compatible. Key words: Three-country model; Global imbalances; dollar, euro, yuan exchange rates JEL classification: F41, F42, F47

3 1. Introduction The overall macroeconomic adjustments have been analyzed in previous papers with a SFC three-country model on the basis of different exchange rate regimes with two cases. One consists of all currencies floating, with the possibility of the Chinese central bank having a managed exchange-rate regime. The other case has the yuan pegged to the dollar while the euro and the dollar float against each other. But the current world economy is more quadro-polar than tri-polar. Thus, beside USA, China and Europe, the study of trade, exchange rates, and financial flows requires a model that takes into account the rest of the world. The novelty of this paper is the introduction of the rest of the world with a dollar-denominated external debt and the potential to address more accurately issues associated with a peg to a basket of currencies. The paper is organized as follow. A second section develops the structure of the model with the yuan and the currency of the rest of the world pegged to the dollar. A third section presents the results of this model with adjustments facing supply shocks (loss of competitiveness). A fourth section presents new versions of the model where the currency of the rest of the world is floating freely while different exchange rate regimes are adopted by the yuan: pegged to the dollar as previously, pure floating or managed dollar-yuan parity. Adjustments facing supply shocks are compared in these different exchange rate regimes. A fifth section explores the impact of different structures when pegging to a basket of currencies to highlight the asymmetries in these countries or areas. Last, a sixth section compares the structure of two new four-country models in which one assumes debt denominated in national currency and the other has the ROW s external debt in dollars. A final section concludes. 2. The balance sheet of the four areas and the t structure of the model The model describes a world economy divided into four areas: the United States, the euro-zone, China, and the rest of the world. The exchange-rate regime adopted in the primary structure of the model is having the yuan and the ROW currency pegged to the dollar. Several scenarios for anchoring to the dollar and a basket of currencies will also be introduced, including an anchor for the rest of the world to the dollar and the yuan s peg to a basket of currencies. Each area is composed of four sectors; households, firms, government, and a banking sector that includes the single central bank and commercial banks. Firms accumulate fixed capital and finance their investments by profit and credit. The wage share and prices are assumed to be constant. Two assets are distinguished in each area, banking deposits and Treasury bills. Previous models (Mazier and Tiou-Tagba Aliti, 2010) were based only on internal and external debt in national currency rather than reflecting a debt structure using a hard currency (the euro and the dollar), while most emerging countries have a composition of debt in different currencies. Indeed, when a country has an important ratio of external debt in foreign currency to total debt, its balance sheet is vulnerable - in case of pure flexibility - to a sudden depreciation of the exchange rate of its currency resulting in the swelling of its debt. The composition of the foreign currency country may also have much influence on the government balance during periods of severe financial crisis when exchange rates may suddenly become unstable and vulnerable to the balance sheet. Therefore, this paper introduces different kinds of debt on the balance sheet to reflect the effects in the adjustment of global current account imbalances. The balance sheet

4 presents several concepts of debt of which we need to clarify the semantics. Every purchase of Treasury bills by foreign investors is considered an external debt. However, if the bills are issued in domestic currency, then we have the external debt in national currency; otherwise if the bills are issued in foreign currency, it will be the external debt in foreign currency. Any purchase of Treasury bills by a local investor is considered a domestic debt. If the bills are issued in domestic currency, it will be a domestic debt in domestic currency. In the model, country of residence is sufficient to determine whether the nature of a debt is external or internal. Two types of models will be studied and distinguished by the type of debt. In the first, Treasury bills are issued by each government in its domestic currency. We shall call this the model of debt in national currency. In the second, Treasury bills are issued in respective domestic currencies by the governments of the United States, the euro-zone, and China, but in dollars and national currency by the government of the rest of the world. Treasury bills issued in domestic currency are held by households and only the Central Bank of the rest of the world while the Treasury bills issued in dollars are held by households and the central banks of the United States, the euro-zone, and China. We call this the model of external debt in dollars (Table 1). The four economies are assumed to be very similar, except that U.S. and European central banks do not hold Treasury bills issued by China in its domestic currency in case of debt in domestic currency, and in dollars for the case of external debt in dollars. The structure of exchange rates is as follows 2 1 = xr1 = xr2 = xr4 # 1 = xr6 # = xr3 1 # = xr5 2 To facilitate the reading of the exchange rate, read 1 = XR1 noted dollar / euro, in case of decline, a depreciation of the dollar against the euro and if it rose, a stronger dollar against the euro. Make a similar reading for entries dollar / yuan (xr2), euro / yuan (XR3), dollar / Rdm (XR4) Rdm / yuan (XR5) and Euro / Rdm (XR6)

5 Table 1: The balance sheet of the four areas with a model of external debt in dollars = Euro zone = United States Capital Money Bills, / 1, / 1 Bills 1, Bills / 3, Bills # 1, / 2 Continued below Bills #/ #, 1, 1 #, #,, Loan Wealth Sum 0 0 0 0 0 0 0 0 = China # = Rest of the world H F G B H F G B Sum Capital # Money # # 0 Bills 3, 3 # 6 #, 6 0 Bills 2, 2 # 4 #, 4 0 Bills, # / 5 #, / 5 0 Bills # #,# # #,# #,# #, 0 Bills #/ #, 2, 2 #,. 4 0 Loan # # 0 Wealth # # # # Sum 0 0 0 0 0 0 0 0 0

