Balance of Payments Adjustment Thorvaldur Gylfason

Outline Real versus nominal exchange rates Balance of payments adjustment and welfare The scourge of overvaluation Balance of payments adjustment through economic policy

Real versus nominal exchange rates 1 Real versus nominal exchange rates Increase in r means real appreciation r = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad

Real versus nominal exchange rates Devaluation or depreciation of the currency – i.e., decrease in e – makes r also decrease unless P rises so as to leave r unchanged r = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad

Balance of payments and welfare 2 Balance of payments and welfare Payments for imports of goods, services, and capital Imports Real exchange rate Equilibrium Earnings from exports of goods, services, and capital Exports Foreign exchange

Balance of payments and welfare Equilibrium between demand and supply in foreign exchange market establishes Equilibrium real exchange rate Equilibrium in the balance of payments BOP = X + Fx – Z – Fz = X – Z + F = current account + capital account = 0

Balance of payments adjustment and welfare Deficit Imports Overvaluation Real exchange rate Exports Foreign exchange

Balance of payments adjustment and welfare Supply (exports) Overvaluation works like a price ceiling Price of foreign exchange Overvaluation Demand (imports) Deficit Foreign exchange

Market equilibrium and economic welfare Price Consumer surplus Supply A Total welfare gain associated with market equilibrium equals producer surplus (= ABE) plus consumer surplus (= BCE) B E Producer surplus C Demand Quantity

Market intervention and economic welfare Consumer surplus = AFGH Producer surplus = CGH Price Welfare loss Total surplus = AFGC Supply A F Price ceiling imposes a welfare loss equivalent to the triangle EFG J B E H Price ceiling G C Demand Quantity

The scourge of overvaluation 3 The scourge of overvaluation Governments may try to keep the national currency overvalued To keep foreign exchange cheap To have power to ration scarce foreign exchange To make GNP look larger than it is Other examples of price ceilings Negative real interest rates Rent controls

Market intervention and economic welfare, again Price Welfare loss Supply A F Price ceiling imposes a welfare loss equivalent to the triangle EFG J B E H Price ceiling G C Demand Shortage Quantity

Inflation and overvaluation Inflation can result in an overvaluation of the national currency Remember: r = eP/P* Suppose e adjusts to P with a lag Then r is directly proportional to the price level P Numerical example as follows

Inflation and overvaluation Real exchange rate Suppose inflation is 10 percent per year Devaluation 110 105 Average 100 Time

Inflation and overvaluation Hence, increased inflation increases the real exchange rate as long as the nominal exchange rate adjusts with a lag Real exchange rate Suppose inflation rises to 20 percent per year 120 110 Average 100 Devaluation Time

How to correct overvaluation Under a floating exchange rate regime Adjustment is automatic: e moves Under a fixed exchange rate regime Devaluation will reduce e and thereby also r – provided inflation is kept under control Does devaluation improve the current account? The Marshall-Lerner condition

The Marshall-Lerner condition: Theory Suppose prices are fixed T = eX – Z = eX(e) – Z(e) Not obvious that a lower e helps T When we do the arithmetic, i.e., compute the derivative dT/de, the bottom line turns out to be: Devaluation improves the current account as long as

The Marshall-Lerner condition: Evidence Econometric studies indicate that the Marshall-Lerner condition is almost invariably satisfied Industrial countries: a = 1, b = 1 Developing countries: a = 1, b = 1.5 Hence, Devaluation improves the current account

Empirical evidence from industrial countries Elasticity of Elasticity of exports imports Austria 1.0 1.2 Belgium 1.1 1.3 Canada 0.7 1.3 France 1.3 0.9 Germany 1.0 0.8 Italy 1.3 0.8 Japan 1.4 1.0 Netherlands 1.5 0.7 Sweden 1.6 0.9 United Kingdom 1.0 1.3 United States 1.2 1.2 Average 1.2 1.1

The importance of appropriate side measures Remember: It is crucial to accompany devaluation by fiscal and monetary restraint in order to prevent prices from rising and thus eating up the benefits of devaluation To work, nominal devaluation must result in real devaluation

Balance of payments adjustment and economic policy 4 Balance of payments adjustment and economic policy Price level Aggregate supply An increase in prices induces producers to produce more, so that aggregate supply increases P Equilibrium An increase in prices induces consumers to buy less, so that aggregate demand decreases Aggregate demand GNP Y

Experiment: Export boom Price level AS AD GNP

Experiment: Export boom Price level AS B Exports increase, so that aggregate demand expands A AD’ AD GNP

