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Balance of Payments and Exchange Rates
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Balance of Payments and Exchange Rates
Alternative Exchange Rate Regimes
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ALTERNATIVE EXCHANGE RATE REGIMES
Internal and external policy objectives internal balance external balance narrow sense: current account balance broad sense: total currency flow balance 2
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Internal and external balance
W, J (a) Internal balance W1 J1 O YF Ye1 National income
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Internal and external balance
S1 by UK D by overseas residents (b) External balance Exchange rate r1 Fixed exchange rate O Quantity of £s
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ALTERNATIVE EXCHANGE RATE REGIMES
Internal and external policy objectives internal balance external balance narrow sense: current account balance broad sense: total currency flow balance possible conflicts between internal and external objectives 2
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Internal and external balance
W, J Assume that initially there is internal imbalance: at Ye2 W2 W1 J1 J2 O Ye2 YF Ye1 National income
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Internal and external balance
W, J Assume that the government increases aggregate demand to achieve internal balance. W2 W1 J1 J2 O Ye2 YF Ye1 National income
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Internal and external balance
This creates external imbalance: i.e. currency flow deficit S1 by UK S2 by UK Exchange rate r1 Fixed exchange rate D by overseas residents O Quantity of £s
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Internal and external balance
S1 by UK S2 by UK Exchange rate r1 Or an imbalance in the narrow sense (a current account deficit) under a floating exchange rate r2 D by overseas residents O Quantity of £s
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Effects on internal and (narrow) external balance
Current account surplus 1 2 Contractionary fiscal policy Lower consumption Exchange rate depreciation Foreign boom Internal balance External balance Recession Boom Exchange rate appreciation Foreign recession Expansionary fiscal policy Higher consumption 3 4 Current account deficit
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UK balance of payments as % of GDP, 1970–2007
Source: Financial Statement and Budget Report (H M Treasury, 2005)
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ALTERNATIVE EXCHANGE RATE REGIMES
Internal and external policy objectives internal balance external balance narrow sense: current account balance broad sense: total currency flow balance possible conflicts between internal and external objectives Nominal and real exchange rates 2
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ALTERNATIVE EXCHANGE RATE REGIMES
Internal and external policy objectives internal balance external balance narrow sense: current account balance broad sense: total currency flow balance possible conflicts between internal and external objectives Nominal and real exchange rates real exchange rate index RERI = NERI × PX / PM 2
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Sterling nominal and real exchange rate indices
(1990 = 100) Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)
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Sterling nominal and real exchange rate indices
(1990 = 100) Nominal exchange rate Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)
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Sterling nominal and real exchange rate indices
(1990 = 100) Nominal exchange rate Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)
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Sterling nominal and real exchange rate indices
(1990 = 100) Real exchange rate Nominal exchange rate Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)
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Sterling nominal and real exchange rate indices
(1990 = 100) Real exchange rate Nominal exchange rate Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)
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ALTERNATIVE EXCHANGE RATE REGIMES
completely fixed 2
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(a) Total currency flow deficit
S by UK D from abroad Exchange rate b a Fixed rate O Quantity of £s
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(b) Total currency flow surplus
S by UK Exchange rate d c Fixed rate D from abroad O Quantity of £s
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ALTERNATIVE EXCHANGE RATE REGIMES
completely fixed freely floating 2
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ALTERNATIVE EXCHANGE RATE REGIMES
completely fixed freely floating intermediate 2
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ALTERNATIVE EXCHANGE RATE REGIMES
Fixed exchange rates foreign exchange intervention effects on the money supply sterilisation correcting a disequilibrium expenditure reducing expenditure switching 3
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ALTERNATIVE EXCHANGE RATE REGIMES