6 Equilibrium of goods and services i =,,, # avec = (1-4) The equilibrium of goods and services in the area i (Euro zone) is described by a national income identity that equalizes the production of goods and services for area i (Euro zone) with consumption ( ), government spending ( ), investment ( ) and the trade balance ( ). The trade balance is calculated as the difference between exports and imports. Government spending is exogenous and growing at a rate (ω) based on expenditure of the previous year ( ). In the market for goods and services, the equilibrium is not systematic. The goods may be sold or not. Thus, the fluctuations of stocks are an essential element in the analysis. Foreign trade Multilateral export relationship Exports from the area i (euro zone) are designed for areas j (U.S., China and ROW) and are as such at the same time imports of j areas from the area i. That is to say, for example in the case of the euro zone, its exports to the United States, China and the Rest Of World and vice versa for each area. The notation ( ) denotes exports of area i (euro zone) to area j (U.S., ROW, or China). The export of the Euro zone to the United States will be denoted by ( ). = ( ) i, j =,,, # (5-8) Bilateral import relationship Bilateral import relations are described in a conventional manner between the areas with the demand effect, the bilateral price effect, and the multilateral price effect. Imports of the Euro zone from its partners (9-20) =µ µ µ (1/ 1 µ 1/ 3 1/ 6 =µ µ µ 3 µ 1/ 6 1 # =µ µ µ 6 µ 1/ 3 1 Imports of the United States from its partners =µ µ µ 1 µ 1/ 4 ) (1/ 1 =µ µ µ 2 ) µ ((1/ 2 ) (1/ 4 )) # =µ µ µ ( 4 ) µ ((1/ 1 1/ 2 )) China s imports from its partners =µ µ µ (1/ 2 ) µ ( 3 5 ) =µ µ µ (1/ 3 µ 2 5 ) # =µ µ µ (1/ 5 ) µ ( 2 3

7 Imports of the rest of the world from its partners # µ # µ # # µ # 1/ 4 µ # 1/ 5 6 # µ # µ # # µ # 1/ 6 µ # 1/ 5 4 # µ # µ # # µ # 5 µ # 4 5 Parameters µ,µ µ Euro zone ; µ,µ µ are the elasticities of import volume production, µ,µ µ Euro zone; µ,µ µ then the volume of bilateral import prices, and µ,µ µ Euro zone; µ,µ µ and then the multilateral volume of imports. The first group of parameters gives the share of foreign production areas j USA, China and Rest of World of goods imported by area i Euro zone. The second group of parameters deals with the bilateral substitution effects abroad between locally produced goods and imported goods, and competition among bilateral imported goods themselves. The third group of parameters also discusses the multilateral substitution effects abroad between locally produced goods and imported goods, and multilateral competition between imported goods themselves. Parameters µ,µ µ are the cause of shock s loss or gain in competitiveness which are highlighted in the model simulations. Also note that a loss of the region I s Euro zone competitiveness towards the areas j USA, China and ROW is completely symmetric - When writing the model in the simulations model with a gain of the area s j competitiveness towards the area i. Parameters µ,µ µ Euro zone; µ,µ µ are constants in the equations of imports volume. Multilateral import relationship This quadrilateral relationship shows the imports of a partner from the other three partners. This means that imports of area i Euro zone from areas j USA, China and ROW are at the same time area j s exports to the area i. For example, imports from the Euro zone came from the U.S., China and the rest of the world, and vice versa for each area, and are at the same time exports from the United States, China and the rest of the world towards the Euro zone. The notation denotes imports of area i Euro zone from area j USA or Rest of World or China. For example, an import from the Euro zone and the U.S. will be denoted by. i, j,,, # 21-24 Bilateral export relationship Relations below establish equality between imports and exports by applying the bilateral nominal exchange rate correspondent. Exports to the Euro zone partners. 1 / 3 # # / 6 25-36

8 Exports to the United States partners / 1 / 2 # # / 4 China's exports to its partners. 3. 2 # #. 5 Exports to the rest of the world partners # #. 4 # #. 6 # # / 5 Households Disposable income of each area,,,,,,,,,,,,,,, #,#,# # # #,, #,,,,,,,, #,, #, #,,, #, #,,, #, #,,,, # #,,,, 37-40, # #, # Household disposable income Euro zone,, comprises wage income Euro zone,, income earned on domestic Treasury bills held by households in euro zone,,,,,, #, #,,,,, income earned on Treasury bills issued by other governments income from monetary financial assets money earned on monetary bank deposits Euro zone,, minus the taxes households Euro zone, pay to their government Euro zone. Dollar-denominated Treasury bills issued by the government of the rest of the world yields reported income for U.S. #, #,,,, European #, #,,, and Chinese #, #,,, households at an #, international interest rate. Households in the U.S., the EU, and China now have in their dollar-denominated foreign-asset portfolio two assets issued by U.S. government and the rest of the world in contrast to the model of debt in national currency. Haig-Simons disposable income including capital gains of each area,,, 1,, #,,,,,,,,,,,,,,, #, 3, 2,,,,,#,,# 6 #, 4 #,, 1 5 #,, 41-44 In addition to disposable income, households in each area may realize capital gains or losses arising from changes in exchange rates on Treasury bills they hold from the other three governments. There are no such valuation effects on treasury bills issued by the #, rest of the world in dollars and purchased by the United States,,. These income

