Balance of Balance of Payments Payments

AdjustmentAdjustment

Thorvaldur Gylfason

OutlineOutline

1.1. Real versus nominal exchange Real versus nominal exchange ratesrates

2.2. Balance of payments Balance of payments adjustment and welfareadjustment and welfare

3.3. The scourge of overvaluationThe scourge of overvaluation4.4. Balance of payments Balance of payments

adjustment through economic adjustment through economic policypolicy

Real versus nominal Real versus nominal exchange ratesexchange rates11

*P

ePr

r = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad

Increase in r means real appreciation

Real versus nominal Real versus nominal exchange ratesexchange rates

*P

ePr

r = real exchange ratee = nominal exchange rateP = price level at homeP* = 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

Foreign exchangeForeign exchange

Real exch

an

ge r

ate

Real exch

an

ge r

ate

Imports

Exports

Balance of payments Balance of payments and welfareand welfare22

Earnings from exports of goods, services, and capital

Payments for imports of goods, services, and capital

Equilibrium

Equilibrium between demand and supply in foreign exchange market establishesEquilibrium real exchange rateEquilibrium in the balance of

paymentsBOP = X + Fx – Z – Fz

= X – Z + F = current account + capital

account = 0

Balance of payments Balance of payments and welfareand welfare

Foreign exchangeForeign exchange

Real exch

an

ge r

ate

Real exch

an

ge r

ate

Imports

Exports

Balance of payments Balance of payments adjustment and welfareadjustment and welfare

Overvaluation

Deficit

Foreign exchangeForeign exchange

Pri

ce o

f fo

reig

n e

xch

ang

ePri

ce o

f fo

reig

n e

xch

an

ge

Supply (exports)

Demand (imports)

Balance of payments Balance of payments adjustment and welfareadjustment and welfare

Overvaluation

Deficit

Overvaluation works like a price ceiling

Market equilibrium and Market equilibrium and economic welfareeconomic welfare

SupplySupply

DemandDemand

EE

ProducerProducersurplussurplus

ConsumeConsumerrsurplussurplus

Quantity

Price

AA

BB

CC

Total Total welfare gainwelfare gain associated associatedwith market equilibrium equalswith market equilibrium equalsproducer surplus (= ABE) plusproducer surplus (= ABE) plusconsumer surplus (= BCE)consumer surplus (= BCE)

SupplySupply

DemandDemand

Price ceilingPrice ceiling

EE

FF

GG

Quantity

PriceWelfareWelfarelossloss

Price ceiling imposes aPrice ceiling imposes awelfare losswelfare loss equivalent to equivalent tothe triangle the triangle EFGEFG

AA

BB

CC

Consumer surplus = AFGHConsumer surplus = AFGH

HH

JJ

Market intervention and Market intervention and economic welfareeconomic welfare

Producer surplus = CGHProducer surplus = CGH

Total surplus = AFGC

The scourge of The scourge of overvaluationovervaluation

Governments may try to keep the national currency overvaluedTo keep foreign exchange cheapTo have power to ration scarce

foreign exchangeTo make GNP look larger than it is

Other examples of price ceilingsNegative real interest ratesRent controls

33

SupplySupply

DemandDemand

Price ceilingPrice ceiling

EE

FF

GG

Quantity

PriceWelfareWelfarelossloss

Price ceiling imposes aPrice ceiling imposes awelfare losswelfare loss equivalent to equivalent tothe triangle the triangle EFGEFG

AA

BB

CC

HH

JJ

Market intervention Market intervention and economic welfare, and economic welfare,

againagain

Shortage

Inflation and Inflation and overvaluationovervaluation

Inflation can result in an overvaluation of the national currencyRemember: r = eP/P*

Suppose e adjusts to P with a lagThen r is directly proportional to

the price level PNumerical example as follows

Inflation and Inflation and overvaluationovervaluation

Time

Real exchange rate

100

110

105 Average

Suppose inflation is 10 percent per year

Devaluation

Time

100

120

Real exchange rate

110 Average

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 Inflation and overvaluationovervaluation

Devaluation

How to correct How to correct overvaluationovervaluation

Under a floating exchange rate regimeAdjustment is automatic: e moves

Under a fixed exchange rate regimeDevaluation will reduce e and

thereby also r – provided inflation is kept under control

Does devaluation improve the current account?The Marshall-Lerner condition

The Marshall-Lerner The Marshall-Lerner condition: Theorycondition: Theory

T = eX – Z = eX(e) – Z(e)Not obvious that a lower e helps TWhen 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

