balance of payments and exchange rates. balance of payments and exchange rates alternative exchange...
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Balance of PaymentsBalance of Paymentsand Exchange Ratesand Exchange Rates
Balance of Payments and Exchange RatesBalance of Payments and Exchange Rates
Alternative Exchange Rate Regimes
Alternative Exchange Rate Regimes
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE EXCHANGE RATE REGIMES
• Internal and external policy objectives– internal balance
– external balance• narrow sense: current account balance
• broad sense: total currency flow balance
• Internal and external policy objectives– internal balance
– external balance• narrow sense: current account balance
• broad sense: total currency flow balance
W1
J1
O
W, J
National income
(a) Internal balance
YF
Ye1
Internal and external balanceInternal and external balance
O
Exc
ha
nge
ra
te
Quantity of £s
S1 by UK
D by overseasresidents
r1
(b) External balance
Fixedexchange rate
Internal and external balanceInternal and external balance
• 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
• 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
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE EXCHANGE RATE REGIMES
O
W, J
National income
W1
J1
YF
Ye1
Assume that initially thereis internal imbalance: at Ye2
W2
J2
Ye2
Internal and external balanceInternal and external balance
O
W, J
National income
W1
J1
YF
Ye1
W2
J2
Ye2
Assume that the governmentincreases aggregate demandto achieve internal balance.
Internal and external balanceInternal and external balance
O
Exc
ha
nge
ra
te
Quantity of £s
S1 by UK
D by overseasresidents
r1 Fixedexchange rate
S2 by UK
This createsexternal imbalance:
i.e. currency flow deficit
Internal and external balanceInternal and external balance
O
Exc
ha
nge
ra
te
Quantity of £s
S1 by UK
D by overseasresidents
r1
S2 by UK
r2
Or an imbalance in the narrow sense (a current account deficit) under a
floating exchange rate
Internal and external balanceInternal and external balance
Recession Boom
Current account surplus
Current account deficit
Exchange rate depreciationForeign boom
Exchange rate appreciationForeign recession
Contractionary fiscal policyLower consumption
Expansionary fiscal policyHigher consumption
Internal balance
Ext
ern
al
b
alan
ce
1
3 4
2
Effects on internal and (narrow) external balanceEffects on internal and (narrow) external balance
UK balance of payments as % of GDP, 1970–2007UK balance of payments as % of GDP, 1970–2007
Source: Financial Statement and Budget Report (H M Treasury, 2005)
• 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
• 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
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE 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
• 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
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE EXCHANGE RATE REGIMES
80
90
100
110
120
130
140
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Sterling nominal and real exchange rate indices(1990 = 100)
Sterling nominal and real exchange rate indices(1990 = 100)
Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)
80
90
100
110
120
130
140
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Sterling nominal and real exchange rate indices(1990 = 100)
Sterling nominal and real exchange rate indices(1990 = 100)
Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)
Nominal exchange rate
80
90
100
110
120
130
140
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Sterling nominal and real exchange rate indices(1990 = 100)
Sterling nominal and real exchange rate indices(1990 = 100)
Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)
Nominal exchange rate
80
90
100
110
120
130
140
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Sterling nominal and real exchange rate indices(1990 = 100)
Sterling nominal and real exchange rate indices(1990 = 100)
Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)
Realexchange rate
Nominal exchange rate
80
90
100
110
120
130
140
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Sterling nominal and real exchange rate indices(1990 = 100)
