Balance of Payment and Exchange Rate
Overshooting
T hre approaches to the balance of pay m ent
K ey nesian or A bsorption (U K E xperience 1970-90)
M onetary approach (G erm an and Japanese E xperience)
E lasticity (M arshall- L erner-R obinson conditions)
Internal and E xternal B alance and T inbergenian A ssignm ent P roblem
E xchanger R ate O vershooting
B alance O f P ay m ent:  P x X  P M   KA  0
M




Macroeconomic Themes:10
1
Open Economy Model: Equilibrium in Six
Different Markets
B alance o f P aym e nt a nalysis: G rap hical ap p ro ach
L ab o ur M arket
LD
LS
G oo d s and M o ne y
M o ney m arket
IS
AS LM
MD MS
W age
i
D o m estic b o nd s
BS
BD
i
F o reign B o nd s
i*
F oreign E xc ha nge
i
Interest rt
L
Y
M /P
DB
FB
exchan ge rate
O utp u t
Y
E m p lo ym e nt
O utp ut
P
P rice
R eal m o ne y b alance
Macroeconomic Themes:10
P ortfo lio allo catio n
e
2
Internal and External Balance Under the Fixed
Exchange Rate Regime
analysis o f internal and e xternal stab ility u sin g IS -L M and in ternatio nal fina ncial inte gratio n line ca n b e
A nalysis o f Internal and E x ternal S tab ility
Interest
R ate
i  i
*
BOP +
U ne m p l.
K inflo w
C o nverge nce p ro cess to m acro eq uilib riu m
BOP+
Inflatio n/B o o m
K -in flo w
ESM
EDG
BOP+
ESM
ESG
BOP+
B O P = X -M = 0
BOPU ne m p lo ym en t
K -o utflo w
BOPB oo m
K -O utflo w
ESG
EDM
BOP+
BOP=0
ESM
EDG
BOP-
EDM
EDG
BOP-
EDM
ESG
BOP-
YF
N o tes: Y F full e m p lo ym e nt o utp ut, B O P = B alance o f P aym ent, K = cap ital, E S G = E xcess su p p ly o f
go o d s, E D G = E xcess d e m and fo r go o d s, E S M = exce ss sup p ly o f m o ne y, E D M = e xcess d e m a nd fo r
m o ne y
co nd ucted usin g this d iagra m .
Macroeconomic Themes:10
3
Policy Spill-over Effects in Interdependent
Economies
A nsw er: U se a tw o country M und ell-F lem in g M odel
E xp ansio nary fiscal p o licy in co u ntry 1
Im p act in co u ntry 2
i2 = i2 *
i1 = i1 *
BOP
LM 2’
LM 2
LM 1 LM 2
IS 2 IS 2 ’
IS 1 ’
O
y0
y1
IS 1
y2
o
y0 y2 y1
Y
In fix ed ex change rate w ith perfect capital m obility:  g
Macroeconomic Themes:10
 0
;
Y
*
g
0
R
; g
0
R *
; g  0
4
BOP: Keynesian Approach
C a p ita l a c c o u n t
E x p o rts , im p o rts a n d tra d e b a la n c e to In c o m e
KA+
Im p o rts
CA
e x p o rts
tra d e b a la n c e
In te re s t ra te
In c o m e
KA-
In te re s t
R a te
in te re s t ra te
In te re s t ra te
Macroeconomic Themes:10
E x te rn a l b a la n c e
In c o m e
5
Monetary Approach to BOP
M oney dem and
M oney supply
M d  pf Y , r 


M s RD
G row th rate of reserves: g r    y g y   g
0
1 d
G row th of incom e raises reserves and favourable to B O P
H as just opposite result than the K ey nesian M odel.
Macroeconomic Themes:10
6
BOP: Elasticity Approach
T rade b alance:  P x X
 P M M   KA  0
C o untry 1
C o untry 2
PD
PM
A
B
C
S
E
I
J
K
O
E
E xp o rt F
O
G
H
H o m e Im p o rt
P*
L
M
P*
PP* N
O
P
R
V
W
Q
S F oreign im p o rt O
T
Macroeconomic Themes:10
U
F oreing E xo p o rt
7
BOP: Elasticity Approach (Marshall-Lerner
Condition)

N et ex port function
NX  X  eM
*
NX  X Y , e  eM Y , e 


F or sim plicity assum e that NX  X  eM . T hen three are three sources of ch an ges in the
net ex ports:
1. E x ports 2. Im po rts and 3. E x chan ge rate
 NX
X
M
e


e

M
 NX   X  e  M  M  e
D ivide each term b y X ,
X
X
X
X
e
1
M
1


X

eM
NX

0
N o w using the fact that
w he n the trad e is b ala nced (
);
and
.
X
M
X
e
 NX
X
M
e
 NX
X
e M
e




0


1
=>
X
X
M
e
X
X
e
M
e
Macroeconomic Themes:10
8
Exchange Rate Overshooting
G o o d s and M o ne y m arket eq uilib riu m a nd the e xc han ge rate
E xchan ge R a te O versho o tin g
G o od s m arket
G oo d s m arket eq .
P rice
P rice
L e vel
c
  0
a
e e 
1

b
p  p
m o ne y m arket eq .
E xchange R ate
Macroeconomic Themes:10
E xchan ge R a te
9
Internal and External Balance and Tibergenian TargetInstrument Assignment Problem
Fiscal and Monetary Policies for Stability
B ud get
S urp lu s
B ud get
surp lus
E xcess
d em a nd
B oom
Inflatio n
E xcess sup p ly
R ecessio n
B O P surp lus
BOP
deficit
Internal b alance
E xternal b alance
Interest rate
Interest rate
B ud get
S urp lu s
D eflatio n a nd B O P surp lus
F iscal P o lic y
Inflatio n and B O P d eficit
EB
Interest rate
m
o netary
p o lic y
Macroeconomic
Themes:10
IB
10
Assignment Problem in the Mundel-Fleming Model
A ssuring Internal and ex ternal stability usin g the fiscal and m onetary policies
U nd er im p erfect C ap ital M o b ility S cenario
LM 2
LM 1
Interest rate
b
a
BOP
IS 2
IS 1
Y*
Inco m e
O riginally the internal equilibrium is at point a w here both goods and m one y
m arket are in equilibrium but the ex ternal account is im balance b y am ount
ab. M one y supply is reduced to raise the interest by shifting L M 1 to L M 2.
H ow ever, this policy action w ill create an intern al im balance and
unem plo ym ent w ill result because econom y is operating und er full capacity
at point c. A ccom m odatin g fiscal polic y can shift IS 1 to IS 2 at point b w here
both internal and ex ternal account are balan ces and stability is achiev ed.
H ow does this curve look like und er a p erfect capital m obility condition?
Macroeconomic Themes:10
11
Exchange Rate in the Long Run
P u rch asin g p o w er p arity :
p  EP *
M o n ey d e m an d at h o m e
M  KY 
p
M o n ey d e m an d ab ro ad :
M *  K *Y *
p*
* *
E M K Y
KY 
M*

 E
p
P*













L o n g ru n ex ch an g e rate e   m  m *    k *  k     y *   y 






Macroeconomic Themes:10
12
J-curve hy pothesis:
 d ev alu ation o f a cu rren cy d eterio rates th e trade
b alan ce con d ition in th e sho rt run b ecau se
im p o rts can n o t d ecrease an d expo rt cann o t
in crease im m ed iately.
 H ow ev er ov er tim e ad ju stm en ts w ill tak e p lace
so th at expo rts in crease and im p o rts can d ecrease
Im p act o f d ev alu atio n o n n et expo rts
N et E x po rts
T im e
Macroeconomic Themes:10
13
A Small open economy model of trade
P referen ce (C D orC E S ): U  U ( D , M )
expenditure : PY  P D  P M
D
M
T ran sform ation fu n ction (C E T ) :
T  T (E , D )
(1) T otal
(2)
(3)
PY  P D  P E
(4)
D
E
D = dom estically produced and consum ed good
M = im ports
E = exports
F rom optim izing behaviour on the dem and side,
T otal Incom e :
U
P
T
P
D 
D
E  E
R eal exch an ge rate: Macroeconomic
;
Themes:10
U
P
(1  t ) T D PD
M
M
14
Economy wide Income and Trade Balance in
a Small Open Economy
E conom y w ide incom e, I, trade balance and m arket
clearing conditions:
D om estic sales exports and T ariff:
IP DP ER
(6)
D
E
T rad e B alan ce con d ition :
P M P EB
(7)
M
E
D em an d an d su p p ly of d om estic good s:
DD  DS
(8)
P
P
M and E w orld prices of im ports and exports.
D om estic econom y is too sm all to change the w orld price.
Macroeconomic Themes:10
15
Global Trade model
P roduction :
 INT
j ,i , r

Y
 min 
i,r
 ai , j , r

1  r
 
,  K r L
i,r i,r



 


(1)
D om estic S upply and exports:
1

i,r
i , r  i , r

Y
  YD
 (1   ) X
i,r  i,r
i,r
i,r
i,r 



(2)

1

i,r
i , r   i , r

A
  YD
 (1   ) M
i,r  i,r
i,r
i,r
i,r 

A rm ington:
T ran sp ortation :

T
H ou seh old In com e:
R even u e:
(8)
(3)

P referen ces:
P u b lic sector:

i,r ,s

i,r ,s
M
i,r ,s

Ur  C
i,r
i,r
(4)
(5)
I r   wr L
 rr K
 RV r
i,r 
i,r
r
i
Gr 
 GD 
i ,r
i ,r
(6)
(7)
G r   rr K r   w w r L r   P Y

