Transition from chapter 1 to chapter 2 Ch

Transition from chapter 1 to chapter 2 Ch 2/ER 1

• Bo. P = + = 0 • FA = private (and Gov’t) + CA is balance on account FA is balance on (capital and) CB is change in central bank foreign account FA includes the accounts i. e US bank balance abroad (in for curr. ) {incr (-)} and For bank balance in US (in $) {incr (+)} Ch 2/ER 2

Flexible exchange rate start w/ CA + FA = Assume US demand for IM CA (CA< 0) Immediate adjustment: US must pay for new imports either w/ (FC) or w/ 1. Either US bank balance abroad (in FC) ( ) 2. Or foreign bank balance in US (in $) ( ) So FA turns >0 and Bo. P still = 0 Ch 2/ER 3

Short term adjustment through foreign exchange market: 1. Means that demand foreign currency (FC) 2. Means that supply of $ held by foreigners $/FC FC/$ S D’ S’ D D Q of $ Q of FC Depreciation of $ S equivalent to Ch 2/ER Appreciation of FC 4

Then US demand for Import while foreign demand for US goods i. e. X hence CA = X - IM Ch 2/ER 5

Fixed exchange rate Same situation but the $ ______ depreciate $/FC Fixed ER S FC/$ D’ S S’ D D Q of $ Q of FC The bold segment shows excess _______ foreign currency on the first graph and excess ______ of dollar on the second graph at the fixed ER. Need for ______ by the Central Bank(s) Ch 2/ER 6

2 possibilities: Unilateral intervention - the Fed uphold the ER by _______ FC to the public at the _______ ER. Concerted intervention - the Fed _____ FC to the public and the foreign central bank ____ dollars (to soak out the excess supply of $). No short run adjustment through the market forces possible - ______ remains. Ch 2/ER 7

Intervention and the Central Bank Assets Liabilities Monetary Base When the CB sells FC to the public, the public pays with _____ currency i. e. the liabilities of the CB ____ - the monetary base (MB) and thus the money supply (M) _____. Ch 2/ER 8

Short run monetary adjustment - Keynesian (P fixed) The monetary contraction slows down demand overall and also demand for _____- thus _____ the CA. The opposite effect will happen to the trade partner - there will be a monetary _____ due to the increase in FC at their CB which will _____ the economy and the demand for import (i. e. the export of the other country) thus ______ their CA. Ch 2/ER 9

Medium run adjustment - classical (P flexible) M and P are proportional - economy ______ at FE As the money supply contracts, the price level ____ resulting in a real ______ (an _____ in RER) and an _______ in the country’s international competitiveness - thus _____ equilibrium in the CA. Again the opposite will happen to the trade partner - the monetary expansion resulting in an ______ in their price level and a ______ in the trade partner’s international competitiveness. Ch 2/ER 10

Adjustment Mechanism with Various Exchange Rate Arrangements Flexible Exchange Rate Fixed Exchange Rate Ch 2/ER 11

Flexible Exchange Rate Adjustment through supply and demand foreign currency. The S & D equilibrium determines the equilibrium price of the foreign currency in terms of the domestic currency i. e. the ________. Ch 2/ER 12

The determinants of the demand foreign currency We need to go back to the balance of payments and find out which agents need foreign currency. In the current account: US ______ - to pay for imports of foreign goods and services US _____ who must pay dividends to foreigners holding their stocks The US _____ planning to send money to the victims of the tsunami Ch 2/ER 13

In the financial account: US ______ who reshuffle their portfolio into Canadian bonds US ______ who plan to carry out some FDI into Indian IT US ______ rebuilding some destroyed schools you know where US ______ in the process of rebuilding its foreign reserves The demand foreign currency is a _____ demand. Ch 2/ER 14

