Chapter 10 International Linkages Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Objectives Analyse the international links between economies Understand how different exchange rate regimes operate Consider the balance of payments and capital flows Extend the IS–LM model to include the international sector Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 10.1 The Balance of Payments and Exchange Rates 10.2 The Exchange Rate in the Long Run 10.3 Trade in Goods, Market Equilibrium and the Balance of Trade 10.4 The Balance of Payments and Capital Flows 10.5 The Mundell–Fleming Model: Perfect Capital Mobility Under Fixed Exchange Rates 10.6 Perfect Capital Mobility and Flexible Exchange Rates Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

10.1 The Balance of Payments (BOP) and Exchange Rates The BOP is the record of transactions of the residents of a country with the rest of the world. There are two main accounts. Current account (CA): Records trade in goods and services, as well as transfer payments The current account is in surplus if exports exceed imports plus net transfers. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

External Accounts Must Balance Capital account (KA): Records purchases and sales of assets The capital account is in surplus when receipts from sales exceeds domestic payments for foreign assets. The overall balance of payments is the sum of the current account and capital account balances. CA balance + net capital inflow = 0 (10.1) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Balance of Payments (BOP) and Exchange Rates Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Exchange Rate Determination The exchange rate is the domestic price of foreign currency (direct notation). Example: A quote for the Australian dollar–US dollar exchange rate is A$2 per US$1, not 50 US cents per Australian dollar. The exchange rate is a relative price. If the domestic price of foreign currency increases, the domestic currency is worth less (i.e. it depreciates). Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Flexible Exchange Rate Under a flexible exchange rate regime market forces determine the exchange rate. The supply of foreign currency is determined by exports and capital inflow: Foreigners supply foreign currency in return for domestic currency (Australia) So they can purchase Australia’s exports and capital. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Flexible Exchange Rate The supply curve of foreign currency is upward-sloping since: A depreciation implies the Australian currency is cheaper to purchase. This increases the supply of foreign exchange (increased capital inflow) to buy Australian currency. The supply is also increased because the cost of Australian exports and capital in foreign markets is lower. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Flexible Exchange Rates The demand curve for foreign currency is downward-sloping since: An increase in the price of foreign exchange (depreciation) raises the costs of imports and foreign capital. The demand for foreign currency to pay for imports and capital outflows will fall. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Flexible Exchange Rates Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fixed Exchange Rates Under a fixed exchange rate regime, the central bank buys and sells domestic currency at a fixed price in terms of foreign currency. If the price is fixed below the equilibrium level the central bank must exchange foreign currency for Australian dollars to meet the excess demand and vice versa. A devaluation takes place when the value of the currency in terms of foreign exchange is officially reduced. A revaluation takes place when the value of the currency in terms of foreign exchange is officially increased. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fixed Exchange Rates What determines the amount of intervention the central bank must do in a fixed exchange rate system? The BOP measures the amount of intervention the central bank must take. Example: If Australia were running a BOP deficit with the UK (implying the demand for £ exceeds the supply for £), then the Bank of England must buy the excess dollars with the pound to meet the excess demand for pounds. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Floating, Clean and Dirty Under a system of clean floating, the central bank allows the exchange rate to be freely determined in the foreign exchange market. This implies that the official reserve transactions must equal zero. As well, BOP must be zero as the exchange rate adjusts to make the CA and KA sum to zero. Under a managed (dirty) float, the central bank intervenes to buy and sell foreign currency to try and influence the exchange rate. Accordingly, official reserve transactions do not equal zero. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 10.1 The Balance of Payments and Exchange Rates 10.2 The Exchange Rate in the Long Run 10.3 Trade in Goods, Market Equilibrium and the Balance of Trade 10.4 The Balance of Payments and Capital Flows 10.5 The Mundell–Fleming Model: Perfect Capital Mobility Under Fixed Exchange Rates 10.6 Perfect Capital Mobility and Flexible Exchange Rates Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