Sterling nominal and real exchange rate indices(1990 = 100)
Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)
Realexchange rate
Nominal exchange rate
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE EXCHANGE RATE REGIMES
• Alternative exchange rate regimes
– completely fixed
• Alternative exchange rate regimes
– completely fixed
O
Exc
ha
nge
ra
te
Quantity of £s
S by UK
D from abroad
Fixed rateb a
(a) Total currency flow deficit(a) Total currency flow deficit
O
Exc
ha
nge
ra
te
Quantity of £s
S by UK
D from abroad
Fixed rated c
(b) Total currency flow surplus (b) Total currency flow surplus
• Alternative exchange rate regimes
– completely fixed
– freely floating
• Alternative exchange rate regimes
– completely fixed
– freely floating
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE EXCHANGE RATE REGIMES
• Alternative exchange rate regimes
– completely fixed
– freely floating
– intermediate
• Alternative exchange rate regimes
– completely fixed
– freely floating
– intermediate
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE EXCHANGE RATE REGIMES
• Fixed exchange rates
– foreign exchange intervention
• effects on the money supply
• sterilisation
– correcting a disequilibrium
• expenditure reducing
• expenditure switching
• Fixed exchange rates
– foreign exchange intervention
• effects on the money supply
• sterilisation
– correcting a disequilibrium
• expenditure reducing
• expenditure switching
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE EXCHANGE RATE REGIMES
• Free-floating exchange rates
– automatic correction
• Free-floating exchange rates
– automatic correction
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE EXCHANGE RATE REGIMES
Adjustment of the exchange rate to a shift in demand and supplyAdjustment of the exchange rate to a shift in demand and supply
O
Exc
ha
nge
ra
te
Quantity of £s
S1
D1
er1
er2
S2
D2
Depreciation
O
Exc
ha
nge
ra
te
Quantity of £s
S1
D1
er1
S3
D3
er3
Appreciation
Adjustment of the exchange rate to a shift in demand and supplyAdjustment of the exchange rate to a shift in demand and supply
• Free-floating exchange rates
– automatic correction
– expenditure switching (the substitution effect)
• Free-floating exchange rates
– automatic correction
– expenditure switching (the substitution effect)
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE EXCHANGE RATE REGIMES
• Free-floating exchange rates
– automatic correction
– expenditure switching (the substitution effect)
• the process of adjustment
• Free-floating exchange rates
– automatic correction
– expenditure switching (the substitution effect)
• the process of adjustment
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE EXCHANGE RATE REGIMES
• Free-floating exchange rates
– automatic correction
– expenditure switching (the substitution effect)
• the process of adjustment
• elasticities of currency demand and supply
• Free-floating exchange rates
– automatic correction
– expenditure switching (the substitution effect)
• the process of adjustment
• elasticities of currency demand and supply
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE EXCHANGE RATE REGIMES
Supply of pounds and the elasticity of demand for importsSupply of pounds and the elasticity of demand for imports
O
Exc
ha
nge
ra
te
Quantity of £s
S
Elastic demandfor imports
O
Exc
ha
nge
ra
te
Quantity of £s
S
Inelastic demandfor imports
Supply of pounds and the elasticity of demand for importsSupply of pounds and the elasticity of demand for imports
O
Exc
ha
nge
ra
te
Quantity of £s
SD
r
Unstable equilibriumUnstable equilibrium
O
Exc
ha
nge
ra
te
Quantity of £s
SD
r
Unstable equilibriumUnstable equilibrium
• 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
• 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
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE 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)
• 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)
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE 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
• 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
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE EXCHANGE RATE REGIMES
Y1
O
Exp
en
ditu
re (
E),
exp
orts
(X
), im
port
