Macroeconomics

Chapter 12 (International Linkages)

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Chapter Highlights:
Economies are linked internationally through
trade in goods and through financial
markets.
Exchange rate price of a foreign currency
in terms of local currency.
A high exchange rate a weak local
currency reduces imports and increases
exports, stimulating aggregate demand.
Under fixed exchange rates, central banks
buy and sell foreign currency to peg the
exchange rate.
Under floating exchange rates, market
determines the value of one currency in
terms of another.
If a country wishes to maintain a fixed
exchange rate in the presence of balance
deficit, the central bank must buy back
domestic currency, using its reserves of
foreign currency and gold or borrowing
reserves from abroad. If the balance of
payments deficit persists long enough for the
country to run out of reserves, it must allow
the value of its currency to fall.
In the very long run, exchange rates adjust
so as to equalize the real cost of goods
across countries.
With perfect capital mobility and fixed
exchange rates, fiscal policy is powerful.
With perfect capital mobility and floating
exchange rates, monetary policy is
powerful.
THE BALANCE OF PAYMENTS AND
EXCHANGE RATES
The balance of payments is the record of
the transactions of the residents of a country
with the rest of the world.
BOP is the overall of current account and
capital account.
Current account trade
Capital account finance
Trade trade surplus(X>Q), trade
deficit(X<Q), and trade balance(X=Q)
Finance buying of bonds and stocks
BOP surplus increases official reserves
The simple rule for BOP accounting is that
any transactions that gives rise to a payment
by a countrys residents is a deficit item in
that countrys BOP.
Deficit items items from the foreign
country
Surplus items sales of local country
abroad, purchases of foreign residents
The current account records trade in goods
and services, as well as transfer payments.
The capital account records purchases and
sales of assets such as stocks, bonds, and
land.
The increase in official reserves is also called
the BOP surplus.
BOP surplus = increase in official exchange
reserves
BOP surplus = current account surplus +
net private capital inflow
Depreciation and Appreciation flexible
exchange rates
Devaluation and Revaluation fixed
exchange rates
Nominal exchange rate (e) = local
currency/foreign currency
High exchange rate depreciation of local
currency local currency is weak
Exchange rate is the price of one currency
in terms of another.
Fixed exchange rate government
specifies and protects just one rate.
In a fixed exchange rate system foreign
central banks stand ready to buy and sell
their currencies at a fixed price in terms of
local currency.
Intervention the buying and selling of
foreign exchange by the central bank
The BOP measures the amount of foreign
exchange intervention needed from the
central banks.
However, if a country persistently runs
deficits in the balance of payments, the
central bank will eventually run out of
reserves of foreign exchange and will be
unable to continue its intervention.
Flexible exchange rates government
does not set a price.
Under the fixed exchange rate, the central
banks have to provide whatever amounts of
foreign currency are needed to finance
payments imbalances.
In a flexible (floating) exchange rate
system, the central banks allow the
exchange rate to adjust to equate the supply
and demand for foreign currency.
In a system of clean floating, central
banks stand aside completely and allow
exchange rates to be freely determined in the
foreign exchange markets. (BOP = 0)
Under managed (dirty) floating, central
banks intervene to buy and sell foreign
currencies in attempts to influence exchange
rates.
If the exchange rate falls, the domestic
currency is worth more; it costs fewer local
currencies to buy a unit of the foreign
currency.


Macroeconomics
Chapter 12 (International Linkages)

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Devaluation takes place when the price of
foreign currencies under fixed exchange rate
regime is increased by official action.
A currency depreciates when, under floating
rates, it becomes less expensive in terms of
foreign currencies.
The BOP accounts are a record of
transactions of the economy with other
economies.
The capital account describes transactions
in assets.
The current account covers transactions in
goods and services, as well as transfers.
Any payment to foreigners is a deficit item
in the BOP.
Any payment from foreigners is a surplus
item.
Under fixed exchange rates, central banks
stand ready to meet all demands for foreign
currencies at a fixed price in terms of the
domestic currency. They finance the excess
demands for, or supplies of, foreign currency
at the pegged (fixed) exchange rate by
running down, or adding to, their reserves of
foreign currency.
Under flexible exchange rates, the
demands for and supplies of foreign currency
are equated through movements in exchange
rates.
Under clean floating, there is no central
bank intervention and the BOP=0.
Central banks sometimes intervene in a
floating rate system, engaging in so-called
dirty floating.
THE EXCHANGE RATE IN THE LONG
RUN
Two currencies are at purchasing power
parity (PPP) when a unit of domestic
currency can buy the same basket of goods
at home or abroad.
The relative purchasing power of two
currencies is measured by the real
exchange rate (R).
R is the ratio of foreign to domestic prices,
measured in the same currency.
R measures a countrys competitiveness in
international trade.