9 gains or losses in foreign exchange markets need to be added or deducted from disposable income, giving us disposable income including capital gains or losses recorded for each area as follows (,,,,,,,,,#, and written as Haig-Simons disposable income available in the area. Taxes i,,, # (45-48) The State of area i applies a tax rate (Euro zone, ) on the Haig-Simons households disposable income to obtain government revenues (Euro zone, ). Households consumption with wealth effect = α, α, i =,,, # (49-52) Households in the area i consume (Euro zone, ) with a wealth effect(, ). Their disposable income (, ) includes wages ( ), interest income and capital gains or losses related to currency fluctuations minus taxes paid ( ). Parameters α α (Euro zone, α α ) respectively represent the marginal propensity to consume the available Haig-Simons income and the marginal propensity to consume the stock of wealth of households in each area. Wealth accumulation by households V =, i =,,, # (53-56) The accumulation of wealth of households in each area follows from the difference between the Haig-Simons household disposable income (Euro zone,,, ) and consumption (Euro zone, ). Demand for Treasury bills by households Under the Godley-Tobin approach, asset demand depends on the rate of return on different assets. For foreign assets, changes in exchange rates should be included to advance a better understanding of the determination of exchange rates. However, this issue was discussed by Daigle and Lavoie (2009) in a simple two-country model. They introduced the fundamental analysis and / or expectations, respectively based on fundamental values and historical trends. They found that if the proportion of Chartist players relative to fundamentalist agents is not too large, the main conclusions of the standard lacking exchange-rate anticipations remain even if the introduction of such anticipations had a significant impact. exchange rates had a significant impact. When chartists dominate the fundamentalists, the model becomes unstable and there is no convergence in case of shock. This case of instability will not be considered in this model and the fundamentalists will be expected to be dominant. It is simply assumed at this level, as do Godley and Lavoie, that the anticipated

10 fluctuations are constant (positive or negative) and hence can be considered nil on average. Demand for Treasury bills by households in the Euro zone = #, (57-61a),,, = #, = #, #,, = #, = #, Demand for Treasury bills by U.S. households, = #, (62-66a) = #,,, = #, #,, = #, = #, Demand for Treasury bills by Chinese households = #, (67-71a),,, = #, = #, #,, = #, = #, Demand for Treasury bills by households in the ROW #,# = # # # # # # #, # # (72-76a) #, #, #, = # # # # # # #, # # = # # # # # # #, #, = # # # # # # #, # = # # # # # # #, The coefficients must meet certain constraints given in the appendix in accordance with the approach of Godley and Tobin. =,, #,,, (61, 66, 71,76),, #,,,,,, # # #,# #, #, #, #,, #, The demand for money (Euro zone, ) is the stock of wealth (Euro zone, ) which must be subtracted using the currency demand for Treasury bills from euro-zone governments by their own households (Euro zone,, ) and demand for Treasury bills of euro-zone governments by foreign households (United States, China and Rest of World) noted,,, #,,. Given the accounting constraint applied to the wealth

11 of households, only four asset demand equations are independent. Requests for deposits,, # (61a, 66a, 71a and 76a) will not be written in the model. Government Government budget deficits are financed by issuing Treasury bills. B, i =,, (77-79) ( # ) = # # # #,#, #, #, # (,. ) (80) The issue of new Treasury bills by the government i (Euro zone, B ) depends on the public-sector balance ( ), plus interest on the stock of government debt accrued from previous periods (, ), minus the exceptional profit fully repaid by the Central Bank of each area to its respective state (Euro zone, ). As the rest of the world issues bills in both dollars and national currency, it also pays interest on bills purchased by households and domestic banks at the domestic interest-rate level #,# ), and interest on Treasury bills purchased by households and foreign banks ( #, #, #, (, at the international interest-rate level (. )). Since the external debt of the rest of the world is in dollars, interest is calculated in national currency using the exchange rate between the dollar and the currency of the rest of the world. Recall that public spending is exogenous and growing at a constant rate ω from last year s level of public spending. =,,, =,,,,,,,, # # #,# #,,, # # #,, #,,, 1 #, #,,,,,, (81-84)*,,,,,, #,,, / 1 #, #,,,,,, 2,,, 3 #, #,,,, 4 #,,, 6 #,,, / 5 Banks make their exceptional profits (Euro zone, ) earning interest on Treasury bills they bought with their government (Euro zone,,,, ), from other governments (,,, 1 and #, #,,,, ) and on loans to households (Euro zone,, ), while paying interest on household deposits (Euro zone,, ). Treasury bills of U.S., the euro zone, and the rest of the world are bought by banks and households in four areas. Chinese Treasury bills are only bought by Chinese banks and the rest of the world, and households in four areas. Recall that these profits are paid in full to the state. Supply-demand equilibrium in Treasury bills =,,, ( ), ( ),,, =,,,# (85-87) Treasury bills (Euro zone, ) offered by the government of area i (Euro zone) equalize the demand for treasury bills by households in the region i (Euro zone,, ) and the Central Bank of the area i (,, ) as well as the demand for Treasury bills by