s (M
)
Y
E1
(X – M)1
Yb
a
Current accountdeficit of a – b
The income effect (stable prices)The income effect (stable prices)
Y1
O
Exp
en
ditu
re (
E),
exp
orts
(X
), im
port
s (M
)
Y
E1
(X – M)1
Y
Exchange rate
depreciates
b
a
The income effect (stable prices)The income effect (stable prices)
Y1
O
Exp
en
ditu
re (
E),
exp
orts
(X
), im
port
s (M
)
Y
E1
(X – M)1
Y
Exports rise;
imports fall
b
a
The income effect (stable prices)The income effect (stable prices)
Y1
O
Exp
en
ditu
re (
E),
exp
orts
(X
), im
port
s (M
)
Y
E1
(X – M)1
Y
Expenditure
rises
b
a
The income effect (stable prices)The income effect (stable prices)
Y1
O
Exp
en
ditu
re (
E),
exp
orts
(X
), im
port
s (M
)
Y
E1
(X – M)1
Y
Income effectExports fall back somewhat;
imports rise back somewhat
b
a
The income effect (stable prices)The income effect (stable prices)
a
Y1
O
Exp
en
ditu
re (
E),
exp
orts
(X
), im
port
s (M
)
Y
E1
(X – M)1
Y
Eventual equilibrium (Y2)Positive substitution effect: c – b
Negative income effect: c – a
Net balance of payments effect: a – b
E2
(X – M)2
Y2
c
b
The income effect (stable prices)The income effect (stable prices)
• 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
• 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
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE EXCHANGE RATE REGIMES
• Intermediate exchange rate regimes
– adjustable peg
– dirty floating
– crawling peg
• Intermediate exchange rate regimes
– adjustable peg
– dirty floating
– crawling peg
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE EXCHANGE RATE REGIMES
The crawling peg within exchange rate bandsThe crawling peg within exchange rate bands
O
Exc
ha
nge
ra
te
Nointervention
Central bankbuys domestic
currency
Nointervention
Central banksells domestic
currency
Nointervention
$1.60
$1.40
Time
• Intermediate exchange rate regimes
– adjustable peg
– dirty floating
– crawling peg
– joint float
• Intermediate exchange rate regimes
– adjustable peg
– dirty floating
– crawling peg
– joint float
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE EXCHANGE RATE REGIMES
• Intermediate exchange rate regimes
– adjustable peg
– dirty floating
– crawling peg
– joint float
– exchange rate bands
• Intermediate exchange rate regimes
– adjustable peg
– dirty floating
– crawling peg
– joint float
– exchange rate bands
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE 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
• Intermediate exchange rate regimes
– adjustable peg
– dirty floating
– crawling peg
– joint float
– exchange rate bands
• exchange rate bands under the old ERM
ALTERNATIVE EXCHANGE RATE REGIMESALTERNATIVE EXCHANGE RATE REGIMES
Balance of Payments and Exchange RatesBalance of Payments and Exchange Rates
Fixed Exchange RatesFixed Exchange Rates
FIXED EXCHANGE RATESFIXED 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 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
• Response to contractionary internal shock
– short-run effect
• assumption: relatively inflexible wages & prices
• effects of reduced aggregate demand– current account surplus
– reduced interest rates 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
FIXED EXCHANGE RATESFIXED 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
• 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
FIXED EXCHANGE RATESFIXED EXCHANGE RATES
• Response to contractionary external shock
– short-run effect
• assumption: fall in exports
• current account deficit
– fall in X fall in AD fall in M
• financial account
– fall in AD fall in r
– if r is allowed to fall financial account deficit
– money supply must be reduced to prevent this happening this allows r to rise
• rise in r makes recession worse
• Response to contractionary external shock
– short-run effect
• assumption: fall in exports
• current account deficit
– fall in X fall in AD fall in M
• financial account
– fall in AD fall in r
– if r is allowed to fall financial account deficit
– money supply must be reduced to prevent this happening this allows r to rise
• rise in r makes recession worse
FIXED EXCHANGE RATESFIXED 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!
• 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!