Free-floating exchange rates automatic correction 4
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Adjustment of the exchange rate to a shift in demand and supply
Depreciation er2 D1 O Quantity of £s
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Adjustment of the exchange rate to a shift in demand and supply
Appreciation er1 Exchange rate D1 O Quantity of £s
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ALTERNATIVE EXCHANGE RATE REGIMES
Free-floating exchange rates automatic correction expenditure switching (the substitution effect) 4
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ALTERNATIVE EXCHANGE RATE REGIMES
Free-floating exchange rates automatic correction expenditure switching (the substitution effect) the process of adjustment 4
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ALTERNATIVE EXCHANGE RATE REGIMES
Free-floating exchange rates automatic correction expenditure switching (the substitution effect) the process of adjustment elasticities of currency demand and supply 4
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Supply of pounds and the elasticity of demand for imports
Exchange rate Elastic demand for imports O Quantity of £s
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Supply of pounds and the elasticity of demand for imports
Exchange rate Inelastic demand for imports S O Quantity of £s
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Unstable equilibrium Exchange rate r S D O Quantity of £s
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Unstable equilibrium Exchange rate r S D O Quantity of £s
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ALTERNATIVE EXCHANGE RATE REGIMES
Free-floating exchange rates automatic correction expenditure switching (the substitution effect) the process of adjustment elasticities of currency demand and supply the Marshall–Lerner condition 4
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ALTERNATIVE EXCHANGE RATE REGIMES
Free-floating exchange rates automatic correction expenditure switching (the substitution effect) the process of adjustment elasticities of currency demand and supply the Marshall–Lerner condition expenditure changing (the income effect) 4
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ALTERNATIVE EXCHANGE RATE REGIMES
Free-floating exchange rates automatic correction expenditure switching (the substitution effect) the process of adjustment elasticities of currency demand and supply the Marshall–Lerner condition expenditure changing (the income effect) a rise in income 4
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The income effect (stable prices)
Y E1 Y1 Current account deficit of a – b Expenditure (E), exports (X), imports (M) (X – M)1 b a O Y
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The income effect (stable prices)
Y E1 Exchange rate depreciates Expenditure (E), exports (X), imports (M) a O Y1 Y b (X – M)1
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The income effect (stable prices)
Y E1 Exports rise; imports fall Expenditure (E), exports (X), imports (M) a O Y1 Y b (X – M)1
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The income effect (stable prices)
Y E1 Expenditure rises Expenditure (E), exports (X), imports (M) a O Y1 Y b (X – M)1
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The income effect (stable prices)
Y E1 Income effect Exports fall back somewhat; imports rise back somewhat Expenditure (E), exports (X), imports (M) a O Y1 Y b (X – M)1
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The income effect (stable prices)
Y E2 E1 Y2 Eventual equilibrium (Y2) Positive substitution effect: c – b Negative income effect: c – a Net balance of payments effect: a – b Expenditure (E), exports (X), imports (M) (X – M)2 c a O Y1 Y b (X – M)1
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ALTERNATIVE EXCHANGE RATE REGIMES
Free-floating exchange rates automatic correction expenditure switching (the substitution effect) the process of adjustment elasticities of currency demand and supply the Marshall–Lerner condition expenditure changing (the income effect) a rise in income a rise in prices 4
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ALTERNATIVE EXCHANGE RATE REGIMES
Intermediate exchange rate regimes adjustable peg dirty floating crawling peg 5
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The crawling peg within exchange rate bands
$1.60 $1.40 Exchange rate O Time No intervention Central bank buys domestic currency No intervention Central bank sells domestic currency No intervention
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ALTERNATIVE EXCHANGE RATE REGIMES
Intermediate exchange rate regimes adjustable peg dirty floating crawling peg joint float 5
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ALTERNATIVE EXCHANGE RATE REGIMES
Intermediate exchange rate regimes adjustable peg dirty floating crawling peg joint float exchange rate bands 5
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ALTERNATIVE EXCHANGE RATE REGIMES
Intermediate exchange rate regimes adjustable peg dirty floating crawling peg joint float exchange rate bands exchange rate bands under the old ERM 5