12 households in areas j (,, #,, ) and the central banks of areas j (,,,,, #,, ). It should be added that requests for Treasury bills are converted using the exchange rate offered for Treasury bills to ensure equivalency between supply and demand. In this model of four areas - the United States, the euro zone, China and the rest of the world - the treasury bills of U.S., Europe, and the rest of the world are bought by households and the central banks of four areas. To make the model more realistic, we assume that the Chinese Treasury bills are purchased by households of the four areas and the central banks of China and the rest of the world. This isolates from the above equation the following notation: (,,,, ). Given the specificity of the rest of the world, its equation of supply and demand for Treasury bills is isolated from the development of equation (85-87). Equation (88) is written separately to illustrate that specificity more accurately. This characteristic is linked to debt in national currency and dollars by the rest of the world. # #,# ( #,. ) (88) All treasury bills issued by the rest of the world ( # ) can be divided into Treasury bills issued in national currency ( #,# ) and treasury bills issued in dollars ( #,. ), written in national currency. # #, #,# #,# #,, ( (, #, #,,, #, #,,,,, #, #,,, ) (88a) Equation (88) is rewritten as equation (88a) to detail the issue of Treasury bills. Equation (88) is the main accounting constraint pertaining to the issue of Treasury bills by the rest of the world. For the simulation model, it will be replaced by its components of domestic debt in national currency and foreign debt in dollars. Accounting constraint on domestic debt in domestic currency #,# #,# #,# # #, Accounting constraint on external debt in dollars #, #, #, #,,,,, #,,,, #, #,,, (88-1) (88-2) Supply-demand equilibrium in treasury bills by domestic households,, (89-91),, All Treasury bills supplied by the government of the area i to area i households (Euro zone,, ) correspond to all Treasury bills in area i demanded by area i households (Euro zone,, ). For the rest of the world, the relationship becomes: #,# #,# #, #, (92) Supply-demand equilibrium of international Treasury bills by households

13 All Treasury bills supplied by the government of area i (Euro zone) to households in areas j (USA, China and Rest of World), correspond to all Treasury bills in area i demanded by households in area j, to which we apply a nominal exchange rate.,, 3 (93-103) #, / 1 #,,,,, 1 2,, #, #,,,,, / 3 / 2,, #,,, #, / 2 #, #, #, #, #, #, Firms Wage / 4 / 6 5,,,# 104-107 The wage share of area i Euro zone, ) is a simple relationship given by the ratio of the wages in value ( ) and output ( ), and is constant. Profit =, =,,,# (108-111) Firms in the area i get their profits (Euro zone, ) by deducting the production, the wage ( ) paid and interest paid (, ) to banks on loans they received earlier. That is to say that profit is determined as a function of sales. γ, δ =,,,# (112-123) The investment of area i (Euro zone, ) is determined through an accelerator with a very simplified desired capital stock (, ) ensuring the stability of capital productivity in the long term and taking into account depreciation of capital stock (δ ). 1 δ The capital stock of area i (Euro zone, ) is equal to the capital stock of the previous

14 year ( ) increased investment in the current year ( ) minus the depreciated capital stock. The parameter (δ ) is the coefficient of depreciation of capital stock., The desired capital stock of the area i represents a (Euro zone, ) from the previous year's production ( ), where the parameter ( ) is considered desired capital ratio noted (, ). Debt firms The investment is financed by cash flow and debt. L,,,# (124-127) The change in loan demand from area i (Euro zone, L ) is the residue of investments ( ) that were not funded by the profits ( ). The firm's debt by the credit application (L ) assumes no rationing of loan demand. That is to say, all appropriations requested by creditworthy firms are financed by banks. The wealth of the firms can be written as follows: δ,,,# (128-131) The firms wealth in the area i (Euro zone, ) is equal to the capital stock ( ) minus loans ( ). Banks,,,,,,,,,,,, #,# # # #,, #, 1,, #, / 1,, 3,, #,, 6 #,, (132-135) #, 2,, 4 #,, / 5 The money supply (Euro zone, ) is endogenous, consisting of the currency used by commercial banks to grant loans (, the currency used by the Central Bank to buy Treasury bills from its government,, ), the currency used by the Central Bank to #, buy Treasury bills with from other governments (,, 1,, ), minus money held as wealth by the central bank (, ). Remember that the banking system is aggregated and includes commercial banks as well as the Central Bank. Assume that the U.S. central bank does not hold treasury bills due to the international status of the dollar. Nor does the Fed need foreign exchange reserves (, 0. It holds treasury bills issued by the rest of the world in conjunction with a debt in national currency and dollars. Writing the model in this way makes it easier to compare the two types of debt. The European Central Bank, The People s Bank of China, and the Central Bank of the Rest of the world have instead of holding reserves and foreign treasury bills : U.S. and the ROW bills for the ECB; U.S., ECB and the ROW

15 bills in the case of China's central bank; and U.S., ECB and Chinese bills for the rest of the world. Equilibrium between supply and demand for money by households = =,,,# (136-139) Equilibrium between supply and demand for money expresses the equality between money supply in area i and the money demand for area i for the four areas. Supply-demand equilibrium in loans = =,,,# (140-143) The relationship between credit supply and demand expresses the equality between loans offered by commercial banks to firms to the area i and the appropriations requested by firms to commercial banks by the area i for the four areas. Supply-demand equilibrium in treasury bills by the national Central Bank,, =,, =,, (144-146) The demand for Treasury bills of area i by its Central Bank correspond to the supply of Treasury bills proposed by the government of the area i. Given the special nature of the rest of the world, its equation of supply-demand equilibrium of treasury bills by the national central bank becomes: #,# #,, #,# #,, (147) Supply-demand equilibrium in international treasury bills by the Central Bank All offers of Treasury bills (Euro zone,,, ) to a foreign Central Bank (United States) correspond to all requests for Treasury bills in the same area (Euro zone,,, 1) by a foreign Central Bank (e.g. United States) denominated in foreign currency for which use an exchange rate designed to ensure equivalence in the supply-demand balance in the same monetary unit.,,,, #,, #,,,,, #,, #,,,,, #,,, #,,, #,, 3 (148-155) 1 / 6 #,,, #,,, #,,,,,, / 5 1 All exchange rates are float freely, except for dollar-yuan and dollar-row exchange rates, it is assumed that foreign exchange reserves held by the various central banks are constant, except equations 158 and 161 which are not written.

