The balance of payments and the exchange rate Imports, exports Savings and investment in an open economy Exchange rate regimes

Balance of payments and exchange rate Up until now, we have worked only in the case of closed economies No trade considerations were present However, we know that in fact trade is important in understanding macroeconomics, particularly so with globalisation. As for previous models, this means we have to introduce corrections to the model to obtain a better understanding of what trade does to the economy

Balance of payments and exchange rate Imports, exports and exchange rates Current account, capital account and balance of payments Exchange rate regimes

Imports, exports and exchange rates The first element to take into account in an open economy is the presence of imports M and exports X in aggregate demand These represent another possible leakage from the circular flow of income In particular, agents will have a propensity to import which will have to be taken into account when calculating multipliers

Imports, exports and exchange rates Second problem: in terms of national accounting, exports / imports are not measured in the same units: We need to convert imports paid in foreign currency into national currency Exports towards other countries are also affected by the value of the currency This is where the exchange rate comes in

Imports, exports and exchange rates The exchange rate (e) is the price of one currency in terms of another currency Note of caution ! There are 2 ways of working it out: The amount of $ you can buy with 1€ : 1€ = 1.35$ The amount of € required to buy 1$ : 1$ = 0.75€ These two measures are equivalent, but be careful, the second one (often used in models) is not intuitive : If e falls, less € are needed to purchase 1$, so the euro has appreciated (it is worth more in $ terms) If e increases, more € are needed to purchase 1$, so the euro has depreciated (it is worth less in $ terms)

Imports, exports and exchange rates The exchange rate is a price e=price of the currency (dollars/euro) Supply of euros Purchase of dollar-denominated assets, imports Equilibrium exchange rate e* Ici cotation au certain: une augmentation de e est une appréciation de l’euro. Purchase of euro-denominated assets, exports Demand for euros Quantity

Imports, exports and exchange rates The exchange rate is in nominal terms It is possible to define a real exchange rate which accounts for the price levels in the two currency areas The real exchange rate gives a relative price It expresses the relative value of a representative basket in the euro zone to the same basket in the USA.

Imports, exports and exchange rates This allows us to define the purchasing power parity (PPP) exchange rate. The PPP exchange rate is the nominal exchange rate that occurs when the real exchange rate is 1. The PPP exchange rate is often considered to be the long run equilibrium exchange rate It is also used to compare economic variables across countries, particularly measures related to standards of living or welfare

Balance of payments and exchange rate Imports, exports and exchange rates Current account, capital account and balance of payments Exchange rate regimes

Current account and capital account The current account is not the only element of international trade. The balance of payments composed of: The current account CA: Tracks outflows minus inflows of goods and services It corresponds to the Exports – Imports component. The capital account KA: Tracks inflows minus outflows of capital of a country Either as direct investment (building factories, etc) Or purchases/sales of assets

Current account and capital account The current account was explained in the previous section as the ‘net exports’ added to C + I + G. What role does the capital account play ? To understand their relation, let’s derive the savings/investment balance for an open economy Setting Z = Y :

Current account and capital account This gives us the equilibrium condition in terms of investment and savings: Simplifying assumption: the government budget is in equilibrium (G-T = 0) If there is a CA deficit (X-M < 0), there are not enough savings (agents are spending too much). Some of the financing of investment (I) must come from abroad. If there is a CA surplus (X-M > 0), there is excess savings (agents are not spending enough). The excess saving are used to fund foreign investment. The adjustment to the current account balance occurs through an inflow or outflow of savings: This is the capital account. S-I représente les sorties nettes de capitaux. Elles sont comptablement toujours équivalentes aux exportations nettes des exportations.

Current account and capital account The BoP is in equilibrium when CA+KA = 0 The current account and capital imbalances add to 0 As seen in the previous slide, this is equivalent to saying that S = I in an open economy

Current account and capital account Source: BIS,2007 World Report

Current account and capital account The USA have been net importers and net borrowers since the 1980’s. The US current account deficit in 2006 was 6,6% of its GDP. Europe has recently seen positive balances on its current account, which reflects a relatively low level of growth. Japan has traditionally been a net exporter and a net lender. The current accounts surpluses of emerging Asian countries (particularly China) have grown during the 1990’s

Current account and capital account The amount of savings required to finance the current account deficit of the USA has tripled since 1997. On the other had, the emerging economies have become net providers of savings flows. Europe and Asie (including Japan) has covered 2/3 of the funding needs of the USA in 2002.

