1. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 0

2. C H A P T E R 9 International Adjustment: Aggregate Demand and Supply in an Open Economy Learning objectives äUnderstand that national economies are linked through trade flows. äUnderstand that the real exchange rate is a measure of the price of Canadian goods relative to the price of foreign goods measured in one country. äUnderstand that an increase in real exchange rate, which is called an improvement in the terms of trade, will lead to an increase in net exports, through a decrease in imports and an increase in exports. PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa Copyright 2005 © McGraw-Hill Ryerson Ltd.

3. C H A P T E R 9 International Adjustment: Aggregate Demand and Supply in an Open Economy Learning objectives (cont’d) äUnderstand that, in the long run, a monetary expansion will depreciate the nominal exchange rate and raise the domestic price level, leaving the domestic exchange rate unaltered. äUnderstand that the monetary approach to the balance of payments emphasizes the connection between the changing supply and the level of the balance of payments. PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa Copyright 2005 © McGraw-Hill Ryerson Ltd.

4. Slide 3 AD, AS, and net exports oReal exchange rate (or terms of trade) oReal exchange rate (or terms of trade): The ratio of foreign prices to Canadian prices, measured in a common currency. Chapter 9: International Adjustment (1)(1) oe oe: nominal exchange rate oP f oP f : nominal price of foreign goods, measured in foreign currency. oP oP: Canadian dollar price of Canadian goods.

5. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 4 AD, AS, and net exports oOpen Economy Aggregate Demand Curve oOpen Economy Aggregate Demand Curve: The aggregate demand curve that takes into account changes in the real exchange rate. Chapter 9: International Adjustment

6. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 5 AD, AS, and net exports Figure 9-1: The Open Economy AD Curve Price level Y In an open economy, an additional reason for the AD curve to slope downward is that, for a given foreign price level and nominal exchange rate, a decrease in the Canadian Price Level improves the terms of trade and increases net exports. For a given Canadian price level, a depreciation in the nominal exchange rate or an increase in the foreign price level will increase the terms of trade and shift the AD curve outward

7. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 6 AD, AS, and net exports oExternal Equilibrium oExternal Equilibrium: Chapter 9: International Adjustment (2) S - I = NX (2)

8. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 7 Appreciation and Depreciation: Is it Up or Down? BOXBOX 9-1 When the nominal exchange rate is expressed in Canadian dollars: When the nominal exchange rate is expressed in US dollars:

9. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 8 AD, AS, and net exports Figure 9-2: Supply and Demand for Canadian Dollars Chapter 9: International Adjustment Real Exchange Rate Q Demand (Net exports) Supply (Net foreign lending) R0R0 The supply of Canadian dollars comes from net foreign investment that is supplied to the exchange market to buy foreign assets, such as foreign bonds. The demand for dollars comes from the need to pay for our net exports. Supply and demand determine the equilibrium real exchange rate, R. $ CDA

10. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 9 AD, AS, and net exports oEffects of expansionary Monetary Policy oEffects of expansionary Monetary Policy: An increase in the nominal money supply shifts the AD curve outward to AD’ and the Canadian price level increase to P’. In the short run, for a given nominal exchange rate and a given foreign price level, the terms of trade worsen. This is shown as a new short run real exchange rate of R’ in Figure 9-3(b). At the new long run equilibrium, the price level in the Canadian economy is P 1, which is consistent with the quantity theory of money. This price level is also consistent with PPP, as the real exchange rate and the level of net exports are the same as they were prior to the monetary expansion. Chapter 9: International Adjustment

11. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 10 AD, AS, and net exports P Y P0P0 E P1P1 E1E1 Y* Figure 9-3: Open Economy Adjustment to a Money Shock Real Exchange Rate $ CDAR’ R0R0 E R R0R0 E P’

12. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 11 AD, AS, and net exports Figure 9-4: The Real Exchange Rate and Net Exports

13. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 12 The J-Curve BOXBOX 9-2 The trade balance in terms of domestic goods: X: Foreign demand for our goods or exports. Q: Our import quantity. eP f /P: Value of our imports in term of domestic goods.

14. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 13 Fixed Exchange rates and Devaluation BOXBOX 9-3 oPrior to the early 70s most countries, Canada included were on a fixed exchange rate regime oPrior to the early 70s most countries, Canada included were on a fixed exchange rate regime. oIf there was a balance of payment deficit position = Excess supply of Canadian dollars (or excess demand of foreign currency). oThe Bank of Canada would then buy Canadian dollars with foreign currency. oThis situation cannot be maintained indefinitely. oA country must adjust by lowering the price level = recession = higher unemployment. oA less painful strategy would be to devalue the domestic currency leading to an improvement of the terms of trade by increasing exports and decreasing imports and thus correcting the trade imbalance.

15. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 14 The Monetary Approach to the BOP oSuggestion: External balance problems are monetary in nature and that balance of payment deficits are a reflection of excessive money supply. oSimple version: Money contraction => rise in interest rates => reduces pending => reduces incomes => reduces imports. oSophisticated version: A sale of foreign exchange => reduces the stock of high powered money => reduces the money stock. Chapter 9: International Adjustment

16. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 15 The Monetary Approach to the BOP oSterilization oSterilization: To offset (or sterilize) the impact of monetary intervention on the foreign exchange market, the central bank will engage in open market operations. oA deficit country that is selling foreign exchange may offset the resulting reduction in the money supply by purchasing bonds. Chapter 9: International Adjustment

17. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 16 The Monetary Approach to the BOP oMonetary Approach oMonetary Approach: The emphasis on monetary considerations in the interpretation of external balance problems. oThis approach has been used extensively by the IMF in its analysis and design of economic policies for countries with balance of payment trouble. Chapter 9: International Adjustment(3)(3)

18. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 17 Exchange Rates and Interdependence oSpillover (interdependence) effects oSpillover (interdependence) effects: Occur when policy changes or supply/demand shocks in one country affect output in another. oThrough monetary policy oThrough prices oThrough fiscal policy Chapter 9: International Adjustment

19. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 18 Chapter Summary The real exchange rate measures the relative price of domestic goods to foreign goods. An increase in the real exchange rate will lead to an increase in net exports. In the long run, a monetary expansion increases the price level and depreciates the nominal exchange rate. The monetary approach to the balance of payments draws attention to the fact that a payment deficit is always a reflection of a monetary disequilibrium and is always self- correcting. Chapter 9: International Adjustment

20. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 19 Chapter Summary (cont’d) Even under flexible exchange rates, economies are closely tied to one another. A monetary expansion at home will lead to unemployment and disinflation abroad. Chapter 9: International Adjustment

21. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 20 The End Chapter 9: International Adjustment