16 10 5 10 #,, #,, #,, (156-165) #,,,,,,,,, #,,, 5 5 5 0 0,, #,,, 5 5 The increasing wealth of central banks is related to valuation effects. The wealth of the U.S. central bank is zero because of the lack of reserves (,,, 0) and the fact that Treasury bills it buys from the ROW government are denominated in dollars ( #, ).,,, In the case of debts denominated in a national currency, the U.S. central bank realizes gains or losses on changes in exchange rates. V #,,,, 1,,, (166-169) V,,, V,,, 3,,, #, 2,,, V # #,,, 6 #,,, 4 #,,, Interest rates are exogenous and identical in each area., Behavior margin may be introduced through a possible distinction between domestic and foreign rates. The interest rate (, ) on dollar Treasury bills issued by China is endogeneized directly by an explicit equation. It indicates that the rate on the international market is even higher than public debt in dollars or the total debt or current account balance from China, which yields:, ((, 4)/ ), ( / ), ( / )

17 Exchange rates determination with the yuan and the currency of the rest of the world pegged ged to the dollar All exchange rates float freely and independently to the central banks except XR2 and XR4 which are anchored to the dollar. Fixed dollar-yuan parity Equation 161 will not be written in the model. The Chinese central bank manages its reserves.,, 5 The exchange rate of yuan-dollar (xr2) becomes exogenous.,,,, 2 (170) Currency of the rest of the world pegged to the dollar Equation 158 will not be written in the model #,, 10 The exchange rate of the rest of the world against the dollar (XR4) becomes exogenous. The dollar reserves held by the Central Bank of the ROW are endogenous in the model. #,, #,, 4 (171) Exchange rates XR1, XR2, XR3, XR4, XR5 and XR6 are determined by the interaction of supply and demand for Treasury bills. xr1 B, /B, (172) xr2 = B,, /B,, (170 bis) xr3 = 2/ 1 (173) xr4 = B #,, /B #,, (171 bis) xr5 2/ 4 (174) xr6 = 4/ 1 (175) All accounting equations must be written except one, because it is the equation (85) describing the equilibrium between supply and demand for Euro zone Treasury bills, which will not be written in the model and used to verify consistency accounting model.,,,,,,,,, #, #,, (85 bis) The current account balance (CAB),, (,,,,,, ),, (,,,,,, ),, #, #,,,,,, # #,,,,,, #, #,,, # #,,,,,,,

18,, # #,,,, # # # #,,,, #, #,,,,,,,,,,,, #,, #,, #,# #,,, # #, #,, The capital account balance KAB #,# #,,,,, #,,, #,,,,,, #, #,,,,,, é,, #,,,,,,, #, #,,,,,,, #,,, #, #,,,,,, #, #,,,,, # #,, #,, #, #,,,, #, #,, #, #,, #, #,, #,,,,,,,, #,,, 0 0 0 # # 0 Lastly the world s net wealth equals the total fixed capital accumulated. 1 # # # " 3 6 1. / 3 # / 6 With #, #,,,, 3. Adjustments with the yuan and the currency of the rest of the world pegged to the dollar A loss-of-competitiveness shock is simulated successively for each main area USA, euro area, rest of the world towards its partners through an increase of the import elasticity 0.5 to 0.52, with in all the cases the yuan and the currency of the rest of the world pegged to the dollar. Loss of United States competitiveness towards its partners A competitiveness gain of the China, the Euro zone and the rest of the world improves each of the region s GDP in the medium term between 0.16% and 2.5%. In contrast, the production is deteriorating in the United States in all instances between -1.75 and - 2.5%. The U.S. debt is growing between 8% and 12% due to increased issues of Treasury bills following to decline in activity which contrasts with the debt reduction of the rest of the world in three cases. This decline in U.S. GDP is in contrast with the improvement in Chinese and the rest of the world activity as they both improves their competitiveness against the United States. In the case of China s increased competitiveness, its GDP growth is explained by a low appreciation of the yuan against the euro 0.017% and also a small appreciation of the dollar against the euro 0.017%. The yuan peg to the dollar and the currency of ROW limit the diffusion of increased Chinese competitiveness in the Euro zone and the rest of

