TOPIC 9
International Economics
Goals of Topic 9
•
What is the exchange rate?
•
NX back! What is the link between the exchange rate and net exports?
•
What is the current account? What is the role of global imbalances?
•
How do different shocks affect the exchange rate and net exports?
•
How do different policies affect the trade deficit?
•
What are potential problems in a monetary union?
2
Nominal Exchange Rate
•
The nominal exchange rate is the rate at which two currencies are exchanged
•
Example:
E
l the
th nominal
i l exchange
h
rate
t between
b t
the
th US dollars
d ll andd the
th euro is
i 0.7
07
euro per dollar
•
It means that 1 dollar can buy 0.7 euro in the foreign exchange market (the
market for international currencies)
•
Definition:
enom = nominal
o
exchange
e c
ge ratee = number
u be of
o units
u s of
o foreign
o e g currency
cu e cy that can
c
be purchased with 1 unit of domestic currency
3
Real Exchange Rate
•
If you know that enom = 0.7 euro, do you know if it is cheaper to leave
in Europe or in the US?
•
NO! You need information about prices …
•
The real exchange rate is the price of domestic goods relative to
foreign goods
•
Definition:
e = real exchange rate = number of foreign goods that can be
obtained in exchange for 1 unit of the domestic good:
e = (enom · P) / Pf
4
Purchasing Power Parity (PPP)
•
How are nominal and real exchange rates related?
•
Imagine two countries produce and consume the same good
•
If the good is freely traded,
traded then the real exchange rate must be 1!
•
PPP = the price of the domestic good must equal the price of the
foreign good, in terms of domestic currency:
P = Pf / enom → enom = Pf / P → e = 1
•
Empirical evidence: PPP tends to hold in the long run, but not in the
short run. Why? Non-traded goods, trade tariffs, monopoly power…
5
Why Does the Real Exchange Rate Matters?
•
Real exchange rate represents the rate at which domestic goods (and services)
can be traded for those produced abroad
•
Why an increase in the real exchange matters?
•
It increases the price of domestic goods relative to foreign goods
•
Substitution effect → net export is going to be lower
•
Example: dollar appreciates → German cars become cheaper relative to US
carss → Americans
ca
e ca s demand
de a d more
o e Ge
German
a cars,
ca s, so import
po increases,
c eases, and
a d
Germans demand less US cars, so export decreases → NX decrease!
•
IMPORTANT: NX is a decreasing function of the exchange rate
6
Different Exchange Rate Systems
•
In a flexible (or floating) exchange rate system, exchange rates are
y demand and supply
pp y in the foreign
g exchange
g market
determined by
•
In a fixed exchange rate system, exchange rates are set at officially
predetermined levels → the central bank commits to buy and sell its own
currency at that rate (e.g. gold standard, Bretton Woods)
•
We focus on flexible exchange rate system and think about two
countries: the domestic (US) and the foreign country (Europe)
•
We focus on how the nominal exchange rate is determined
•
Increase in the exchange rate = appreciation
•
Decrease in the exchange rate = depreciation
7
How Is the Exchange Rate Determined?
Value of dollar
Supply of dollars
enom
Demand of dollars
Dollars traded
Number of dollars
Value of the dollar (in euros) = exchange rate
8
Demand and Supply
•
Supply for dollars is upward-sloping: when the value of the dollar is higher
(you get a lot of euros for 1 dollar), people supply more dollars
•
Demand for dollars is downward-sloping: when the value of the dollar is
higher (you have to pay a lot of euros for1 dollar), people demand less dollars
•
The amount of dollars traded in equilibrium and the equilibrium exchange
rate is determined by the intersection of demand and supply
•
Why do Europeans demand dollars?
1. To buy US goods and services (US exports)
2. To buy US real and financial assets (US financial inflows)
•
Why do Americans supply dollars (to get euros)?
1. To buy European goods and services (US imports)
2. To buy European real and financial assets (US financial outflows)
9
Increase in Quality of US Exports (iPad)
Value of dollar
Demand of dollars
Supply of dollars
enom
Dollars traded
Number of dollars
If Europeans wants to buy more US goods, they have to buy more dollars!
Hence, the value of dollar increases = appreciation of the dollar
(Movement along demand: substitution effect tend to reduce NX back)
10
Increase in US GDP
Value of dollars
Demand of dollars
Supply of dollars
enom
Dollars traded
Number of dollars
Americans want to consumer more of all goods, including European ones
Hence they need more euros…
Hence,
euros
11
Changes in GDP
•
Increase in US GDP:
1 Eff
1.