To simplify, let’s assume that the demand foreign currency has only one determinant - the demand for imports. When the exchange rate E increases (the $ ______), the price of imports PIM$ in $ _______ as PIM$ = PIMFC * E so the quantity of import demanded QIM _______ as they become _______ expensive for the US. However the foreign price of imports PIMFC _____. so the total demand for FC equal to PIMFC * QIM must _____ resulting in a ____ sloping demand curve. Ch 2/ER 15

When E increases, the demand for FC _____. $/FC D Q of FC Ch 2/ER 16

The determinants of the supply of foreign currency In the current account: US ______ - receipts for exports of US goods and services US _______ receiving dividend income on their foreign stock holdings. ______ by the sheik of Arabia to Harvard University to endow a professorship. Ch 2/ER 17

In the financial account: Foreign ______ who reshuffle their portfolio into US bonds. Foreign ______ who plan to set up new factories in the US. Foreign _____ remodeling their embassy in Washington. Foreign _____ selling $ back to the US. The supply of foreign currency is a ______ supply. Ch 2/ER 18

To simplify, let’s assume that the supply of foreign currency has only one determinant - the supply of ______. This case is more complicated because we are now 2 steps removed from the _____ of foreign currency. Indeed the supply of export is really the _______ for our goods and services. When the exchange rate E increases (the $ ______), the price of export PX$ in $ does _____ change, but, for the foreign importers, the price of our goods converted into their currency i. e. in FC _____ as Ch 2/ER PXFC = PX$ / E. 19

so the quantity of export supplied QX ____ as they become _____ expensive for the foreigners. The question is what happens to the _______ supply of FC which is equal to PXFC * QX Indeed PXFC ______ while QX _______ so the result is ambivalent. Assuming high elasticities, the percentage change (increase) in quantities is _______ than the percentage change (drop) in price, thus resulting in an ____ in the supply of FC i. e. an _______ sloping supply curve. Ch 2/ER 20

When E increases, the supply of FC _____ $/FC S Q of FC Assuming high elasticities cf Marshall Lerner conditions Ch 2/ER 21

Foreign Exchange Market Equilibrium $/FC S E D Q of FC The intersection of the supply and the demand foreign currency determines the ______ exchange rate E and the ____ of FC traded. Ch 2/ER 22

Impact of a change in the demand or in the supply of FC The demand curve or the supply curve may shift due to a change in _______ or to a change in _____ in anyone of the trade partner. For instance US consumers are told that bananas are very good for their health and the demand for bananas shots up (the US does not produce bananas). This triggers an ______ in the demand for FC (to buy the bananas). Ch 2/ER 23

Impact of a shift in demand with a flexible exchange rate arrangement $/FC S E’ E D’ D Q of FC The $ ______ from E to E’ to restore equilibrium in the FC market while the quantity of FC traded ______. Ch 2/ER 24

Impact of a shift in supply with a flexible exchange rate arrangement $/FC S S’ E E’ D Story: Dubai decides to buy a fleet of Boeing for their national airline. Q of FC The $ ______ from E to E’ to restore equilibrium in the FC market while the quantity of FC traded ______. Ch 2/ER 25

Fixed Exchange Rate Adjustment through intervention by Central Bank (CB or Fed in the US) in the market foreign currency. The CB commits itself into upholding a specific ER and adds its own supply or its own demand to the market to keep the exchange rate fixed. Ch 2/ER 26

Foreign Exchange Market Equilibrium Fixed exchange rate Ef : market is in equilibrium at the fixed ER Ef $/FC S Ef D Q of FC Ch 2/ER 27

Case 1 Increase in demand of FC and intervention by CB Goal: to keep ER at Ef $/FC S E Ef D’ ED To stop the $ from ____ to E, the Fed must _______ (sell) quantity ED of FC at the fixed ER Ef thus ____ the FC and _____ the $ D Q of FC Ch 2/ER 28