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Balance of Payments and Exchange Rates
Fixed Exchange Rates
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FIXED EXCHANGE RATES Response to contractionary internal shock
short-run effect assumption: relatively inflexible wages & prices effects of reduced aggregate demand current account surplus reduced interest rates ï‚® financial account deficit financial account effect likely to be the bigger to prevent exchange rate falling, the interest rate must thus not be allowed to fall so far money supply must be allowed to contract to match the fall in demand for money internal imbalance will persist 6
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FIXED EXCHANGE RATES Response to contractionary internal shock
long-run effect assume: greater flexibility of wages & prices this allows internal balance to be restored external effects of reduced AD large current account surplus from fall in real exchange rate reduced somewhat by the rise again in aggregate demand from higher exports and lower imports overall external balance restored current account surplus may persist 7
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FIXED EXCHANGE RATES Response to contractionary external shock
short-run effect assumption: fall in exports current account deficit fall in X ï‚® fall in AD ï‚® fall in M financial account fall in AD ï‚® fall in r if r is allowed to fall ï‚® financial account deficit money supply must be reduced to prevent this happening ï‚® this allows r to rise rise in r makes recession worse 6
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FIXED EXCHANGE RATES Response to contractionary external shock
long-run effect assumption: fall in exports reduction in AD reduces inflation this reduces real exchange rate current account deficit is eliminated flexible prices restore internal balance too but the ‘long term’ may be very long in coming! 7
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FIXED EXCHANGE RATES Effectiveness of government policies
monetary policy relatively ineffective fiscal policy relatively effective Causes of balance of payments problems under fixed rates different rates of inflation different rates of growth income elasticities of demand for imports higher than for exports long-term structural changes 8
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FIXED EXCHANGE RATES Advantages of fixed exchange rates certainty
no speculation (if rate is absolutely fixed) automatic correction of monetary errors prevents ‘irresponsible’ government policies 9
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FIXED EXCHANGE RATES Disadvantages of fixed exchange rates
new classical view make monetary policy ineffective anti free market Keynesian view balance of payments deficits can lead to recession possibility of competitive deflation problems of international liquidity inability to adjust to shocks speculation 9
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Balance of Payments and Exchange Rates
Free-floating Exchange Rates
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FREE-FLOATING RATES Response to shocks internal shocks external shocks
purchasing-power parity theory limitations of theory in short run changes in interest rates affect financial account this affects current account in opposite direction external shocks changes in exchange rate help to insulate domestic economy from such shocks the path to long-run equilibrium 10
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Exchange rate path to long-run equilibrium
after a shock at time t1 er1 Exchange rate path Nominal exchange rate erL t1 O Time
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Exchange rate path to long-run equilibrium
after a shock at time t1 er1 Exchange rate path Nominal exchange rate erL t2 O t1 Time
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FREE-FLOATING RATES Speculation stabilising speculation 10
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Stabilising speculation
D3 D2 er1 People believe that exchange rate change is only temporary. er3 Exchange rate er2 D1 O Quantity of £s
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FREE-FLOATING RATES Speculation stabilising speculation
destabilising speculation 10
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Destabilising speculation
er1 People believe that exchange rate change indicates a trend. er2 Exchange rate er3 D1 O Quantity of £s
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FREE-FLOATING RATES Speculation stabilising speculation
destabilising speculation overshooting 10
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FREE-FLOATING RATES Effectiveness of government policy monetary policy
relatively effective direct effect on aggregate demand reinforced by a change in the exchange rate effect of speculation fiscal policy relatively ineffective offset by effect on interest rates & exchange rate 10
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FREE-FLOATING RATES Advantages of free-floating rates
automatic correction no problem of international liquidity and reserves insulation from external events governments free to pursue domestic policy Disadvantages of free-floating rates unstable exchange rates 11
