Macroeconomics help
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18 The Goods Market in an Open Economy n 2009, countries around the world worried about the risk of a recession in the United States. But their worries were not so much for the United States as they were for themselves. To them, a U.S. recession meant lower exports to the United States, a deterioration of their trade position, and weaker growth at home.
Were their worries justified? Figure 17-1 from the previous chapter certainly suggested they were. The U.S. recession clearly led to a world recession. To understand what happened, we must expand the treatment of the goods market in Chapter 3 of the core and account for open- ness in the analysis of goods markets. This is what we do in this chapter.
Section 18-1 characterizes equilibrium in the goods market for an open economy.
Sections 18-2 and 18-3 show the effects of domestic shocks and foreign shocks on the domestic economy’s output and trade balance.
Sections 18-4 and 18-5 look at the effects of a real depreciation on output and the trade balance.
Section 18-6 gives an alternative description of the equilibrium that shows the close connection among saving, investment, and the trade balance.
370 The Open Economy Extensions
18-1 The IS Relation in the Open Economy When we were assuming the economy was closed to trade, there was no need to distinguish between the domestic demand for goods and the demand for domestic goods; they were clearly the same thing. Now, we must distinguish between the two. Some domestic demand falls on foreign goods, and some of the demand for domestic goods comes from foreigners. Let’s look at this distinction more closely.
The Demand for Domestic Goods In an open economy, the demand for domestic goods, Z, is given by
Z = C + I + G - IM>e + X (18.1) The first three terms—consumption, C, investment, I, and government spending, G— constitute the total domestic demand for goods, domestic or foreign. If the economy were closed, C + I + G would also be the demand for domestic goods. This is why, until now, we have only looked at C + I + G. But now we have to make two adjustments:
■■ First, we must subtract imports—that part of the domestic demand that falls on for- eign goods rather than on domestic goods.
We must be careful here. Foreign goods are different from domestic goods, so we cannot just subtract the quantity of imports, IM. If we were to do so, we would be subtracting apples (foreign goods) from oranges (domestic goods). We must first express the value of imports in terms of domestic goods. This is what IM>e in equation (18.1) stands for. Recall from Chapter 17 that e, the real exchange rate, is defined as the price of domestic goods in terms of foreign goods. Equivalently, 1>e is the price of foreign goods in terms of domestic goods. So IM, 11>e2—or, equiva- lently, IM>e —is the value of imports in terms of domestic goods.
■■ Second, we must add exports—that part of the demand for domestic goods that comes from abroad. This is captured by the term X in equation (18.1).
The Determinants of C, I, and G Having listed the five components of demand, the next task is to specify their determi- nants. Let’s start with the first three: C, I, and G. Now that we are assuming the economy is open, how should we modify our earlier descriptions of consumption, investment, and government spending? The answer: not very much, if at all. How much consumers de- cide to spend still depends on their income and their wealth. Although the real exchange rate surely affects the composition of consumption spending between domestic goods and foreign goods, there is no obvious reason why it should affect the overall level of consump- tion. The same is true of investment; the real exchange rate may affect whether firms buy domestic machines or foreign machines, but it should not affect total investment.
This is good news because it implies that we can use the descriptions of consump- tion, investment, and government spending that we developed earlier. Therefore, I assume that domestic demand is given by:
Domestic demand: C + I + G = C1Y - T2 + I1Y, r2 + G 1 + 2 1 + , - 2
Consumption depends positively on disposable income, Y - T and investment depends positively on production, Y, and negatively on the real policy rate, r. Note that I leave aside some of the refinements I introduced earlier, i.e the presence of a risk pre- mium which we focused on in Chapters 6 and 14, and the role of expectations which we
c
“The domestic demand for goods” and “the demand for domestic goods” sound close but are not the same. Part of domestic demand falls on foreign goods. Part of foreign demand falls on domestic goods.
c
In Chapter 3, I ignored the real exchange rate and subtracted IM, not IM>e. But I was cheat- ing; I did not want to have to talk about the real exchange rate—and complicate matters— so early in the book.
cDomestic demand for goods C + I + G
- Domestic demand for for- eign goods (imports), IM>e
+ Foreign demand for do- mestic goods (exports), X
= Demand for domestic goods C + I + G - IM>e + X
c
I again cheat a bit here. Income should include not only domes- tic income but also net income and transfers from abroad. For simplicity, I ignore these two additional terms here.
Chapter 18 The Goods Market in an Open Economy 371
focused on in Chapters 14 to 16. I want to take things one step at a time to understand the effects of opening the economy; I shall reintroduce some of those refinements later.
The Determinants of Imports Imports are the part of domestic demand that falls on foreign goods. What do they de- pend on? They clearly depend on domestic income. Higher domestic income leads to a higher domestic demand for all goods, both domestic and foreign. So a higher domestic income leads to higher imports. They also clearly depend on the real exchange rate— the price of domestic goods in terms of foreign goods. The more expensive domestic goods are relative to foreign goods—equivalently, the cheaper foreign goods are relative to domestic goods—the higher is the domestic demand for foreign goods. So a higher real exchange rate leads to higher imports. Thus, we write imports as:
IM = IM1Y, e2 (18.2) 1 + , + 2
■■ An increase in domestic income, Y (equivalently, an increase in domestic output— income and output are still equal in an open economy) leads to an increase in im- ports. This positive effect of income on imports is captured by the positive sign under Y in equation (18.2).
■■ An increase in the real exchange rate, e (a real appreciation), leads to an increase in imports, IM. This positive effect of the real exchange rate on imports is captured by the positive sign under e in equation (18.2). (As e goes up, note that IM goes up, but 1>e goes down, so what happens to IM>e, the value of imports in terms of domestic goods, is ambiguous. We return to this point shortly.)
The Determinants of Exports Exports are the part of foreign demand that falls on domestic goods. What do they depend on? They depend on foreign income. Higher foreign income means higher for- eign demand for all goods, both foreign and domestic. So higher foreign income leads to higher exports. They depend also on the real exchange rate. The higher the price of domestic goods in terms of foreign goods, the lower the foreign demand for domestic goods. In other words, the higher the real exchange rate, the lower are exports.
Let Y* denote foreign income (equivalently, foreign output). We therefore write exports as
X = X1Y *, e2 (18.3) 1 + , - 2
■■ An increase in foreign income, Y*, leads to an increase in exports. ■■ An increase in the real exchange rate, e, leads to a decrease in exports.
Putting the Components Together Figure 18-1 puts together what we have learned so far. It plots the various components of demand against output, keeping constant all other variables (the interest rate, taxes, government spending, foreign output, and the real exchange rate) that affect demand.
In Figure 18-1(a), the line DD plots domestic demand, C + I + G as a function of output, Y. This relation between demand and output is familiar from Chapter 3. Under our standard assumptions, the slope of the relation between demand and out- put is positive but less than one. An increase in output—equivalently, an increase in
b
Recall the discussion at the start of this chapter. Coun- tries in the rest of the world worry about a U.S. recession. The reason: A U.S. recession means a decrease in the U.S. demand for foreign goods.
Recall that asterisks refer to foreign variables.
b
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372 The Open Economy Extensions
D e m
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d , Z
DD
Domestic demand (C 1 I 1 G)
Output, Y (a)
D e m
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Output, Y
(c) Y
N e t
ex p
o rt
s , N
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NX Trade deficit
Trade surplus
BC
(d)
YTB
YTB
Figure 18-1
The Demand for Domestic Goods and Net Exports
(a), The domestic demand for goods is an increasing func- tion of income (output).
(b) and (c), The demand for domestic goods is obtained by subtracting the value of im- ports from domestic demand and then adding exports.
(d), The trade balance is a decreasing function of output.
MyEconLab Animation
income—increases demand but less than one-for-one. (In the absence of good reasons to the contrary, we draw the relation between demand and output, and the other relations in this chapter, as lines rather than curves. This is purely for convenience, and none of the discussions that follow depend on this assumption.)
To arrive at the demand for domestic goods, we must first subtract imports. This is done in Figure 18-1(b) and it gives us the line AA. The line AA represents the domes- tic demand for domestic goods. The distance between DD and AA equals the value of
Chapter 18 The Goods Market in an Open Economy 373
imports, IM>e. Because the quantity of imports increases with income, the distance between the two lines increases with income. We can establish two facts about line AA, which will be useful later in the chapter:
■■ AA is flatter than DD. As income increases, some of the additional domestic de- mand falls on foreign goods rather than on domestic goods. In other words, as income increases, the domestic demand for domestic goods increases less than total domestic demand.
■■ As long as some of the additional demand falls on domestic goods, AA has a positive slope. An increase in income leads to some increase in the demand for domestic goods.
Finally, we must add exports. This is done in Figure 18-1(c) and it gives us the line ZZ, which is above AA. The line ZZ represents the demand for domestic goods. The distance between ZZ and AA equals exports, X. Because exports do not depend on domestic income (they depend on foreign income), the distance between ZZ and AA is constant, which is why the two lines are parallel. Because AA is flatter than DD, ZZ is also flatter than DD.
From the information in Figure 18-1(c) we can characterize the behavior of net exports—the difference between exports and imports 1X - IM>e2—as a function of output. At output level Y, for example, exports are given by the distance AC and imports by the distance AB, so net exports are given by the distance BC.
This relation between net exports and output is represented as the line NX (for Net eXports) in Figure 18-1(d). Net exports are a decreasing function of output. As output increases, imports increase and exports are unaffected, so net exports decrease. Call YTB (TB for trade balance) the level of output at which the value of imports equals the value of exports, so that net exports are equal to zero. Levels of output above YTB lead to higher imports and to a trade deficit. Levels of output below YTB lead to lower imports and to a trade surplus.
18-2 Equilibrium Output and the Trade Balance The goods market is in equilibrium when domestic output equals the demand—both domestic and foreign—for domestic goods.
Y = Z
Collecting the relations we derived for the components of the demand for domestic goods, Z, we get
Y = C1Y - T2 + I1Y, r2 + G - IM1Y, e2>e + X1Y *, e2 (18.4) This equilibrium condition determines output as a function of all the variables we
take as given, from taxes to the real exchange rate to foreign output. This is not a simple relation; Figure 18-2 represents it graphically, in a more user-friendly way.
In Figure 18-2(a), demand is measured on the vertical axis, output (equivalently production or income) on the horizontal axis. The line ZZ plots demand as a function of output; this line just replicates the line ZZ in Figure 18-1(c); ZZ is upward sloping, but with slope less than 1.
Equilibrium output is at the point where demand equals output, at the intersection of the line ZZ and the 45-degree line: point A in Figure 18-2(a), with associated output level Y.
Figure 18-2(b) replicates Figure 18-1(d), drawing net exports as a decreasing func- tion of output. There is in general no reason why the equilibrium level of output, Y, should be the same as the level of output at which trade is balanced, YTB . As we have drawn the figure, equilibrium output is associated with a trade deficit, equal to the
For a given real exchange rate e, IM>e—the value of imports in terms of domestic goods— moves exactly with IM, the quantity of imports.
b
b
Recall that net exports is synonymous with trade bal- ance. Positive net exports correspond to a trade surplus, whereas negative net exports correspond to a trade deficit.
b
The equilibrium level of out- put is given by the condition Y = Z. The level of output at which there is trade bal- ance is given by the condi- tion X = IM>e. These are two different conditions.
374 The Open Economy Extensions
D e m
a n
d , Z
ZZ
Output, Y
Output, Y
Y
A
(a) 45°
N e t
ex p
o rt
s , N
X
NX
Trade deficit
(b)
0 B
C
YTB
Figure 18-2
Equilibrium Output and Net Exports
The goods market is in equi- librium when domestic output is equal to the demand for do- mestic goods. At the equilib- rium level of output, the trade balance may show a deficit or a surplus.
MyEconLab Animation
distance BC. Note that we could have drawn it differently, so equilibrium output was associated instead with a trade surplus.
We now have the tools needed to answer the questions we asked at the beginning of this chapter.
18-3 Increases in Demand—Domestic or Foreign How do changes in demand affect output in an open economy? Let’s start with an old favorite—an increase in government spending—then turn to a new exercise, the effects of an increase in foreign demand.
Increases in Domestic Demand Suppose the economy is in a recession and the government decides to increase govern- ment spending in order to increase domestic demand and, in turn, output. What will be the effects on output and on the trade balance?
The answer is given in Figure 18-3. Before the increase in government spending, demand is given by ZZ in Figure 18-3(a), and the equilibrium is at point A, where output equals Y. Let’s assume that trade is initially balanced—even though, as we have seen, there is no reason why this should be true in general. So, in Figure 18-3(b), Y = YTB .
What happens if the government increases spending by ∆G? At any level of out- put, demand is higher by ∆G, shifting the demand relation up by ∆G from ZZ to ZZ=.
c
As in the core, we start with just the goods market, and in- troduce financial markets and labor markets later on.
Chapter 18 The Goods Market in an Open Economy 375
D e m
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ZZ
Output, Y
Output, Y
Y
A
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N e t
e x p
o rt
s , N
X
NX
Trade deficit
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0 B
DG > 0
C
ZZ
YTB
Y
A Figure 18-3
The Effects of an Increase in Government Spending
An increase in government spending leads to an increase in output and to a trade deficit.
MyEconLab Animation
The equilibrium point moves from A to A=, and output increases from Y to Y=. The in- crease in output is larger than the increase in government spending: There is a multiplier effect.
So far, the story sounds the same as the story for a closed economy in Chapter 3. However, there are two important differences:
■■ There is now an effect on the trade balance. Because government spending enters neither the exports relation nor the imports relation directly, the relation between net exports and output in Figure 18-3(b) does not shift. So the increase in output from Y to Y= leads to a trade deficit equal to BC: Imports go up, and exports do not change.
■■ Not only does government spending now generate a trade deficit, but the effect of government spending on output is smaller than it would be in a closed economy. Recall from Chapter 3 that the smaller the slope of the demand relation, the smaller the multiplier (for example, if ZZ were horizontal, the multiplier would be 1). And recall from Figure 18-1 that the demand relation, ZZ, is flatter than the de- mand relation in the closed economy, DD. This means the multiplier is smaller in the open economy.
The trade deficit and the smaller multiplier have the same origin. Because the economy is open, an increase in demand now falls not only on domestic goods but also on foreign goods. So when income increases, the effect on the demand for domestic goods is smaller than it would be in a closed economy, leading to a smaller multiplier. And be- cause some of the increase in demand falls on imports—and exports are unchanged— the result is a trade deficit.
b
Starting from trade balance, an increase in government spending leads to a trade deficit.
An increase in government spending increases output. The multiplier is smaller than in a closed economy.
b
b
The smaller multiplier and the trade deficit have the same or- igin. Some domestic demand falls on foreign goods.
376 The Open Economy Extensions
D e m
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ZZ
Output, Y
Output, Y
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(a) 45°
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NX
(b)
0
DX > 0
DNX
Domestic demand for goods
DNX
DX > 0
Demand for domestic goods
ZZ
YTB NX
A
Y
Figure 18-4
The Effects of an Increase in Foreign Demand
An increase in foreign demand leads to an increase in output and to a trade surplus.
MyEconLab Animation
These two implications are important. In an open economy, an increase in domestic demand has a smaller effect on output than in a closed economy, and an adverse ef- fect on the trade balance. Indeed, the more open the economy, the smaller the effect on output and the larger the adverse effect on the trade balance. Take the Netherlands, for example. As we saw in Chapter 17, the Netherlands’ ratio of exports to GDP is very high. It is also true that the Netherlands’ ratio of imports to GDP is very high. When domestic demand increases in the Netherlands, much of the increase in demand is likely to result in an increase in the demand for foreign goods rather than an increase in the demand for domestic goods. The effect of an increase in government spending is therefore likely to be a large increase in the Netherlands’ trade deficit and only a small increase in its output, making domestic demand expansion a rather unattractive policy for the Netherlands. Even for the United States, which has a much lower import ratio, an increase in demand will be associated with a worsening of the trade balance.
Increases in Foreign Demand Consider now an increase in foreign output, that is, an increase in Y*. This could be due to an increase in foreign government spending, G*—the policy change we just analyzed, but now taking place abroad. But we do not need to know where the increase in Y* comes from to analyze its effects on the U.S. economy.
Figure 18-4 shows the effects of an increase in foreign activity on domestic out- put and the trade balance. The initial demand for domestic goods is given by ZZ in
Chapter 18 The Goods Market in an Open Economy 377
Figure 18-4(a). The equilibrium is at point A, with output level Y. Let’s again assume trade is balanced, so that in Figure 18-4(b) the net exports associated with Y equal zero 1Y = YTB2.
It will be useful below to refer to the line that shows the domestic demand for goods C + I + G as a function of income. This line is drawn as DD. Recall from Figure 18-1 that DD is steeper than ZZ. The difference between ZZ and DD equal net exports, so that if trade is balanced at point A, then ZZ and DD intersect at point A.
Now consider the effects of an increase in foreign output, ∆Y * (for the moment, ignore the line DD ; we only need it later). Higher foreign output means higher foreign demand, in- cluding higher foreign demand for U.S. goods. So the direct effect of the increase in foreign output is an increase in U.S. exports by some amount, which we shall denote by ∆X.
■■ For a given level of output, this increase in exports leads to an increase in the de- mand for U.S. goods by ∆X, so the line showing the demand for domestic goods as a function of output shifts up by ∆X, from ZZ to ZZ=.
■■ For a given level of output, net exports go up by ∆X. So the line showing net exports as a function of output in Figure 18-4(b) also shifts up by ∆X, from NX to NX=.
The new equilibrium is at point A= in Figure 18-4(a), with output level Y=. The increase in foreign output leads to an increase in domestic output. The channel is clear. Higher foreign output leads to higher exports of domestic goods, which increases domestic output and the domestic demand for goods through the multiplier.
What happens to the trade balance? We know that exports go up. But could it be that the increase in domestic output leads to such a large increase in imports that the trade balance actually deteriorates? No: The trade balance must improve. To see why, note that, when foreign demand increases, the demand for domestic goods shifts up from ZZ to ZZ=; but the line DD, which gives the domestic demand for goods as a function of output, does not shift. At the new equilibrium level of output Y=, domestic demand is given by the distance DC, and the demand for domestic goods is given by DA=. Net exports are therefore given by the distance CA=—which, because DD is necessarily below ZZ=, is nec- essarily positive. Thus, while imports increase, the increase does not offset the increase in exports, and the trade balance improves.
Fiscal Policy Revisited We have derived two results so far:
■■ An increase in domestic demand leads to an increase in domestic output but leads also to a deterioration of the trade balance. (We looked at an increase in govern- ment spending, but the results would have been the same for a decrease in taxes, an increase in consumer spending, and so on.)
■■ An increase in foreign demand (which could come from the same types of changes taking place abroad) leads to an increase in domestic output and an improvement in the trade balance.
These results, in turn, have two important implications. Both have been in evidence in the recent crisis.
First, and most obviously, they imply that shocks to demand in one country affect all other countries. The stronger the trade links between countries, the stronger the interactions, and the more countries will move together. This is what we saw in Figure 17-1. Although the crisis started in the United States, it quickly affected the rest of the world. Trade links were not the only reason; financial links also played a central role. But the evidence points to a strong effect of trade, starting with a decrease in exports from other countries to the United States.
DD is the domestic demand for goods. ZZ is the demand for domestic goods. The dif- ference between the two is equal to the trade deficit.
b
b
Y* directly affects exports and so enters the relation between the demand for domestic goods and output. An increase in Y* shifts ZZ up. Y* does not affect domestic consumption, domestic investment, or do- mestic government spending directly, and so it does not enter the relation between the domestic demand for goods and output. An increase in Y* does not shift DD.
An increase in foreign output increases domestic output and improves the trade balance.
b
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378 The Open Economy Extensions
The G20 and the 2009 Fiscal Stimulus F
o c
u S
In November 2008, the leaders of the G20 met in an emer- gency meeting in Washington. The G20, a group of ministers of finance and central bank governors from 20 countries, including both the major advanced and the major emerging countries in the world, had been created in 1999 but had not played a major role until the crisis. With mounting evidence that the crisis was going to be both deep and widespread, the group met to coordinate their responses in terms of both macroeconomic and financial policies.
On the macroeconomic front, it had become clear that monetary policy would not be enough, and so the focus turned to fiscal policy. The decrease in output was going to lead to a decrease in revenues, and thus an increase in bud- get deficits. Dominique Strauss-Kahn, the then managing director of the International Monetary Fund, argued that further fiscal actions were needed and suggested taking ad- ditional discretionary measures—either decreases in taxes or increases in spending—adding up to roughly 2% of GDP on average for each country. This is what he said:
“The fiscal stimulus is now essential to restore global growth. Each country’s fiscal stimulus can be twice as effec- tive in raising domestic output growth if its major trading partners also have a stimulus package.”
He noted that some countries had more room for maneu- ver than others. “We believe that those countries—advanced and emerging economies—with the strongest fiscal policy frameworks, the best ability to finance fiscal expansion, and the most clearly sustainable debt should take the lead.”
Over the next few months, most countries indeed adopted discretionary measures, aimed at either increasing private or public spending. For the G20 as a whole, discretionary measures added up to about 2.3% of GDP in 2009. Some countries, with less fiscal room, such as Italy, did less. Some countries, such as the United States or France, did more.
Was this fiscal stimulus successful? Some have argued that it was not. After all, the world economy had large
negative growth in 2009. The issue here is one of coun- terfactuals. What would have happened in the absence of the stimulus? Many believe that, absent the fiscal stimulus, growth would have been even more negative, perhaps cata- strophically so. Counterfactuals are hard to prove or disprove, and thus the controversy is likely to go on. (On the issue of counterfactuals and the difference between economists and politicians, there is a nice quote from former U.S. congress- man Barney Frank:
“Not for the first time, as an elected official, I envy econo- mists. Economists have available to them, in an analytical approach, the counterfactual. Economists can explain that a given decision was the best one that could be made, because they can show what would have happened in the counter- factual situation. They can contrast what happened to what would have happened. No one has ever gotten re-elected where the bumper sticker said, ‘It would have been worse without me.’ You probably can get tenure with that. But you can’t win office.”)
Was this fiscal stimulus dangerous? Some have argued that it has led to a large increase in public debt, which is now forcing governments to adjust, leading to a fiscal con- traction and making recovery more difficult (we discussed this in Chapter 6 and will return to it in Chapter 22). This argument is largely misplaced. Most of the increase in debt does not come from the discretionary measures that were taken, but from the decrease in revenues that came from the decrease in output during the crisis. And a number of countries were running large deficits before the crisis. It remains true, however, that this large increase in debt is now making it more difficult to use fiscal policy to help the recovery.