19 the world where the effects on production remains close to zero while they are 2.5% in China and - 2.5% in the United States. The U.S. current account deficit contrasts with the Chinese current account surplus. In the case of the euro zone s increased competitiveness, its GDP improves in the shortterm by 0.75% but quickly returns to a level close to 0.16% in the medium term. The rest of the world and China benefit more from increased euro- zone competitiveness. Their GDP is growing over the medium term between 0.65 and 0.9%. The reason for the spillover to the activity of the rest of the world and China is due to an appreciation of the euro against the currencies of its partners (1.7%). This appreciation of the euro penalizes its current account by 0.05% over the medium term, but less so than the current accounts of China (0.2%) and the rest of the world (0.15%). The United States current account deficit (-0.5% in the medium term) is worsening due to the loss of United States competitiveness towards the euro zone. In the case of increased RoW competitiveness, its GDP increases 2.5% in contrast with that of the United States. The impact on GDP of China and the euro zone remains around zero. The low diffusion of this increased RoW competitiveness towards China and the euro zone is partly explained by a low appreciation of the yuan against the dollar (0.02%) in light of its pegs to the dollar and currency of the rest of the world which limit adjustments. Loss of euro area competitiveness towards China and the rest of the world In the case of increased Chinese competitiveness, the Chinese GDP increases 1.75% and deteriorates with its partners in the euro zone (- 0.35% in the short-term, - 0.15% medium term ), the rest of the world (-0.9% in the medium term) and U.S. (-0.7%). The debt increases due to new issues of Treasury bills. The euro zone, the rest of the world, and the United States are penalized because the dollar appreciated against the euro (1.75%) and thus also against the rest of the world's currency and the yuan. This appreciation of the dollar, the yuan and the rest of the world currency penalizes the three countries current accounts but allows the euro area to achieve a current account surplus. In the case of increased RoW competitiveness, its GDP grew by 1.5% with a slower growth of its partners (between - 0.2% and -0.8%). The exchange rate of the dollar appreciates against the euro (1.75%). To the extent that the currency of rest of the world and the yuan are anchored to the dollar, both currencies appreciate against the euro. The increased RoW competitiveness improves its current account (0.3%) at the expense of its partners Loss of RoW competitiveness towards China The loss of RoW competitiveness vis-à-vis China is the last case we examine. This simulation provides traditional outcomes. The Chinese GDP (2.5%) contrasts with the deterioration of production in the rest of the world. The GDP declines in the rest of the world which deteriorates its public-sector balance. This leads to increased emissions of Treasury bills in the rest of world. The debt of the rest of the world increases. The RoW s current account deficit (-1% in the short-term) is partially reduced in the medium term due to the depreciation of the dollar against the euro (0.003%). The Chinese current account surplus also partially adjusts in the medium term (0.75%) due to a low

20 depreciation of the yuan against the euro (0.004%). The United States takes advantage a very low depreciation of the dollar against the euro, the yuan, and the rest of the world to maintain its current account balance to a level close to zero. Table 2: Loss of competitiveness, anchoring the ROW and yuan to the dollar Anchoring the yuan and Row to the dollar Loss of competitiveness Impact on United States towards China United States towards the Euro area United States towards Row exchange rates 1970 1975 1980 1985 1990 1995 2000 1970 1975 1980 1985 1990 1995 2000 1970 1975 1980 1985 1990 1995 2000 Dollar/Euro 0,016 0,016 0,017 0,017 0,017 0,017 0,017-1,342-1,504-1,57-1,615-1,655-1,692-1,73 0,021 0,022 0,022 0,022 0,022 0,023 0,022 Impact on Euro area towards China Euro area towards Row Row towards China exchange rates 1970 1975 1980 1985 1990 1995 2000 1970 1975 1980 1985 1990 1995 2000 1970 1975 1980 1985 1990 1995 2000 Dollar/Euro 1,374 1,542 1,61 1,656 1,697 1,736 1,774 1,379 1,547 1,615 1,661 1,701 1,74 1,778-0,004-0,004-0,004-0,004-0,003-0,003-0,003 Impact on GDP United States towards China United States towards the Euro area United States towards Row 1970 1975 1980 1985 1990 1995 2000 1970 1975 1980 1985 1990 1995 2000 1970 1975 1980 1985 1990 1995 2000 China 1,77 1,963 2,115 2,244 2,354 2,447 2,526 0,422 0,506 0,557 0,596 0,628 0,656 0,679-0,008-0,01-0,012-0,014-0,015-0,017-0,018 Euro area 0,017 0,018 0,019 0,02 0,02 0,02 0,02 0,355 0,23 0,196 0,184 0,176 0,17 0,164 0,022 0,022 0,023 0,023 0,023 0,023 0,023 Row -0,011-0,015-0,02-0,024-0,029-0,034-0,038 0,561 0,689 0,76 0,814 0,859 0,896 0,928 1,779 1,965 2,112 2,238 2,346 2,437 2,515 United States -1,760-1,952-2,103-2,232-2,343-2,437-2,517-1,272-1,378-1,475-1,56-1,634-1,696-1,749-1,76-1,953-2,106-2,236-2,347-2,441-2,521 Impact on GDP Euro area towards China Euro area towards Row Row towards China 1970 1975 1980 1985 1990 1995 2000 1970 1975 1980 1985 1990 1995 2000 1970 1975 1980 1985 1990 1995 2000 China 1,308 1,413 1,51 1,596 1,67 1,732 1,785-0,425-0,511-0,563-0,603-0,636-0,664-0,688 1,724 1,912 2,059 2,184 2,29 2,381 2,457 Euro area -0,344-0,216-0,181-0,167-0,159-0,152-0,147-0,34-0,212-0,177-0,164-0,156-0,15-0,144-0,005-0,004-0,004-0,004-0,003-0,003-0,002 Row -0,567-0,698-0,774-0,831-0,879-0,921-0,956 1,179 1,233 1,305 1,373 1,433 1,485 1,528-1,736-1,918-2,063-2,187-2,294-2,386-2,465 United States -0,456-0,537-0,589-0,629-0,664-0,693-0,718-0,458-0,54-0,593-0,634-0,669-0,699-0,724 0,00 0,001 0,002 0,002 0,003 0,003 0,003 Impact on current United States towards China United States towards the Euro area United States towards Row account 1970 1975 1980 1985 1990 1995 2000 1970 1975 1980 1985 1990 1995 2000 1970 1975 1980 1985 1990 1995 2000 China 0,631 0,636 0,65 0,666 0,683 0,702 0,721 0,151 0,168 0,176 0,181 0,186 0,192 0,198-0,003-0,004-0,004-0,004-0,005-0,005-0,005 Euro area 0,006 0,006 0,006 0,006 0,006 0,006 0,006 0,121 0,067 0,055 0,052 0,051 0,051 0,051 0,008 0,007 0,007 0,007 0,007 0,007 0,007 Row -0,002-0,002-0,002-0,001-0,001-0,001-0,001 0,193 0,197 0,189 0,181 0,173 0,166 0,161 0,583 0,542 0,512 0,487 0,467 0,449 0,435 United States -0,664-0,675-0,693-0,713-0,734-0,756-0,779-0,487-0,475-0,483-0,495-0,509-0,524-0,539-0,665-0,675-0,694-0,714-0,735-0,758-0,78 Impact on current Euro area towards China Euro area towards Row Row towards China account 1970 1975 1980 1985 1990 1995 2000 1970 1975 1980 1985 1990 1995 2000 1970 1975 1980 1985 1990 1995 2000 China 0,469 0,458 0,464 0,475 0,487 0,50 0,513-0,154-0,172-0,18-0,186-0,191-0,197-0,203 0,614 0,619 0,633 0,648 0,665 0,683 0,702 Euro area -0,118-0,062-0,05-0,047-0,046-0,046-0,046-0,116-0,061-0,049-0,046-0,045-0,045-0,045-0,002-0,001-0,001-0,001-0,001-0,001-0,001 Row -0,196-0,20-0,192-0,184-0,176-0,169-0,163 0,382 0,338 0,316 0,30 0,288 0,277 0,268-0,588-0,547-0,517-0,493-0,473-0,456-0,441 United States -0,161-0,181-0,190-0,197-0,203-0,21-0,216-0,161-0,183-0,192-0,199-0,205-0,212-0,218 0,00 0,001 0,001 0,001 0,001 0,001 0,001