Current account and capital account The problem with current account deficits The central problem is that these deficits can create speculative flows of capital, whereby agents start betting against the currency of the country (depreciation expectations), which creates distortions and can lead to currency crises. Depreciation expectations can also give incentives for capital holders to invest abroad (strong capital outflows). Foreign debt creates financial burdens for the country. These costs can further increase the current account deficit, leading to requiring more foreign capital, which leads to a vicious cycle.

Current account and capital account How is a BoP disequilibrium corrected? What happens if CA + KA > 0 or < 0 ? One needs to separate: What happens on the foreign exchange market in terms of supply/demand The effective outcome, which depends on the exchange rate regime (which is why we see them in the next section) In a fixed exchange rate regime, the BC intervenes

Current account and capital account When BP = CA + KA > 0 Overall, exports and capital inflows are larger than imports and capital outflows There is excess demand for the home currency on the foreign exchange market This tends to increase the value of the home currency When BP = CA + KA < 0 Overall, imports and capital outflows are larger than exports and capital inflows There is excess supply for the home currency on the foreign exchange market This tends to decrease the value of the home currency

Current account and capital account In other words, the foreign exchange market will be at equilibrium when the balance of payments is at equilibrium. Outside of equilibrium, there will be pressures on the exchange rate Under flexible rates, if BoP < 0, the home currency will depreciate relative to foreign currencies (excess supply of home currency). Under fixed rates, if BoP < 0, the central bank will have to intervene on the foreign exchange market to purchase its currency back with foreign reserves. From time to time, the exchange rate may be changed (devaluation), particularly if the CB is low on foreign reserves.

Current account and capital account Evolution of the current account following a depreciation: The J-curve Depreciation CA CA deficit worsens t CA deficit is corrected

Current account and capital account After a depreciation, the increase in exports and the fall in imports is not automatic: The volume of exports can remain fixed in the short run because of the rigidity of short-run contracts. Imports can be slow to fall because foreign exporters can initially compensate the depreciation by reducing their margins. The effectiveness of depreciation depends on the price elasticity of imports and exports (the Marshall-Lerner condition) The sum of the absolute values of the price elasticity of imports and exports must be greater than 1. Because trade contracts tend to be signed in advance of delivery

Balance of payments and exchange rate Imports, exports and exchange rates Current account, capital account and balance of payments Exchange rate regimes

Exchange rate regimes Fixed exchange rate regime: Gold standard system (Bretton woods) Euro Zone, ‘dollarisation’ Floating or flexible exchange rate regime: Post-Bretton Wood system Intermediate regimes: Crawling peg (Tunisia, Bolivia) Currency board (Hong Kong, Estonia, Lithuania) Dirty float (ex: Indonesia, India, Egypt) One of the most debated issue in international economics concerns the choice of exchange rate regime. In practice, neither extreme has ever existed, but it remains useful to use these ideal types as the basis for drawing some positive and normative conclusions of relevance when choosing a hybrid system. Best here implies that a competitive foreign exchange market would be both a more efficient means of maintaining BOP equilibrium, but also that it would be a more desirable solution than leaving the decisions to government officials. This argument is based on the efficient market clearing mechanism implying that if the US was running a current account deficit, this would imply an excess demand for foreign exchange rate and lead to a depreciation of the dollar. This will make imports more expensive ans exports cheaper and providing the relevant elasticities were high enough, the current account would be brought back into balance. The advantage of floating is that, in principle, it frees the government from the BOP constraint in as much as the exchange rate automatically adjusts to maintain external balance. For example, the governement might select an appropriate rate of increase for the domestic money supply compatible with its objectives of internal equilibrium and let the exchange rate to adjust taking into account any discrepancies between the domestic inflation rate and inflation in the rest of the world.

Exchange rate regimes Typology of exchange rate regimes Increasing flexibility Currency board Monetary Union Fixed exchange rate Crawling peg Pure float Dollarisation/ euroisation Fixed exchange rate with fluctuation bands Dirty float

Exchange rate regimes Arguments in favour of flexible rates: The market is a more efficient regulator. The central bank is more flexible in terms of policy, as it does not have to worry about monitoring the exchange rate (next week) The Central Bank does not have to hold foreign reserves, as it does not have to intervene The Balance of payments automatically adjusts to equilibrium. Note: under floating rates, the exchange rate appreciates or depreciates

Exchange rate regimes Arguments in favour of fixed rates: Reduces exchange rate fluctuations (volatility) that increase uncertainty and pose a risk to trade Reduces speculative activity, which can be destabilising. Is not inflationary (the way flexible exchange rates can be). Note: under fixed rates, changes in the exchange rate are referred to revaluations or devaluations.