Case 2 Increase in supply of FC and intervention by CB Goal: to keep ER at Ef S $/FC Ef S’ ES E D To stop the $ from _____ to E, the Fed must _____ quantity ED of FC at the fixed ER Ef thus ____ the FC and _____ the $ Q of FC Ch 2/ER 29

Intervention and the money supply: case 1 To prevent the $ from depreciating, the Fed must _____ the excess _______ of FC to the public (the importers mainly). So the Fed _____ FC in the foreign exchange market and receives payments in ___. The FC were part of its assets so the Fed’s assets _____ while the $ payments from the public to the Fed correspond to a _____ of the Fed’s liabilities towards the public. Ch 2/ER 30

Impact of Intervention on the Central Bank Balance Sheet Assets Domestic assets Domestic Bonds Foreign Assets Foreign Bonds Foreign Currency Gold Liabilities Currency Commercial Bank Reserves Monetary Base When the CB sells FC to the public, the public pays with domestic currency i. e. the liabilities of the CB ____ - the monetary base (MB) and thus the money supply. Ch 2/ER (M) ____. 31

Sterilization Since a decrease in the money supply is ______, the government may wish in certain circumstances (a recession for instance) to avoid worsening the state of the economy. In this case the government can _____ the impact of intervention on the money supply by performing an ________ of the same size but in the _____ direction to cancel out (sterilize) the effect on the money supply. Ch 2/ER 32

Impact of Intervention followed by Sterilization on the Central Bank Balance Sheet Assets Domestic assets Domestic Bonds Foreign Assets Foreign Bonds Foreign Currency Gold Liabilities Currency Commercial Bank Reserves Monetary Base As the CB sells FC to the public, it also _____ domestic bonds from the public thus putting back in circulation the currency wiped by the sale of FC to the public. The monetary base (MB) and thus the money supply (M) thus ___________. Ch 2/ER 33

Exercise: rework slides 30 to 33 in the case of excess supply of FC (Case 2) Ch 2/ER 34

National Income Accounting in the Open Economy It is clear that exports are foreign demand for ____ goods and services and so ____ to the total demand for domestic output. On the other hand, imports are domestic demand for goods produced ______ so they will detract from total demand for domestically produced output as they are income earned domestically that does not add to demand for domestically produced output. Ch 2/ER 35

Demand Z for domestic production Y is defined as: Z = C + I + G + X - IM C, I and G are total demand from _____, _______ and the ____, so Zt can be broken down into demand for _____ produced goods and services and demand for ____ goods and services. X is export, IM import and the real exchange rate. With C = Cd + Cf I = Id + If and G = Gd + Gf The subscript d corresponds to domestically produced and the subscript f corresponds to imported. Ch 2/ER 36

The imported goods and services are expressed in baskets of _____ goods. So they must be converted into baskets of ____ goods using the ______ exchange rate = EP*/P Since Z is defined as the demand for domestically produced goods and C, I and G also include the demand for imported goods, the latter has to be _____ away from Z. So we have: and Z = C d + C f + I d + If + G d + G f + X - C f - If - G f - Cf - If - Gf = - IM Ch 2/ER 37

Definitions - Summary • Z is the total demand - domestic and foreign for domestically produced goods and services. • C + I + G is the domestic demand for ____ goods - produced domestically or abroad it is called _____ • X - IM is the net foreign demand for domestic goods - the balance of ____ - net ______ • IM are the imports expressed in _______ units (baskets) - so imports must be converted into domestic units (baskets) using the real ER Ch 2/ER 38

Marshall-Lerner condition In principle, one would think that a depreciation (or a devaluation) should result in an _______ in the balance of trade. A cheaper $ means that US goods will be ______ for the foreign buyers of our goods and they will ____ their purchases, _______ exports from our point of view More expensive FC means that foreign goods will be ______ expensive for us and we will buy _______ imports from our point of view Ch 2/ER 39