Experiment: Export boom Price level AS B Excess demand drives prices up A C AD’ AD GNP

Experiment: Export boom Price level AS B As the price level rises, so does GNP along the upward-sloping AS curve A AD’ AD GNP

Comments on experiment An export boom stimulates aggregate demand because Y = C + I + G + X - Z Therefore, all other comparable boosts to aggregate demand will have same effect: Consumption C (e.g., through lower taxes) Investment I (e.g., via lower interest rates) Government spending G GNP will rise when AD increases as long as AS curve slopes up

Economic policy Economic policy instruments Exogenous variables Fiscal policy: Government spending, taxes Monetary policy: Money, credit, interest rates Exchange rate policy: Exchange rate (if fixed) Structural policy: Liberalization, privatization, etc. Economic objectives or targets Endogenous variables GNP level or growth Price level or inflation Employment, unemployment BOP, exchange rate (if flexible), external debt

Aims of economic policy Apply policy instruments to attain given economic objectives External balance: conduct monetary, fiscal, and exchange rate policy so as to make the balance of payments position sustainable Key to financial programming Not only crisis management in short run Internal balance: conduct policy so as to foster rapid, sustainable economic growth with low inflation and unemployment Key to economic and social prosperity

Aggregate demand Y = C + I + G + X – Z C = c(Y-T) = (1-s)(1-t)Y where s = saving rate and t = tax rate I = k(M/P) through interest rates G = exogenous X = aY* - br Z = mY + cr where r = eP/P* (real exchange rate) and increase in r means appreciation, as before

Aggregate demand Y = (1-s)(1-t)Y + k(M/P) + G + Monetary expansion shifts AD schedule right Aggregate demand Domestic credit Y = (1-s)(1-t)Y + k(M/P) + G + (aY* - b(eP/P*)) – (mY + c(eP/P*)) which means: Y = F(P; M, G, t, e; Y*, P*) - + + - - + + Aggregate demand schedule slopes down via real balances and the real exchange rate ... and shifts in response to changes in exogenous variables, including policy AD schedule slopes down Devaluation shifts AD schedule right

Aggregate supply Y = F(N) N = N(W/P) Y = F(W/P) – or, equivalently, Labor demand varies inversely with real wages Y = F(W/P) – or, equivalently, Y = F(P; W) + - Aggregate supply slopes up through real wages ... and shifts in response to changes in exogenous variables, including nominal wages and other costs, e.g., price of imported oil

Macroeconomic equilibrium Price level AS W up M up; G up; t down; e down AD GNP

Monetary or fiscal expansion Price level An increase in M or G or a decrease in t increases both Y and P for given W AS B A AD’ M up; G up; t down AD GNP

An increase in wages AS’ Price level An increase in W increases P, but reduces Y AS W up B An increase in the price of imported oil has the same effect: stagflation A AD GNP

Devaluation Price level AS’ B AS W up AD’ A e down AD GNP When e decreases, W often also rises, so that P increases, but Y may either rise or fall. Even if W stays put, AS will shift to the left as devaluation raises the price of oil and other imported inputs. AS’ B AS W up AD’ A e down AD GNP

Balance of payments B = X – Z + F X = aY* - br Z = mY + cr r = eP/P* F = exogenous B = F(Y, P; e, F; Y*, P*) - - - + + + To reduce deficit in the balance of payments: Must apply monetary or fiscal restraint to decrease Y or P or reduce e (devaluation) or F (capital inflow)

Balance of payments adjustment Price level Suppose, at A, there is a deficit in the balance of payments (B  0) Can offset decrease in aggregate demand by increasing e or F AS Then, to reduce deficit, must reduce M or G or raise t to reduce demand (shift AD left) End result is still point A, but now with balance of payments equilibrium (B = 0). Level of GNP is unchanged, but its composition has changed. A e or F up AD M or G down, t up GNP

Macroeconomic adjustment and structural reform Price level Start, at A, with a deficit in the balance of payments (B  0) Stimulate supply side by liberalization, stabilization, privatization, etc. AS Then, to reduce deficit, try to stimulate supply (shift AS right) in addition to reducing demand AS’ End result is point E with balance of payments equilibrium (B = 0). Level of GNP is unchanged, but its composition has changed. Price level is lower. A AD’ E AD M or G down, t up GNP

Conclusion The essence of financial programming is to find the right combination of monetary, fiscal, and structural policy measures that improve the balance of payments ... ... without damaging other important macroeconomic variables, including output and employment Theory and experience indicate that such measures are generally good for growth The End