1. Balance of Payments Adjustment Thorvaldur Gylfason

2. Outline 1.Real versus nominal exchange rates 2.Balance of payments adjustment and welfare 3.The scourge of overvaluation 4.Balance of payments adjustment through economic policy

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

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

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

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

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

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

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

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

11. 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 3

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

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

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

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 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 Suppose prices are fixed

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 exports imports Austria1.01.2 Belgium1.11.3 Canada0.71.3 France1.30.9 Germany1.00.8 Italy1.30.8 Japan1.41.0 Netherlands1.50.7 Sweden1.60.9 United Kingdom1.01.3 United States1.21.2 Average1.21.1

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

22. Experiment: Export boom Price level GNP AS AD

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

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

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

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

28. Aims of economic policy Apply policy instruments to attain given economic objectives External balance 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 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 + (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 Domesticcredit AD schedule slopes downDevaluation shifts AD schedule right Monetary expansion shifts AD schedule right

31. Aggregate supply Y = F(N) N = N(W/P) 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 GNP AS AD M up; G up; t down; e down W up

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

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

35. Devaluation Price level GNP AS AD e down W up AD’ AS’ A B 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.

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. Price level GNP AS AD Balance of payments adjustment A Suppose, at A, there is a deficit in the balance of payments (B  0) Then, to reduce deficit, must reduce M or G or raise t to reduce demand (shift AD left) M or G down, t up e or F up 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. Can offset decrease in aggregate demand by increasing e or F

38. Price level GNP AS AD Macroeconomic adjustment and structural reform A Start, at A, with a deficit in the balance of payments (B  0) Then, to reduce deficit, try to stimulate supply (shift AS right) in addition to reducing demand M or G down, t up 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. Stimulate supply side by liberalization, stabilization, privatization, etc. E AS’ AD’

39. Conclusion The End 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 good for growth Theory and experience indicate that such measures are generally good for growth