21 4. From intermediate regimes to pure floating f or managed dollar-yuan parity The currency of the rest of the world is now supposed to be freely floating. First the yuan will remain pegged to the dollar. Second, it will become purely floating. Last, managed float dollar-yuan parity regimes will be considered. 4.1. Floating the currency of the rest of the world with a yuan peg to the dollar All exchange rates float freely and independently to the central banks, except XR2 which are anchored to the dollar. Fixed dollar-yuan parity Equation 161 will not be written in the model. The Chinese central bank manages its reserves.,, 5 The exchange rate of yuan-dollar (xr2) becomes exogenous.,,,, 2 (170) The exchange rate of the rest of the world against the dollar (XR4) becomes endogenous. The dollar reserves held by the Central Bank of the ROW are constants in the model. xr4 = B #,, /B #,, (171) A loss of United States competitiveness towards China, the Euro zone and the rest of the world A loss of United States competitiveness respectively towards China, Euro zone and the rest of the world reduces the GDP of the United States, but is beneficial to China in three instances (between 0.7% and 2.5%). If RoW and the euro zone increase their respective competitiveness, their production grows by 1% in the short-term and is reduced from 0.35% to 0.06% in the medium term. The exception here is increased competitiveness in China in which case there is no discernible spillover effect on the euro area and the rest of the world GDP. America s debt is rising (between 6% and 12%), financed with correspondingly larger issues of Treasury bills in the wake of reduced activity, in sharp contrast to Chinese debt reduction in all three instances. The United States current account deteriorates relative to China s current account surplus (by between 0.4% and 0.7%) in the short-term. In the case of RoW s increased competitiveness its short-term current account gain wanes over the medium term (0.6%) as its currency appreciates against the dollar (0.01%), the euro (0.025%), and yuan (0.01%). While Chinese surplus persists thanks to a depreciation of the yuan against the currency of the rest of the world (-0.01%). But the yuan appreciates against the euro (0.015%). In the case of increased competitiveness of the euro area, its short-term current account gain erodes over the medium term (0.75%) as the euro appreciates against the yuan (2%), the currency of the rest of the world (1.2%) and the dollar (2%). But China s