P price level in local country
Pf price level in foreign country (foreign
prices)
R= 1, currencies are at PPP
R > 1, goods abroad are more expensive
As long as R>1, we expect the relative
demand for domestically produced goods to
rise.
TRADE IN GOODS, MARKET
EQUILIBRIUM, AND THE BALANCEOF
TRADE
In an open economy, part of domestic
output is sold to foreigners (exports) and part
of the spending by domestic residents
purchases foreign goods (imports).
Spending on domestic goods determines
domestic output.
DS spending by domestic residents
Spending by domestic residents = DS
DS = C + I + G
Spending on domestic goods = DS + NX
DS + NX = (C + I + G) + (X Q)
X exports (consumption function of
foreigners)
Q imports (consumption function from
abroad)
DS = DS(Y, i)
NX = X(Yf, R) Q(Y, R) = NX(Y, Yf, R)
A rise in foreign income, other things
being equal, improves the home countrys
trade balance and therefore raises the home
countrys aggregate demand.
A real depreciation by the home country
improves the trade balance and therefore
increases aggregate demand.
A rise in home income raises import
spending and hence worsens the trade
balance.
IS curve in open economy is steeper than in
closed economy.
IS curve: DS(Y, i) + NX(Y, Yf, R)
X = f(Yf, R) ; increase NX
X = f(Yf, R) ; increase NX
Q = f(Y, R) ; lowers NX
Q = f(Y, R) ; increases NX
R (depreciation)- we will buy local goods or
import less and foreigners would think its
cheaper so X (shifts IS to the right)
R (appreciation) - you will prefer to buy a
foreign good (shifts IS to the left)
CAPITAL MOBILITY
Capital is perfectly mobile internationally
when investors can purchase assets in any
country they choose, quickly, with low
transaction costs, and in unlimited amounts.
i local interest rate
if foreign interest rate
i> if (finance part) ROW will come to you
Capital flight - investors go out
i> if, Capital account surplus; capital inflow
i< if, Capital account deficit; capital outflow
BP = NX(Y, Yf, R) + CF(i if)
CF capital account surplus
i if = interest rate differential


Macroeconomics
Chapter 12 (International Linkages)

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External balance exists when the balance
of payments is close to balance. (Otherwise
the bank is either losing reserves which it
cannot keep on doing or gaining reserves
which it does not want to do forever.)
Internal balance exits when output is at
the full-employment level.
Internal balance goal: Ye(income) =
Y*(full-employment)
External balance goal: BOP = 0
Internal and External balance under
fixed exchange rates (Figure)









THE MUNDELL-FLEMING MODEL:
PERFECT CAPITAL MOBILITY UNDER
FIXED EXCHANGE RATE
Under fixed exchange rates and perfect
capital mobility, a country cannot pursue
an independent monetary policy. Interest
rates cannot move out of line with those
prevailing in the world market.
The commitment to maintain a fixed
exchange rate makes the money stock
endogenous.
PERFECT CAPITAL MOBILITY AND
FLEXIBLE EXCHANGE RATES
Under fully flexible exchange rates the
absence of intervention implies a zero
balance of payments. Any current account
deficit must be financed by private capital
inflows: a current account surplus is balanced
by capital outflows. Adjustments in the
exchange rate ensure that the sum of the
current and capital accounts is zero.
The important lesson here is that real
disturbances to demand do not affect
equilibrium output under flexible rates with
perfect capital mobility.
Under fixed rates, the monetary
authorities cannot control the nominal
money stock.
The fact that the central bank can control the
money stock under fixed exchange rates is a
key aspect of that exchange rate system.
SUMMARY
The balance-of-payments (BOP)
accounts are a record of the international
transactions of the economy.
The current account records trade in goods
and services as well as transfer payments.
The capital account records purchases and
sales of assets.
The overall BOP surplus is the sum of the
current and capital accounts surpluses.
If the overall balance is in deficit, we have to
make more payments to foreigners than they
make us. The foreign currency for making
these payments is supplied by central banks.
Under fixed exchange rates, the central
bank holds constant the price of foreign
currencies in terms of the domestic currency.
Under floating, or flexible, exchange rates,
the exchange rate may change from moment
to moment.
In a system of clean floating, the exchange
rate is determined by supply and demand
without central bank intervention.
Under dirty floating, the central bank
intervenes by buying and selling foreign
exchange in attempt to influence but not fix
the exchange rate.
A real depreciation or increase in
foreign income increases net exports and
shifts the IS curve out to the right.
There is equilibrium in the goods market
when the demand for domestically produced
goods is equal to the output of those goods.
Capital inflow can finance a current
account deficit.
Fiscal policy is highly effective under fixed
exchange rates with complete capital
mobility.
A fiscal expansion (fixed exchange rate)
tends to raise the interest rate, thereby
leading the central bank to increase the
money stock to keep the exchange rate
constant, reinforcing the expansionary fiscal
effect.
Under floating rates, monetary policy is
highly effective and fiscal policy is ineffective
in changing output.
A monetary expansion (floating) leads to
depreciation, increased exports, and
increased output.
Fiscal expansion (floating) causes an
appreciation and completely crowds out net
exports.
If an economy with floating rates finds itself
with unemployment, the central bank can
E4
Surplus
Unemployment
E3
Surplus
Overemployment
E1
Deficit
Unemployment
E2
Deficit
Overemployment
i
if
Y Y* 0
BP = 0


Macroeconomics
Chapter 12 (International Linkages)

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intervene to depreciate the exchange rate
and increase net exports and thus aggregate
demand. Such policies are known as
beggar-thy-neighbour policies because
the increase in demand for domestic output
comes at the expense of demand for foreign
output.
R appreciates, X decreases, Q increases,
therefore trade deficit which causes IS to
shift to the left.







Effects of Monetary and Fiscal Policy
under Perfect Capital Mobility.
FIXED EXCHANGE
RATE
FLEXIBLE EXCHANGE
RATE
CF outflow CF outflow
BOP deficit BOP deficit
Ms decreases Dif>Sif
LM shifts to the left
until it intersects
with the new IS and
BOP
e increases R
increases X
increases and Q
decreases (trade
surplus)
You go back to the
same i but with
lower income
IS shifts to the right
and you go back to
the same i and Y
POLICY FIXED EXCHANGE
RATES
FLEXIBLE
EXCHANGE
RATES
MONETARY
EXPANSION
No output
change; reserve
losses equal to
money increase
Output
expansion; trade
balance improves;
exchange
depreciation
FISCAL
EXPANSION
Output
expansion; trade
balance worsens
No output
change; reduced
net exports;
exchange
appreciation