10.2 The Exchange Rate in the Long Run In the long run, the exchange rate between two nations is determined by the relative purchasing power of each nation’s currency. The relative purchasing power is measured by the real exchange rate. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Exchange Rate in the Long Run The real exchange rate R is defined as: where e is the domestic price of foreign exchange P and Pf are respectively domestic and overseas prices (10.2) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Exchange Rate in the Long Run Purchasing power parity suggests that the exchange rate adjusts to maintain equal purchasing power of foreign and domestic currency. If R = 1, the currencies are at purchasing power. If R > 1, then goods abroad are more expensive than goods at home. People switch to goods at home and drive up domestic prices and this drives down the foreign exchange rate, moving us closer to PPP. If R < 1, then goods abroad are cheaper. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Exchange Rate in the Long Run PPP is a long-term phenomenon. In the short run, PPP may not hold because: Market baskets differ across nations. There are barriers to the movement of goods between nations (i.e. transportation costs and tariffs). Many goods are non-tradable (i.e. land). Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 10.1 The Balance of Payments and Exchange Rates 10.2 The Exchange Rate in the Long Run 10.3 Trade in Goods, Market Equilibrium and the Balance of Trade 10.4 The Balance of Payments and Capital Flows 10.5 The Mundell–Fleming Model: Perfect Capital Mobility Under Fixed Exchange Rates 10.6 Perfect Capital Mobility and Flexible Exchange Rates Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

10.3 Trade in Goods, Market Equilibrium and the Balance of Trade In an open economy, part of domestic output is sold overseas (exports). In an open economy, part of domestic spending consists of the purchase of foreign goods (imports). Our IS curve must be modified to incorporate an open economy. Domestic output is no longer determined by domestic spending. Spending on domestic goods determines domestic output. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Net Exports In an open economy, net exports depend on: Domestic income Y Foreign income (Yf) The real exchange rate (R). A rise in Yf improves the nation’s trade balance and thus increases AD. A rise in the real exchange rate (R) raises import spending and worsens the trade balance. A real depreciation by the home nation (increased R) improves the trade balance and increases AD. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Goods Market Equilibrium The IS curve becomes Equation (10.7). Y = А(Y, i) + NX(Y, Yf, R) The marginal propensity to import measures the fraction of every dollar of Y spent on imports. This reduces the size of the multiplier and implies a steeper IS curve. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Goods Market Equilibrium Changes in foreign income and real exchange rates have an impact on domestic income and demand. A real depreciation increases demand for domestic goods shifting the IS curve rightwards. An increase in Yf increases demand for Australian exports so output increases and the IS curve shifts rightwards. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Goods Market Equilibrium The impact of the effects of different disturbances on the equilibrium levels of income and net exports is summarised in Table 10.2. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 10.1 The Balance of Payments and Exchange Rates 10.2 The Exchange Rate in the Long Run 10.3 Trade in Goods, Market Equilibrium and the Balance of Trade 10.4 The Balance of Payments and Capital Flows 10.5 The Mundell–Fleming Model: Perfect Capital Mobility Under Fixed Exchange Rates 10.6 Perfect Capital Mobility and Flexible Exchange Rates Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

10.4 The Balance of Payments and Capital Flows Assume: A given price of imports A given export demand A given world interest rate, if The BOP is equal to the trade balance (NX) plus the capital balance (CF): Equation (10.8). Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Balance of Payments and Capital Flows The trade balance NX is a function of: Domestic (Y) and foreign income (Yf) Real exchange rate (R) Marginal propensity to import (m) Responsiveness of net exports to the real exchange rate (v). The capital account CF is a function of: The interest rate differential (i – if) Degree of capital mobility (a). Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Capital Mobility High international capital mobility implies Small interest rate differentials among industrialised nations (adjusted for exchange rate risks). We assume perfect international capital mobility. This implies that a nation’s interest rates cannot differ from those of the rest of the world. Any differential will cause large international capital flows which restore rates to world levels. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Policy Dilemmas: Internal and External Balance External balance exists when the BOP is balanced: NX + CF = 0. Internal balances exists when output is at the full-employment level: Y = Y*. Given perfect international capital mobility, the BP curve must be horizontal. Domestic interest rates must always equal international interest rates. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Policy Dilemmas: Internal and External Balance Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Policy Dilemmas Referring to Figure 10.6: E is the only point of internal/external balance. At E1 there is problem with a balance of payments deficit and unemployment. At E2 the problem is a balance of payments deficit and overemployment. At E3 the problem is a balance of payments surplus and overemployment. At E4 the problem is a balance of payments surplus and unemployment. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Policy Dilemmas Policy dilemmas occur when policies designed to alleviate one problem make another worse. Example: Suppose the economy is at E1 There is a deficit in the BOP and unemployment. Expansion monetary policy will reduce unemployment. The capital outflow will worsen the BOP. The appropriate policy and adjustment process depends upon the exchange rate regime. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 10.1 The Balance of Payments and Exchange Rates 10.2 The Exchange Rate in the Long Run 10.3 Trade in Goods, Market Equilibrium and the Balance of Trade 10.4 The Balance of Payments and Capital Flows 10.5 The Mundell–Fleming Model: Perfect Capital Mobility under Fixed Exchange Rates 10.6 Perfect Capital Mobility and Flexible Exchange Rates Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