1ba

Suppose prices are fixed

The Marshall-Lerner The Marshall-Lerner condition: Evidencecondition: Evidence

Econometric studies indicate that the Marshall-Lerner condition is almost invariably satisfied

Industrial countries: a = 1, b = 1Developing countries: a = 1, b =

1.5Hence,

1ba Devaluation

improves the

current account

Empirical evidence from industrial countries

Elasticity of Elasticity of exports imports

Austria 1.0 1.2Belgium 1.1 1.3Canada 0.7 1.3France 1.3 0.9Germany 1.0 0.8Italy 1.3 0.8Japan 1.4 1.0Netherlands 1.5 0.7Sweden 1.6 0.9United Kingdom 1.0 1.3United States 1.2 1.2

Average 1.2 1.1

The importance of The importance of appropriate side measuresappropriate 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

*P

ePr

Balance of payments Balance of payments adjustment and economic adjustment and economic

policypolicyPrice level

GNP

Aggregate supply

Aggregate demand

P

Y

Equilibrium

An increase in prices inducesproducers to produce more, so that aggregate supply increases

An increase in prices inducesconsumers to buy less, so thataggregate demand decreases

44

Experiment: Export boomExperiment: Export boomPrice level

GNP

AS

AD

Price level

GNP

AS

AD

AD’

A

B

Exports increase, so that aggregate demand expands

Experiment: Export boomExperiment: Export boom

Price level

GNP

AS

AD

Excess demanddrives prices up

AD’

A

B

C

Experiment: Export boomExperiment: Export boom

Price level

GNP

AS

AD

AD’

A

BAs the price level rises, so does GNP along the upward-sloping AS curve

Experiment: Export boomExperiment: Export boom

Comments on experimentComments on experimentAn export boom stimulates aggregate

demand because Y = C + I + G + X - ZTherefore, 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

Economic policyEconomic policy

Economic policy instrumentsExogenous 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 targetsEndogenous variables

GNP level or growth Price level or inflation Employment, unemployment BOP, exchange rate (if flexible), external debt

Aims of economic policyAims of economic policy

Apply policy instruments to attain given economic objectives

External balanceExternal balance: conduct monetary, fiscal, and exchange rate policy so as to make the balance of payments position sustainableKey to financial programmingNot only crisis management in short run

Internal balanceInternal balance: conduct policy so as to foster rapid, sustainable economic growth with low inflation and unemploymentKey to economic and social prosperity

Aggregate demandAggregate demand

Y = C + I + G + X – ZC = c(Y-T) = (1-s)(1-t)Y

where s = saving rate and t = tax rate

I = k(M/P)through interest rates

G = exogenousX = aY* - brZ = mY + cr

where r = eP/P* (real exchange rate) andincrease in r means appreciation, as before

Aggregate demandAggregate 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 downvia real balances and the real exchange rate

... and shifts in response to changes in exogenous variables, including policy

Domestic Domestic creditcredit

AD schedule slopes down Devaluation shifts AD schedule right

Monetary expansion shifts AD schedule right

Aggregate supplyAggregate supplyY = 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 upthrough real wages

... and shifts in response to changes in exogenous variables, including nominal wages and other costs, e.g., price of imported oil

Macroeconomic Macroeconomic equilibriumequilibrium

Price level

GNP

AS

AD

M up; G up; t down; e down

W up

Monetary or fiscal Monetary or fiscal expansionexpansion

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’

An increase in wagesAn increase in wagesPrice 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

DevaluationDevaluationPrice 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.

Balance of paymentsBalance of paymentsB = X – Z + FX = aY* - brZ = mY + crr = eP/P*F = exogenousB = 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)

Price level

GNP

AS

AD

Balance of payments Balance of payments adjustmentadjustment

A

Suppose, at A, there is a deficitin the balance of payments (B 0)

Then, to reduce deficit, must reduce M or G or raise t toreduce demand (shift AD left)

M or G down, t up

e or F upEnd result is still point A, but now with balance of paymentsequilibrium (B = 0). Level of GNP is unchanged, but its composition has changed.

Can offset decreasein aggregate demand by increasing e or F

Price level

GNP

AS

AD

Macroeconomic adjustment Macroeconomic adjustment and structural reformand 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 Ewith balance of paymentsequilibrium (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’

ConclusionConclusion

The EndThe 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

Theory and experience indicate that such measures are generally good for growthgood for growth