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Fluctuations between the euro and the dollar
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Fluctuations between the euro and the dollar
US interest rate
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Fluctuations between the euro and the dollar
US interest rate ECB interest rate
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Fluctuations between the euro and the dollar
US interest rate ECB interest rate
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Fluctuations between the euro and the dollar
US interest rate $ / € ECB interest rate
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FREE-FLOATING RATES Advantages of free-floating rates
automatic correction no problem of international liquidity and reserves insulation from external events governments free to pursue domestic policy Disadvantages of free-floating rates unstable exchange rates speculation 11
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FREE-FLOATING RATES Advantages of free-floating rates
automatic correction no problem of international liquidity and reserves insulation from external events governments free to pursue domestic policy Disadvantages of free-floating rates unstable exchange rates speculation uncertainty for business 11
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FREE-FLOATING RATES Advantages of free-floating rates
automatic correction no problem of international liquidity and reserves insulation from external events governments free to pursue domestic policy Disadvantages of free-floating rates unstable exchange rates speculation uncertainty for business lack of discipline on economy 11
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Balance of Payments and Exchange Rates
Exchange Rate Systems in Practice
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EXCHANGE RATE SYSTEMS IN PRACTICE
The Bretton Woods system (1943–73) the system role of the IMF correction through deflation or reflation correction through devaluation or revaluation Problems of adjustment disruption of devaluations J-curve effect of devaluation 14
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The J-curve effect t1 X - M Devaluation takes place at t1 Surplus
Deficit t1 Time
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EXCHANGE RATE SYSTEMS IN PRACTICE
The Bretton Woods system (1943–73) the system role of the IMF correction through deflation or reflation correction through devaluation or revaluation Problems of adjustment disruption of devaluations J-curve effect of devaluation stop–go policies 14
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EXCHANGE RATE SYSTEMS IN PRACTICE
The Bretton Woods system (1943–73) the system role of the IMF correction through deflation or reflation correction through devaluation or revaluation Problems of adjustment disruption of devaluations J-curve effect of devaluation stop–go policies speculation 14
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EXCHANGE RATE SYSTEMS IN PRACTICE
The Bretton Woods system (cont.) problems of international liquidity over-reliance on US dollar problem of US deficits and excess liquidity decline in confidence in the system the collapse of the system 15
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EXCHANGE RATE SYSTEMS IN PRACTICE
Managed floating: 1972 onwards forms of managed flexibility extent of intervention forms of intervention justification of managed floating focus on long-term equilibrium exchange rate adjustment is less disruptive Problems with managed floating predicting the long-term equilibrium rate speculative financial movements conflicts with internal policy 16
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Exchange rate indices averages for each period (1995 = 100)
Based on data in European Economy Statistical Annex (Commission of the European Union)
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EXCHANGE RATE SYSTEMS IN PRACTICE
UK experience of managed floating 17
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$ / £ exchange rate and £ exchange rate index: 1976–2005
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$ / £ exchange rate and £ exchange rate index: 1976–2005
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$ / £ exchange rate and £ exchange rate index: 1976–2005
1990=100 $ / £
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$ / £ exchange rate and £ exchange rate index: 1976–2005
1990=100 $ / £
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EXCHANGE RATE SYSTEMS IN PRACTICE
UK experience of managed floating effects of first oil crisis: 1973–6 6 17
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EXCHANGE RATE SYSTEMS IN PRACTICE
UK experience of managed floating effects of first oil crisis: 1973–6 second oil crisis and the rise in monetarism 17
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$ / £ exchange rate and £ exchange rate index: 1976–2005
1990=100 $ / £
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EXCHANGE RATE SYSTEMS IN PRACTICE
UK experience of managed floating effects of first oil crisis: 1973–6 second oil crisis and the rise in monetarism effects of growing US budget and trade deficits in the 1980s 17