FIXED EXCHANGE RATESFIXED 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
• 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
FIXED EXCHANGE RATESFIXED EXCHANGE RATES
• Advantages of fixed exchange rates
– certainty
– no speculation (if rate is absolutely fixed)
– automatic correction of monetary errors
– prevents ‘irresponsible’ government policies
• Advantages of fixed exchange rates
– certainty
– no speculation (if rate is absolutely fixed)
– automatic correction of monetary errors
– prevents ‘irresponsible’ government policies
FIXED EXCHANGE RATESFIXED 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
• 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
Balance of Payments and Exchange RatesBalance of Payments and Exchange Rates
Free-floating Exchange Rates
Free-floating Exchange Rates
FREE-FLOATING RATESFREE-FLOATING RATES
• Response to shocks
– internal 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
• Response to shocks
– internal 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
O
No
min
al e
xcha
nge
ra
te
Time
erL
t1
er1
Exchangerate path
Exchange rate path to long-run equilibriumafter a shock at time t1
Exchange rate path to long-run equilibriumafter a shock at time t1
O
No
min
al e
xcha
nge
ra
te
Time
erL
t1
er1
t2
Exchangerate path
Exchange rate path to long-run equilibriumafter a shock at time t1
Exchange rate path to long-run equilibriumafter a shock at time t1
FREE-FLOATING RATESFREE-FLOATING RATES
• Speculation
– stabilising speculation
• Speculation
– stabilising speculation
O
Exc
ha
nge
ra
te
Quantity of £s
S3
D3
er3
er2
S2
D2
er1
S1
D1
Stabilising speculationStabilising speculation
People believe that exchange rate change
is only temporary.
FREE-FLOATING RATESFREE-FLOATING RATES
• Speculation
– stabilising speculation
– destabilising speculation
• Speculation
– stabilising speculation
– destabilising speculation
O
Exc
ha
nge
ra
te
Quantity of £s
S2
D2
er2
er3
S3
D3
er1
S1
D1
Destabilising speculationDestabilising speculation
People believe that exchange rate change
indicates a trend.
FREE-FLOATING RATESFREE-FLOATING RATES
• Speculation
– stabilising speculation
– destabilising speculation
• overshooting
• Speculation
– stabilising speculation
– destabilising speculation
• overshooting
FREE-FLOATING RATESFREE-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
– direct effect on aggregate demand
– offset by effect on interest rates & exchange rate
• 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
– direct effect on aggregate demand
– offset by effect on interest rates & exchange rate
FREE-FLOATING RATESFREE-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
• 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
Fluctuations between the euro and the dollarFluctuations between the euro and the dollar
Fluctuations between the euro and the dollarFluctuations between the euro and the dollar
US interest rate
Fluctuations between the euro and the dollarFluctuations between the euro and the dollar
US interest rate
ECBinterest rate
Fluctuations between the euro and the dollarFluctuations between the euro and the dollar
US interest rate
ECBinterest rate
Fluctuations between the euro and the dollarFluctuations between the euro and the dollar
$ / €US interest
rate
ECBinterest rate
FREE-FLOATING RATESFREE-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
• 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
FREE-FLOATING RATESFREE-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
• 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
FREE-FLOATING RATESFREE-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
• 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
Balance of Payments and Exchange RatesBalance of Payments and Exchange Rates
Exchange Rate Systems in Practice
Exchange Rate Systems in Practice
EXCHANGE RATE SYSTEMS IN PRACTICEEXCHANGE 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
• 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
0
X M
Time
Surplus
Deficit
t1
Devaluation takesplace at t1
The J-curve effectThe J-curve effect
• 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
• 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