For more discussion at the time, see “Financial Crisis Response: IMF Spells Out Need for Global Fiscal Stimulus,” in IMF Survey Magazine Online, December 29, 2008. (http://www.imf.org/ external/pubs/ft/survey/so/2008/int122908a.htm).
Second, these interactions complicate the task of policy makers, especially in the case of fiscal policy. Let’s explore this argument more closely.
Start with the following observation: Governments do not like to run trade deficits and for good reasons. The main reason: A country that consistently runs a trade deficit accumulates debt vis-à-vis the rest of the world, and therefore has to pay steadily higher interest payments to the rest of the world. Thus, it is no wonder that countries prefer increases in foreign demand (which improve the trade balance) to increases in domestic demand (which worsen the trade balance).
But these preferences can have disastrous implications. Consider a group of coun- tries, all doing a large amount of trade with each other, so that an increase in demand in any one country falls largely on the goods produced in the other countries. Suppose all these countries are in recession and each has roughly balanced trade to start. In this case, each country might be reluctant to take measures to increase domestic demand. Were it to do so, the result might be a small increase in output but also a large trade deficit. Instead, each country might just wait for the other countries to increase their demand. This way, it
Chapter 18 The Goods Market in an Open Economy 379
gets the best of both worlds, higher output and an improvement in its trade balance. But if all the countries wait, nothing will happen and the recession may last a long time.
Is there a way out? There is—at least in theory. If all countries coordinate their macroeconomic policies so as to increase domestic demand simultaneously, each can in- crease demand and output without increasing its trade deficit (vis-à-vis the others; their combined trade deficit with respect to the rest of the world will still increase). The reason is clear. The coordinated increase in demand leads to increases in both exports and im- ports in each country. It is still true that domestic demand expansion leads to larger im- ports; but this increase in imports is offset by the increase in exports, which comes from the foreign demand expansions.
In practice, however, policy coordination is not so easy to achieve. Some countries might have to do more than others and may not want to do so.
Suppose that only some countries are in recession. Countries that are not in a recession will be reluctant to increase their own demand; but if they do not, the countries that expand will run a trade deficit vis-à-vis countries that do not. Or suppose some countries are al- ready running a large budget deficit. These countries might not want to cut taxes or further increase spending as this would further increase their deficits. They will ask other countries to take on more of the adjustment. Those other countries may be reluctant to do so.
Countries also have a strong incentive to promise to coordinate and then not deliver on their promise. Once all countries have agreed, say, to an increase in spending, each country has an incentive not to deliver, so as to benefit from the increase in demand elsewhere and thereby improve its trade position. But if each country cheats, or does not do everything it promised, there will be insufficient demand expansion to get out of the recession.
The result is that, despite declarations by governments at international meetings, coordination often fizzles. Only when things are really bad, does coordination appear to take hold. This was the case in 2009 and is explored in the Focus box “The G20 and the 2009 Fiscal Stimulus.”
18-4 Depreciation, the Trade Balance, and Output Suppose the U.S. government takes policy measures that lead to a depreciation of the dollar—a decrease in the nominal exchange rate. (We shall see in Chapter 20 how it can do this by using monetary policy. For the moment we will assume the government can simply choose the exchange rate.)
Recall that the real exchange rate is given by
e = E P P *
The real exchange rate, U (the price of domestic goods in terms of foreign goods) is equal to the nominal exchange rate, E (the price of domestic currency in terms of foreign currency) times the domestic price level, P, divided by the foreign price level, P *. In the short run, we can take the two price levels P and P * as given. This implies that the nominal depreciation is reflected one-for-one in a real depreciation. More concretely, if the dollar depreciates vis-à-vis the yen by 10% (a 10% nominal depreciation), and if the price levels in Japan and the United States do not change, U.S. goods will be 10% cheaper compared to Japanese goods (a 10% real depreciation).
Let’s now ask how this real depreciation will affect the U.S. trade balance and U.S. output.
b
Given P and P *, E increases
1 e = E P P*
increases.
A look ahead: In Chapter 20, we shall look at the effects of a nominal depreciation when we allow the price level to adjust over time. You will see that a nominal depreciation leads to a real depreciation in the short run but not in the medium run.b
380 The Open Economy Extensions
Depreciation and the Trade Balance: The Marshall-Lerner Condition Return to the definition of net exports:
NX = X - IM>e Replace X and IM by their expressions from equations (18.2) and (18.3):
NX = X1Y*, e2 - IM1Y, e2>e As the real exchange rate e enters the right side of the equation in three places, this
makes it clear that the real depreciation affects the trade balance through three separate channels:
■■ Exports, X, increase. The real depreciation makes U.S. goods relatively less expensive abroad. This leads to an increase in foreign demand for U.S. goods—an increase in U.S. exports.
■■ Imports, IM, decrease. The real depreciation makes foreign goods relatively more expensive in the United States. This leads to a shift in domestic demand toward domestic goods and to a decrease in the quantity of imports.
■■ The relative price of foreign goods in terms of domestic goods, 1>e increases. This increases the import bill, IM>e. The same quantity of imports now costs more to buy (in terms of domestic goods).
For the trade balance to improve following a depreciation, exports must increase enough and imports must decrease enough to compensate for the increase in the price of imports. The condition under which a real depreciation leads to an increase in net exports is known as the Marshall-Lerner condition. (It is derived formally in the appendix, called “Derivation of the Marshall Lerner Condition,” at the end of this chapter.) It turns out— with a complication we will state when we introduce dynamics later in this chapter—that this condition is satisfied in reality. So, for the rest of this book, we shall assume that a real depreciation—a decrease in e—leads to an increase in net exports—an increase in NX.
The Effects of a Real Depreciation We have looked so far at the direct effects of a depreciation on the trade balance—that is, the effects given U.S. and foreign output. But the effects do not end there. The change in net exports changes domestic output, which affects net exports further.
Because the effects of a real depreciation are much like those of an increase in for- eign output, we can use Figure 18-4, the same figure that we used previously to show the effects of an increase in foreign output.
Just like an increase in foreign output, a depreciation leads to an increase in net exports (assuming, as we do, that the Marshall-Lerner condition holds), at any level of output. Both the demand relation (ZZ in Figure 18-4(a)) and the net exports relation (NX in Figure 18-4(b)) shift up. The equilibrium moves from A to A=, and output increases from Y to Y=. By the same argument we used previously, the trade balance improves. The increase in imports induced by the increase in output is smaller than the direct improve- ment in the trade balance induced by the depreciation.
Let’s summarize. The depreciation leads to a shift in demand, both foreign and domestic, toward domestic goods. This shift in demand leads, in turn, to both an increase in domestic output and an improvement in the trade balance.
Although a depreciation and an increase in foreign output have the same effect on domestic output and the trade balance, there is a subtle but important difference be- tween the two. A depreciation works by making foreign goods relatively more expensive.
c
More concretely, if the dollar depreciates vis-à-vis the yen by 10%:
U.S. goods will be cheaper in Japan, leading to a larger quantity of U.S. exports to Japan. Japanese goods will be more expensive in the United States, leading to a smaller quantity of imports of Japanese goods to the United States. Japanese goods will be more expensive, leading to a higher import bill for a given quantity of imports of Japanese goods to the United States.
c It is named after the two econ- omists, Alfred Marshall and Abba Lerner, who were the first to derive it.
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Chapter 18 The Goods Market in an Open Economy 381
But this means that, for a given income, people—who now have to pay more to buy foreign goods because of the depreciation—are worse off. This mechanism is strongly felt in countries that go through a large depreciation. Governments trying to achieve a large depreciation often find themselves with strikes and riots in the streets, as people react to the much higher prices of imported goods. This was the case in Mexico, for ex- ample, where the large depreciation of the peso in 1994 -1995—from 29 cents per peso in November 1994 to 17 cents per peso in May 1995—led to a large decline in workers’ living standards and to social unrest.
Combining Exchange Rate and Fiscal Policies Suppose output is at its natural level, but the economy is running a large trade deficit. The government would like to reduce the trade deficit while leaving output unchanged so as to avoid overheating. What should it do?
A depreciation alone will not do. It will reduce the trade deficit, but it will also increase output. Nor will a fiscal contraction do. It will reduce the trade deficit, but it will decrease output. What should the government do? The answer: Use the right combination of de- preciation and fiscal contraction. Figure 18-5 shows what this combination should be.
Suppose the initial equilibrium in Figure 18-5 (a) is at A, associated with output Y. At this level of output, there is a trade deficit, given by the distance BC in Figure 18-5 (b).
There is an alternative to riots—asking for and obtain- ing an increase in wages. But, if wages increase, the prices of domestic goods will follow and increase as well, leading to a smaller real depreciation. To discuss this mechanism, we need to look at the sup- ply side in more detail than we have done so far. We return to the dynamics of depreciation, wage, and price movements in Chapter 20.
b
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Figure 18-5
Reducing the Trade Deficit without Changing Output
To reduce the trade deficit without changing output, the government must both achieve a depreciation and decrease government spending.
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382 The Open Economy Extensions
If the government wants to eliminate the trade deficit without changing output, it must do two things:
■■ It must achieve a depreciation sufficient to eliminate the trade deficit at the initial level of output. So the depreciation must be such as to shift the net exports relation from NX to NX= in Figure 18-5 (b). The problem is that this depreciation, and the associated increase in net exports, also shifts the demand relation in Figure 18-5 (a) from ZZ to ZZ=. In the absence of other measures, the equilibrium would move from A to A=, and output would increase from Y to Y=.
■■ To avoid the increase in output, the government must reduce government spending so as to shift ZZ= back to ZZ. This combination of a depreciation and a fiscal contrac- tion leads to the same level of output and an improved trade balance.
There is a general point behind this example. To the extent that governments care about both the level of output and the trade balance, they have to use both fiscal policy and exchange rate policies. We just saw one such combination. Table 18-1 gives you others, de- pending on the initial output and trade situation. Take, for example, the box in the top right corner of the table: Initial output is too low (put another way, unemployment is too high), and the economy has a trade deficit. A depreciation will help on both the trade and the out- put fronts. It reduces the trade deficit and increases output. But there is no reason for the depreciation to achieve both the correct increase in output and the elimination of the trade deficit. Depending on the initial situation and the relative effects of the depreciation on output and the trade balance, the government may need to complement the depreciation with either an increase or a decrease in government spending. This ambiguity is captured by the question mark in the box. Make sure that you understand the logic behind each of the other three boxes. (For another example of the role of the real exchange rate and out- put in affecting the current account balance, look at the Focus Box “The Disappearance of Current Account Deficits in Euro Periphery Countries: Good News or Bad News?”)
A general lesson: If you want to achieve two targets (here, output and trade balance), you better have two instru- ments (here, fiscal policy and the exchange rate).
c
The Disappearance of current Account Deficits in Euro Periphery countries: Good News or Bad News?
F o
c u
S
Starting in the early 2000s, a number of Euro periphery countries ran larger and larger current account deficits. Figure 1 shows the evolution of the current account balances of Spain, Portugal, and Greece, from 2000 on. Although the deficits were already substantial in 2000, they continued to increase, reaching 9% of GDP for Spain, 12% for Portugal, and 14% for Greece by 2008.
When the crisis started in 2008, those three countries found it increasingly difficult to borrow abroad, forcing them to reduce borrowing and thus to reduce their current account deficits. And reduce they did. Figure 1 shows that by 2013, the deficits had turned into surpluses in all three countries.
It is an impressive turnaround. Is it unambiguously good news? Not necessarily. The discussion in the text suggests that there are two reasons why a current account may improve. The first is that the country becomes more competitive. The real exchange rate decreases. Exports increase, imports decrease, and the current account balance improves. The second is the country’s output decreases. Exports, which depend on what happens in the rest of the world, may remain the same; but im- ports come down with output, and the current account balance improves.
Unfortunately, the evidence is that the second mechanism has played the dominant role so far.
Table 18-1 Exchange Rate and Fiscal Policy Combinations
Initial Conditions Trade Surplus Trade Deficit
Low output E? Gy Ev G?
High output Ey G? E? Gv
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Chapter 18 The Goods Market in an Open Economy 383
0.8
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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Real imports
Real GDP
Real exports
In d
e x 2
0 0 0 5
1
Figure 2 Imports, Exports, and GDP in Greece since 2000
Source: IMF, World Economic Outlook.
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rc e
n t
o f
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P
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0
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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Spain
Portugal
Greece
Figure 1 Euro periphery Current Account Deficits since 2000
Given that these countries are members of the Euro area, they could not rely on an adjustment of the nominal ex- change rate to become more competitive, at least vis-à-vis their Euro partners. They had to rely on a decrease in wages and prices, and this has proven to be slow and difficult (more on this in Chapter 20).
Instead, much of the adjustment has taken place through a decrease in imports, triggered by a decrease in output, an adjustment known as import compression. As shown in Figure 2, this has been particularly true of Greece. The figure shows the evolution of imports, exports, and GDP in Greece since 2000. All three series are normalized to equal 1.0 in 2000. Note first how much output has decreased, by roughly 25% since 2008. Note then how imports have moved in tan- dem with output, also decreasing by 25%. Exports have not
done great either. After sharply decreasing in 2009, reflecting the world crisis and the decrease in demand from the rest of the world, they have not yet recovered to their 2008 level.
In short, the disappearance of the current account deficits in the Euro periphery is, on net, largely bad news. What hap- pens to the current account next depends largely on what happens to output. And this in turn depends on where output is relative to potential output. If much of the decrease in ac- tual output reflects a decrease in potential output, then output will remain low, and the current account surplus will remain. If, as seems more likely, actual output is far below potential output (if there is, in terminology of Chapter 9, a large nega- tive output gap), then unless further real depreciation takes place, the return of output to potential will come with higher imports, and thus a likely return to current account deficits.
384 The Open Economy Extensions
18-5 Looking at Dynamics: The J-Curve We have ignored dynamics so far in this chapter. It is time to reintroduce them. The dynamics of consumption, investment, sales, and production we discussed in Chapter 3 are as relevant to the open economy as they are to the closed economy. But there are ad- ditional dynamic effects as well, which come from the dynamics of exports and imports. We focus on these effects here.
Return to the effects of the exchange rate on the trade balance. We argued that depreciation leads to an increase in exports and to a decrease in imports. But this does not happen overnight. Think of the dynamic effects of, say, a 10% dollar depreciation.
In the first few months following the depreciation, the effect of the depreciation is likely to be reflected much more in prices than in quantities. The price of imports in the United States goes up, and the price of U.S. exports abroad goes down. But the quantity of imports and exports is likely to adjust only slowly. It takes a while for consumers to realize that relative prices have changed, it takes a while for firms to shift to cheaper suppliers, and so on. So a depreciation may well lead to an initial deterioration of the trade balance; e decreases, but neither X nor IM adjusts very much initially, leading to a decline in net exports (X - IM>e).
As time passes, the effects of the change in the relative prices of both exports and imports become stronger. Cheaper U.S. goods cause U.S. consumers and firms to de- crease their demand for foreign goods; U.S. imports decrease. Cheaper U.S. goods abroad lead foreign consumers and firms to increase their demand for U.S. goods; U.S. exports increase. If the Marshall-Lerner condition eventually holds—and we have argued that it does—the response of exports and imports eventually becomes stronger than the adverse price effect, and the eventual effect of the depreciation is an improvement of the trade balance.
Figure 18-6 captures this adjustment by plotting the evolution of the trade balance against time in response to a real depreciation. The pre-depreciation trade deficit is OA. The depreciation initially increases the trade deficit to OB: e decreases, but neither IM nor X changes right away. Over time, however, exports increase and imports decrease, reducing the trade deficit. Eventually (if the Marshall-Lerner condition is satisfied), the trade balance improves beyond its initial level; this is what happens from point C onward in the figure. Economists refer to this adjustment process as the J-curve, because— admittedly, with a bit of imagination—the curve in the figure resembles a “J”: first down, then up.
The importance of the dynamic effects of the real exchange rate on the trade bal- ance were seen in the United States in the mid-1980s: Figure 18-7 plots the U.S. trade deficit against the U.S. real exchange rate from 1980 to 1990. As we saw in the previ- ous chapter, the period from 1980 to 1985 was one of sharp real appreciation, and the period from 1985 to 1988 one of sharp real depreciation. Turning to the trade deficit, which is expressed as a proportion of GDP, two facts are clear:
1. Movements in the real exchange rate were reflected in parallel movements in net exports. The appreciation was associated with a large increase in the trade deficit, and the later depreciation was associated with a large decrease in the trade balance.
2. There were, however, substantial lags in the response of the trade balance to changes in the real exchange rate. Note how from 1981 to 1983, the trade deficit remained small while the dollar was appreciating. And note how the steady depreciation of
c
And even these prices may adjust slowly. Consider a dol- lar depreciation. If you are an exporter to the United States, you may want to increase your price less than implied by the exchange rate. In other words, you may decrease your markup to remain competitive with your U.S. competitors. If you are a U.S. exporter, you may decrease your price abroad by less than implied by the exchange rate. In other words, you may increase your markup.
c
The response of the trade bal- ance to the real exchange rate:
Initially: X, IM unchanged, e decreases 1 1X - IM>e2 decreases. Eventually: X increases, IM decreases, e decreases 1 1X - IM>e2 increases.
Chapter 18 The Goods Market in an Open Economy 385
the dollar from 1985 onward was not immediately reflected in an improvement in the trade balance before 1987. The dynamics of the J-curve were very much at work during both episodes.
In general, the econometric evidence on the dynamic relation among exports, im- ports, and the real exchange rate suggests that in all OECD countries, a real depreciation eventually leads to a trade balance improvement. But it also suggests that this process takes some time, typically between six months and a year. These lags have implications not only for the effects of a depreciation on the trade balance but also for the effects of a depreciation on output. If a depreciation initially decreases net exports, it also initially exerts a contractionary effect on output. Thus, if a government relies on a depreciation both to improve the trade balance and to expand domestic output, the effects will go the “wrong” way for a while.
The delays in 1985–1988 were unusually long, prompting some economists at the time to question whether there was still a relation between the real exchange rate and the trade balance. In retrospect, the relation was still there; the delays were just longer than usual.
b
N e t
e x p
o rt
s , N
X
A
B
Depreciation
C
0 0
1
2
Time
Figure 18-6
The J-Curve
A real depreciation leads ini- tially to a deterioration and then to an improvement of the trade balance.
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R e a l e x c h
a n
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1980 1981 1982 19841983 1986 19871985 1988 19901989
Trade deficit (scale at right)
Real exchange rate (scale at left)
Figure 18-7
The Real Exchange Rate and the Ratio of the Trade Deficit to GDP: United States, 1980–1990
The large real appreciation and subsequent real depreci- ation from 1980 to 1990 were mirrored, with a lag, by an increase and then a decrease in the trade deficit.
Source: Series GDPDEF, GBRGDPDEFQISMEI and EXUSUK from Federal Reserve Economic Data (FRED).
MyEconLab Real-time data
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386 The Open Economy Extensions
18-6 Saving, Investment, and the Current Account Balance You saw in Chapter 3 how we could rewrite the condition for equilibrium in the goods market as the condition that investment was equal to saving—the sum of private sav- ing and public saving. We can now derive the corresponding condition for the open economy, and you will see how useful this alternative way of looking at the equilibrium can be.
Start from our equilibrium condition
Y = C + I + G - IM>e + X
Move consumption, C, from the right side to the left side of the equation, subtract taxes, T, from both sides, denote net exports 1IM>e + X2 by NX to get
Y - T - C = I + 1G - T2 + NX
Recall that, in an open economy, the income of domestic residents is equal to output, Y, plus net income from abroad, NI, plus net transfers received. Denote these transfers by NT, and add NI and NT to both sides of the equation:
1Y + NI + NT - T2 - C = I + 1G - T2 + 1NX + NI + NT2
Note that the term in parentheses on left side is equal to disposable income, so the left side is equal to disposable income minus consumption (i.e., saving, S). Note that the sum of net exports, net income from abroad, and net transfers on the right side is equal to the current account. Denote the current account by CA and rewrite the previous equation as:
S = I + 1G - T2 + CA
Reorganize the equation to read:
CA = S + 1T - G2 - I (18.5)
The current account balance is equal to saving—the sum of private saving and public saving—minus investment. A current account surplus implies that the country is saving more than it invests. A current account deficit implies that the country is saving less than it invests.
One way of getting more intuition for this relation is to go back to the discussion of the current account and the capital account in Chapter 17. There we saw that a current account surplus implies net lending from the country to the rest of the world, and a cur- rent account deficit implies net borrowing by the country from the rest of the world. So consider a country that invests more than it saves, so that S + 1T - G2 - I is negative. That country must be borrowing the difference from the rest of the world; it must there- fore be running a current account deficit. Symmetrically, a country that lends to the rest of the world is a country that saves more than it invests.
Note some of the things that equation (18.5) says:
■■ An increase in investment must be reflected in either an increase in private saving or public saving, or in a deterioration of the current account balance—a smaller
c
Getting there involves some manipulations, but do not worry; the end result is intuitive.
c
Commentators often do not make a distinction between the trade balance and the cur- rent account balance. This is not necessarily a major crime: Because net income and net transfers typically move slowly over time, the trade and the current account balances typi- cally move closely together.
Chapter 18 The Goods Market in an Open Economy 387
current account surplus, or a larger current account deficit, depending on whether the current account is initially in surplus or in deficit.
■■ A deterioration in the government budget balance—either a smaller budget surplus or a larger budget deficit—must be reflected in an increase in either private saving, or in a decrease in investment, or else in a deterioration of the current account balance.
■■ A country with a high saving rate (private plus government) must have either a high investment rate or a large current account surplus.
Note also, however, what equation (18.5) does not say. It does not say, for example, whether a government budget deficit will lead to a current account deficit, or instead, to an increase in private saving, or to a decrease in investment. To find out what hap- pens in response to a budget deficit, we must explicitly solve for what happens to out- put and its components using the assumptions that we have made about consumption, investment, exports, and imports. That is, we need to do the complete analysis laid out in this chapter. Using only equation (18.5) can, if you are not careful, be very mislead- ing. To see how misleading, consider, for example, the following argument (which is so common that you may have read something similar in newspapers):
“It is clear the United States cannot reduce its large current account deficit through a depreciation.” Look at equation (18.5). It shows that the current ac- count deficit is equal to investment minus saving. Why should a depreciation affect either saving or investment? So, how can a depreciation affect the current account deficit?