22 current account surplus (0.25%) is maintained in the medium term due to the depreciation of its currency against the rest of the world (-0.7%) and Euro (-2%). In the case of a gain in competitiveness in the rest of the world, the contrast is marked between Chinese current account surplus (0.4%) and the United States deficit (-0.4%). This is mainly due to an appreciation of the currency of the rest of world against the euro (1.2%) and yuan (1.7%) despite a depreciation of the dollar against the currency of the rest of world (1,7%) and the euro (0.6%). A loss of the Euro area competitiveness towards China and the rest of the world A loss of the euro zone s competitiveness respectively towards China and the rest of world penalizes its production in the short-term (0.75%) in both cases. The debt of the euro zone increased due to emissions of new Treasury bills. Looking at China s increased competitiveness, the current account deficit of the euro zone shrinks in the medium term (-0.8%). with a corresponding increase in China s current account surplus (0.8%) in medium term. because the euro is depreciating against the yuan (-2%), the dollar (- 2%), and the currency of the rest of the world (-1.2%); the yuan appreciates against the euro (2 %) and the currency of the rest of the world (0.7%). In the case of a gain in competitiveness in the rest of the world, its production increases by 0.8% in contrast with the euro area (- 0.8%) and also penalizes the production in the U.S. (0.15% in medium term) to push up the latter s debt whereas that of the RoW shrinks. The euro zone s current account deficit (-0.7%) adjusts in medium term relative to the RoW s current account surplus by 0.8% and also adjusts partially to 0.25% in the medium term relative to the United States, leaving a very small current account deficit persisting over the medium term in the U.S.. This is primarily the result of a depreciation of the euro against the dollar (-1.3%), the yuan (-1.3%), and the currency of the rest of the world (-2.4%), with a parallel appreciation of the dollar against the euro (1.3%). A loss of RoW s competitiveness towards China Such a situation is characterized by a decrease in production in the United States (-1%) and parallel improvement in China in the medium term (1%). The euro area is penalized in the short-term by the increased Chinese competitiveness, which saw its initial production decline (-0.6%) reduced to zero in the medium term. The decline in activity in the United States degrades its public account, which leads to increased issue of Treasury bills. The debt of the United States increases. The short-term increase in the rest of the world s current account deficit (-0.8%) is reduced in the medium term partly due to the depreciation of its currency against the yuan (-1.69%) and the euro (-1.2 %). China s short-term improvement in current account surplus (0.7%) reverses in the medium term thanks to an appreciation of its currency against the euro (0.6%) and the rest of the world (1.69%). The appreciation of the yuan against the euro (0.6%) and the currency of the rest of the world (1.7%) was not enough to reduce its current account surpluses.

23 Table 3: Loss of competitiveness, ROW floating and yuan pegged to the dollar Anchoring the yuan to the dollar Loss of competitiveness United States towards China United States towards the Euro area United States towards Row 1970 1975 1980 1985 1990 1995 2000 1970 1975 1980 1985 1990 1995 2000 1970 1975 1980 1985 1990 1995 2000 Impact on exchange rates Dollar/Euro 0,02 0,02 0,02 0,02 0,02 0,02 0,02-1,53-1,71-1,79-1,84-1,88-1,93-1,97-0,46-0,50-0,52-0,53-0,55-0,56-0,57 Dollar/Row 0 0 0-0,01-0,01-0,01-0,01-0,61-0,64-0,65-0,67-0,69-0,7-0,72-1,54-1,60-1,64-1,68-1,72-1,75-1,79 Euro/Row -0,02-0,02-0,02-0,02-0,02-0,02-0,03 0,94 1,09 1,15 1,19 1,22 1,25 1,28-1,08-1,1-1,13-1,15-1,18-1,2-1,23 Impact on GDP China 1,781 1,976 2,129 2,259 2,370 2,464 2,545 0,770 0,926 1,017 1,089 1,149 1,200 1,244 0,889 1,050 1,147 1,224 1,290 1,346 1,394 Euro area 0,018 0,018 0,019 0,020 0,021 0,021 0,021 0,353 0,230 0,196 0,183 0,176 0,169 0,164 0,012 0,018 0,018 0,018 0,018 0,019 0,019 Row -0,013-0,019-0,025-0,032-0,039-0,046-0,052-0,100-0,059-0,050-0,050-0,052-0,054-0,056 0,060 0,046 0,041 0,035 0,028 0,021 0,015 United States -1,778-1,972-2,125-2,255-2,366-2,461-2,541-1,028-1,086-1,154-1,217-1,272-1,318-1,357-1,094-1,173-1,253-1,325-1,386-1,438-1,482 Impact on current account China 0,626 0,630 0,643 0,658 0,675 0,693 0,711 0,283 0,304 0,315 0,324 0,333 0,343 0,353 0,338 0,346 0,355 0,364 0,374 0,384 0,395 Euro area 0,006 0,006 0,006 0,006 0,006 0,006 0,006 0,126 0,068 0,056 0,052 0,051 0,051 0,051 0,018 0,009 0,007 0,007 0,006 0,006 0,006 Row -0,003-0,003-0,003-0,003-0,004-0,004-0,004-0,025-0,008-0,004-0,003-0,003-0,003-0,003 0,034 0,030 0,029 0,029 0,029 0,029 0,029 United States -0,665-0,674-0,691-0,711-0,732-0,753-0,775-0,385-0,367-0,371-0,379-0,389-0,400-0,411-0,396-0,393-0,402-0,412-0,423-0,435-0,447 4.2. A pure floating regime Exchange rates float freely determination xr1 B, /B, 172 xr2 B,, /B,, (170) xr3 2/ 1 (173) xr4 B #,, /B #,, (171) xr5 2/ 4 (174) xr6 4/ 1 (175) A loss of U.S. competitiveness towards China (0.5 to 0.52) improves China's GDP (0.8%) while lowering the GDP of the United States (- 0.6%). China s increased competitiveness penalizes the GDP of the rest of the world (- 0.3%). Note that in the case of the nationalcurrency debt model, the increased competitiveness of China and the euro zone has no effect on the GDP of the rest of the world, so this effect is linked to foreign debt of the rest of the world in dollars. Despite a decline in GDP in the rest of the world due to loss of United States competitiveness towards China and the euro zone, issues of Treasury bills in the rest of the world are shrinking. Indeed, the external debt of the government of RoW is denominated in dollars, that bloc must then find a sustainable balance between external competitiveness and the structure of its external debt in foreign currency. Assuming all exchange rates are floating freely, then a loss of United States competitiveness towards China or the rest of the world induces a depreciation of the dollar against the currency of the rest of the world. Compared to the case where the