EXCHANGE RATE SYSTEMS IN PRACTICEEXCHANGE 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
• 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
EXCHANGE RATE SYSTEMS IN PRACTICEEXCHANGE 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
• 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
EXCHANGE RATE SYSTEMS IN PRACTICEEXCHANGE 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
• 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
EXCHANGE RATE SYSTEMS IN PRACTICEEXCHANGE RATE SYSTEMS IN PRACTICE
Exchange rate indicesaverages for each period (1995 = 100)
1970-3 1974-7 1978-81 1982-5 1986-9 1990-3 1994-6 1997-9 2000–2 2003-5
USA
Japan
Germany
UK
Italy
61
17
36
163
256
58
19
44
122
181
57
25
53
118
134
80
30
58
113
112
77
51
71
106
113
86
64
82
107
118
101
94
97
102
106
121
90
98
125
113
133
96
94
129
112
124
91
103
128
122
Based on data in European Economy Statistical Annex (Commission of the European Union)
• UK experience of managed floating• UK experience of managed floating
EXCHANGE RATE SYSTEMS IN PRACTICEEXCHANGE RATE SYSTEMS IN PRACTICE
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
$2.40
1975 1980 1985 1990 1995 2000 2005
70
80
90
100
110
120
130
140
150
$ / £
$ / £ exchange rate and £ exchange rate index: 1976–2005$ / £ exchange rate and £ exchange rate index: 1976–2005
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
$2.40
1975 1980 1985 1990 1995 2000 2005
70
80
90
100
110
120
130
140
150
$ / £
$ / £ exchange rate and £ exchange rate index: 1976–2005$ / £ exchange rate and £ exchange rate index: 1976–2005
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
$2.40
1975 1980 1985 1990 1995 2000 2005
70
80
90
100
110
120
130
140
150
$ / £Index
1990=100
$ / £ exchange rate and £ exchange rate index: 1976–2005$ / £ exchange rate and £ exchange rate index: 1976–2005
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
$2.40
1975 1980 1985 1990 1995 2000 2005
70
80
90
100
110
120
130
140
150
$ / £Index
1990=100
$ / £ exchange rate and £ exchange rate index: 1976–2005$ / £ exchange rate and £ exchange rate index: 1976–2005
• UK experience of managed floating– effects of first oil crisis: 1973–6 6
• UK experience of managed floating– effects of first oil crisis: 1973–6 6
EXCHANGE RATE SYSTEMS IN PRACTICEEXCHANGE RATE SYSTEMS IN PRACTICE
• UK experience of managed floating– effects of first oil crisis: 1973–6
– second oil crisis and the rise in monetarism
• UK experience of managed floating– effects of first oil crisis: 1973–6
– second oil crisis and the rise in monetarism
EXCHANGE RATE SYSTEMS IN PRACTICEEXCHANGE RATE SYSTEMS IN PRACTICE
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
$2.40
1975 1980 1985 1990 1995 2000 2005
70
80
90
100
110
120
130
140
150
$ / £Index
1990=100
$ / £ exchange rate and £ exchange rate index: 1976–2005$ / £ exchange rate and £ exchange rate index: 1976–2005
• 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
• 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
EXCHANGE RATE SYSTEMS IN PRACTICEEXCHANGE 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
• 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
EXCHANGE RATE SYSTEMS IN PRACTICEEXCHANGE RATE SYSTEMS IN PRACTICE
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
$2.40
1975 1980 1985 1990 1995 2000 2005
70
80
90
100
110
120
130
140
150
$ / £Index
1990=100
$ / £ exchange rate and £ exchange rate index: 1976–2005$ / £ exchange rate and £ exchange rate index: 1976–2005
• 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
• 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
EXCHANGE RATE SYSTEMS IN PRACTICEEXCHANGE 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
• 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
EXCHANGE RATE SYSTEMS IN PRACTICEEXCHANGE RATE SYSTEMS IN PRACTICE
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
$2.40
1975 1980 1985 1990 1995 2000 2005
70
80
90
100
110
120
130
140
150
$ / £Index
1990=100
$ / £ exchange rate and £ exchange rate index: 1976–2005$ / £ exchange rate and £ exchange rate index: 1976–2005
• 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
• 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