The argument might sound convincing, but we know it is wrong. We showed ear- lier that a depreciation leads to an improvement in a country’s trade position and, by implication—given net income and transfers—an improvement in the current account. So what is wrong with the argument? A depreciation actually does affect saving and investment. It does so by affecting the demand for domestic goods, thereby increasing output. Higher output leads to an increase in saving over investment, or equivalently, to a decrease in the current account deficit.
A good way of making sure that you understand the material in this section is to go back and look at the various cases we have considered, from changes in government spending, to changes in foreign output, to combinations of depreciation and fiscal con- traction, and so on. Trace what happens in each case to each of the four components of equation (18.5): private saving, public saving (equivalently, the budget surplus), invest- ment, and the current account balance. Make sure, as always, that you can tell the story in words.
Let me end the chapter with a challenge. Assess the following three statements and decide which one(s) is (are) right:
■■ The U.S. current account deficit (which we saw in Chapter 17) shows that the U.S is no longer competitive. It is a sign of weakness. Forget saving or investment. The United States must urgently improve its competitiveness.
■■ The U.S. current account deficit shows that the United States just does not save enough to finance its investment. It is a sign of weakness. Forget competitiveness. The United States must urgently increase its saving rate.
■■ The U.S. current account deficit is just a mirror image of the U.S. capital account surplus. What is happening is that the rest of the world wants to put its funds in the United States. The U.S. capital account surplus, and by implication, the U.S. current account deficit, is in fact a sign of strength, and there is no need to take policy mea- sures to reduce it.
Suppose, for example, that the U.S. government wants to re- duce the current account defi- cit without changing the level of output, so it uses a combina- tion of depreciation and fiscal contraction. What happens to private saving, public saving, and investment?
b
388 The Open Economy Extensions
Summary
foreign demand to move them out of a recession. When a group of countries is in recession, coordination can, in prin- ciple, help their recovery.
■■ If the Marshall-Lerner condition is satisfied—and the em- pirical evidence indicates that it is—a real depreciation leads to an improvement in net exports.
■■ A real depreciation leads first to a deterioration of the trade balance, and then to an improvement. This adjustment pro- cess is known as the J-curve.
■■ The condition for equilibrium in the goods market can be rewritten as the condition that saving (public and private) minus investment must be equal to the current account bal- ance. A current account surplus corresponds to an excess of saving over investment. A current account deficit usually corresponds to an excess of investment over saving.
■■ In an open economy, the demand for domestic goods is equal to the domestic demand for goods (consumption, plus investment, plus government spending) minus the value of imports (in terms of domestic goods), plus exports.
■■ In an open economy, an increase in domestic demand leads to a smaller increase in output than it would in a closed economy because some of the additional demand falls on imports. For the same reason, an increase in domestic de- mand also leads to a deterioration of the trade balance.
■■ An increase in foreign demand leads, as a result of increased exports, to both an increase in domestic output and an im- provement of the trade balance.
■■ Because increases in foreign demand improve the trade bal- ance and increases in domestic demand worsen the trade balance, countries might be tempted to wait for increases in
Key Terms
demand for domestic goods, 370 domestic demand for goods, 370 G20, 378 policy coordination, 379
Marshall-Lerner condition, 380 import compression, 383 J-curve, 384
Questions and Problems
QuICk CHeCk MyEconLab Visit www.myeconlab.com to complete all Quick Check problems and get instant feedback. 1. Using the information in this chapter, label each of the following statements true, false, or uncertain. Explain briefly.
a. The current U.S. trade deficit is the result of unusually high investment, not the result of a decline in national saving.
b. The national income identity implies that budget deficits cause trade deficits.
c. Opening the economy to trade tends to increase the mul- tiplier because an increase in expenditure leads to more exports.
d. If the trade deficit is equal to zero, then the domestic de- mand for goods and the demand for domestic goods are equal.
e. A real depreciation leads to an immediate improvement in the trade balance.
f. A small open economy can reduce its trade deficit through fiscal contraction at a smaller cost in output than can a large open economy.
g. The experience of the United States in the 1990s shows that real exchange rate appreciations lead to trade defi- cits and real exchange rate depreciations lead to trade surpluses.
h. A decline in real income can lead to a decline in imports and thus a trade surplus.
2. Real and nominal exchange rates and inflation Using the definition of the real exchange rate (and Propositions
7 and 8 in Appendix 2 at the end of the book), you can show that
1et - et - 12 et - 1
= 1Et - Et - 12
Et - 1 + pt - pt*
In words, the percentage real appreciation equals the percent- age nominal appreciation plus the difference between domestic and foreign inflation.
a. If domestic inflation is higher than foreign inflation, and the domestic country has a fixed exchange rate, what hap- pens to the real exchange rate over time? Assume that the Marshall-Lerner condition holds. What happens to the trade balance over time? Explain in words.
b. Suppose the real exchange rate is currently at the level required for net exports (or the current account) to equal zero. In this case, if domestic inflation is higher than foreign inflation, what must happen over time to maintain a trade balance of zero?
3. A European recession and the U.S. economy a. In 2014, European Union spending on U.S. goods accounted for
18% of U.S. exports (see Table 17-2), and U.S. exports amount- ed to 15% of U.S. GDP (see Table 17-1). What was the share of European Union spending on U.S. goods relative to U.S. GDP?
b. Assume that the multiplier in the United States is 2 and that a major slump in Europe would reduce output and
Chapter 18 The Goods Market in an Open Economy 389
imports from the U.S. by 5% (relative to its normal level). Given your answer to part (a), what is the impact on U.S. GDP of the European slump?
c. If the European slump also leads to a slowdown of the other economies that import goods from the United States, the effect could be larger. To put a bound to the size of the effect, assume that U.S. exports decrease by 5% (as a result of changes in foreign output) in one year. What is the effect of a 5% drop in exports on U.S. GDP?
d. Comment on this statement. “Unless Europe can avoid a major slump following the problems with sovereign debt and the Euro, U.S. growth will grind to a halt.”
4. A further look at Table 18-1 Table 18-1 has four entries. Using Figure 18-5 as a guide, draw the situations illustrated in each of the 4 entries in Table 18-1. Be sure you understand why the direc- tion of change in government spending and the real exchange rate is labeled as ambiguous in each entry.
DIg Deeper MyEconLab Visit www.myeconlab.com to complete all Dig Deeper problems and get instant feedback.
5. Net exports and foreign demand a. Suppose there is an increase in foreign output. Show the effect
on the domestic economy (i.e., replicate Figure 18-4). What is the effect on domestic output? On domestic net exports?
b. If the interest rate remains constant, what will happen to domestic investment? If taxes are fixed, what will happen to the domestic budget deficit?
c. Using equation (18.5), what must happen to private saving? Explain.
d. Foreign output does not appear in equation (18.5), yet it evidently affects net exports. Explain how this is possible.
6. Eliminating a trade deficit a. Consider an economy with a trade deficit (NX 6 0) and with
output equal to its natural level. Suppose that, even though output may deviate from its natural level in the short run, it returns to its natural level in the medium run. Assume that the natural level is unaffected by the real exchange rate. What must happen to the real exchange rate over the medium run to eliminate the trade deficit (i.e., to increase NX to 0)?
b. Now write down the national income identity. Assume again that output returns to its natural level in the medium run. If NX increases to 0, what must happen to domestic de- mand (C + I + G) in the medium run? What government policies are available to reduce domestic demand in the me- dium run? Identify which components of domestic demand each of these policies affect.
7. Multipliers, openness, and fiscal policy Consider an open economy characterized by the following
equations:
C = c0 + c1(Y - T) I = d0 + d1Y
IM = m1Y X = x1Y *
The parameters m1 and x1 are the propensities to import and export. Assume that the real exchange rate is fixed at a value of 1 and treat foreign income, Y *, as fixed. Also assume that taxes are fixed and that government purchases are exogenous (i.e., decided by the government). We explore the effectiveness of changes in G under alternative assumptions about the propensity to import.
a. Write the equilibrium condition in the market for domestic goods and solve for Y.
b. Suppose government purchases increase by one unit. What is the effect on output? (Assume that 0 6 m1 6 c1 + d1 6 1. Explain why.)
c. How do net exports change when government purchases increase by one unit?
Now consider two economies, one with m1 = 0.5 and the other with m1 = 0.1. Each economy is characterized by (c1 + d1) = 0.6.
d. Suppose one of the economies is much larger than the other. Which economy do you expect to have the larger value of m1? Explain.
e. Calculate your answers to parts (b) and (c) for each econ- omy by substituting the appropriate parameter values.
f. In which economy will fiscal policy have a larger effect on output? In which economy will fiscal policy have a larger ef- fect on net exports?
8. Policy coordination and the world economy Consider an open economy in which the real exchange rate
is fixed and equal to one. Consumption, investment, government spending, and taxes are given by
C = 10 + 0.8(Y - T), I = 10, G = 10, and T = 10 Imports and exports are given by
IM = 0.3 Y and X = 0.3 Y * where Y* denotes foreign output.
a. Solve for equilibrium output in the domestic economy, given Y*. What is the multiplier in this economy? If we were to close the economy—so exports and imports were identically equal to zero—what would the multiplier be? Why would the multiplier be different in a closed economy?
b. Assume that the foreign economy is characterized by the same equations as the domestic economy (with asterisks reversed). Use the two sets of equations to solve for the equilibrium output of each country. [Hint: Use the equa- tions for the foreign economy to solve for Y * as a function of Y and substitute this solution for Y * in part (a).] What is the multiplier for each country now? Why is it different from the open economy multiplier in part (a)?
c. Assume that the domestic government, G, has a target level of output of 125. Assuming that the foreign government does not change G*, what is the increase in G necessary to achieve the target output in the domestic economy? Solve for net exports and the budget deficit in each country.
d. Suppose each government has a target level of output of 125 and that each government increases government spending by the same amount. What is the common increase in G and G* necessary to achieve the target output in both countries? Solve for net exports and the budget deficit in each country.
e. Why is fiscal coordination, such as the common increase in G and G* in part (d), difficult to achieve in practice?
390 The Open Economy Extensions
value of the trade balance as a percent of GDP in three periods: 1980 –1989, 1990 –1999, 2000 to the latest point. Would it appear that trade deficits have been used to finance investment?
d. Is a trade deficit more worrisome when not accompanied by a corresponding increase in investment? Explain your answer.
e. The previous question focuses on the trade deficit rather than the current account deficit. How does net invest- ment income (NI) relate to the difference between the trade deficit and the current account deficit in the United States? You can download GDP (series GDP) and GNP (se- ries GNP) from the FRED database at the Federal reserve Bank of St. Louis. This difference is a measure of NI. Is this value rising or falling over time? What is the implication of such changes?
expLore FurTHer
9. The U.S. trade deficit, current account deficit, and investment a. Define national saving as private saving plus the govern-
ment surplus—that is, as S + T - G. Now, using equation (18.5), describe the relation among the current account deficit, net investment income, and the difference between national saving and domestic investment.
b. Using the FRED economic database retrieve annual data for nominal GDP (series GDP), gross domestic investment (se- ries GDPIA), and net exports (series A019RC1A027NBEA) from 1980 to the most recent year available. Divide gross domestic investment and net exports by GDP in each year to express their values as a percentage of GDP. What year has the largest trade deficit as a percentage of GDP?
c. The trade surplus in 1980 was roughly zero. Compute the average percentage of GDP invested and the average
Further Readings
■■ A good discussion of the relation among trade deficits, current account deficits, budget deficits, private saving, and investment is given in Barry Bosworth’s Saving and In- vestment in a Global Economy (Brookings Institution, 1993).
■■ For more on the relation between the exchange rate and the trade balance, read “Exchange Rates and Trade Flows: Disconnected?” Chapter 3, World Economic Outlook, International Monetary Fund, October 2015.
Start from the definition of net exports
NX = X - IM>e Assume trade to be initially balanced, so that NX = 0 and
X = IM>e or, equivalently, eX = IM. The Marshall-Lerner condition is the condition under
which a real depreciation, a decrease in U, leads to an increase in net exports.
To derive this condition, first multiply both sides of the equation above by e to get
eNX = eX - IM
Now consider a change in the real exchange rate of ∆e. The effect of the change in the real exchange rate on the left side of the equation is given by 1∆e2 NX + e∆1NX2.
Note that, if trade is initially balanced, NX = 0, so the first term in this expression is equal to zero, and the effect of the change on the left side is simply given by e∆1NX2.
The effect of the change in the real exchange rate on the right side of the equation is given by 1∆e2 X + e∆1X2 - 1∆IM2. Putting the two sides together gives
e1∆NX2 = 1∆e2 X + e1∆X2 - 1∆ IM2 Divide both sides by eX to get:
[e1∆NX2]>eX = [1∆e2X]>eX + [e1∆X2]>eX - [∆IM]>eX
Simplify, and use the fact that, if trade is initially balanced, eX = IM to replace eX by IM in the last term on the right. This gives
1∆NX2>X = 1∆e2>e + 1∆X2>X - ∆IM>IM The change in the trade balance (as a ratio to exports)
in response to a real depreciation is equal to the sum of three terms:
■■ The first term is equal to the proportional change in the real exchange rate. It is negative if there is a real depreciation.
■■ The second term is equal to the proportional change in ex- ports. It is positive if there is a real depreciation.
■■ The third term is equal to minus the proportional change in imports. It is positive if there is a real depreciation.
The Marshall-Lerner condition is the condition that the sum of these three terms be positive. If it is satisfied, a real de- preciation leads to an improvement in the trade balance.
A numerical example will help here. Suppose that a 1% depreciation leads to a proportional increase in exports of 0.9%, and to a proportional decrease in imports of 0.8%. (Econometric evidence on the relation of exports and imports to the real exchange rate suggest that these are indeed reason- able numbers.) In this case, the right-hand side of the equa- tion is equal to - 1% + 0.9% - 1 - 0.8%2 = 0.7%. Thus, the trade balance improves, and the Marshall-Lerner condition is satisfied.
APPEnDIx: Derivation of the Marshall-Lerner Condition
391
I
19 Output, the Interest Rate, and the Exchange Rate n Chapter 18, we treated the exchange rate as one of the policy instruments available to the government. But the exchange rate is not a policy instrument. Rather, it is determined in the for- eign exchange market—a market where, as you saw in Chapter 17, there is an enormous amount of trading. This fact raises two obvious questions: What determines the exchange rate? How can policy makers affect it?
These questions motivate this chapter. To answer them, we reintroduce financial markets, which we had left aside in Chapter 18. We examine the implications of equilibrium in both the goods market and financial markets, including the foreign exchange market. This allows us to characterize the joint movements of output, the interest rate, and the exchange rate in an open economy. The model we develop is an extension to the open economy of the IS-LM model you first saw in Chapter 5 and is known as the Mundell-Fleming model—after the two economists, Robert Mundell and Marcus Fleming, who first put it together in the 1960s. ( The model presented here retains the spirit of the original Mundell-Fleming model but differs in its details.)
Section 19-1 looks at equilibrium in the goods market.
Section 19-2 looks at equilibrium in financial markets, including the foreign exchange market.
Section 19-3 puts the two equilibrium conditions together and looks at the determination of output, the interest rate, and the exchange rate.
Section 19-4 looks at the role of policy under flexible exchange rates.
Section 19-5 looks at the role of policy under fixed exchange rates.
392 The Open Economy Extensions
19-1 Equilibrium in the Goods Market Equilibrium in the goods market was the focus of Chapter 18, where we derived the equilibrium condition equation (18.4):
Y = C1Y - T2 + I1Y, r2 + G - IM1Y, e2>e + X1Y *, e2 1 + 2 1 + , - 2 1 + ,+2 1 + , - 2
For the goods market to be in equilibrium, output (the left side of the equation) must be equal to the demand for domestic goods (the right side of the equation). The demand for domestic goods is equal to consumption, C, plus investment, I, plus government spending, G minus the value of imports, IM>e, plus exports, X.
■■ Consumption, C, depends positively on disposable income Y - T. ■■ Investment, I, depends positively on output, Y, and negatively on the real interest
rate, r. ■■ Government spending, G, is taken as given. ■■ The quantity of imports, IM, depends positively on both output, Y, and the real
exchange rate, e. The value of imports in terms of domestic goods is equal to the quantity of imports divided by the real exchange rate.
■■ Exports, X, depend positively on foreign output, Y*, and negatively on the real exchange rate, e.
It will be convenient in what follows to regroup the last two terms under “net exports,” defined as exports minus the value of imports:
NX 1Y, Y *, e2 = X 1Y *, e2 - IM 1Y, e2>e It follows from our assumptions about imports and exports that net exports, NX, depend on domestic output, Y, foreign output, Y*, and the real exchange rate e. An increase in domestic output increases imports, thus decreasing net exports. An increase in foreign output increases exports, thus increasing net exports. An increase in the real exchange rate leads to a decrease in net exports.
Using this definition of net exports, we can rewrite the equilibrium condition as
Y = C1Y - T2 + I1Y, r2 + G + NX 1Y, Y *, e2 (19.1) 1 + 2 1 + , -2 1- , + , -2
For our purposes, the main implication of equation (19.1) is that both the real interest rate and the real exchange rate affect demand, and in turn equilibrium output.
■■ An increase in the real interest rate leads to a decrease in investment spending, and as a result, to a decrease in the demand for domestic goods. This leads, through the multiplier, to a decrease in output.
■■ An increase in the real exchange rate leads to a shift in demand toward foreign goods, and as a result, to a decrease in net exports. The decrease in net exports decreases the demand for domestic goods. This leads, through the multiplier, to a decrease in output.
For the remainder of the chapter, we shall simplify equation (19.1) in two ways:
■■ Given our focus on the short run, we assumed in our previous treatment of the IS-LM model that the (domestic) price level was given. We shall make the same assumption here and extend this assumption to the foreign price level, so the real exchange rate, e = EP>P *, and the nominal exchange rate, E, move together. A de- crease in the nominal exchange rate —a nominal depreciation—leads, one-for-one, to a decrease in the real exchange rate —a real depreciation. Conversely, an increase in the nominal exchange rate —a nominal appreciation—leads, one-for-one,
c
Goods market equilibrium (IS): Output = Demand for domes- tic goods.
We shall assume, throughout the chapter, that the Marshall- Lerner condition holds. Under this condition, an increase in the real exchange rate—a real appreciation—leads to a decrease in net exports (see Chapter 18).
c
Chapter 19 Output, the Interest Rate, and the Exchange Rate 393
to an increase in the real exchange rate —a real appreciation. If, for notational con- venience, we choose P and P * so that P>P * = 1 (and we can do so because both are index numbers), then e = E and we can replace e by E in equation (19.1).
■■ Because we take the domestic price level as given, there is no inflation, neither actual nor expected. Therefore, the nominal interest rate and the real interest rate are the same, and we can replace the real interest rate, r, in equation (19.1) by the nominal interest rate, i.
With these two simplifications, equation (19.1) becomes
Y = C1Y - T2 + I1Y, i 2 + G + NX1Y, Y *, E2 (19.2) 1 + 2 1 + , -2 1- , + , -2
In words: Goods market equilibrium implies that output depends negatively on both the nominal interest rate and the nominal exchange rate.
19-2 Equilibrium in Financial Markets When we looked at financial markets in the IS-LM model, we assumed that people chose only between two financial assets, money and bonds. Now that we look at a financially open economy, we must also take into account the fact that people have a choice between domestic bonds and foreign bonds.
Domestic Bonds versus Foreign Bonds As we look at the choice between domestic bonds and foreign bonds, we shall rely on the assumption we introduced in Chapter 17: Financial investors, domestic or foreign, go for the highest expected rate of return, ignoring risk. This implies that, in equilibrium, both domestic bonds and foreign bonds must have the same expected rate of return; other- wise, investors would be willing to hold only one or the other, but not both, and this could not be an equilibrium. (Like all economic relations, this relation is only an approxima- tion to reality and does not always hold. For more on this, see the Focus box on page 394 “Sudden Stops, Safe Havens, and the Limits of the Interest Parity Condition.”)
As we saw in Chapter 17 (equation 17.2), this assumption implies that the following arbitrage relation —the interest parity condition —must hold:
11 + it2 = 11 + it*2 a Et
Et + 1 e b (19.3)
where it is the domestic interest rate, it* is the foreign interest rate, Et is the current exchange rate, and Et + 1
e is the future expected exchange rate. The left side of the equa- tion gives the return, in terms of domestic currency, from holding domestic bonds. The right side of the equation gives the expected return, also in terms of domestic currency, from holding foreign bonds. In equilibrium, the two expected returns must be equal.
Multiply both sides by Et + 1 e and reorganize to get
Et = 1 + it 1 + it*
Et + 1 e (19.4)
For now, we shall take the expected future exchange rate as given and denote it as EQ e (we shall relax this assumption in Chapter 20). Under this assumption, and dropping time indexes, the interest parity condition becomes
E = 1 + i 1 + i*
EQ e (19.5)
b First simplification: P = P* = 1, so e = E.
b Second simplification: pe = 0, so r = i.
By now, you realize that the way to understand various macroeconomic mechanisms is to refine the basic model in one direction, and simplify it in others (here, opening the econ- omy but ignoring risk). Keeping all the refinements would lead to a rich model (and this is what macro econometric mod- els do), but would make for a terrible textbook. Things would become far too complicated.
b
Remember that we have as- sumed that people are not will- ing to hold domestic or foreign currency on its own.
b
b The presence of Et comes from the fact that to buy the foreign bond, you must first exchange domestic currency for foreign currency. The pres- ence of E t + 1
e comes from the fact that to bring the funds back next period, you will have to exchange foreign cur- rency for domestic currency.
394 The Open Economy Extensions
Sudden Stops, Safe Havens, and the Limits to the Interest Parity Condition
F o
C u
S
The interest parity condition assumes that financial inves- tors care only about expected returns. As we discussed in Chapter 14, investors, however, care not only about expected returns but also about risk and liquidity. Much of the time,
one can ignore these other factors. Sometimes however, these factors play a big role in investors’ decisions and in determining exchange rate movements.
–
–
Figure 1 The Equity Flows to Emerging Countries since June 2008
Source: International Monetary Fund.
–7,000
–6,000
–5,000
–4,000
–3,000
–2,000
–1,000
0
1,000
2,000
3,000
2008 2009 2010 2011 2012 2013 2014 2015
10/28/2015
Bond Fund Flows
B il li o
n s o
f d
o ll a rs
( w
e e k ly
fl o
w s )
Time
Chapter 19 Output, the Interest Rate, and the Exchange Rate 395
As shown in Figure 1, capital flows, captured here by eq- uity inflows —purchases of emerging market firms’ stocks by foreigners —to emerging market countries, have been very volatile since the beginning of the crisis. Volatile capital flows are an issue that many emerging countries know well, and they often reflect changes in investors’ perceptions of risk rather than changes in relative interest rates.