10.5 The Mundell-Fleming Model Under fixed exchange rates and perfect capital mobility, central banks cannot pursue independent monetary policy. Why? Monetary contraction increases domestic interest rates. Induced capital inflow creates a BOPs surplus, causes pressure for currency appreciation. The central bank must sell domestic currency and buy foreign currency (an expansion in the money supply). This monetary expansion lowers interest rates back to initial interest rates levels. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Monetary Expansion Consider a monetary expansion (Figure 10.7). LM shifts right and economy moves from E to E'. The BOP's deficit creates pressure for the exchange rate to depreciate. The central bank must sell foreign currency and buy domestic currency. The supply of domestic currency declines so that LM shifts back to initial equilibrium E. Monetary policy is powerless with fixed exchange rates. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Monetary Expansion Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fiscal Expansion Consider a fiscal expansion: IS shifts right and the economy moves from E to E' with higher interest rates and output. Higher interest rates induce capital inflows creating pressure for the exchange rate to appreciate. The central bank must expand the money supply to maintain the exchange rate. The LM curve shifts rightward and Y increases further. Fiscal policy is potent with fixed exchange rates. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fiscal Expansion Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 10.1 The Balance of Payments and Exchange Rates 10.2 The Exchange Rate in the Long Run 10.3 Trade in Goods, Market Equilibrium and the Balance of Trade 10.4 The Balance of Payments and Capital Flows 10.5 The Mundell–Fleming Model: Perfect Capital Mobility Under Fixed Exchange Rates 10.6 Perfect Capital Mobility and Flexible Exchange Rates Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

10.6 Perfect Capital Mobility and Flexible Exchange Rates Under a flexible exchange rate system the central bank does not intervene in the foreign exchange market. The absence of intervention implies a zero BOP. Any current account deficit must be financed (and matched) by private capital inflows. Perfect capital mobility implies that the BOP will only balance if i = if . Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Flexible Exchange Rates If i > if capital inflows would cause currency appreciation: Domestic goods become more expensive and AD decreases The IS curve would shift leftwards. If i < if capital outflows would cause currency depreciation: Domestic goods become cheaper and AD increases The IS curve would shift rightwards. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fiscal Policy Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fiscal Policy Consider an increase in G. The IS curve would shift rightwards moving the economy from E to E' as in Figure 10.8. At this point rY and domestic interest rates are higher. The BOP is in disequilibria. There is a balance of payments surplus. The higher interest rates induce capital inflows which cause the domestic currency to appreciate. The currency appreciation leads NX to fall as imports are cheaper and exports become more expensive. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fiscal Policy Consider an increase in G. Declining NXs shift the IS curve leftwards. The economy moves back to the initial equilibrium E. There is full crowding out as increased G causes higher domestic interest rates which appreciates the currency and reduces NX. Fiscal policy is powerless with flexible exchange rates. Real disturbances to demand do not affect equilibrium output under flexible rates. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Monetary Policy Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Monetary Policy Consider an increase in the quantity of nominal money supply. As P is given, LM shifts right and the economy moves to E' with higher Y. Interest rates fall, income increases and there is a balance of payments deficit. The lower interest rates create capital outflow, causing the exchange rate to depreciate. The depreciation reduces the domestic demand for imports and raises overseas demand for exports. Net exports increase. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Monetary Policy Consider an increase in the quantity of nominal money supply. The increase in NX causes the IS to shift rightwards. The economy moves to E'' with even higher Y. Expansionary monetary improves the current account through induced depreciation and is very effective under a floating exchange rate regime. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Monetary Policy Versus Fiscal Policy Fixed exchange rates Monetary policy is ineffective in influencing output. Fiscal policy is very effective in influencing output. Flexible exchange rates Monetary policy is very effective in influencing output. Fiscal policy is ineffective in influencing output. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.