However we were referring to _______ or _____ of imports and exports. The balance of trade will actually improve only if there is an _____ in the $ value of export minus the $ value of import. So will the $ value of export ____ and will the $ value of import ____ as a result of a depreciation (or devaluation)? We will show that the $ value of exports increases ______ while the $ value of imports may _______ or _______. Finally if the value of imports increases and this increase is greater than the increase in the value of exports, then the balance of trade will definitely _______ as a result of a depreciation. Ch 2/ER 40

Let’s be more rigorous. Assumptions: short run - prices are fixed and the nominal and real ER are proportional so we can focus on E only. Assume P = P* = 1 then = E The balance of trade X - *IM becomes X - E*IM A depreciation is an _____ in E X - volume of exports _____ IM - volume of imports ____ E*IM may _______ or _____ Ch 2/ER 41

Assume that all the prices remain fixed in term of their own currency. PX is the price of export (in $) and PM the price of imports (in FC) So the balance of trade is PX*X - EPM*IM EPM is the foreign price of imports converted into $ The depreciation does not affect PX but X increases so the value of exports [PX*X] However EPM the price of imports converted into $ ____ while IM ____, so the value of imports in $ [EPM*IM] may or Ch 2/ER 42

If the deterioration on the import side is greater than the improvement on the export side, the balance of trade will _____. How can we predict whethere will be an increase in the value of imports? If the increase in price of imports results in a ____ reduction in the quantity demanded i. e. import demand is _______, then the value of imports will _____. Moreover if the decrease in the price of export results only in a _______ increase in the value of export i. e. export supply (foreign demand for our exports) is ____. The increase in the value of exports may not be large enough to _____ the increase in the value of imports and the balance of trade will _________. Ch 2/ER 43

Elasticities are defined as: % change in quantity/% change in price Low elasticities 1 correspond to _____ demand or supply. Marshall-Lerner conditions A depreciation/devaluation will improve the balance of trade only if the sum of the absolute value of the elasticities of supply of exports ex (i. e. foreign demand for our exports) and domestic demand for imports em are ex + em <1 Ch 2/ER 44

Example: E PX X PM $PM= EPM 1 $1= FC 1 2 FC 1 $1 2 2 -2=0 2 $1= FC 0. 5 3 FC 1 $2 1. 9 3 - 3. 8 = -0. 8 Ch 2/ER M BT = PX *X - EPM*M 45

Let’s approximate the elasticities in this example: em = %change in IM / % change in PM = [(1. 9 -2)/1. 95]/[(2 -1)/1. 5] = - 0. 0769 _______ The elasticity of export supply is the elasticity of foreign import demand for our good. To calculate it we must convert the domestic price of export into FC ex = %change in X / % change in PX/E = [(3 -2)/2. 5] / [(. 5 -1)/. 75] = - 0. 6 ______ The sum of the 2 absolute values is 0. 6769 < 1 Ch 2/ER 46

Example: Calculate whether M-L is fulfilled E PX X PM $PM= EPM 1 $1= FC 1 2 FC 1 $1 2 2 $1= FC 0. 5 4 FC 1 $2 . 5 Ch 2/ER M BT = PX *X - EPM*M 47

Let’s approximate the elasticities in this example: em = %change in IM / % change in PM = [( )/ ]/[(2 -1)/1. 5] = The elasticity of export supply is the elasticity of foreign import demand for our good. To calculate it we must convert the domestic price of export into FC ex = %change in X / % change in PX/E = [( )/ ] / [(. 5 -1)/. 75] = The sum of the 2 absolute values is Ch 2/ER 48

The J-curve • Why does the balance of trade worsens immediately after a depreciation? • Because quantities do not adjust ______ (orders are placed in advance - several months) • Immediate effect of the depreciation (in $): • PM ______ but QM ______ • PX and QX are ______ affected – So PXQX - PMQM _______ • Effect on monetary expansion: more overshooting Ch 2/ER 49

The J-Curve BT t t+3 t At time t+3 quantities start to adjust to the depreciation Ch 2/ER 50