Perceptions of risk play an important role in the decision of foreign investors, such as pension funds, to invest or not invest in their country. Sometimes, the perception that risk has increased leads investors to want to sell all the assets they have in the country, no matter what the interest rate. These selling episodes, which have affected many Latin American and Asian emerging economies in the past, are known as sudden stops. During these episodes, the interest parity condition fails, and the exchange rate of these emerging market countries may decrease a lot, without much change in domestic or foreign interest rates.
Indeed, the start of the crisis was associated with large capital movements which had little to do with expected re- turns. Worried about uncertainty, many investors from ad- vanced countries decided to take their funds home, where they felt safer. The result was large capital outflows from a number of emerging countries, leading to strong downward pressure on their exchange rates and serious financial prob- lems. For example, some domestic banks that had relied on foreign investors for funds found themselves short of funds, which forced them in turn to cut lending to domestic firms and households. This was an important channel of transmission of the crisis from the United States to the rest of the world.
A symmetrical phenomenon is at play in some advanced countries. Because of their characteristics, some countries
are seen as particularly attractive by investors when uncer- tainty is high. This is the case for the United States. Even in normal times, there is a large foreign demand for U.S. T-bills. The reason is the size and the liquidity of U.S. T-bill market. One can sell or buy large quantities of T-bills quickly and without moving the price very much. Going back to the long standing U.S. trade deficit we saw in Chapter 17, one reason why the United States has been able to run such a trade defi- cit, and thus to borrow from the rest of the world for such a long time, is the high foreign demand for T-bills (this is a par- tial answer to the challenge stated at the end of Chapter 18).
In times of crisis, the preference for U.S. T-bills becomes even stronger. The United States is widely seen by investors as being a safe haven, a country in which it is safe to move funds. The result is that periods of higher uncertainty are often associated with a stronger demand for U.S. assets and thus some upward pressure on the dollar. Interestingly, the beginning of the recent crisis was associated with a strong dollar appreciation. There is some irony here, given that the crisis originated in the United States. Indeed, some econo- mists wonder how long the United States will continue to be perceived as a safe haven. If this were to change, the dollar would depreciate.
Further reading: Among the countries affected by large capital outflows in 2008 and 2009 were also a number of small ad- vanced economies, notably Ireland and Iceland. A number of these countries had built up the same financial vulnerabilities as the United States (those we studied in Chapter 6), and a number of them suffered badly. A good and easy read is Michael Lewis’s chapters on Ireland and Iceland in Boomerang: Travels in a New Third World, Norton Books (2011).
This relation tells us that the current exchange rate depends on the domestic inter- est rate, on the foreign interest rate, and on the expected future exchange rate.
■■ An increase in the domestic interest rate leads to an increase in the exchange rate. ■■ An increase in the foreign interest rate leads to a decrease in the exchange rate. ■■ An increase in the expected future exchange rate leads to an increase in the current
exchange rate.
This relation plays a central role in the real world and will play a central role in this chapter. To understand the relation further, consider the following example:
Consider financial investors —investors, for short — choosing between U.S. bonds and Japanese bonds. Suppose that the one-year interest rate on U.S. bonds is 2%, and the one-year interest rate on Japanese bonds is also 2%. Suppose that the current exchange rate is 100 (one dollar is worth 100 yen), and the expected exchange rate a year from now is also 100. Under these assumptions, both U.S. and Japanese bonds have the same expected return in dollars, and the interest parity condition holds.
Suppose that investors now expect the exchange rate to be 10% higher a year from now, so EQ e is now equal to 110. At an unchanged current exchange rate, U.S. bonds are now much more attractive than Japanese bonds. U.S. bonds offer an interest rate
396 The Open Economy Extensions
of 2% in dollars. Japanese bonds still offer an interest rate of 2% in yen, but the yen a year from today are now expected to be worth 10% less in terms of dollars. In terms of dollars, the return on Japanese bonds is therefore 2% (the interest rate) - 10% (the expected depreciation of the yen relative to the dollar), or - 8%.
So what will happen to the current exchange rate? At the initial exchange rate of 100, investors want to shift out of Japanese bonds into U.S. bonds. To do so, they must first sell Japanese bonds for yen, then sell yen for dollars, and then use the dollars to buy U.S. bonds. As investors sell yen and buy dollars, the dollar ap- preciates relative to the yen. By how much? Equation (19.5) gives us the answer: E = 11.02>1.022110 = 110. The current exchange rate must increase in the same proportion as the expected future exchange rate. Put another way, the dollar must appreciate today by 10%. When it has appreciated by 10% so E = EQ e = 110, the ex- pected returns on U.S. and Japanese bonds are again equal, and there is equilibrium in the foreign exchange market.
Suppose instead that the Fed raises the domestic interest rate in the U.S. from 2% to 5%. Assume that the Japanese interest rate remains unchanged at 2%, and that the expected future exchange rate remains unchanged at 100. At an unchanged current exchange rate, U.S. bonds are now again much more attractive than Japanese bonds. U.S. bonds yield a return of 5% in dollars. Japanese bonds give a return of 2% in yen, and —because the exchange rate is expected to be the same next year as it is today—an expected return of 5% in dollars as well.
So what will happen to the current exchange rate? Again, at the initial exchange rate of 100, investors want to shift out of Japanese bonds into U.S. bonds. As they do so, they sell yen for dollars, and the dollar appreciates. By how much? Equation (19.5) gives the answer: E = 11.05>1.022100 ≈ 103. The current exchange rate increases by ap- proximately 3%.
Why 3%? Think of what happens when the dollar appreciates. If, as we have as- sumed, investors do not change their expectation of the future exchange rate, then the more the dollar appreciates today, the more investors expect it to depreciate in the future (as it is expected to return to the same value in the future). When the dollar has appreciated by 3% today, investors expect it to depreciate by 3% during the coming year. Equivalently, they expect the yen to appreciate relative to the dollar by 3% over the coming year. The expected rate of return in dollars from holding Japanese bonds is therefore 2% 1the interest rate in yen2 + 3% (the expected yen appreciation), or 5%. This expected rate of return is the same as the rate of return on holding U.S. bonds, so there is equilibrium in the foreign exchange market.
Note that our argument relies heavily on the assumption that, when the interest rate changes, the expected exchange rate remains unchanged. This implies that an ap- preciation today leads to an expected depreciation in the future because the exchange rate is expected to return to the same, unchanged, value. We shall relax the assumption that the future expected exchange rate is fixed in Chapter 20. But the basic conclusion will remain: An increase in the domestic interest rate relative to the foreign interest rate leads to an appreciation.
Figure 19-1 plots the relation between the domestic interest rate, i, and the exchange rate, E, implied by equation (19.5) —the interest parity relation. The relation is drawn for a given expected future exchange rate, EQ e, and a given foreign interest rate, i*, and is represented by an upward-sloping line. The higher the domestic interest rate, the higher the exchange rate. Equation (19.5) also implies that when the domestic interest rate is equal to the foreign interest rate 1i = i*2, the exchange rate is equal to the expected future exchange rate 1E = EQ e2. This implies that the line corresponding to the interest parity condition goes through point A (where i = i*) in the figure.
Make sure you understand the argument. Why doesn’t the dollar appreciate by, say, 20%?
c
c
What happens to the line if (1) i* increases? (2) EQ e increases?
MyEconLab Video
Chapter 19 Output, the Interest Rate, and the Exchange Rate 397
19-3 Putting Goods and Financial Markets Together We now have the elements we need to understand the movements of output, the interest rate, and the exchange rate.
Goods-market equilibrium implies that output depends, among other factors, on the interest rate and the exchange rate:
Y = C1Y - T2 + I1Y, i2 + G + NX1Y, Y *, E2 Let’s think of the interest rate, i, as the policy rate set by the central bank:
i = iQ
And the interest parity condition implies a positive relation between the domestic interest rate and the exchange rate:
E = 1 + i 1 + i *
EQ e
Together, these three relations determine output, the interest rate, and the exchange rate. Working with three equations and three variables is not easy. But we can easily re- duce them to two by using the interest parity condition to eliminate the exchange rate in the goods-market equilibrium relation. Doing this gives us the following two equations, the open economy versions of our familiar IS and LM relations:
IS: Y = C1Y - T2 + I1Y, i2 + G + NX aY, Y *, 1 + i 1 + i *
EQ e b LM: i = iQ
Together, the two equations determine the interest rate and equilibrium output. Using equation (19.5) then gives us the implied exchange rate. Take the IS relation first and consider the effects of an increase in the interest rate on output. An increase in the interest rate now has two effects:
D o
m e s ti
c i n
te re
s t
ra te
, i
Exchange rate, E
A i 5 i *
Interest parity relation given (i *, E e )
E e
Figure 19-1
The Relation between the Interest Rate and the Exchange Rate Implied by Interest Parity
A higher domestic interest rate leads to a higher exchange rate—an appreciation.
398 The Open Economy Extensions
■■ The first effect, which was already present in a closed economy, is the direct effect on investment. A higher interest rate leads to a decrease in investment, a decrease in the demand for domestic goods, and a decrease in output.
■■ The second effect, which is only present in the open economy, is the effect through the exchange rate. A higher interest rate leads to an increase in the exchange rate — an appreciation. The appreciation, which makes domestic goods more expensive rel- ative to foreign goods, leads to a decrease in net exports, and therefore to a decrease in the demand for domestic goods and a decrease in output.
Both effects work in the same direction. An increase in the interest rate decreases demand directly and indirectly —through the adverse effect of the appreciation on demand.
The IS relation between the interest rate and output is drawn in Figure 19-2(a), for given values of all the other variables in the relation—namely T, G, Y *, i *, and EQ e. The IS curve is downward sloping. An increase in the interest rate leads to lower output. The curve looks much the same as in the closed economy, but it hides a more complex relation than before. The interest rate affects output not only directly, but also indirectly through the exchange rate.
The LM relation is the same as in the closed economy; it is a horizontal line, at the level of the interest rate iQ set by the central bank.
Equilibrium in the goods and financial markets is attained at point A in Figure 19-2(a), with output level Y and interest rate iQ. The equilibrium value of the exchange rate can- not be read directly from the graph. But it is easily obtained from Figure 19-2(b), which replicates Figure 19-1 and gives the exchange rate associated with a given interest rate found at point B, given also the foreign interest rate i* and the expected exchange rate. The exchange rate associated with the equilibrium interest rate iQ is equal to E.
Let’s summarize. We have derived the IS and the LM relations for an open economy:
The IS curve is downward sloping. An increase in the interest rate leads both directly and indirectly (through the exchange rate), to a decrease in demand and a decrease in output.
The LM curve is horizontal at the interest rate set by the central bank. Equilibrium output and the equilibrium interest rate are given by the intersection
of the IS and the LM curves. Given the foreign interest rate and the expected future exchange rate, the equilibrium interest rate determines the equilibrium exchange rate.
c
An increase in the interest rate leads, both directly and indi- rectly (through the exchange rate), to a decrease in output.
Exchange rate, E Y E
LM
Output, Y
A
(a) (b)
B
IS
D o
m e s ti
c i n
te re
s t
ra te
, i
D o
m e s ti
c i n
te re
s t
ra te
, i
Interest parity relation given (i *, E e )
i i
Figure 19-2
The IS-LM Model in an Open Economy
An increase in the interest rate reduces output both directly and indirectly (through the exchange rate). The IS curve is downward sloping. The LM curve is horizontal, as in Chapter 6.
Chapter 19 Output, the Interest Rate, and the Exchange Rate 399
19-4 The Effects of Policy in an Open Economy Having derived the IS-LM model for the open economy, we can now put it to use and look at the effects of policy.
The Effects of Monetary Policy in an Open Economy Let’s start from the effects of the central bank’s decision to increase the domestic in- terest rate. Look at Figure 19-3(a). At a given level of output, with a higher interest rate, the LM curve shifts up, from LM to LM=. The IS curve does not shift (remember that the IS curve only shifts if G or T or Y * or i * change). The equilibrium moves from point A to point A=. In Figure 19-3(b), the increase in the interest rate leads to an appreciation.
So, in the open economy, monetary policy works through two channels; first, as in the closed economy, it works through the effect of the interest rate on spending; second, it works through the effect of the interest rate on the exchange rate and the effect of the exchange rate on exports and imports. Both effects work in the same direction. In the case of a monetary contraction, the higher interest rate and the appreciation both decrease demand and output.
The Effects of Fiscal Policy in an Open Economy Let’s look now at a change in government spending. Suppose that, starting from a bal- anced budget, the government decides to increase defense spending without raising taxes, and so runs a budget deficit. What happens to the level of output? To the composi- tion of output? To the interest rate? To the exchange rate?
Let us first assume that before the increase in government spending, the level of output, Y, was below potential. If the increase in G moves output towards potential, but not above potential, the central bank will not be worried that inflation might increase (remember our discussion in Chapter 9, particularly Figure 9-3) and will keep the interest rate unchanged. What happens to the economy is described in Figure 19-4 on page 400. The economy is initially at point A. The increase in government spending by,
A monetary contraction shifts the LM curve up. It shifts neither the IS curve nor the interest parity curve.
Can you tell what happens to net exports?
b
D o
m e
s ti
c i
n te
re s
t ra
te ,
i
D o
m e
s ti
c i
n te
re s
t ra
te ,
i
IS
Y E
Exchange rate, EOutput, Y
(a) (b)
LMA A
Interest parity relation given (i *, E e )
Y
A i
i
i
i
ALM
E
Figure 19-3
The Effects of an Increase in the Interest Rate
An increase in the interest rate leads to a decrease in output and an appreciation.
b
400 The Open Economy Extensions
say, ∆G 7 0, increases output at a given interest rate, shifting the IS curve to the right, from IS to IS= in Figure 19-4(a). Because the central bank does not change the policy rate, the LM curve does not shift. The new equilibrium is at point A=, with a higher level of output, Y=. In panel (b), because the interest rate has not changed, neither has the exchange rate. So an increase in government spending, when the central bank keeps the interest rate unchanged, leads to an increase in output with no change in the exchange rate.
Can we tell what happens to the various components of demand?
■■ Clearly, consumption and government spending both increase: Consumption goes up because of the increase in income; government spending goes up by assumption.
■■ Investment also rises because it depends on both output and the interest rate: I = I1Y, i2. Here output rises and the interest rate does not change, thus investment rises.
■■ What about net exports? Recall that net exports depend on domestic output, foreign output, and the exchange rate: NX = NX1Y, Y *, E2. Foreign output is unchanged, as we are assuming that the rest of the world does not respond to the increase in domestic government spending. The exchange rate is also unchanged, because the interest rate does not change. We are left with the effect of higher domestic output; as the increase in output increases imports at an unchanged exchange rate, net exports decrease. As a result, the budget deficit leads to a deterioration of the trade balance. If trade was balanced to start, then the budget deficit leads to a trade deficit. Note that, although an increase in the budget deficit increases the trade deficit, the effect is far from mechanical. It works through the effect of the budget deficit on output, and in turn, on the trade deficit.
Now assume instead that the increase in G happens in an economy where output is close to potential output, Yn. The government could decide to increase government spending even if the economy is already at potential output for example because it needs to pay for an exceptional event, such as a big flood, and wants to postpone tax increases (more on this in Chapter 22). In this case the central bank will worry that the increase in G, by moving the economy above potential output, might push inflation up. It is likely
c
An increase in government spending shifts the IS curve to the right. It shifts neither the LM curve nor the interest parity line.
Interest parity relation given (i *, E e )
E eY
∆G > 0
D o
m e
s ti
c i
n te
re s
t ra
te ,
i
A
Y
Exchange rate, EOutput, Y
(a) (b)
IS
LMA A
IS D o
m e
s ti
c i
n te
re s
t ra
te ,
i
Figure 19-4
The Effects of an Increase in Government Spending with an Unchanged Interest Rate
An increase in government spending leads to an increase in output. If the central bank keeps the interest rate un- changed, the exchange rate also remains unchanged.
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Chapter 19 Output, the Interest Rate, and the Exchange Rate 401
Yn Exchange rate, EOutput, Y
(a) (b)
IS
A A
D o
m e s ti
c i n
te re
s t
ra te
, i
D o
m e s ti
c i n
te re
s t
ra te
, i
LM
∆G > 0
EY Y
A
A ALM
IS
E
Figure 19-5
The Effects of an Increase in Government Spending when the Central Bank Responds by Raising the Interest Rate
An increase in government spending leads to an increase in output. If the central bank responds by raising the inter- est rate, the exchange rate will appreciate.
to respond by raising the interest rate. What happens then is described in Figure 19-5. At an unchanged interest rate, output would increase from Yn to Y′ and the exchange rate would not change. But if the central bank accompanies the increase in government spending with an increase in the interest rate, output will increase by less, from Yn to Y
==, and the exchange rate will appreciate, from E to E==.
Again, can we tell what happens to the various components of demand?
■■ As before, consumption and government spending both increase; consumption goes up because of the increase in income, and government spending goes up by assumption.
■■ What happens to investment is now ambiguous. Investment depends on both output and the interest rate: I = I1Y, i2. Here output rises but so does the interest rate.
■■ Net exports decrease, for two reasons: Output goes up, increasing imports. The exchange rate appreciates, increasing imports, and decreasing exports. The budget deficit leads to a trade deficit. (Whether however the trade deficit is larger than if the policy rate remained constant is ambiguous. The appreciation makes it worse; but the higher interest rate leads to a smaller increase in output, and thus a smaller increase in imports.)
This version of the IS-LM model for the open economy was first put together in the 1960s by the two economists we mentioned at the outset of the chapter, Robert Mundell, at Columbia University, and Marcus Fleming, at the International Monetary Fund —although their model reflected the economies of the 1960s, when central banks used to set the supply of money, M, rather than the interest rate as they do today (remember our discussion in Chapter 6). How well does the Mundell-Fleming model fit the facts? Typically quite well, and this is why the model is still in use today. Like all simple models, it often needs to be extended. One should incorporate for example the role of risk in affecting portfolio decisions, or the implications of the zero lower bound, two important aspects of the crisis. But the simple exercises we worked through in Figures 19-3, 19-4, and 19-5 are a good starting point to organize thoughts. (See for example the Focus Box on page 402 “Monetary Contraction and Fiscal Expansion: The United States in the Early 1980s.” The Mundell-Fleming model and its predictions pass with flying colors.)
b
Robert Mundell was awarded the Nobel Prize in Economics in 1999.
402 The Open Economy Extensions
Monetary Contraction and Fiscal Expansion: The united States in the Early 1980s
The early 1980s in the United States were dominated by sharp changes both in monetary policy and in fiscal policy.
In the late 1970s, the Chairman of the Fed, Paul Volcker, concluded that U.S. inflation was too high and had to be re- duced. Starting in late 1979, Volcker embarked on a path of sharp increases in interest rates, realizing this might lead to a re- cession in the short run but lower inflation in the medium run.
The change in fiscal policy was triggered by the election of Ronald Reagan in 1980. Reagan was elected on the prom- ise of more conservative policies, namely a scaling down of taxation and the government’s role in economic activity. This commitment was the inspiration for the Economic Recovery Act of August 1981. Personal income taxes were cut by a total of 23%, in three installments from 1981 to 1983. Corporate taxes were also reduced. These tax cuts were not, however, ac- companied by corresponding decreases in government spend- ing, and the result was a steady increase in budget deficits, which reached a peak in 1983 at 5.6% of GDP. Table 1 gives spending and revenue numbers for 1980 –1984.
What were the Reagan administration’s motivations for cutting taxes without implementing corresponding cuts in spending? These are still being debated today, but there is agreement that there were two main motivations:
One motivation came from the beliefs of a fringe, but influential, group of economists called the supply siders, who argued that a cut in tax rates would cause people and firms to work much harder and more productively, and that the resulting increase in activity would actually lead to an increase, not a decrease, in tax revenues. Whatever the merits of the argument appeared to be then, it proved wrong. Even if some people did work harder and more productively after the tax cuts, tax revenues decreased and the fiscal deficit increased.
The other motivation was more cynical. It was a bet that the cut in taxes, and the resulting increase in deficits, would
scare Congress into cutting spending or, at the least, into not increasing spending further —a strategy known as “starve the beast.” This motivation turned out to be partly right; Congress found itself under enormous pressure not to increase spend- ing, and the growth of spending in the 1980s was surely lower than it would have been otherwise. Nonetheless, the adjustment of spending was not enough to offset the shortfall in tax revenues and avoid the rapid increase in deficits.
Whatever the reason for the deficits, the combined ef- fects of higher interest rates and a fiscal expansion were very much in line with what the Mundell-Fleming model predicts. Table 2 gives the evolution of the main macroeconomic vari- ables from 1980 to 1984.
Table 1 The Emergence of Large U.S. Budget Deficits, 1980 –1984 (Percentage of GDP)
1980 1981 1982 1983 1984
Spending 22.0 22.8 24.0 25.0 23.7
Revenues 20.2 20.8 20.5 19.4 19.2
Personal taxes
9.4 9.6 9.9 8.8 8.2
Corporate taxes
2.6 2.3 1.6 1.6 2.0
Budget surplus
21.8 22.0 23.5 25.6 24.5
Numbers are for fiscal years, which start in October of the previous calendar year. All numbers are expressed as a percentage of GDP. A budget deficit is a negative budget surplus.
Source: Historical Tables, Office of Management and Budget.
Table 2 Major U.S. Macroeconomic Variables, 1980 –1984
1980 1981 1982 1983 1984
GDP growth (%) − 0.5 1.8 − 2.2 3.9 6.2
Unemployment rate (%) 7.1 7.6 9.7 9.6 7.5
Inflation (CPI) (%) 12.5 8.9 3.8 3.8 3.9
Interest rate (real) (%) 11.5 2.5
14.0 4.9
10.6 6.0
8.6 5.1
9.6 5.9
Real exchange rate 85 101 111 117 129
Trade surplus (% of GDP) − 0.5 − 0.4 − 0.6 - 1.5 - 2.7
Inflation: rate of change of the CPI. The nominal interest rate is the three-month T-bill rate. The real interest rate is equal to the nominal rate minus the forecast of inflation by DRI, a private forecasting firm. The real exchange rate is the trade-weighted real exchange rate, normalized so that 1973 = 100. A negative trade surplus is a trade deficit.
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Chapter 19 Output, the Interest Rate, and the Exchange Rate 403
From 1980 to 1982, the evolution of the economy was dominated by the effects of the increase in interest rates. Interest rates, both nominal and real, increased sharply, lead- ing both to a large dollar appreciation and to a recession. The goal of lowering inflation was achieved; by 1982, inflation was down to about 4%, down from 12.5% in 1980. Lower output and the dollar appreciation had opposing effects on the trade balance (lower output leading to lower imports and an improvement in the trade balance; the appreciation of the dollar leading to a deterioration in the trade balance), result- ing in little change in the trade deficit before 1982.
From 1982 on, the evolution of the economy was domi- nated by the effects of the fiscal expansion. As our model predicts, these effects were strong output growth, high interest rates, and further dollar appreciation. The effects of high output growth and the dollar appreciation were an increase in the trade deficit to 2.7% of GDP by 1984. By the mid-1980s, the main macroeconomic policy issue had become that of the twin deficits: the budget deficit and the trade deficit. The twin deficits were to remain one of the central macroeconomic issues throughout the 1980s and early 1990s.
19-5 Fixed Exchange Rates We have assumed so far that the central bank chose the interest rate and let the exchange rate adjust freely in whatever manner was implied by equilibrium in the foreign exchange market. In many countries, this assumption does not reflect reality. Central banks act under implicit or explicit exchange rate targets and use monetary policy to achieve those targets. The targets are sometimes implicit, sometimes explicit; they are sometimes spe- cific values, sometimes bands or ranges. These exchange rate arrangements (or regimes, as they are called) come under many names. Let’s first see what the names mean.
Pegs, Crawling Pegs, Bands, the EMS, and the Euro At one end of the spectrum are countries with flexible exchange rates such as the United States, the United Kingdom, Japan, and Canada. These countries have no explicit exchange rate targets. Although their central banks do not ignore movements in the exchange rate, they have shown themselves quite willing to let their exchange rates fluc- tuate considerably.
At the other end are countries that operate under fixed exchange rates. Those coun- tries maintain a fixed exchange rate in terms of some foreign currency. Some peg their currency to the dollar. For example, from 1991 to 2001, Argentina pegged its currency, the peso, at the highly symbolic exchange rate of one dollar for one peso (more on this in Chapter 20). Other countries used to peg their currency to the French franc (most of these are former French colonies in Africa); as the French franc has been replaced by the euro, they are now pegged to the euro. Still other countries peg their currency to a basket of foreign currencies, with the weights reflecting the composition of their trade.
The label fixed is a bit misleading. It is not the case that the exchange rate in coun- tries with fixed exchange rates never actually changes. But changes are rare. An extreme case is that of the African countries pegged to the French franc. When their exchange rates were readjusted in January 1994, this was the first adjustment in 45 years! Because these changes are rare, economists use specific words to distinguish them from the daily changes that occur under flexible exchange rates. A decrease in the exchange rate under a regime of fixed exchange rates is called a devaluation rather than a depreciation, and an increase in the exchange rate under a regime of fixed exchange rates is called a revalua- tion rather than an appreciation.
Between these extremes are countries with various degrees of commitment to an exchange rate target. For example, some countries operate under a crawling peg. The name describes it well. These countries typically have inflation rates that exceed the U.S. inflation rate. If they were to peg their nominal exchange rate against the dollar, the more rapid increase in their domestic price level above the U.S. price level would lead to a steady real appreciation and rapidly make their goods uncompetitive. To avoid this effect,
b These terms were first intro- duced in Chapter 17.
b
Recall the definition of the real exchange rate P = EP>P *.
If domestic inflation is higher than foreign inflation:
P increases faster than P *. If E is fixed, EP>P * steadily increases.
Equivalently: There is a steady real appreciation. Domestic goods become steadily more expensive relative to foreign goods.
404 The Open Economy Extensions
these countries choose a predetermined rate of depreciation against the dollar. They choose to “crawl” (move slowly) vis-à-vis the dollar.
Yet another arrangement is for a group of countries to maintain their bilateral exchange rates (the exchange rate between each pair of countries) within some bands. Perhaps the most prominent example was the European Monetary System (EMS), which determined the movements of exchange rates within the European Union from 1978 to 1998. Under the EMS rules, member countries agreed to maintain their ex- change rate relative to the other currencies in the system within narrow limits or bands around a central parity —a given value for the exchange rate. Changes in the central parity and devaluations or revaluations of specific currencies could occur, but only by common agreement among member countries. After a major crisis in 1992, which led a number of countries to drop out of the EMS altogether, exchange rate adjustments be- came more and more infrequent, leading a number of countries to move one step further and adopt a common currency, the euro. The conversion from domestic currencies to the euro began on January 1, 1999, and was completed in early 2002. We shall return to the implications of the move to the euro in Chapter 20.
We shall discuss the pros and cons of different exchange regimes in the next chapter. But first, we must understand how pegging (also called fixing) the exchange rate affects monetary policy and fiscal policy. This is what we do in the rest of this section.
Monetary Policy when the Exchange Rate Is Fixed Suppose a country decides to peg its exchange rate at some chosen value, call it EQ. How does it actually achieve this? The government cannot just announce the value of the ex- change rate and remain idle. Rather, it must take measures so that its chosen exchange rate will prevail in the foreign exchange market. Let’s look at the implications and mechanics of pegging.
Pegging or no pegging, the exchange rate and the nominal interest rate must satisfy the interest parity condition
11 + it2 = 11 + it*2 a Et
Et + 1 e b
Now suppose the country pegs the exchange rate at EQ, so the current exchange rate Et = EQ. If financial and foreign exchange markets believe that the exchange rate will remain pegged at this value, then their expectation of the future exchange rate, Et + 1
e , is also equal to EQ, and the interest parity relation becomes
11 + it2 = 11 + it*2 1 it = it* In words: If financial investors expect the exchange rate to remain unchanged, they
will require the same nominal interest rate in both countries. Under a fixed exchange rate and perfect capital mobility, the domestic interest rate must be equal to the foreign interest rate.
Let’s summarize. Under fixed exchange rates, the central bank gives up monetary policy as a policy instrument. With a fixed exchange rate, the domestic interest rate must be equal to the foreign interest rate.
Fiscal Policy when the Exchange Rate Is Fixed If monetary policy can no longer be used under fixed exchange rates, what about fiscal policy?
The effects of an increase in government spending when the central bank pegs the exchange rate are identical to those we saw in Figure 19-4 for the case of flexible ex- change rates. This is because if the increase in spending is not accompanied by a change
cWe shall look at the 1992 crisis in Chapter 20.
cYou can think of countries adopting a common currency as adopting an extreme form of fixed exchange rates. Their “exchange rate” is fixed at one-to-one between any pair of countries.
These results depend on the interest rate parity condition, which in turn depends on the assumption of perfect capital mobility—that financial inves- tors go for the highest expect- ed rate of return. The case of fixed exchange rates with im- perfect capital mobility, which is more relevant for middle- income countries, such as in Latin America or Asia, is treated in the appendix to this chapter.
c
Chapter 19 Output, the Interest Rate, and the Exchange Rate 405
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Under a fixed exchange rate regime such as the European Monetary System (EMS)—the system which prevailed before the introduction of the euro —no individual country can change its interest rate if the other countries do not change theirs as well. So, how do interest rates actually change? Two arrangements are possible. One is for all the member coun- tries to coordinate changes in their interest rates. Another is for one of the countries to take the lead and for the other countries to follow —this is in effect what happened in the EMS, with Germany as the leader.
During the 1980s, most European central banks shared similar goals and were happy to let the Bundesbank (the German central bank) take the lead. But in 1990, German unification led to a sharp divergence in goals between the Bundesbank and the central banks of the other EMS coun- tries. Large budget deficits, triggered by transfers to people and firms in Eastern Germany, together with an investment boom, led to a large increase in demand in Germany. The Bundesbank’s fear that this shift would generate too strong an increase in activity led it to adopt a restrictive monetary policy. The result was strong growth in Germany together with a large increase in interest rates.
This may have been the right policy mix for Germany. But for the other European countries, this policy mix was much less appealing. They were not experiencing the same increase in demand, but to stay in the EMS, they had to match German interest rates. The net result was a sharp decrease in demand and output in the other countries. These results are presented in Table 1, which gives nominal interest rates, real interest rates, inflation rates, and GDP growth from 1990 to 1992 for Germany and for two of its EMS partners, France and Belgium.
Note first how the high German nominal interest rates were matched by both France and Belgium. In fact, nominal
interest rates were actually higher in France than in Germany in all three years! This is because France needed higher inter- est rates than Germany to maintain the Deutsche Mark (DM)/franc parity. The reason is that financial markets were not sure that France would actually keep the parity of the franc relative to the DM. Worried about a possible devalua- tion of the franc, financial investors asked for a higher inter- est rate on French bonds than on German bonds.
Although France and Belgium had to match —or, as we have just seen, more than match —German nominal rates, both countries had less inflation than Germany. The result was very high real interest rates, much higher than the rate in Germany: In both France and Belgium, average real inter- est rates from 1990 to 1992 were close to 7%. And in both countries, the period 1990 –1992 was characterized by slow growth and rising unemployment. Unemployment in France in 1992 was 10.4%, up from 8.9% in 1990. The correspond- ing numbers for Belgium were 12.1% and 8.7%.
A similar story was unfolding in the other EMS countries. By 1992, average unemployment in the European Union, which had been 8.7% in 1990, had increased to 10.3%. The effects of high real interest rates on spending were not the only source of this slowdown, but they were the main one.
By 1992, an increasing number of countries were won- dering whether to keep defending their EMS parity or to give it up and lower their interest rates. Worried about the risk of devaluations, financial markets started to ask for higher inter- est rates in those countries where they thought devaluations were more likely. The result was two major exchange rate crises, one in the fall of 1992, and the other in the summer of 1993. By the end of these two crises, two countries, Italy and the United Kingdom, had left the EMS. We shall look at these crises, their origins, and their implications, in Chapter 20.
Table 1 German Reunification, Interest Rates, and Output Growth: Germany, France, and Belgium, 1990 –1992
Nominal Interest Rates (%) Inflation (%)
1990 1991 1992 1990 1991 1992
Germany 8.5 9.2 9.5 2.7 3.7 4.7
France 10.3 9.6 10.3 2.9 3.0 2.4
Belgium 9.6 9.4 9.4 2.9 2.7 2.4
Real Interest Rates (%) GDP Growth (%)
1990 1991 1992 1990 1991 1992
Germany 5.8 5.5 4.8 5.7 4.5 2.1
France 7.4 6.6 7.9 2.5 0.7 1.4
Belgium 6.7 6.7 7.0 3.3 2.1 0.8
The nominal interest rate is the short-term nominal interest rate. The real interest rate is the realized real interest rate over the year—that is, the nominal interest rate minus actual inflation over the year. All rates are annual.
Source: OECD Economic Outlook.
406 The Open Economy Extensions
in the interest rate, the exchange rate doesn’t move. Thus, when government spending increases whether or not the country pegs its exchange rate makes no difference. The dif- ference between fixed and flexible exchange is the ability of the central bank to respond. We saw in Figure 19-5 that if the increase in government spending pushed the economy above potential output, thus raising the possibility that inflation might increase, the central bank could respond by raising the interest rate. This option is no longer available under fixed exchange rates because the interest rate must be equal to the foreign rate.
As this chapter comes to an end, a question should have started to form in your mind: Why would a country choose to fix its exchange rate? You have seen a number of reasons why this appears to be a bad idea:
■■ By fixing the exchange rate, a country gives up a powerful tool for correcting trade imbalances or changing the level of economic activity.
■■ By committing to a particular exchange rate, a country also gives up control of its policy rate. Not only that, but the country must match movements in the foreign in- terest rate, at the risk of unwanted effects on its own activity. This is what happened in the early 1990s in Europe. Because of the increase in demand as a result of the reunification of West and East Germany, Germany felt it had to increase its inter- est rate. To maintain their parity with the Deutsche Mark, other countries in the European Monetary System (EMS) were forced to also increase their interest rates, something that they would rather have avoided. (This is the topic of the Focus box “German Reunification, Interest Rates, and the EMS.”)
■■ Although the country retains control of fiscal policy, one policy instrument may not be enough. As you saw in Chapter 18, for example, a fiscal expansion can help the economy get out of a recession, but only at the cost of a larger trade deficit. And a country that wants, for example, to decrease its budget deficit cannot, under fixed exchange rates, use monetary policy to offset the contractionary effect of its fiscal policy on output.
So why do some countries fix their exchange rate? Why have 19 European countries — with more to come —adopted a common currency? To answer these questions, we must do some more work. We must look at what happens not only in the short run —which is what we did in this chapter —but also in the medium run, when the price level can adjust. We must look at the nature of exchange rate crises. Once we have done this, we shall then be able to assess the pros and cons of different exchange rate regimes. These are the topics we take up in Chapter 20.
c
Under flexible exchange rates the central bank could respond to an increase in government spending by raising the inter- est rate, as in Figure 19-5. This option is no longer available under fixed exchange rates because the interest rate must be equal to the foreign rate.
Summary
■■ In an open economy, the demand for domestic goods, and in turn output, depends both on the interest rate and on the exchange rate. An increase in the interest rate decreases the demand for domestic goods. An increase in the ex- change rate —an appreciation —also decreases the demand for domestic goods.
■■ The exchange rate is determined by the interest parity con- dition, which states that domestic and foreign bonds must have the same expected rate of return in terms of domestic currency.
■■ Given the expected future exchange rate and the foreign in- terest rate, increases in the domestic interest rate lead to an
increase in the exchange rate —an appreciation. Decreases in the domestic interest rate lead to a decrease in the ex- change rate —a depreciation.
■■ Under flexible exchange rates, an expansionary fiscal policy leads to an increase in output. If the fiscal expansion is par- tially offset by tighter monetary policy, it leads to an increase in the interest rate, and an appreciation.
■■ Under flexible exchange rates, a contractionary monetary policy leads to a decrease in output, an increase in the inter- est rate, and an appreciation.
■■ There are many types of exchange rate arrangements. They range from fully flexible exchange rates to crawling pegs, to
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Chapter 19 Output, the Interest Rate, and the Exchange Rate 407
fixed exchange rates (or pegs), to the adoption of a common currency. Under fixed exchange rates, a country maintains a fixed exchange rate in terms of a foreign currency or a basket of currencies.
■■ Under fixed exchange rates and the interest parity condi- tion, a country must maintain an interest rate equal to the
foreign interest rate. The central bank loses the use of mon- etary policy as a policy instrument. Fiscal policy becomes more powerful than under flexible exchange rates, however, because fiscal policy triggers monetary accommodation, and so does not lead to offsetting changes in the domestic interest rate and exchange rate.
Key Terms
Mundell-Fleming model, 391 sudden stops, 395 safe haven, 395 supply siders, 402 twin deficits, 403 peg, 403
crawling peg, 403 European Monetary System (EMS), 404 bands, 404 central parity, 404 euro, 404
Questions and Problems
QUICk CheCk MyEconLab Visit www.myeconlab.com to complete all Quick Check problems and get instant feedback. 1. Using the information in this chapter, label each of the following statements true, false, or uncertain. Explain briefly.
a. The interest rate parity condition means that interest rates are equal across countries.
b. Other things being equal, the interest parity condition im- plies that the domestic currency will appreciate in response to an increase in the expected exchange rate.
c. If financial investors expect the dollar to depreciate against the yen over the coming year, one-year interest rates will be higher in the United States than in Japan.
d. If the expected exchange rate appreciates, the current exchange rate immediately appreciates.
e. The central bank influences the value of the exchange rate by changing the domestic interest rate relative to the for- eign interest rate.
f. An increase in domestic interest rates, all other factors equal, increases exports.
g. A fiscal expansion, all other factors equal, tends to increase net exports.
h. Fiscal policy has a greater effect on output in an economy with fixed exchange rates than in an economy with flexible exchange rates.
i. Under a fixed exchange rate, the central bank must keep the domestic interest rate equal to the foreign interest rates.
2. Consider an open economy with flexible exchange rates. Suppose output is at the natural level, but there is a trade deficit. The goal of policy is to reduce the trade deficit and leave the level of output at its natural level. What is the appropriate fiscal and monetary policy mix?
3. In this chapter, we showed that a reduction in the interest rate in an economy operating under flexible exchange rates leads to an increase in output and a depreciation of the domestic currency.
a. How does the reduction in interest rates in an economy with flexible exchange rates affect consumption and investment?
b. How does the reduction in interest rates in an economy with flexible exchange rates affect net exports?
4. Flexible exchange rates and foreign macroeconomic events Consider an open economy with flexible exchange rates. Let
UIP stand for the uncovered interest parity condition. a. In an IS-LM–UIP diagram, show the effect of an increase
in foreign output, Y *, on domestic output 1Y2 and the exchange rate 1E2, when the domestic central bank leaves the policy interest rate unchanged. Explain in words.
b. In an IS-LM–UIP diagram, show the effect of an increase in the foreign interest rate, i *, on domestic output 1Y2 and the exchange rate 1E2, when the domestic central bank leaves the policy interest rate unchanged. Explain in words.
5. Flexible exchange rates and the responses to changes in foreign macroeconomic policy
Suppose there is an expansionary fiscal policy in the foreign country that increases Y * and i * at the same time.
a. In an IS-LM–UIP diagram, show the effect of the increase in foreign output, Y *, and the increase in the foreign interest rate, i *, on domestic output 1Y 2 and the exchange rate 1E2, when the domestic central bank leaves the policy interest rate unchanged. Explain in words.
b. In an IS-LM–UIP diagram, show the effect of the increase in foreign output, Y *, and the increase in the foreign interest rate, i*, on domestic output 1Y 2 and the exchange rate (E), when the domestic central bank matches the increase in the foreign interest rate with an equal increase in the domestic interest rate. Explain in words.
c. In an IS-LM–UIP diagram, show the required domestic monetary policy following the increase in foreign out- put, Y *, and the increase in the foreign interest rate, i *, if the goal of domestic monetary policy is to leave domestic output 1Y 2 unchanged. Explain in words. When might such a policy be necessary?
408 The Open Economy Extensions
DIG DeePeR MyEconLab Visit www.myeconlab.com to complete all Dig Deeper problems and get instant feedback. 6. Fixed exchange rates and foreign macroeconomic policy
Consider a fixed exchange rate system, in which a group of countries (called follower countries) peg their currencies to the currency of one country (called the leader country). Because the currency of the leader country is not fixed against the currencies of countries outside the fixed exchange rate system, the leader country can conduct monetary policy as it wishes. For this problem, consider the domestic country to be a follower country and the foreign country to be the leader country.
a. How does an increase in interest rates in the leader country affect the interest rate and output in the follower country?
b. How does the increase in leader country interest rates change the composition of output in the follower country? Assume the follower country does not change fiscal policy.
c. Can the follower country use fiscal policy to offset the ef- fects of the leader country’s reduction in interest rates and leave domestic output unchanged? When might such a fis- cal policy be desirable?
d. Fiscal policy involves changing government spending or changing taxes. Design a fiscal policy mix that leaves con- sumption and domestic output unchanged when the leader country increases interest rates. What component of out- put is changed?
7. The exchange rate as a policy tool A flexible exchange rate combined with a willingness to change
the domestic interest rate can increase the effectiveness of monetary policy in an open economy. Consider an economy that suffers a fall in business confidence (which tends to reduce investment).
a. In an IS-LM–UIP diagram, show the short-run effect of the fall in business confidence on output and the exchange rate when the central bank leaves the interest rate unchanged. How does the composition of output change?
b. The central bank is willing to cut the interest rate to re- store the level of output to its original value. How does this change the composition of output?
c. If the exchange rate was fixed and the central bank could not change the interest rate (remember it is fixed at the foreign value i*) what policy options are left for the central bank?
d. Central banks generally favor flexible exchange rates. Ex- plain why.
exPloRe FURTheR
8. Demand for U.S. assets, the dollar, and the trade deficit This question explores how an increase in demand for U.S.
assets may have slowed the depreciation of the dollar that many economists believe is warranted by the large U.S. trade deficit and the need to stimulate the demand for domestic goods after the crisis. Here, we modify the IS-LM–UIP framework to analyze the effects of an increase in demand for U.S. assets. Write the modified uncovered interest parity condition as
11 + it2 = 11 + it* 21Et>Et + 1e 2 - x
where the parameter x represents factors affecting the relative demand for domestic assets. An increase in x means that investors are willing to hold domestic assets at a lower interest rate (given the foreign interest rate and the current and expected exchange rates).
a. Solve the UIP condition for the current exchange rate, Et . b. Substitute the result from part (a) in the IS curve and con-
struct the UIP diagram. As in the text, you may assume that P and P * are constant and equal to one.
c. Suppose that as a result of a large trade deficit in the domestic economy, financial market participants believe that the domestic currency must depreciate in the future. Therefore, the expected exchange rate, Et + 1
e , decreases. Show the effect of the decrease in the expected exchange rate in the IS-LM–UIP diagram. What are the effects on the exchange rate and the trade balance? (Hint: In analyzing the effect on the trade balance, remember why the IS curve shifted in the first place.)
d. Now suppose that the relative demand for domestic assets, x, increases. As a benchmark, suppose that the increase in x is exactly enough to return the IS curve to its original position, before the decrease in the expected exchange rate. Show the combined effects of the decrease in Et + 1
e and the increase in x in your IS-LM–UIP diagram. What are the ultimate effects on the exchange rate and the trade balance?
e. Based on your analysis, is it possible that an increase in demand for U.S. assets could prevent the dollar from depre- ciating? Is it possible that an increase in demand for U.S. assets could worsen the U.S. trade balance? Explain your answers.
9. Bond yields and long run currency movements a. Go the web site of The Economist (www.economist.com)
and find data on 10-year interest rates. Look in the section “Markets & Data” and then the subsection “Economic and Financial Indicators.” Look at the 10-year interest rates for the United States, Japan, China, Britain, Canada, Mexico, and the Euro area. For each country (treating the Euro area as a country), calculate the spreads as that country’s inter- est rate minus the U.S. interest rate.
b. From the uncovered interest parity condition, the spreads from part (a) are the annualized expected appreciation rates of the dollar against other currencies. To calculate the 10-year expected appreciation, you must compound. (So, if x is the spread, the 10-year expected appreciation is [11 + x210 - 1]. Be careful about decimal points.) Is the dollar expected to depreciate or appreciate by much against the currency of any of its six major trading partners?
c. Given your answer to part (b), for which country(ies) is a significant appreciation or depreciation of the dollar expected over the next decade? Does your answer seem plausible?
Chapter 19 Output, the Interest Rate, and the Exchange Rate 409
The assumption of perfect capital mobility is a good approxi- mation of what happens in countries with highly developed financial markets and few capital controls, such as the United States, the United Kingdom, Japan, and the Euro area. But this assumption is more questionable in countries that have less developed financial markets or have capital controls in place. In these countries, domestic financial investors may have nei- ther the savvy nor the legal right to buy foreign bonds when domestic interest rates are low. The central bank may thus be able to decrease the interest rate while maintaining a given exchange rate.
To look at these issues, we need to have another look at the balance sheet of the central bank. In Chapter 4, we assumed the only asset held by the central bank was domestic bonds. In an open economy, the central bank actually holds two types of as- sets: (1) domestic bonds and (2) foreign exchange reserves, which we shall think of as foreign currency—although they also take the form of foreign bonds or foreign interest-paying assets. Think of the balance sheet of the central bank as repre- sented in Figure 1.
On the asset side are bonds and foreign exchange reserves, and on the liability side is the monetary base. There are now two ways in which the central bank can change the monetary base: either by purchases or sales of bonds in the bond market or by purchases or sales of foreign currency in the foreign ex- change market. (If you did not read Section 4-3 in Chapter 4, replace monetary base with money supply and you will still get the basic argument.)
Perfect Capital Mobility and Fixed Exchange Rates
Consider first the effects of an open market operation under the joint assumptions of perfect capital mobility and fixed ex- change rates (the assumptions we made in the last section of this chapter).
■■ Assume the domestic interest rate and the foreign interest rate are initially equal, so i = i *. Now suppose the central bank embarks on an expansionary open market operation, buying bonds in the bond market in amount ∆B, and creat- ing money —increasing the monetary base—in exchange. This purchase of bonds leads to a decrease in the domestic in- terest rate, i. This is, however, only the beginning of the story.
■■ Now that the domestic interest rate is lower than the foreign interest rate, financial investors prefer to hold foreign bonds. To buy foreign bonds, they must first buy foreign currency.
They then go to the foreign exchange market and sell domes- tic currency for foreign currency.
■■ If the central bank did nothing, the price of domestic cur- rency would fall, and the result would be a depreciation. Under its commitment to a fixed exchange rate however, the central bank cannot allow the currency to depreciate. So it must intervene in the foreign exchange market and sell foreign currency for domestic currency. As it sells for- eign currency and buys domestic money, the monetary base decreases.
■■ How much foreign currency must the central bank sell? It must keep selling until the monetary base is back to its pre- open market operation level, so the domestic interest rate is again equal to the foreign interest rate. Only then are finan- cial investors willing to hold domestic bonds.
How long do all these steps take? Under perfect capital mo- bility, all this may happen within minutes or so of the original open market operation. After these steps, the balance sheet of the central bank looks as represented in Figure 2. Bond hold- ings are up by ∆B, reserves of foreign currency are down by ∆B, and the monetary base is unchanged, having gone up by ∆B in the open market operation and down by ∆B as a result of the sale of foreign currency in the foreign exchange market.
Let’s summarize. Under fixed exchange rates and perfect capital mobility, the only effect of the open market operation is to change the composition of the central bank’s balance sheet but not the monetary base, nor the interest rate.
Imperfect Capital Mobility and Fixed Exchange Rates
Let’s now move away from the assumption of perfect capital mobility. Suppose it takes some time for financial investors to shift between domestic bonds and foreign bonds.
Now an expansionary open market operation can initially bring the domestic interest rate below the foreign interest rate. But over time, investors shift to foreign bonds, leading to an increase in the demand for foreign currency in the foreign exchange market. To avoid a depreciation of the domestic cur- rency, the central bank must again stand ready to sell foreign currency and buy domestic currency. Eventually, the central bank buys enough domestic currency to offset the effects of the initial open market operation. The monetary base is back to its pre-open market operation level, and so is the interest rate. The central bank holds more domestic bonds and smaller reserves of foreign currency.
APPEnDIx: Fixed Exchange Rates, Interest Rates, and Capital Mobility
Assets Liabilities
Bonds Foreign exchange
reserves
Monetary base
Figure 1
Balance Sheet of the Central Bank
Assets Liabilities
Bonds: ∆B Reserves: −∆B
Monetary base: ∆B - ∆B = 0
Figure 2
Balance Sheet of the Central Bank after an Open Market Operation, and the Induced Intervention in the Foreign Exchange Market
410 The Open Economy Extensions
The difference between this case and the case of perfect capital mobility is that, by accepting a loss in foreign exchange reserves, the central bank is now able to decrease interest rates for some time. If it takes just a few days for financial investors to adjust, the trade-off can be very unattractive —as many countries that have suffered large losses in reserves without much effect on the interest rate have discovered at their ex- pense. But if the central bank can affect the domestic interest rate for a few weeks or months, it may, in some circumstances, be willing to do so.
Now let’s deviate further from perfect capital mobility. Suppose, in response to a decrease in the domestic interest rate, financial investors are either unwilling or unable to move much of their portfolio into foreign bonds. For example, there are administrative and legal controls on financial transactions, making it illegal or very expensive for domestic residents to in- vest outside the country. This is the relevant case for a number of emerging economies, from Latin America to China.
After an expansionary open market operation, the do- mestic interest rate decreases, making domestic bonds less attractive. Some domestic investors move into foreign bonds, selling domestic currency for foreign currency. To maintain the exchange rate, the central bank must buy domestic cur- rency and supply foreign currency. However, the foreign ex- change intervention by the central bank may now be small compared to the initial open market operation. And if capital controls truly prevent investors from moving into foreign bonds at all, there may be no need for such a foreign exchange intervention.
Even leaving this extreme case aside, the net effects of the initial open market operation and the following foreign ex- change interventions are likely to be an increase in the monetary base; a decrease in the domestic interest rate; an increase in the cen- tral bank’s bond holdings; and some —but limited —loss in reserves of foreign currency. With imperfect capital mobility, a country has some freedom to move the domestic interest rate while maintaining its exchange rate. This freedom depends primarily on three factors:
■■ The degree of development of its financial markets, and the willingness of domestic and foreign investors to shift be- tween domestic assets and foreign assets.
■■ The degree of capital controls it is able to impose on both domestic and foreign investors.
■■ The amount of foreign exchange reserves it holds. The higher the reserves it has, the more it can afford the loss in reserves it is likely to sustain if it decreases the interest rate at a given exchange rate.
With the large movements in capital flows we documented in the chapter, all of these issues are hot topics. Many countries are considering a more active use of capital controls than in the past. Many countries are also accumulating large reserves as a precaution against large capital outflows.
Key Term foreign-exchange reserves, 409
411
I
20 Exchange Rate Regimes n July 1944, representatives of 44 countries met in Bretton Woods, New Hampshire, to design a new international monetary and exchange rate system. The system they adopted was based on fixed exchange rates, with all member countries other than the United States fixing the price of their currency in terms of dollars. In 1973, a series of exchange rate crises brought an abrupt end
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412 The Open Economy Extensions
to the system—and an end to what is now called “the Bretton Woods period.” Since then, the world has been characterized by many exchange rate arrangements. Many countries operate under flexible exchange rates; some operate under fixed exchange rates; some go back and forth between regimes. Which exchange rate regime to choose is one of the most debated issues in macroeconomics and, as the cartoon suggests, a decision facing every country in the world. This chapter discusses this issue.
Section 20-1 looks at the medium run. It shows that, in contrast to the results we derived for the short run in Chapter 19, an economy ends up with the same real exchange rate and output level in the medium run, whether it operates under fixed exchange rates or flexible exchange rates. This obviously does not make the exchange rate regime irrelevant—the short run matters very much—but it is an important qualification to our previous analysis.
Section 20-2 takes another look at fixed exchange rates and focuses on exchange rate crises. During a typical exchange rate crisis, a country operating under a fixed exchange rate is forced, often under dramatic conditions, to abandon its parity and to devalue. Such crises were behind the breakdown of the Bretton Woods system. They rocked the European Monetary System in the early 1990s, and were a major element of the Asian Crisis of the late 1990s. It is important to understand why they happen, and what they imply.
Section 20-3 takes another look at flexible exchange rates. It shows that the behavior of exchange rates and the relation of the exchange rate to monetary policy are more complex than we assumed in Chapter 19. Large fluctuations in the exchange rate, and the difficulties in using monetary policy to affect the exchange rate, make a flexible exchange rate regime less attractive than it appeared to be in Chapter 19.
Section 20-4 puts all these conclusions together and reviews the case for flexible or fixed rates. It discusses two important developments: the use of a common currency in much of Europe, and the move toward strong forms of fixed exchange rate regimes, from currency boards to dollarization.
20-1 The Medium Run When we focused on the short run in Chapter 19, we drew a sharp contrast between the behavior of an economy with flexible exchange rates and an economy with fixed exchange rates.
■■ Under flexible exchange rates, a country that needed to achieve a real depreciation (for example, to reduce its trade deficit, or to get out of a recession, or both) could do so by relying on an expansionary monetary policy to achieve both a lower interest rate and a decrease in the exchange rate—a depreciation.
■■ Under fixed exchange rates, a country lost both of these instruments. By definition, its nominal exchange rate was fixed and thus could not be adjusted. Moreover, the fixed exchange rate and the interest parity condition implied that the country could not adjust its interest rate either; the domestic interest rate had to remain equal to the foreign interest rate.
This appeared to make a flexible exchange rate regime definitely more attractive than a fixed exchange rate regime. Why should a country give up two macroeconomic instruments—the exchange rate and the interest rate? As we now shift focus from the short run to the medium run, you shall see that this previous conclusion needs to be qualified. Although our conclusions about the short run were valid, we shall see that, in the medium run, the difference between the two regimes fades away. More specifically,
Chapter 20 Exchange Rate Regimes 413
in the medium run, the economy reaches the same real exchange rate and the same level of output whether it operates under fixed or under flexible exchange rates.
The intuition for this result is actually easy to give. Recall the definition of the real exchange rate:
e = EP P *
The real exchange rate, e, is equal to the nominal exchange rate, E (the price of domestic currency in terms of foreign currency) times the domestic price level, P, divided by the foreign price level, P *. There are, therefore, two ways in which the real exchange rate can adjust:
■■ Through a change in the nominal exchange rate E: By definition, this can only be done under flexible exchange rates. And if we assume the domestic price level, P, and the foreign price level, P *, do not change in the short run, it is the only way to adjust the real exchange rate in the short run.
■■ Through a change in the domestic price level, P, relative to the foreign price level, P *. In the medium run, as prices adjust, this option is open even to a country operat- ing under a fixed (nominal) exchange rate. And this is indeed what happens under fixed exchange rates. The adjustment takes place through the price level rather than through the nominal exchange rate.
The IS Relation under Fixed Exchange Rates In an open economy with fixed exchange rates, we can write the IS relation as
Y = Y a E QP P*
, G, T, i * - pe, Y *b (20.1) 1- , + , - , - , + 2
The derivation of equation (20.1) is better left to Appendix 1 at the end of this chapter, titled “Deriving the IS Relation under Fixed Exchange Rates.” The intuition be- hind the equation is straightforward, however. Demand, and in turn, output, depend on:
■■ Negatively on the real exchange rate, EQP>P *. EQ denotes the fixed nominal exchange rate; P and P * denote the domestic and foreign price levels, respectively. A higher real exchange rate implies a lower demand for domestic goods, and in turn lower output.
■■ Positively on government spending, G, and negatively on taxes, T. ■■ Negatively on the domestic real interest rate, which itself equal to the domestic
nominal interest rate minus expected inflation. Under the interest parity condition and fixed exchange rates, the domestic nominal interest rate is equal to the foreign nominal interest rate i*, so the domestic real interest rate is given by i * - pe.
■■ Positively on foreign output, Y*, through the effect on exports.
Equilibrium in the Short and the Medium Run Consider an economy where the real exchange rate is too high. As a result, the trade bal- ance is in deficit, and output is below potential.
As we saw in Chapter 19, under a flexible exchange rate regime, the central bank could solve the problem. It could, by decreasing the interest rate, lead to a nominal depre- ciation. Given the domestic and the foreign price levels, which we assumed were fixed in the short run, the nominal depreciation implied a real depreciation, an improvement in the trade balance and an increase in output.
There are three ways in which a U.S. car can become cheap- er relative to a Japanese car. First, through a decrease in the dollar price of the U.S car. Second, through an in- crease in the yen price of the Japanese car. Third, through a decrease in the nominal ex- change rate—a decrease in the value of the dollar in terms of the yen.
b
414 The Open Economy Extensions
Under a fixed exchange rate regime however, the central bank cannot move the domestic interest rate. Thus, in the short run, the trade deficit remains, and the country remains in recession.
In the medium run however, prices can adjust. We saw in the core that the behavior of prices is well described by the Phillips curve relation (Chapter 9, equation (9.3)):
p - pe = 1a>L21Y - Yn2 When output is above potential, the inflation rate (i.e., the rate of change of prices)
is higher than expected. When output is below potential, as is the case we are consider- ing here, the inflation rate is lower than expected. In Chapter 9, we saw that the way peo- ple formed expectations of inflation has changed over time. When inflation was low and not very persistent, expected inflation was roughly constant, and we could take pe to be equal to a constant pQ . When inflation became higher and more persistent, people started expecting inflation this year to be the same as last year, and expected inflation was better captured by pe = p - 1. For simplicity, I shall assume here that expected inflation is constant so that the Phillips curve relation is given by:
p - pQ = 1a>L21Y - Yn2 (20.2) We are now ready to think about the dynamics in the medium run. We need to make
some assumption about the initial domestic and foreign inflation rates. Denote the foreign inflation rate by p*. Suppose that if output was equal to potential output, domestic and foreign inflation would be equal to each other, and both equal to pQ , so p = p* = pQ . That is, if both economies were operating at potential, inflation rates would be the same, relative price levels would remain constant, and so would the real exchange rate. As we are assuming that we start from a situation where output is below potential, equation (20.2) implies that domestic inflation is lower than it would be if output was at potential, and thus lower than foreign inflation. Put another way, the domestic price level increases more slowly than the foreign price level. This implies that, given the nominal exchange rate which is fixed, the real exchange rate decreases. As a result, net exports increase over time, and so does output. In the medium run, output is back to potential, domestic inflation is back to pQ , and thus equal to foreign inflation. With domestic and foreign in- flation being equal, the real exchange rate is constant.
To summarize:
■■ In the short run, a fixed nominal exchange rate implies a fixed real exchange rate. ■■ In the medium run, the real exchange rate can adjust even if the nominal exchange
rate is fixed. This adjustment is achieved through movements in the relative price levels over time.
The Case for and against a Devaluation The result that, even under fixed exchange rates, the economy can return to potential output in the medium run is important. But it does not eliminate the fact that the process of adjustment can be long and painful. Output may remain too low and unemployment may remain too high for a long time.
Are there faster and better ways to return output to potential? The answer, within the model we have just developed, is a clear yes. Suppose that the government decides, while keeping the fixed exchange rate regime, to allow for a one-time devaluation. Given the price level, the devaluation (a decrease in the nominal exchange rate) leads, in the short run, to a real depreciation (a decrease in the real exchange rate), and therefore to an increase in output. In principle, the right size devaluation can thus achieve in the short run what was achieved above only in the medium run, and thus avoid much of the pain. So, whenever a country under fixed exchange rates faces either a large trade
c
Making the alternative as- sumption that expected in- flation is equal to last year’s inflation leads to more com- plicated dynamics but to the same medium-run equilibrium.
cp 6 p* 1 EQP>P * T
Chapter 20 Exchange Rate Regimes 415
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The Return of Britain to the Gold standard: Keynes versus churchill
In 1925, Britain decided to return to the gold standard. The gold standard was a system in which each country fixed the price of its currency in terms of gold and stood ready to exchange gold for currency at the stated parity. This system implied fixed exchange rates between countries. (If for exam- ple, one unit of currency in country A was worth two units of gold, and one unit of currency in country B was worth one unit, the exchange rate between the two was 2 (or ½, depend- ing on which you take as a domestic country).
The gold standard had been in place from 1870 until World War I. Because of the need to finance the war, and to do so in part by money creation, Britain suspended the gold standard in 1914. In 1925, Winston Churchill, then Britain’s Chancellor of the Exchequer (the British equivalent of Secretary of the Treasury in the United States), decided to return to the gold standard, and to return to it at the pre-war parity—that is, at the pre-war value of the pound in terms of gold. But because prices had increased faster in Britain than in many of its trading partners, returning to the pre- war parity implied a large real appreciation: At the same nominal exchange rate as before the war, British goods were now relatively more expensive relative to foreign goods. (Go back to the definition of the real exchange rate, e = EP,P*: The price level in Britain, P, had increased more than the foreign price level, P *. At a given nominal exchange rate, E, this implied that E was higher, that Britain suffered from a real appreciation.)
Keynes severely criticized the decision to return to the pre- war parity. In The Economic Consequences of Mr. Churchill, a book he published in 1925, Keynes argued as follows: If Britain were going to return to the gold standard, it should have done so at a lower price of currency in terms of gold; that is, at a lower nominal exchange rate than the pre-war
nominal exchange rate. In a newspaper article, he articulated his views as follows:
“There remains, however, the objection to which I have never ceased to attach importance, against the return to gold in actual present conditions, in view of the possible conse- quences on the state of trade and employment. I believe that our price level is too high, if it is converted to gold at the par of exchange, in relation to gold prices elsewhere; and if we consider the prices of those articles only which are not the subject of international trade, and of services, i.e. wages, we shall find that these are materially too high—not less than 5 per cent, and probably 10 per cent. Thus, unless the situ- ation is saved by a rise of prices elsewhere, the Chancellor is committing us to a policy of forcing down money wages by perhaps 2 shillings in the Pound.
I do not believe that this can be achieved without the gravest danger to industrial profits and industrial peace. I would much rather leave the gold value of our currency where it was some months ago than embark on a struggle with every trade union in the country to reduce money wages. It seems wiser and simpler and saner to leave the currency to find its own level for some time longer rather than force a situation where employers are faced with the alternative of closing down or of lowering wages, cost what the struggle may.
For this reason, I remain of the opinion that the Chancellor of the Exchequer has done an ill-judged thing— ill judged because we are running the risk for no adequate reward if all goes well.”
Keynes’s prediction turned out to be right. While other countries were growing, Britain remained in recession for the rest of the decade. Most economic historians attribute a good part of the blame to the initial overvaluation.
Source: “The Nation and Athenaeum,” May 2, 1925.
deficit or a severe recession, there is heavy political pressure either to give up the fixed exchange rate regime altogether, or, at least, to have a one-time devaluation. Perhaps the most forceful presentation of this view was made 90 years ago by Keynes, who argued against Winston Churchill’s decision to return the British pound in 1925 to its pre– World War I parity with gold. His arguments are presented in the Focus box “The Return of Britain to the Gold Standard: Keynes versus Churchill.” Most economic historians believe that history proved Keynes right, and that overvaluation of the pound was one of the main reasons for Britain’s poor economic performance after World War I.
Those who oppose a shift to flexible exchange rates or who oppose a devaluation argue that there are good reasons to choose fixed exchange rates, and that too much willingness to devalue defeats the purpose of adopting a fixed exchange rate regime in the first place. They argue that too much willingness on the part of governments to con- sider devaluations actually leads to an increased likelihood of exchange rate crises. To understand their arguments, we now turn to these crises: what triggers them and what their implications might be.
416 The Open Economy Extensions
20-2 Exchange Rate Crises under Fixed Exchange Rates Suppose a country has chosen to operate under a fixed exchange rate. Suppose also that financial investors start believing there may soon be an exchange rate adjustment— either a devaluation or a shift to a flexible exchange rate regime accompanied by a depreciation. We just saw why this might be the case:
■■ The real exchange rate may be too high. Or put another way, the domestic currency may be overvalued, leading to too large a current account deficit. In this case, a real depreciation is called for. Although this could be achieved in the medium run with- out a devaluation, financial investors conclude that the government will take the quickest way out—and devalue.
Such an overvaluation often happens in countries that peg their nominal ex- change rate to the currency of a country with lower inflation. Higher relative infla- tion implies a steadily increasing price of domestic goods relative to foreign goods, a steady real appreciation, and so a steady worsening of the trade position. As time passes, the need for an adjustment of the real exchange rate increases, and financial investors become more and more nervous. They start thinking that a devaluation might be coming.
■■ Internal conditions may call for a decrease in the domestic interest rate. As we have seen, a decrease in the domestic interest rate cannot be achieved under fixed exchange rates. But it can be achieved if the country is willing to shift to a flexible exchange rate regime. If a country lets the exchange rate float and then decreases its domestic interest rate, we know from Chapter 19 that this will trigger a decrease in the nominal exchange rate —a nominal depreciation.
As soon as financial markets believe a devaluation may be coming, then main- taining the exchange rate requires an increase —often a large one —in the domestic interest rate.
To see this, return to the interest parity condition we derived in Chapter 17:
it = it* - 1Et + 1e - Et2
Et (20.3)
In Chapter 17, we interpreted this equation as a relation among the one-year domestic and foreign nominal interest rates, the current exchange rate, and the expected exchange rate a year hence. But the choice of one year as the period was arbitrary. The relation holds over a day, a week, a month. If financial markets expect the exchange rate to be 2% lower a month from now, they will hold domestic bonds only if the one- month domestic interest rate exceeds the one-month foreign interest rate by 2% (or, if we express interest rates at an annual rate, if the annual domestic interest rate exceeds the annual foreign interest rate by 2% * 12 = 24%).
Under fixed exchange rates, the current exchange rate, Et , is set at some level, say Et = EQ. If markets expect the parity will be maintained over the period, then Et + 1
e = EQ, and the interest parity condition simply states that the domestic and the foreign interest rates must be equal.
Suppose, however, participants in financial markets start anticipating a devalua- tion—a decision by the central bank to give up the parity and decrease the exchange rate in the future. Suppose they believe that, over the coming month, there is a 75% chance the parity will be maintained and a 25% chance there will be a 20% devaluation. The term 1Et + 1e - Et2>Et in the interest parity equation (20.3), which we assumed equal
The expression to let a cur- rency “float” is to allow a move from a fixed to a flexible ex- change rate regime. A floating exchange rate regime is the same as a flexible exchange rate regime.
c
c
Because it is more convenient, we use the approximation, equation (17.4), rather than the original interest parity condi- tion, equation (17.2).
Chapter 20 Exchange Rate Regimes 417
to zero earlier, now equals 0.75 * 0% + 0.25 * 1 - 20%2 = - 5% (a 75% chance of no change plus a 25% chance of a devaluation of 20%).
This implies that, if the central bank wants to maintain the existing parity, it must now set a monthly interest rate 5% higher than before—60% higher at an annual rate 112 months * 5% per month2; 60% is the interest differential needed to convince inves- tors to hold domestic bonds rather than foreign bonds! Any smaller interest differential, and investors will not want to hold domestic bonds.
What, then, are the choices confronting the government and the central bank?
■■ First, the government and the central bank can try to convince markets they have no intention of devaluing. This is always the first line of defense: Communiqués are issued, and prime ministers go on TV to reiterate their absolute commitment to the existing parity. But words are cheap, and they rarely convince financial investors.
■■ Second, the central bank can increase the interest rate, but by less than would be needed to satisfy equation (20.3) —in our example, by less than 60%. Although do- mestic interest rates are high, they are not high enough to fully compensate for the perceived risk of devaluation. This action typically leads to a large capital outflow because financial investors still prefer to get out of domestic bonds and into foreign bonds, since the latter offer higher returns in terms of domestic currency. Thus, investors sell domestic bonds, getting the proceeds in domestic currency. They then go to the foreign exchange market to sell domestic currency for foreign currency, in order to buy foreign bonds. If the central bank did not intervene in the foreign exchange market, the large sales of domestic currency for foreign currency would lead to a depreciation. If the central bank wants to maintain the fixed exchange rate, it must therefore stand ready to buy domestic currency and sell foreign currency at the current exchange rate. In doing so, it often loses most of its reserves of foreign currency. (The mechanics of central bank intervention were described in the appen- dix to Chapter 19.)
■■ Eventually—after a few hours or a few weeks—the choice for the central bank becomes either to increase the interest rate enough to satisfy equation (20.3) or to validate the market’s expectations and devalue. Setting a very high short-term do- mestic interest rate can have a devastating effect on demand and on output—no firm wants to invest; no consumer wants to borrow when interest rates are very high. This course of action makes sense only if (1) the perceived probability of a devaluation is small, so the interest rate does not have to be too high; and (2) the government believes markets will soon become convinced that no devaluation is coming, allow- ing domestic interest rates to decrease. Otherwise, the only option is to devalue. (All these steps were at the center of the exchange rate crisis which affected much of Western Europe in 1992. See the Focus box on page 418 “The 1992 EMS Crisis.”)
To summarize: Expectations that a devaluation may be coming can trigger an ex- change rate crisis. Faced with such expectations, the government has two options:
■■ Give in and devalue, or ■■ Fight and maintain the parity, at the cost of very high interest rates and a potential
recession. Fighting may not work anyway; the recession may force the government to change policy later on or force the government out of office.
An interesting twist here is that a devaluation can occur even if the belief that a devaluation was coming was initially groundless. In other words, even if the government initially has no intention of devaluing, it might be forced to do so if financial markets believe that it will devalue. The cost of maintaining the parity would be a long period of high interest rates and a recession; the government might prefer to devalue instead.
b
They may actually require more than that, given that there is clearly a lot of risk involved. Our computation ignores the risk premium.
b
In most countries, the govern- ment is formally in charge of choosing the parity, the cen- tral bank is formally in charge of maintaining it. In practice, choosing and maintaining the parity are joint responsibilities of the government and the central bank.
b In the summer of 1998, Boris Yeltsin announced that the Russian government had no intention of devaluing the ru- ble. Two weeks later, the ruble collapsed.
This should remind you of our discussion of bank runs in Chapter 6. The rumor that a bank is in trouble may trigger a run on the bank and force it to close, whether or not there was truth to the rumor.
b
418 The Open Economy Extensions
The 1992 EMs crisis F
o c
u s An example of the problems we discussed in this section is
the exchange rate crisis that shook the European Monetary System (EMS) in the early 1990s.
At the start of the 1990s, the EMS appeared to work well. The EMS had started in 1979. It was an exchange rate system based on fixed parities with bands. Each member country (among them, France, Germany, Italy, and beginning in 1990, the United Kingdom) had to maintain its exchange rate vis-à-vis all other member countries within narrow bands. The first few years had been rocky, with many realign- ments —adjustment of parities —among member countries. From 1987 to 1992, however, there were only two realign- ments, and there was increasing talk about narrowing the bands further and even moving to the next stage —to the adoption of a common currency.
In 1992, however, financial markets became increasingly convinced that more realignments were soon to come. The reason was one we have already seen in Chapter 19, namely the macroeconomic implications of Germany’s reunification. Because of the pressure on demand coming from reunifi- cation, the Bundesbank (the German central bank) was maintaining high interest rates to avoid too large an increase in output and an increase in inflation in Germany. While Germany’s EMS partners needed lower interest rates to re- duce a growing unemployment problem, they had to match the German interest rates to maintain their EMS parities. To financial markets, the position of Germany’s EMS partners looked increasingly untenable. Lower interest rates outside Germany, and thus devaluations of many currencies relative to the Deutsche Mark (DM), appeared increasingly likely.
Throughout 1992, the perceived probability of a devalu- ation forced a number of EMS countries to maintain higher
nominal interest rates than even those in Germany. Still, the first major crisis did not come until September 1992.
In early September 1992, the belief that a number of countries were soon going to devalue led to speculative at- tacks on a number of currencies, with financial investors selling in anticipation of an oncoming devaluation. All the lines of defense described earlier were used by the central banks and the governments of the countries under attack. First, solemn communiqués were issued but with no discern- ible effect. Then, interest rates were increased. For example, Sweden’s overnight interest rate (the rate for lending and borrowing overnight) increased to 500% (expressed at an an- nual rate)! But even such extremely high interest rates were not enough to prevent capital outflows and large losses of for- eign exchange reserves by the central banks under pressure.
At that point, different countries took different courses of action. Spain devalued its exchange rate. Italy and the United Kingdom suspended their participation in the EMS. France decided to tough it out through higher interest rates until the storm was over. Figure 1 shows the evolution of the exchange rates relative to the DM for a number of European countries from January 1992 to December 1993. You can clearly see the effects of the September 1992 crisis, highlighted in the figure, and the ensuing depreciations/devaluations.
By the end of September, investors, by and large, believed that no further devaluations were imminent. Some coun- tries were no longer in the EMS. Others had devalued but remained in the EMS, and those that had maintained their parity had shown their determination to stay in the EMS, even if this meant very high interest rates. But the underlying problem —the high German interest rates —was still present, and it was only a matter of time before the next crisis started.
J a n
u a ry
1 9 9 2 =
1 .0
0
Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov
1992 1993
1.05
1.00
0.95
0.90
0.85
0.80
0.75
0.70
FINLAND SWEDEN UK ITALY SPAIN FRANCE PORTUGAL
Figure 1 Exchange Rates of Selected European Countries Relative to the Deutsche Mark, January 1992 to December 1993
Source: IMF database.
Chapter 20 Exchange Rate Regimes 419
In November 1992, further speculation forced a devalua- tion of the Spanish peseta, the Portuguese escudo, and the Swedish krona. The peseta and the escudo were further devalued in May 1993. In July 1993, after yet another large speculative attack, EMS countries decided to adopt large fluc- tuation bands (plus or minus 15%) around central parities, in effect moving to a system that allowed for large exchange rate fluctuations.
This system with wider bands was kept until the adoption of a common currency, the Euro, in January 1999.
To summarize: The 1992 EMS crisis came from the per- ception by financial markets that the high interest rates
forced by Germany upon its partners under the rules of the EMS were becoming very costly.
The belief that some countries might want to devalue or get out of the EMS led investors to ask for even higher inter- est rates, making it even more costly for those countries to maintain their parity.
In the end, some countries could not bear the cost; some devalued, some dropped out. Others remained in the system, but at a substantial cost in terms of output. (For example, average growth in France from 1990 to 1996 was 1.2%, compared to 2.3% for Germany over the same period.)
20-3 Exchange Rate Movements under Flexible Exchange Rates In the model we developed in Chapter 19, there was a simple relation between the inter- est rate and the exchange rate: The lower the interest rate, the lower the exchange rate. This implied that a country that wanted to maintain a stable exchange rate just had to maintain its interest rate close to the foreign interest rate. A country that wanted to achieve a given depreciation just had to decrease its interest rate by the right amount.
In reality, the relation between the interest rate and the exchange rate is not so simple. Exchange rates often move even in the absence of movements in interest rates. Furthermore, the size of the effect of a given change in the interest rate on the exchange rate is hard to predict. This makes it much harder for monetary policy to achieve its de- sired outcome.
To see why things are more complicated, we must return once again to the interest parity condition we derived in Chapter 17, equation (17.2):
11 + it2 = 11 + it*2a Et
Et + 1 e b
As we did in Chapter 19 (equation (19.5)), multiply both sides by Et + 1 e , and
reorganiz e to get
Et = 1 + it 1 + it*
Et + 1 e (20.4)
Think of the time period (from t to t + 1) as one year. The exchange rate this year depends on the one-year domestic interest rate, the one-year foreign interest rate, and the exchange rate expected for next year.
We assumed in Chapter 19 that the expected exchange rate next year, Et + 1 e , was
constant. But this was a simplification. The exchange rate expected one year hence is not constant. Using equation (20.4), but now for next year, it is clear that the exchange rate next year will depend on next year’s one-year domestic interest rate, the one-year foreign interest rate, the exchange rate expected for the year after, and so on. So, any change in expectations of current and future domestic and foreign interest rates, as well as changes in the expected exchange rate in the far future, will affect the exchange rate today.
Let’s explore this more closely. Write equation (20.4) for year t + 1 rather than for year t :
Et + 1 = 1 + it + 1 1 + it + 1*
Et + 2 e
420 The Open Economy Extensions
The exchange rate in year t + 1 depends on the domestic interest rate and the for- eign interest rate for year t + 1, as well as on the expected future exchange rate in year t + 2. So, the expectation of the exchange rate in year t + 1 held as of year t, is given by:
Et + 1 e =
1 + it + 1e
1 + i* et + 1 Et + 2
e
Replacing Et + 1 e in equation (20.4) with the expression above gives:
Et = 11 + it211 + it + 1e 2 11 + it*211 + i *et + 12
Et + 2 e
The current exchange rate depends on this year’s domestic and foreign interest rates, on next year’s expected domestic and foreign interest rates, and on the expected exchange rate two years from now. Continuing to solve forward in time in the same way (by replacing Et + 2
e , Et + 3 e , and so on until, say, year t + n), we get:
Et = 11 + it211 + it + 1e 2 g 11 + it + ne 2 11 + i*t 211 + i* et + 12 g 11 + i * et + n2
Et + n + 1 e (20.5)
Suppose we take n to be large, say 10 years (equation (20.5) holds for any value of n). This relation tells us that the current exchange rate depends on two sets of factors:
■■ Current and expected domestic and foreign interest rates for each year over the next 10 years.
■■ The expected exchange rate 10 years from now.
For some purposes, it is useful to go further and derive a relation among current and expected future domestic and foreign real interest rates, the current real exchange rate, and the expected future real exchange rate. This is done in Appendix 2 at the end of this chapter. (The derivation is not much fun, but it is a useful way of brushing up on the relation between real interest rates and nominal interest rates, and real exchange rates and nominal exchange rates.) Equation (20.5) is sufficient to make three important points, each outlined in more detail below:
■■ The level of today’s exchange rate will move one-for-one with the future expected exchange rate.
■■ Today’s exchange rate will move when future expected interest rates move in either country.
■■ Because today’s exchange rate moves with any change in expectations, the ex- change rate will be volatile, that is, move frequently and perhaps by large amounts.
Exchange Rates and the Current Account Any factor that moves the expected future exchange rate, Et + n
e , also moves the current exchange rate, Et . Indeed, if the domestic interest rate and the foreign interest rate are ex- pected to be the same in both countries from t to t + n, the fraction on the right in equa- tion (20.5) is equal to 1, so the relation reduces to Et = Et + n
e . In words: The effect of any change in the expected future exchange rate on the current exchange rate is one-for-one.
If we think of n as large (say 10 years or more), we can think of Et + n e as the exchange
rate required to achieve current account balance in the medium or long run. Countries cannot borrow—run a current account deficit—forever, and will not want to lend—run a current account surplus—forever either. Thus, any news that affects forecasts of the current account balance in the future is likely to have an effect on the expected future exchange rate, and in turn on the exchange rate today. For example, the announcement of a larger-than-expected current account deficit may lead investors to conclude that a
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The basic lesson from Appendix 2: For all the statements, you can put “real” in front of exchange rates and interest rates, and the statements will also hold.
c
Chapter 20 Exchange Rate Regimes 421
depreciation will eventually be needed to repay the increased debt. Thus, Et + n e will de-
crease, leading in turn to a decrease in Et today.
Exchange Rates and Current and Future Interest Rates Any factor that moves current or expected future domestic or foreign interest rates be- tween years t and t + n moves the current exchange rate, too. For example, given foreign interest rates, an increase in current or expected future domestic interest rates leads to an increase in Et —an appreciation.
This implies that any variable that causes investors to change their expectations of future interest rates will lead to a change in the exchange rate today. For example, the “dance of the dollar” in the 1980s that we discussed in Chapter 17—the sharp apprecia- tion of the dollar in the first half of the decade, followed by an equally sharp depreciation later—can be largely explained by the movement in current and expected future U.S. interest rates relative to interest rates in the rest of the world during that period. During the first half of the 1980s, tight monetary policy and expansionary fiscal policy com- bined to increase both U.S. short-term interest rates and long-term interest rates; with the increase in long-term rates reflecting anticipations of high short-term interest rates in the future. This increase in both current and expected future interest rates was, in turn, the main cause of the dollar appreciation. Both fiscal and monetary policy were reversed in the second half of the decade, leading to lower U.S. interest rates and a depre- ciation of the dollar.
Exchange Rate Volatility The third implication follows from the first two. In reality, and in contrast to our analy- sis in Chapter 19, the relation between the interest rate, it , and the exchange rate, Et , is anything but mechanical. When the central bank cuts the policy rate, financial markets have to assess whether this action signals a major shift in monetary policy and the cut in the interest rate is just the first of many such cuts, or whether this cut is just a temporary movement in interest rates. Announcements by the central bank may not be useful. The central bank itself may not even know what it will do in the future. Typically, it will be reacting to early signals, which may be reversed later. Investors also have to assess how foreign central banks will react: whether they will stay put or follow suit and cut their own interest rates. All this makes it much harder to predict what the effect of the change in the interest rate will be on the exchange rate.
Let’s be more concrete. Go back to equation (20.5). Assume that Et + n e = 1.
Assume that current and expected future domestic interest rates, and current and expected future foreign interest rates, are all equal to 5%. The current exchange rate is then given by:
Et = 11.052n 11.052n 1 = 1
Now consider a reduction in the current domestic interest rate, it, from 5% to 3%. Will this lead to a decrease in Et —to a depreciation—and if so by how much? The answer: It all depends.
Suppose the interest rate is expected to be lower for just one year, so the n - 1 expected future interest rates remain unchanged. The current exchange rate then decreases to:
Et = 11.03211.052n - 1
11.052n = 1.03 1.05
= 0.98
News about the current account is likely to affect the exchange rate. What would you expect, for example, the effect of the announcement of a major oil discovery to be?
b
News about current and future domestic and foreign interest rates is likely to affect the exchange rate.
b
For more on the relation be- tween long-term interest rates and current and expected fu- ture short-term interest rates, go back to Chapter 14.
b
We leave aside here other factors that also move the ex- change rate, such as chang- ing perceptions of risk, which we discussed in a Focus Box titled “Sudden Stops, Safe Havens, and the Limits to the Interest Parity Condition” in Chapter 19.
b
b
If this reminds you of our dis- cussion in Chapter 14 of how monetary policy affects stock prices, you are right. This is more than a coincidence. Like stock prices, the exchange rate depends very much on expectations of variables far into the future. How expecta- tions change in response to a change in a current variable (here, the interest rate) deter- mines the outcome.
422 The Open Economy Extensions
The lower interest rate leads to a decrease in the exchange rate —a depreciation—of only 2%.
Suppose instead that, when the current interest rate declines from 5% to 3%, in- vestors expect the decline to last for five years 1so it + 4 = g = it + 1 = it = 3%2. The exchange rate then decreases to:
Et = 11.032511.052n - 5
11.052n = 11.0325 11.0525 = 0.90
The lower interest rate now leads to a decrease in the exchange rate —a depreciation— of 10%, a much larger effect.
You can surely think of still more outcomes. Suppose investors had anticipated that the central bank was going to decrease interest rates, and the actual decrease turns out to be smaller than they anticipated. In this case, the investors will revise their expecta- tions of future nominal interest rates upward, leading to an appreciation rather than a depreciation of the currency.
When, at the end of the Bretton Woods period, countries moved from fixed exchange rates to flexible exchange rates, most economists had expected that exchange rates would be stable. The large fluctuations in exchange rates that followed —and have con- tinued to this day—came as a surprise. For some time, these fluctuations were thought to be the result of irrational speculation in foreign exchange markets. It was not until the mid-1970s that economists realized that these large movements could be explained, as we have explained here, by the rational reaction of financial markets to news about future interest rates and the future exchange rate. This has an important implication:
A country that decides to operate under flexible exchange rates must accept the fact that it will be exposed to substantial exchange rate fluctuations over time.
20-4 Choosing between Exchange Rate Regimes Let us now return to the question that motivates this chapter. Should countries choose flexible exchange rates or fixed exchange rates? Are there circumstances under which flexible rates dominate, and others under which fixed rates dominate?
Much of what we have seen in this and the previous chapter would seem to favor flexible exchange rates:
■■ Section 20-1 argued that the exchange rate regime may not matter in the medium run. But it is still the case that it matters in the short run. In the short run, countries that operate under fixed exchange rates and perfect capital mobility give up two macroeconomic instruments: the interest rate and the exchange rate. This not only reduces their ability to respond to shocks but can also lead to exchange rate crises.
■■ Section 20-2 argued that, in a country with fixed exchange rates, the anticipation of a devaluation leads investors to ask for high interest rates. This in turn makes the economic situation worse and puts more pressure on the country to devalue. This is another argument against fixed exchange rates.
■■ Section 20-3 introduced one argument against flexible exchange rates, namely that, under flexible exchange rates, the exchange rate is likely to fluctuate a lot and be dif- ficult to control through monetary policy.
On balance, it therefore appears that, from a macroeconomic viewpoint, flexible exchange rates dominate fixed exchange rates. This indeed is the consensus that has emerged among economists and policy makers. The consensus goes like this:
In general, flexible exchange rates are preferable. There are, however, two excep- tions. First, when a group of countries is already tightly integrated, a common currency
Chapter 20 Exchange Rate Regimes 423
may be the right solution. Second, when the central bank cannot be trusted to follow a responsible monetary policy under flexible exchange rates, a strong form of fixed ex- change rates, such as a currency board or dollarization, may be the right solution.
Let us discuss in turn each of these two exceptions.
Common Currency Areas Countries that operate under a fixed exchange rate regime are constrained to have the same interest rate. But how costly is that constraint? If the countries face roughly the same macroeconomic problems and the same shocks, they would have chosen similar policies in the first place. Forcing them to have the same monetary policy may not be much of a constraint.
This argument was first explored by Robert Mundell, who looked at the conditions under which a set of countries might want to operate under fixed exchange rates, or even adopt a common currency. For countries to constitute an optimal currency area, Mundell argued, they need to satisfy one of two conditions:
■■ The countries have to experience similar shocks. We just saw the rationale for this. If they experience similar shocks, then they would have chosen roughly the same monetary policy anyway.
■■ Or if the countries experience different shocks, they must have high factor mobility. For example, if workers are willing to move from countries that are doing poorly to countries that are doing well, factor mobility rather than macroeconomic policy can allow countries to adjust to shocks. When the unemployment rate is high in a coun- try, workers leave that country to take jobs elsewhere, and the unemployment rate in that country decreases back to normal. If the unemployment rate is low, workers come to the country, and the unemployment rate in the country increases back to normal. The exchange rate is not needed.
Following Mundell’s analysis, most economists believe, for example, that the common currency area composed of the 50 states of the United States is close to an optimal currency area. True, the first condition is not satisfied; individual states suffer from different shocks. California is more affected by shifts in demand from Asia than the rest of the United States. Texas is more affected by what happens to the price of oil, and so on. But the second condition is largely satisfied. There is considerable labor mo- bility across states in the United States. When a state does poorly, workers leave that state. When it does well, workers come to that state. State unemployment rates quickly return to normal, not because of state-level macroeconomic policy, but because of labor mobility.
Clearly, there are also many advantages of using a common currency. For firms and consumers within the United States, the benefits of having a common currency are obvious; imagine how complicated life would be if you had to change currency every time you crossed a state line. The benefits go beyond these lower transaction costs. When prices are quoted in the same currency, it becomes much easier for buyers to compare prices, and competition between firms increases, benefiting consumers. Given these ben- efits and the limited macroeconomic costs, it makes good sense for the United States to have a single currency.
In adopting the euro, Europe made the same choice as the United States. When the process of conversion from national currencies to the euro ended in early 2002, the euro became the common currency for 11 European countries. (See the Focus box on page 425 “The Euro: A Short History.”) The count of countries using the euro at time of writing is now 19. Is the economic argument for this new common currency area as compelling as it is for the United States?
This is the same Mundell who put together the “Mundell– Fleming” model you saw in Chapter 19.
b
Each U.S. state could have its own currency that freely floated against other state cur- rencies. But this is not the way things are. The United States is a common currency area, with one currency, the U.S. dollar.
b
424 The Open Economy Extensions
There is little question that a common currency yields for Europe many of the same benefits that it has for the United States. A report by the European Commission estimates that the elimination of foreign exchange transactions within the Euro area leads to a reduction in costs of 0.5% of the combined GDP of these countries. There are also clear signs that the use of a common currency is already increasing competition. When shop- ping for cars, for example, European consumers now search for the lowest euro price anywhere in the area using the euro. This has already led to a decline in the price of cars in a number of countries.
There is, however, less agreement on whether Europe constitutes an optimal com- mon currency area. This is because neither of the two Mundell conditions appears to be satisfied. European countries experienced very different shocks in the past. Recall our discussion of Germany’s reunification and how differently it affected Germany and the other European countries in the 1990s. Furthermore, labor mobility is very low in Europe and likely to remain low. Workers move much less within European countries than they do within the United States. Because of language and cultural differences among European countries, mobility between countries is even lower.