P INT
i,r i,r i,r
j ,i , r
N ,r i,r
k
Macroeconomic Themes:10
16
Equilibrium in the Global Trade Model
G oods M arket:
Y
i,r
INT
  a
 C
i, j ,r
r
,
j
,
i
r
,
i
r
rr , j
C apital M arket
 K r   K r , ri
r
i,r
L abour M arket:
LS r   LS
i,r
i
(9)
(10)
(11)
E quilibrium in the global trade m odel:
A co m p etitive eq uilib riu m in th is glo b al eco no m y is suc h that, given the p rices o f co m m o d ities
and facto rs, d e m a nd s fo r go o d and sup p ly o f go o d s are eq ual at the reg io nal as w ell as the glo b al level;
facto r m arke t clears fo r each reg io n and at the w o rld le vel; co n sum e rs o f eac h regio n m a xim ise their utility
sub ject to their inco m e co nstraints; a nd the go vern m e nt b ud get and trad e are b alanced fo r each regio n.
Macroeconomic Themes:10
17
Dornbusch (1976) Model of Exchange Rate Overshooting
r  r*  x
In terest rate p arity co n d itio n :
(1 )
A d ju stm en t o f th e in terest to th e d ev iatio n o f th e ex ch an g e rate:
x    e  e  (2 )


m  p   r  y
M o n ey d e m an d :
(3 )
B y su b stitu tin g (1 ) an d (2 ) in (3 )
m  p    r *     e  e     y






p  m   r *     e  e     y (4 )






In th e lo n g ru n ,
*
e  e  0  p  m   r  y
U sin g th is in (4 )
p  m  p  m     e  e  
e e 1






p  p   e  e  1


(5 )






p  p 

(6 )
T h u s th e cu rren t ex ch an g e rate d ep en d s o n th e lo n g ru n ex ch an g e
rate p lu s th e d ev iatio n o f cu rren t p rice fro m its tren d .
Macroeconomic Themes:10
18
N ow suppose the aggregate dem and fun ction of the econom y is given b y an IS curv e in
the open econom y m odel
ln D  u   e  p     1 y   r

(7)

In crease in the price is proportional to the ex cess dem and




p   ln  D    u   e  p     1 y   r 
Y 






In
run
(8)
the
lon g
p  0 . u   e  p     1 y   r   0 






 e  p   1    y   r   u


e  p  1 1    y    u


(9)

S im plify (8 ) using (9)




p   ln  D    u   e  p     1 y   r  
Y 











p   u   p    p  1  1    y   r *  u      1 y   r  




















p   u   p  p   r  r *  













 
Macroeconomic Themes:10
19
U sing the relation from (2) and (3) r  r *    e  e  and

ee  1




p  p 




p     p  p     e  e   




 
p     p  p     p  p    p     











p   v  p  p  w here v     






T he
tim e
path

of
the





price
level
thus
is


(6)
p  p  




p  t   p   p  p  exp   vt  .
0


e  e  1  p  p 
ee 1
F rom


 
 

the








tim e

path
e  t   e  e  e exp   vt 
0

of



the
p  p  exp(-vt)

exchange
Macroeconomic Themes:10
rate
is
20
References
K . A .C hrystal a nd S im o n P rice (1 9 94 ) C o ntro versies in M acro eco no m ics, H arve ster W heatshea f, chap ter 6 .
D o rnb usc h R ud iger (1 9 7 6 ) E xp ectatio ns and E xc han ge R ate, Jo urnal o f P o litical E co no m y, v o l. 8 4 , no .6 ,
p p . 11 6 1 -1 17 6 .
F le m in g J. M arcus (1 9 6 2 ) D o m e stic fina ncial p o licies u nd er fixed a nd und er flo atin g
excha n ge rates, IM F sta ff p ap er 9 , N o vem b er , 3 6 9 -3 7 9 .
K rug m a n P aul (1 9 7 9 ) A M o d el o f B alance o f P a ym e nt C risis, Jo urna l o f M o ne y C red it and B an king, 1 1 ,
A u g.
K rug m a n P . and L . T aylo r (1 9 7 8) “C o ntractio n ary E ffects o f D e valuatio n” Jo urnal o f Intern atio nal
E co no m ics, 4 4 5 -5 6 .
M iller, M arcus; S alm o n, M ark W he n D o es C o o rd inatio n P a y? Jo urnal o f E co no m ic D yn a m ics a nd C o ntro l,
July-O ct. 1 9 9 0 , v. 1 4 , iss. 3 -4 , p p . 55 3 -6 9
M und ell R . A (1 9 6 2 ) C ap ital m o b ility a nd stab ilisatio n p o licy und er fixed and fle xib le exch an ge rates,
C anad ia n Jo urnal o f E co no m ic and P o litical S cie nce, 2 9 , 4 75 -8 5 .
S eb astian E (1 9 8 6 ) A re D evalua tio ns C o ntractio nary? R eview o f E co no m ics a nd S tatistics, vo l. 6 8 , 3 , 5 01 508.
G .K .S ha w , M . J. M cC ro stie and D . G reena w a y (2 0 0 1 ) M acroeco no m ic s: T heo ry a nd P o licy in the U K ,
B lack w ell.
T aylo r M ark (1 9 9 5 ) T he E co no m ics o f E xcha n ge R ate s, Jo urnal o f E co no m ic L iterature, M arch, vo l 3 3 ,
N o . 1 , pp . 13 -4 7 .
Macroeconomic Themes:10
21