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EXCHANGE RATE SYSTEMS IN PRACTICE
UK experience of managed floating effects of first oil crisis: 1973–6 second oil crisis and the rise in monetarism effects of growing US budget and trade deficits in the 1980s the 1985 exchange crisis 17
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$ / £ exchange rate and £ exchange rate index: 1976–2005
1990=100 $ / £
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EXCHANGE RATE SYSTEMS IN PRACTICE
UK experience of managed floating effects of first oil crisis: 1973–6 second oil crisis and the rise in monetarism effects of growing US budget and trade deficits in the 1980s the 1985 exchange crisis joining and leaving the ERM 17
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EXCHANGE RATE SYSTEMS IN PRACTICE
UK experience of managed floating effects of first oil crisis: 1973–6 second oil crisis and the rise in monetarism effects of growing US budget and trade deficits in the 1980s the 1985 exchange crisis joining and leaving the ERM sterling in the mid 1990s 17
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$ / £ exchange rate and £ exchange rate index: 1976–2005
1990=100 $ / £
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EXCHANGE RATE SYSTEMS IN PRACTICE
UK experience of managed floating effects of first oil crisis: 1973–6 second oil crisis and the rise in monetarism effects of growing US budget and trade deficits in the 1980s the 1985 exchange crisis joining and leaving the ERM sterling in the mid 1990s recent experience 17
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$ / £ exchange rate and £ exchange rate index: 1976–2005
1990=100 $ / £
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EXCHANGE RATE SYSTEMS IN PRACTICE
UK experience of managed floating effects of first oil crisis: 1973–6 second oil crisis and the rise in monetarism effects of growing US budget and trade deficits in the 1980s the 1985 exchange crisis joining and leaving the ERM sterling in the mid 1990s recent experience problems of a high pound 17
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EXCHANGE RATE SYSTEMS IN PRACTICE
UK experience of managed floating effects of first oil crisis: 1973–6 second oil crisis and the rise in monetarism effects of growing US budget and trade deficits in the 1980s the 1985 exchange crisis joining and leaving the ERM sterling in the mid 1990s recent experience problems of a high pound exchange rate effects of inflation targeting 17
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EXCHANGE RATE SYSTEMS IN PRACTICE
The volatility of exchange rates causes of volatility money supply and inflation targets growth in financial movements abolition of exchange controls growth in IT growth in speculative activity growing belief that governments are powerless to prevent speculation 17
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Balance of Payments and Exchange Rates
The Open Economy and ISLM Analysis
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THE OPEN ECONOMY AND ISLM ANALYSIS
The BP curve 12
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The BP curve r BP SURPLUS r1 DEFICIT O Y
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The BP curve r Y1 SURPLUS BP DEFICIT O Y
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The BP curve r BP a r1 Y1 O Y
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The BP curve r Assume that national income rises BP a r1 O Y1 Y1 Y
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Deficit if rate of interest
The BP curve r Assume that national income rises BP a b r1 Deficit if rate of interest remains at r1 O Y1 Y1 Y
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The BP curve r BP r2 r1 Rate of interest must rise to r2 to restore
balance of payments O Y1 Y1 Y
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THE OPEN ECONOMY AND ISLM ANALYSIS
The BP curve Analysis under a fixed exchange rate 12
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THE OPEN ECONOMY AND ISLM ANALYSIS
The BP curve Analysis under a fixed exchange rate equilibrium in the model 12
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ISLMBP analysis: fixed exchange rates
O Y Full equilibrium in the goods, money and foreign exchange markets
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THE OPEN ECONOMY AND ISLM ANALYSIS
The BP curve Analysis under a fixed exchange rate equilibrium in the model movement to a new equilibrium 12
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THE OPEN ECONOMY AND ISLM ANALYSIS
The BP curve Analysis under a fixed exchange rate equilibrium in the model movement to a new equilibrium effects of fiscal policy 12
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ISLMBP analysis: fixed exchange rates
O Y An expansionary fiscal policy
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ISLMBP analysis: fixed exchange rates
Balance of payments surplus causes money supply to expand a r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy
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ISLMBP analysis: fixed exchange rates