The worry that this might lead to long slumps in member countries, if they were to be hit by a country-specific adverse shock, was present even before the crisis. But the cri- sis showed that the worry was indeed justified. A number of countries, Portugal, Greece, and Ireland, which had seen strong demand growth and large increases in current ac- count deficits (see Focus Box on current account deficits in Chapter 18), suddenly suf- fered a sharp decrease in spending, a sharp decrease in output, and increasing difficulty to finance their current account deficits. A large depreciation would have helped them increase demand and improve their current account, but in a common currency, this could only be done through a decrease in prices relative to their Euro partners. The result was a long and painful adjustment process, which, at the time of writing, is far from over. Figure 20-1 shows the evolution of the real exchange rate for Spain. It shows the steady real appreciation associated with a boom until 2008, and the real depreciation since then. Although the real exchange rate has now returned to its value of the early 2000s, the adjustment is far from complete. As we saw in Chapter 1, the unemployment rate in Spain is still a high 21%.
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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
R e
a l
E ff
e c
ti v
e E
x c
h a
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e R
a te
Figure 20-1
The Evolution of the Real Exchange Rate in Spain since 2000
A steady real appreciation from 2000 to 2008 has been followed by a long real depre- ciation since then.
Chapter 20 Exchange Rate Regimes 425
F o
c u
s
The Euro: A short History
■■ As the European Union (EU) celebrated its 30th anni- versary in 1988, a number of governments decided the time had come to plan a move to a common currency. They asked Jacques Delors, the President of the EU, to prepare a report, which he presented in June 1989.
The Delors report suggested moving to a European Monetary Union (EMU) in three stages: Stage I was the ab- olition of capital controls. Stage II was the choice of fixed parities, to be maintained except for “exceptional circum- stances.” Stage III was the adoption of a single currency.
■■ Stage I was implemented in July 1990. ■■ Stage II began in 1994, after the exchange rate cri-
ses of 1992–1993 had subsided. A minor but symbolic decision involved choosing the name of the new com- mon currency. The French liked Ecu (European currency unit), which is also the name of an old French currency. But its partners preferred euro, and the name was ad- opted in 1995.
■■ In parallel, EU countries held referendums on whether they should adopt the Maastricht treaty. The treaty, negotiated in 1991, set three main conditions for joining the EMU: low inflation, a budget deficit be- low 3%, and a public debt below 60%. The Maastricht treaty was not popular, and in many countries, the outcome of the popular vote was close. In France, the treaty passed with only 51% of the votes. In Denmark, the treaty was rejected. The United Kingdom negotiated an “opt out” clause that allowed Britain not to join the new currency union.
■■ In the mid -1990s, it looked as if few European coun- tries would satisfy the Maastricht conditions. But a number of countries took drastic measures to reduce
their budget deficit. When the time came to decide, in May 1998, which countries would be members of the Euro area, 11 countries made the cut: Austria, Belgium, Finland, France, Germany, Italy, Ireland, Luxembourg, The Netherlands, Portugal, and Spain. The United Kingdom, Denmark, and Sweden decided to stay out, at least for the time being. Greece did not qualify initially and didn’t join until 2001. (In 2004, it was revealed that Greece had “cooked the books” and understated the size of its budget deficit in order to qualify.) Since then, five more small countries, Cyprus, Malta, Slovakia, Slovenia, and Estonia, have joined.
■■ Stage III began in January 1999. Parities between the 11 currencies and the euro were “irrevocably” fixed. The new European Central Bank (ECB) based in Frankfurt became responsible for monetary policy for the Euro area.
From 1999 to 2002, the euro existed as a unit of account, but euro coins and bank notes did not exist. In effect, the Euro area was still functioning as an area with fixed ex- change rates. The next and final step was the introduction of euro coins and bank notes in January 2002. For the first few months of 2002, national currencies and the euro then circulated side by side. Later in the year, national currencies were taken out of circulation.
Today, the euro is the only currency used in the Euro area, as the group of member countries is called. The numbers of countries adopting the euro has now reached 19: Latvia and Lithuania are the latest members.
For more on the euro, go to http://www.euro.ecb.int/. The Wikipedia page on the euro is also very good.
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The challenge for the euro, looking forward, is whether such long slumps can be avoided in the future. Reforms are being explored to eliminate some of the factors which made the slump worse in those countries. A number of reforms are being put in place, from a banking union to a fiscal union, which should allow countries to better resist adverse shocks. Whether these measures will be sufficient to be avoid crises in the future remains to be seen.
Hard Pegs, Currency Boards, and Dollarization The second case for fixed exchange rates is different from the first. It is based on the argument that there may be times when a country may want to limit its ability to use monetary policy.
Look at a country that has had very high inflation in the recent past—perhaps be- cause it was unable to finance its budget deficit by any other means than through money creation, resulting in high money growth and high inflation. Suppose the country de- cides to reduce money growth and inflation. One way of convincing financial markets that it is serious about doing this is to fix its exchange rate. The need to use monetary policy to maintain the parity then ties the hands of the monetary authority.
More on this in Chapter 21.b
426 The Open Economy Extensions
Lessons from Argentina’s currency Board F
o c
u s When Carlos Menem became President of Argentina in
1989, he inherited an economic mess. Inflation was running at more than 30% per month. Output growth was negative.
Menem and his economy minister, Domingo Cavallo, quickly came to the conclusion that under these circum- stances, the only way to bring money growth —and by implication, inflation —under control was to peg the peso (Argentina’s currency) to the dollar, and to do this through a hard peg. So in 1991, Cavallo announced that Argentina would adopt a currency board. The central bank would stand ready to exchange pesos for dollars on demand. Furthermore, it would do so at the highly symbolic rate of one dollar for one peso.
Both the creation of a currency board and the choice of a symbolic exchange rate had the same objective: to convince investors that the government was serious about the peg and to make it more difficult for future governments to give up the parity and devalue; and so by making the fixed exchange rate more credible in this way, decrease the risk of a foreign exchange crisis.
For a while, the currency board appeared to work extremely well. Inflation, which had exceeded 2,300% in 1990, was down to 4% by 1994! This was clearly the result of the tight constraints the currency board put on money growth. Even more impressive, this large drop in inflation was accompanied by strong output growth. Output growth aver- aged 5% per year from 1991 to 1999.
Beginning in 1999, however, growth turned negative, and Argentina went into a long and deep recession. Was the recession the result of the currency board? Yes and no:
■■ Throughout the second half of the 1990s, the dollar steadily appreciated relative to the other major world currencies. Because the peso was pegged to the dollar, the peso also appreciated. By the late 1990s, it was clear that the peso was overvalued, leading to a decrease in demand for goods from Argentina, a decline in output, and an increase in the trade deficit.
■■ Was the currency board fully responsible for the reces- sion? No; there were other causes. But the currency board made it much harder to fight it. Lower interest rates and a depreciation of the peso would have helped the economy recover, but under the currency board, this was not an option.
In 2001, the economic crisis turned into a financial and an exchange rate crisis, along the lines we described in Section 20-2:
■■ Because of the recession, Argentina’s fiscal deficit had increased, leading to an increase in government debt. Worried that the government might default on its debt, financial investors started asking for very high interest rates on government bonds, making the fiscal deficit
even larger, and by doing so, further increasing the risk of default.
■■ Worried that Argentina would abandon the currency board and devalue to fight the recession, investors started asking for very high interest rates in pesos, making it more costly for the government to sus- tain the parity with the dollar, and so making it more likely that the currency board would indeed be abandoned.
In December 2001, the government defaulted on part of its debt. In early 2002, it gave up the currency board and let the peso float. The peso sharply depreciated, reach- ing 3.75 pesos for 1 dollar by June 2002! People and firms that, given their earlier confidence in the peg, had borrowed in dollars found themselves with a large in- crease in the value of their dollar debts in terms of pesos. Many firms went bankrupt. The banking system collapsed. Despite the sharp real depreciation, which should have helped exports, GDP in Argentina fell by 11% in 2002, and unemployment increased to nearly 20%. In 2003, output growth turned positive and has been consistently high since —exceeding 8% a year —and unemployment has decreased. But it took until 2005 for GDP to reach its 1998 level again.
Does this mean that the currency board was a bad idea? Economists still disagree:
■■ Some economists argue that it was a good idea but that it did not go far enough. They argue that Argentina should have simply dollarized (i.e., adopted the dollar outright as its currency and eliminated the peso alto- gether). Eliminating the domestic currency would have eliminated the risk of a devaluation. The lesson, they argue, is that even a currency board does not provide a sufficiently hard peg for the exchange rate. Only dol- larization will do.
■■ Other (indeed, most) economists argue that the cur- rency board might have been a good idea at the start, but that it should not have been kept in place for so long. Once inflation was under control, Argentina should have moved from a currency board to a floating exchange rate regime. The problem is that Argentina kept the fixed parity with the dollar for too long, to the point where the peso was overvalued and an exchange rate crisis was inevitable.
The debate about “fix versus flex,” about soft pegs, hard pegs, currency boards, and common currencies is unlikely to be settled any time soon.
For a fascinating, fun, and strongly opinionated book about Argentina’s crisis, read Paul Blustein’s And the Money Kept Rolling In (and Out): Wall Street, the IMF, and the Bankrupting of Argentina, Perseus Books Group, 2005.
Chapter 20 Exchange Rate Regimes 427
To the extent that financial markets expect the parity to be maintained, they will stop worrying about money growth being used to finance the budget deficit.
Note the qualifier: “To the extent that financial markets expect the parity to be maintained.” Fixing the exchange rate is not a magic solution. The country also needs to convince financial investors that, not only is the exchange rate fixed today, but it will also remain fixed in the future. There are two ways in which it can do so:
■■ Making the fixed exchange rate be part of a more general macroeconomic package. Fixing the exchange rate while continuing to run a large budget deficit will only con- vince financial markets that money growth will start again and that a devaluation is soon to come.
■■ Making it symbolically or technically harder to change the parity, an approach known as a hard peg.
An extreme form of a hard peg is simply to replace the domestic currency with a foreign currency. Because the foreign currency chosen is typically the dollar, this is known as dollarization. Few countries are willing, however, to give up their cur- rency and adopt the currency of another country. A less extreme way is the use of a currency board. Under a currency board, a central bank stands ready to exchange foreign currency for domestic currency at the official exchange rate set by the gov- ernment. Furthermore, and this is the difference with a standard fixed exchange rate regime, the central bank cannot engage in open market operations (that is, buy or sell government bonds).
Perhaps the best known example of a currency board is that adopted by Argentina in 1991 but abandoned in a crisis at the end of 2001. The story is told in the Focus box “Lessons from Argentina’s Currency Board.” Economists differ on what conclusions one should draw from what happened in Argentina. Some conclude that currency boards are not hard enough. They do not prevent exchange rate crises. So if a country decides to adopt a fixed exchange rate, it should go all the way and dollarize. Others conclude that adopting a fixed exchange rate is a bad idea. If currency boards are used at all, they should be used only for a short period of time, until the central bank has reestablished its credibility and the country returns to a floating exchange rate regime.
When Israel was suffering from high inflation in the 1980s, an Israeli finance minister pro- posed such a measure as part of a stabilization program. His proposal was perceived as an attack on the sovereignty of Israel, and he was quickly fired.
b
■■ Even under a fixed exchange rate regime, countries can adjust their real exchange rate in the medium run. They can do so by relying on adjustments in the price level. Nevertheless, the adjustment can be long and painful. Exchange rate adjustments can allow the economy to ad- just faster and thus reduce the pain that comes from a long adjustment.
■■ Exchange rate crises typically start when participants in financial markets believe a currency may soon be devalued. Defending the parity then requires high interest rates, with potentially large adverse macroeconomic effects. These ad- verse effects may force the country to devalue, even if there were no initial plans for such a devaluation.
■■ The exchange rate today depends on both (1) the difference between current and expected future domestic interest rates, and current and expected future foreign interest rates; and (2) the expected future exchange rate.
Any factor that increases current or expected future domestic interest rates leads to an increase in the exchange rate today. Any factor that increases current or expected future foreign interest rates leads to a decrease in the exchange rate today. Any factor that increases the expected future exchange rate leads to an increase in the exchange rate today.
■■ There is wide agreement among economists that flexible exchange regimes generally dominate fixed exchange rate regimes, except in two cases:
1. When a group of countries is highly integrated and forms an optimal currency area. (You can think of a common currency for a group of countries as an extreme form of fixed exchange rates among this group of countries.) For countries to form an optimal currency area, they must either face largely similar shocks, or there must be high labor mobility across these countries.
Summary
428 The Open Economy Extensions
dollarization or a currency board, provides a way of tying the hands of the central bank.
2. When a central bank cannot be trusted to follow a re- sponsible monetary policy under flexible exchange rates. In this case, a strong form of fixed exchange rates, such as
Question and Problems
Key Terms
gold standard, 415 float, 416 optimal currency area, 423 Maastricht treaty, 425
European Central Bank (ECB), 425 hard peg, 427 dollarization, 427 currency board, 427
QuICk ChECk MyEconLab Visit www.myeconlab.com to complete all Quick Check problems and get instant feedback. 1. Using the information in this chapter, label each of the following statements true, false, or uncertain. Explain briefly.
a. If the nominal exchange rate is fixed, the real exchange rate is fixed.
b. When domestic inflation equals foreign inflation, the real exchange rate is fixed.
c. A devaluation is an increase in the nominal exchange rate. d. Britain’s return to the gold standard caused years of high
unemployment. e. A sudden fear that a country is going to devalue leads to an
increase in the domestic interest rate. f. A change in the expected future exchange rate changes the
current exchange rate. g. The effect of a reduction in domestic interest rates on the
exchange rate depends on the length of time domestic in- terest rates are expected to be below foreign interest rates.
h. Because economies tend to return to their natural level of output in the medium run, it makes no difference whether a country chooses a fixed or flexible exchange rate.
i. High labor mobility within Europe makes the Euro area a good candidate for a common currency.
j. A currency board is the best way to operate a fixed exchange rate.
2. Consider a country operating under fixed exchange rates. The IS curve is given by relation (20.1)
Y = Ya E QP P*
, G, T, i* -pe, Y*b 1 - , + , - , - , + 2
a. Explain the term 1i * - pe 2. Why does the foreign nominal interest rate appear in the relation?
b. Explain why when EQP P*
increases, the IS curve shifts left.
c. In the following table, how is the real exchange rate evolv- ing from period 1 to period 5? What is domestic inflation? What is foreign inflation? Draw an IS-LM diagram with the IS curve in period 1 and the IS curve in period 5.
Period P P* E P P* Real exchange rate E
1 100.0 100.0 0.5
2 103.0 102.0 0.5
3 106.1 104.0 0.5
4 109.3 106.1 0.5
5 112.6 108.2 0.5
d. In the following table, how is the real exchange rate evolv- ing from period 1 to period 5? What is domestic inflation? What is foreign inflation? Draw an IS-LM diagram with the IS curve in period 1 and the IS curve in period 5.
Period P P* E P P* Real exchange rate E
1 100.0 100.0 0.5
2 102.0 103.0 0.5
3 104.0 106.1 0.5
4 106.1 109.3 0.5
5 108.2 112.6 0.5
e. In the table that follows, how is the real exchange rate evolving from period 1 to period 4? What is domestic infla- tion? What is foreign inflation? What happened between Period 4 and Period 5? Draw an IS-LM diagram with the IS curve in period 1 and the IS curve in period 5.
Period P P* E P P* Real exchange rate E
1 100.0 100.0 0.5
2 103.0 102.0 0.5
3 106.1 104.0 0.5
4 109.3 106.1 0.5
5 112.6 108.2 0.46
3. Policy choices when the real exchange rate is “too high” and the nominal exchange rate is fixed
An overvalued real exchange rate is a rate such that domestic goods are too expensive relative to foreign goods, net exports are too small, and by implication the demand for domestic goods is too low.
MyEconLab Real-time data exercises are marked .
Chapter 20 Exchange Rate Regimes 429
This leads to difficult policy choices for the goversnment and central bank. The equations that describe the economy are:
The IS curve:
Y = Ya E QP P *
, G, T, i* -pe, Y*b 1 - , + , - , - , + 2
The Phillips curves for the domestic and the foreign economy:
Domestic Phillips curve p-pQ = 1a/L2 1Y - Yn2 Foreign Phillips curve p* -pQ * = 1a*/L*2 1Y* - Yn*2
In the text and in this question, we are going to make two critical assumptions. These are explored in parts (a) and (b). Then we move to the analysis of the policy options when a country is experiencing an overvalued exchange rate.
a. We are going to assume that the foreign economy is always in medium-run equilibrium. What are the implications of that assumption for foreign output and foreign inflation?
b. We are going to assume that the domestic and foreign economies share the same anchored value for the level of expected inflation denoted pQ and pQ *. What is the implica- tion of that assumption once both the domestic and foreign economies are both in medium-run equilibrium?
c. Draw the IS-LM-UIP diagram for the case where the domes- tic country has an overvalued nominal exchange rate. What is the key feature of that diagram? Under fixed exchange rates without a devaluation, how does the economy return to its medium-run equilibrium?
d. Draw the IS-LM-UIP diagram for the case where the do- mestic country has an overvalued nominal exchange rate. Show how the economy can return to its to medium-run equilibrium when a devaluation is a policy choice.
e. Recall that the assumption has been made that interest rate parity holds so i = i * at all times. Compare the returns on the domestic bond and the returns on the foreign bond in the period of the devaluation. Will bond holders continue to believe there is a completely fixed nominal exchange rate? If bond holders believe another devaluation is possible, what are the consequences for domestic interest rates?
4. Modeling an exchange rate crisis An exchange rate crisis occurs when the peg (the fixed exchange
rate) loses its credibility. Bond holders no longer believe that next period’s exchange rate will be this period’s exchange rate. The uncovered interest rate parity equation used is the approximation
it ≈ it* - 1Et + 1e - Et2
Et
Period it i*t E t E t + 1 e
1 3 0.5 0.5
2 3 0.5 0.45
3 3 0.5 0.45
4 3 0.5 0.5
5 15% 3 0.5 0.4
6 3 0.4 0.4
a. Solve the uncovered interest rate parity condition for the value of the domestic interest rate in period 1.
b. In period 2, the crisis begins. Solve the uncovered interest rate parity condition for the value of the domestic interest rate in period 2.
c. The crisis continues in period 3. However, in period 4, the cen- tral bank and government resolve the crisis. How does this occur?
d. Unfortunately, in period 5, the crisis returns bigger and deeper than ever. Has the central bank raised interest rates enough to maintain uncovered interest rate parity? What are the consequences for the level of foreign exchange reserves?
e. How is the crisis resolved in period 6? Does this have impli- cations for the future credibility of the central bank and the government?
5. Modeling the movements in the exchange rate Equation (20.5) provides insight into the movements of
nominal exchange rates between a domestic and a foreign country. Remember that the time periods in equation can refer to any time unit. The equation is:
Et = 11 + it211 + it + 1e 2g11 + it + ne 2 11 + it*211 + i * et + 12g11 + i * et + n2
Et + n + 1 e
a. Suppose we are thinking of one-day time periods. There are overnight (1-day) interest rates. How do we interpret a large movement in the exchange rate over the course of the day if we do not observe any change in the 1-day interest rate?
b. We learned in Chapter 15 that a one-month (30- or 31-day interest rate) is the average of today’s 1-day rate and the expected 1-day rates over the next 30 days. This will be true in both countries. The following headline is observed on February 1: “ECB predicted to cut interest rates February 14, dollar rises.” Does the headline make sense?
c. We learned in Chapter 15 that a two-year bond yield is the average of today’s one-year interest rate and the expected one-year rate one year from now. This will be true in both countries. The following headline is observed on February 1: “Fed announces that interest rates will remain low for the foreseeable future, dollar falls.” Does the headline make sense?
d. The current account is this period’s lending to (if positive) or borrowing from (if negative) the rest of the world. Assume the current account is more negative than expected and this is surprising news. Explain why the exchange rate would depreciate on this surprising news.
DIg DEEpEr MyEconLab Visit www.myeconlab.com to complete all Dig Deeper problems and get instant feedback. 6. Realignments of exchange rate
Look at Figure 1 in the box ‘The 1992 EMS Crisis.” European nominal exchange rates had been fixed between the major currencies from roughly 1979 to 1992.
a. Explain how to read the vertical axis of Figure 1. What country experienced the largest depreciation? What coun- try clearly experienced the smallest depreciation?
b. If two-year nominal interest rates in France and Italy had been similar in January 1992, which country would have generated the highest return on a two-year bond?
- Extensions: The Open Economy
- 18: The Goods Market in an Open Economy
- 18-1 The IS Relation in the Open Economy
- The Demand for Domestic Goods
- The Determinants of
- and
- The Determinants of Imports
- The Determinants of Exports
- Putting the Components Together
- 18-2 Equilibrium Output and the Trade Balance
- 18-3 Increases in Demand—Domestic or Foreign
- Increases in Domestic Demand
- Increases in Foreign Demand
- Fiscal Policy Revisited
- 18-4 Depreciation, the Trade Balance, and Output
- Depreciation and the Trade Balance: The Marshall-Lerner Condition
- The Effects of a Real Depreciation
- Combining Exchange Rate and Fiscal Policies
- 18-5 Looking at Dynamics: The J-Curve
- 18-6 Saving, Investment, and the Current Account Balance
- 19: Output, the Interest Rate, and the Exchange Rate
- 19-1 Equilibrium in the Goods Market
- 19-2 Equilibrium in Financial Markets
- Domestic Bonds versus Foreign Bonds
- 19-3 Putting Goods and Financial Markets Together
- 19-4 The Effects of Policy in an Open Economy
- The Effects of Monetary Policy in an Open Economy
- The Effects of Fiscal Policy in an Open Economy
- 19-5 Fixed Exchange Rates
- Pegs, Crawling Pegs, Bands, the EMS, and the Euro
- Monetary Policy when the Exchange Rate Is Fixed
- Fiscal Policy when the Exchange Rate Is Fixed
- 20: Exchange Rate Regimes
- 20-1 The Medium Run
- The
- Relation under Fixed Exchange Rates
- Equilibrium in the Short and the Medium Run
- The Case for and against a Devaluation
- 20-2 Exchange Rate Crises under Fixed Exchange Rates
- 20-3 Exchange Rate Movements under Flexible Exchange Rates
- Exchange Rates and the Current Account
- Exchange Rates and Current and Future Interest Rates
- Exchange Rate Volatility
- 20-4 Choosing between Exchange Rate Regimes
- Common Currency Areas
- Hard Pegs, Currency Boards, and Dollarization