EXCHANGE RATE SYSTEMS IN PRACTICEEXCHANGE RATE SYSTEMS IN PRACTICE
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
$2.40
1975 1980 1985 1990 1995 2000 2005
70
80
90
100
110
120
130
140
150
$ / £Index
1990=100
$ / £ exchange rate and £ exchange rate index: 1976–2005$ / £ exchange rate and £ exchange rate index: 1976–2005
• 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
• 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 SYSTEMS IN PRACTICEEXCHANGE 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
• 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
EXCHANGE RATE SYSTEMS IN PRACTICEEXCHANGE 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
• 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
EXCHANGE RATE SYSTEMS IN PRACTICEEXCHANGE RATE SYSTEMS IN PRACTICE
Balance of Payments and Exchange RatesBalance of Payments and Exchange Rates
The Open Economy and ISLM Analysis
The Open Economy and ISLM Analysis
THE OPEN ECONOMY AND ISLM ANALYSISTHE OPEN ECONOMY AND ISLM ANALYSIS
• The BP curve• The BP curve
O
r
Y
r1
SURPLUS
DEFICIT
BP
The BP curveThe BP curve
O
r
Y
SURPLUS
DEFICIT
Y1
BP
The BP curveThe BP curve
O
r
Y
r1
Y1
a
BP
The BP curveThe BP curve
O
r
Y
r1
Y1
a
Assume that nationalincome rises
Y1
BP
The BP curveThe BP curve
O
r
Y
r1
Y1
a
Y1
Assume that nationalincome rises
Deficit if rate of interestremains at r1
b
BP
The BP curveThe BP curve
O
r
Y
r1
Y1
a
Y1
Rate of interest mustrise to r2 to restore
balance of payments
cr2
BP
The BP curveThe BP curve
• The BP curve
• Analysis under a fixed exchange rate
• The BP curve
• Analysis under a fixed exchange rate
THE OPEN ECONOMY AND ISLM ANALYSISTHE OPEN ECONOMY AND ISLM ANALYSIS
• The BP curve
• Analysis under a fixed exchange rate
– equilibrium in the model
• The BP curve
• Analysis under a fixed exchange rate
– equilibrium in the model
THE OPEN ECONOMY AND ISLM ANALYSISTHE OPEN ECONOMY AND ISLM ANALYSIS
ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates
O
r
Y
BP
LM
IS
r1
Y1
Full equilibrium in the goods, moneyFull equilibrium in the goods, moneyand foreign exchange marketsand foreign exchange markets
a
• The BP curve
• Analysis under a fixed exchange rate
– equilibrium in the model
– movement to a new equilibrium
• The BP curve
• Analysis under a fixed exchange rate
– equilibrium in the model
– movement to a new equilibrium
THE OPEN ECONOMY AND ISLM ANALYSISTHE 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
• The BP curve
• Analysis under a fixed exchange rate
– equilibrium in the model
– movement to a new equilibrium
– effects of fiscal policy
THE OPEN ECONOMY AND ISLM ANALYSISTHE OPEN ECONOMY AND ISLM ANALYSIS
O
r
Y
BP
LM1
IS1
r1
Y1
An expansionary fiscal policyAn expansionary fiscal policy
IS2
a
r2
Y2
b
ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates
O
r
Y
BP
LM1
IS1
ar1
Y1
An expansionary fiscal policyAn expansionary fiscal policy
IS2
r2
b
Y2
Balance of paymentssurplus causes money
supply to expand
ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates
O
r
Y
BP
LM1
IS1
ar1
Y1
An expansionary fiscal policyAn expansionary fiscal policy
IS2
r2
b
Y2
Restoration of
full equilibrium
LM2
r3
Y3
c
ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates
O
r
Y
BP
LM1
IS1
r1
Y1
An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve
IS2
a
ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates
a
O
r
Y
BP
LM1
IS1
r1
Y1
An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve
IS2
r2
b
Y2
ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates
O
r
Y
BP
LM1
IS1
r1
Y1
An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve
IS2
a
r2
b
Y2
Balance of paymentsdeficit causes money
supply to contract
ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates
O
r
Y
BP
LM1
IS1
r1
Y1
An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve
IS2
a
r2
b
Y2
Restoration of
full equilibrium
LM2
r3
Y3
c
ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates
• 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
• 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
THE OPEN ECONOMY AND ISLM ANALYSISTHE OPEN ECONOMY AND ISLM ANALYSIS
O
r
Y
BP
LM1
IS
ar1
Y1
An expansionary monetary policyAn expansionary monetary policy
ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates
O
r
Y
BP
LM1
IS
ar1
Y1
An expansionary monetary policyAn expansionary monetary policy
LM2
Y2
r2
b
ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates
O
r
Y
BP
LM1
IS
ar1
Y1
An expansionary monetary policyAn expansionary monetary policy
Y2
LM2
r2
bBalance of paymentsdeficit causes money
supply to contract again
ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates
O
r
Y
BP
LM1
IS
ar1
Y1
An expansionary monetary policyAn expansionary monetary policy
Y2
LM2
r2
bFull equilibrium
is restoredback at point a
ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates
• Analysis under free-floating rates
– effects of exchange rate changes on the BP curve
• Analysis under free-floating rates
– effects of exchange rate changes on the BP curve
THE OPEN ECONOMY AND ISLM ANALYSISTHE OPEN ECONOMY AND ISLM ANALYSIS
O
r
Y
BP
SURPLUS
Movements in the BP curveMovements in the BP curve
Appreciation
O
r
Y
BP
DEFICIT
Depreciation
Movements in the BP curveMovements in the BP curve
• Analysis under free-floating rates
– effects of exchange rate changes on the BP curve
– achievement of equilibrium
• Analysis under free-floating rates
– effects of exchange rate changes on the BP curve
– achievement of equilibrium
THE OPEN ECONOMY AND ISLM ANALYSISTHE 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
• Analysis under free-floating rates
– effects of exchange rate changes on the BP curve
– achievement of equilibrium
– effects of fiscal policy
THE OPEN ECONOMY AND ISLM ANALYSISTHE OPEN ECONOMY AND ISLM ANALYSIS
O
r
Y
BP
LM
IS1
Y1
An expansionary fiscal policyAn expansionary fiscal policy
IS2
Y2
r1
r2
b
a
ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates
O
r
Y
BP
LM
IS1
Y1
An expansionary fiscal policyAn expansionary fiscal policy
IS2
a
Y2
r1
r2
b
Balance of paymentssurplus causes the
exchange rate to appreciate
ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates
O
r
Y
BP
LM
IS1
Y1
An expansionary fiscal policyAn expansionary fiscal policy
IS2
a
Y2
r1
r2
b
The appreciationcauses the IS curve
to shift to the left
ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates
O
r
Y
BP1
LM
IS1
Y1
An expansionary fiscal policyAn expansionary fiscal policy
IS2
a
Y2
r1
r2
b
Full equilibrium isrestored at point c
BP2
IS3
Y3
r3
c
ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates
O
r
Y
LM
BP1
IS1
Y1
An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve
ar1
IS2
Y2
r2b
ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates
O
r
Y
LM
BP1
IS1
Y1
An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve
a
Y2
r1
r2b
IS2
Balance of paymentsdeficit causes exchange
rate to depreciate
ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates
O
r
Y
LM
BP1
IS1
Y1
An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve
a
Y2
r1
r2b
IS2
Depreciation causesthe IS curve toshift to the right
ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates
O
r
Y
LM
BP1
IS1
Y1
An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve
IS3
a
Y2
r1
r2b
BP2
IS2
Y3
r3c
Full equilibrium isachieved at point c
ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates
• 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
• 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
THE OPEN ECONOMY AND ISLM ANALYSISTHE OPEN ECONOMY AND ISLM ANALYSIS
O
r
Y
LM1
IS1
Y1
An expansionary monetary policyAn expansionary monetary policy
a
Y2
r1
r2
BP1
LM2
b
ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates
O
r
Y
LM1
IS1
Y1
An expansionary monetary policyAn expansionary monetary policy
a
Y2
r1
r2 b
The balance of paymentsdeficit causes the BP line
to shift downward
BP1
LM2
ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates
O
r
Y
LM1
IS1
Y1
An expansionary monetary policyAn expansionary monetary policy
a
Y2
r1
r2 b
The depreciationcauses the IS curveto shift to the right
BP1
LM2
ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates
O
r
Y
BP2
LM1
IS1
Y1
An expansionary monetary policyAn expansionary monetary policy
a
Y2
r1
r2 b Full equilibrium isrestored at point c
BP1
IS2
Y3
r3
LM2
c
ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates