1. Balance of Payments Adjustment
Thorvaldur Gylfason

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

3. Real versus nominal exchange rates1
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

4. 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

5. Balance of payments and welfare2
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

6. 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

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

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

9. 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

10. 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

11. The scourge of overvaluation3
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

12. 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

13. 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

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

15. 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

16. 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

17. 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

18. 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

19. Empirical evidence from industrial countries
Elasticity of Elasticity of
exports imports
Austria
Belgium
Canada
France
Germany
Italy
Japan
Netherlands
Sweden
United Kingdom
United States
Average

20. 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

21. Balance of payments adjustment and economic policy4
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

22. Experiment: Export boom
Price level AS AD
GNP

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

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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

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

33. 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

34. 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

35. 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

36. 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)

37. 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

38. 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

39. 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