Effectt on nett exports:
t when
h domestic
d
ti income
i
rises,
i
consumers will
ill spendd
more on all goods, including imports → NX decreases (everything else
equal)
2 Effect
2.
Eff t on exchange
h
rate:
t tto iincrease iimports
t they
th needd more euros →
they must supply more dollars → the dollar depreciates
•
Increase in European GDP:
1. Effect on net exports: when European income rises, European consumers
will spend more on all goods, including US goods → US exports
increase and NX increases
2. Effect on exchange rate: to buy more US goods, Europeans need more
dollars → demand for dollars increases and the dollar appreciates
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Increase in US real interest rate
Value of dollars
Demand of dollars
Supply of dollars
enom
Dollars traded
Number of dollars
American assets are more attractive and
• Europeans
E
needd more dollars
d ll to
t invest
i
t in
i them
th …
• Americans need more dollars to invest in them …
13
Increase in US prices
Value of dollars
Demand of dollars
Supply of dollars
enom
Dollars traded
Number of dollars
If US goods are more expensive
• Americans want to buy more European goods
• Europeans want to buy less US goods
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Summing up…
•
GDP:
1. Increase in US GDP decreases NX and the dollar depreciates
2 Increase
2.
I
in
i European
E
GDP increases
i
NX andd the
th dollar
d ll appreciates
i t
•
Interest rate
1. Increase in US real interest rate appreciates the dollar
2. Increase in European real interest rate depreciates the dollar
•
Prices:
1. Increase in US prices decreases NX and the dollar depreciates
2 Increase
2.
I
in
i European
E
prices
i
increases
i
NX andd the
th dollar
d ll appreciates
i t
•
BUT these are partial equilibrium effects… we will see the general
equilibrium with the IS-LM model soon!
15
Current Account
•
Current account = net exports + net factor payments
CA = NX + NFP
•
Current account identity: CA = change in the net financial position of a
country towards
d the
h rest off the
h world
ld
•
Usually net factor payments are relatively small so use CA ≈ NX
•
Trade in assets compensates for trade in goods: if we buy more foreign goods
then we must sell more domestic assets to foreigners
g
to gget the foreign
g
currency needed
•
Always 2 sides of a CA deficit: a portfolio side and a trade side!
16
Global Imbalances
17
Are Global Imbalances to Blame for the Crisis?
•
One story:
•
g g economies want to accumulate safe assets
Emerging
1.
2
2.
Demographics/lack of social insurance
Protection for capital flights
•
They buy US Treasuries (CA deficit increases) pushing down interest rates
•
Bernanke pointed out this “global saving glut” in 2005
•
Interest rates are low → private banks search for yield → increase in
demand for AAA-rated assets with higher returns (MBS,…)
•
This saw the seeds for the current crisis
18
Two Views (and My Comments)
1.
Sachs: who really made interest rates low is the Fed, not Asian countries,
so the Fed is to blame
BUT
•
•
2.
but the Fed objective is to keep Y=Y* if there is no inflation
→ keep r low if NX drops (because of dollar appreciation)
Krugman: the problem of the story is that bankers are greedy
BUT
•
•
•
if there
th is
i limited
li it d supply
l off safe
f assets
t andd demand
d
d increases
i
the
th market
k t
(the banks) is just responding to this scarcity by “creating” more safe
assets (Caballero)
Ho sing usually
Housing
s all is prett
pretty safe
safe...
So the underlying forces are going to stay with us even after the crisis
19
Open-Economy IS-LM Model
•
LM not affected
•
FE not affected
•
IS affected by NX!
Still downward sloping: as r increases,
increases e appreciates and NX decreases
•
Remember: in an open economy, the good market equilibrium is now
Y = C(Y,r,…) + I(r,…) + G + NX(Y,r,…)
or
S – I = NX
•
The excess of national savings over investment is the amount US residents
want to lend abroad and net export is the amount that foreigners (Europeans)
want to borrow from US
20
Factors that shift the IS curve
The IS curve shifts to the right because of:
•
A ffactor
Any
t th
thatt shifts
hift the
th closed
l d economy IS curve
•
Anything that rises NX, given Y and r:
1. An increase in foreign GDP (Yf)
2. An increase in foreign interest rate (rf)
3 A shift
3.
hift in
i the
th world
ld ddemand
d ttowards
d th
the US goods
d (world
(
ld tastes)
t t )
•
That is, net exports can be represented as NX(Y,r, Yf,rf, world tastes,…)
21
International Transmission of the Business Cycle
•
The impact of foreign economic conditions on NX and the real exchange
rate is the principal reason why cycles are transmitted internationally
•
Imagine US is the major importer from Europe
•
If US is in recession, Europe net exports decrease and this can generate a
recession in Europe as well
•
Similarly, a change in world taste for European goods can generate a
recession in Europe
•
Let’s see now the effect of fiscal and monetary policies when US is an
open economy …
22
Monetary Policy in Open Economy
•
Suppose the Fed cut the federal fund rate = real money supply increases
•
As in a closed economy: the monetary policy decreases real interest rate and
stimulates investment and consumption (movement along the IS)
•
Labor market is not affected
•
+ effect on exchange rate …
23
Monetary Policy in Open Economy
For simplicity, imagine that prices are fixed (SRAS version 1 in the background)
LM
r
enom
S of
Dollars
D of
Dollars
IS
Y*
Y
Dollars
24
Monetary Policy in Open Economy
•
Start at a given exchange rate: expansionary monetary policy
11.
2.
r decreases
d
Y increases → NX decreases
→ increase in dollar supply and decrease in dollar demand
•
The dollar depreciates!
•
Dollar depreciation decreases imports and increase exports → NX increases
•
The final effects: Y ↑, P ↑, r ↓, e ↓, NX ambiguous
•
In the long run, money is still neutral! (prices adjust and LM shifts back
but also the real exchange rate goes back)
25
Fiscal Policy in Open Economy
Imagine G increases (assume agents are non-Ricardian and do not think PVLR changes)
LM
r
enom
S of
Dollars
D of
Dollars
IS
Y*
Y
Dollars
26
International Crowding Out
•
Exchange rate effect: ambiguous
11. IIncrease in
i Y tends
t d to
t decrease
d
NX andd depreciates
d
i t the
th dollar
d ll
2. Rise in r tend to appreciate the dollar
•
Which one dominates? It depends on the size of the changes, but typically
the interest rate effect dominates
•
If the interest rate effect dominates, the dollar appreciates, and NX will
unambiguously decrease
•
International crowding out : in an open economy, the increase in imports
crowds out some of the effects of expansionary fiscal policy
•
Hence, the fiscal policy is less effective in the short run (if dollar
appreciates)
27
Fixed Exchange Rates and Currency Union
•
•
If the exchange rate is fixed, and there is a depreciation pressure from the
private market, there are three possibilities:
1.
the country changes the official exchange rate (devaluation)
2
2.
the government restrict international transactions,
transactions such as taxes on
imports or financial outflows (inconvertible currency)
3
3.
the
h centrall bank
b k becomes
b
a demander
d
d andd supplier
li off currency to
counteract the private market forces (convertible currency)
For a country in a currency union (e.g., Greece), any shock that would affect
the exchange rate is absorbed by automatic changes in the country money
supply (euros flow in and out freely)
28
A Recession with Flexible Exchange Rate
Greece before the Euro: effects of a drop in consumer confidence
LM
r
enom
S of
Dracma
D of
Dracma
IS
Y*
Y
Dracma
29
A Recession with Fixed Exchange Rates
Suppose the Greek central bank keeps the Dracma exchange rate fixed
LM
r
enom
S of
Dracma
D of
Dracma
IS
Y*
Y
Dracma
In a currency union, the same happens automatically, as outflows of euros shift
the LM
30
What Should We Have Learned
•
What is the nominal and the real exchange rate
•
When we think about an open economy we have to think about an extra
market: the exchange rate market
•
A appreciation
An
i i off the
h exchange
h
rate tendd to reduce
d
NX
•
What is the impact of a change in Y, r and P on the exchange rate and NX
•
Open-economy IS-LM
•
Monetary and fiscal policies now also have effects through the exchange rate
•
In a currency union it is harder to respond to local shocks
31
Final Exam
When? NEXT WEEK (Afternoon sections 3-6 pm, Evening section 6:30-9:30 pm)
How long? 3 hours
Grading Policy (again!):
30% quizzes, 70% midterm and final
I count midterm ‘once’ and final ‘twice’
I will drop the lowest observation and average the
other two
→ Final counts up to 70% of your grade
→ Study hard!
Readings/Must Reads:
Lecture Notes for Topic 1- 9 + all related book chapters
listed in the syllabus
Closed Book.
Calculator recommended.
Cheat Sheet:
2 PAGES, 2 SIDED – HANDWRITTEN OR TYPED BY
YOURSELF ((FONT 12 minimum,, NO FOTOCOPIES FROM
BOOK OR SLIDES)
Good luck!!!
32