Restoration of full equilibrium a Y3 r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy
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ISLMBP analysis: fixed exchange rates
O Y1 Y An expansionary fiscal policy: BP curve steeper than LM curve
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ISLMBP analysis: fixed exchange rates
O Y1 Y An expansionary fiscal policy: BP curve steeper than LM curve
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ISLMBP analysis: fixed exchange rates
Balance of payments deficit causes money supply to contract a r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy: BP curve steeper than LM curve
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ISLMBP analysis: fixed exchange rates
Restoration of full equilibrium a r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy: BP curve steeper than LM curve
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THE OPEN ECONOMY AND ISLM ANALYSIS
The BP curve Analysis under a fixed exchange rate equilibrium in the model movement to a new equilibrium effects of fiscal policy effects of monetary policy 12
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ISLMBP analysis: fixed exchange rates
O Y1 Y An expansionary monetary policy
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ISLMBP analysis: fixed exchange rates
O Y1 Y An expansionary monetary policy
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ISLMBP analysis: fixed exchange rates
Balance of payments deficit causes money supply to contract again b r2 IS O Y1 Y2 Y An expansionary monetary policy
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ISLMBP analysis: fixed exchange rates
Full equilibrium is restored back at point a b r2 IS O Y1 Y2 Y An expansionary monetary policy
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THE OPEN ECONOMY AND ISLM ANALYSIS
Analysis under free-floating rates effects of exchange rate changes on the BP curve 13
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Movements in the BP curve
Appreciation SURPLUS BP O Y
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Movements in the BP curve
Depreciation DEFICIT O Y
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THE OPEN ECONOMY AND ISLM ANALYSIS
Analysis under free-floating rates effects of exchange rate changes on the BP curve achievement of equilibrium 13
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THE OPEN ECONOMY AND ISLM ANALYSIS
Analysis under free-floating rates effects of exchange rate changes on the BP curve achievement of equilibrium effects of fiscal policy 13
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ISLMBP analysis: floating exchange rates
An expansionary fiscal policy
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ISLMBP analysis: floating exchange rates
Balance of payments surplus causes the exchange rate to appreciate O Y1 Y2 Y An expansionary fiscal policy
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ISLMBP analysis: floating exchange rates
The appreciation causes the IS curve to shift to the left a r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy
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ISLMBP analysis: floating exchange rates
Full equilibrium is restored at point c Y3 a r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy
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ISLMBP analysis: floating exchange rates
An expansionary fiscal policy: BP curve steeper than LM curve
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ISLMBP analysis: floating exchange rates
Balance of payments deficit causes exchange rate to depreciate a r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy: BP curve steeper than LM curve
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ISLMBP analysis: floating exchange rates
Depreciation causes the IS curve to shift to the right r2 a r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy: BP curve steeper than LM curve
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ISLMBP analysis: floating exchange rates
Full equilibrium is achieved at point c b r2 Y3 a r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy: BP curve steeper than LM curve
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THE OPEN ECONOMY AND ISLM ANALYSIS
Analysis under free-floating rates effects of exchange rate changes on the BP curve achievement of equilibrium effects of fiscal policy effects of monetary policy 13
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ISLMBP analysis: floating exchange rates
An expansionary monetary policy
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ISLMBP analysis: floating exchange rates
The balance of payments deficit causes the BP line to shift downward r2 b IS1 O Y1 Y2 Y An expansionary monetary policy
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ISLMBP analysis: floating exchange rates
The depreciation causes the IS curve to shift to the right r2 b IS1 O Y1 Y2 Y An expansionary monetary policy
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ISLMBP analysis: floating exchange rates
Full equilibrium is restored at point c IS1 O Y1 Y2 Y An expansionary monetary policy
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