Balance of Payments
Adjustment
Thorvaldur Gylfason
Outline
1. Real versus nominal exchange rates
2. Balance of payments adjustment
and welfare
3. The scourge of overvaluation
4. Balance of payments adjustment
through economic policy
Real versus nominal
exchange rates
eP
r
P*
Increase in r
means real
appreciation
r = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
Real versus nominal
exchange rates
eP
r
P*
Devaluation or
depreciation of the
currency – i.e.,
decrease in e –
makes r also
decrease unless P
rises so as to leave r
unchanged
r = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
Balance of payments and
welfare Payments for imports of
Real exchange rate
goods, services, and
capital
Imports
Earnings from exports of
goods, services, and
capital
Exports
Foreign exchange
Balance of payments and
welfare
Equilibrium between demand and
supply in foreign exchange market
establishes
Equilibrium real exchange rate
Equilibrium in the balance of payments
BOP = X + Fx – Z – Fz
=X–Z+F
= current account + capital account
=0
Real exchange rate
Balance of payments
adjustment and welfare
Deficit
Imports
Overvaluation
Exports
Foreign exchange
Price of foreign exchange
Balance of payments
adjustment and welfare
Supply (exports)
Overvaluation works
like a price ceiling
Overvaluation
Deficit
Demand (imports)
Foreign exchange
Market equilibrium and
economic welfare
Price
A
B
C
Consumer
surplus
E
Producer
surplus
Supply
Total welfare gain associated
with market equilibrium equals
producer surplus (= ABE) plus
consumer surplus (= BCE)
Demand
Quantity
Market intervention and
economic welfare
Consumer surplus = AFGH
Producer surplus = CGH
Price
Welfare
loss
A
J
F
B
E
Supply
Price ceiling imposes a
welfare loss equivalent to
the triangle EFG
Price ceiling
H
G
C
Total surplus = AFGC
Demand
Quantity
The scourge of
overvaluation
Governments may try to keep the
national currency overvalued
To keep foreign exchange cheap
To have power to ration scarce foreign
exchange
To make GNP look larger than it is
Other examples of price ceilings
Negative real interest rates
Rent controls
Market intervention and
economic welfare, again
Price
Welfare
loss
A
J
F
B
E
Price ceiling imposes a
welfare loss equivalent to
the triangle EFG
Price ceiling
H
G
C
Supply
Shortage
Demand
Quantity
Inflation and overvaluation
Inflation can result in an overvaluation
of the national currency
Remember: r = eP/P*
Suppose e adjusts to P with a lag
Then r is directly proportional to the
price level P
Numerical example as follows
Inflation and overvaluation
Real exchange rate
Suppose inflation is
10 percent per year
Devaluation
110
105
100
Average
Time
Inflation and overvaluation
Real exchange rate
Suppose inflation rises
to 20 percent per year
120
110
Hence, increased
inflation increases
the real exchange
rate as long as
the nominal
exchange rate
adjusts with a lag
Average
100
Devaluation
Time
How to correct
overvaluation
Under a floating exchange rate regime
Adjustment is automatic: e moves
Under a fixed exchange rate regime
Devaluation 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
condition: Theory
T = eX – Z
= eX(e) – Z(e)
Not obvious that a lower e helps T
When 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
a  b 1
The Marshall-Lerner
condition: Evidence
Econometric studies indicate that the
Marshall-Lerner condition is almost
invariably satisfied
Industrial countries: a = 1, b = 1
Developing countries: a = 1, b = 1.5
Hence,
a  b 1
Empirical evidence from
industrial countries
Austria
Belgium
Canada
France
Germany
Italy
Japan
Netherlands
Sweden
United Kingdom
United States
Elasticity of
exports
1.0
1.1
0.7
1.3
1.0
1.3
1.4
1.5
1.6
1.0
1.2
Elasticity of
imports
1.2
1.3
1.3
0.9
0.8
0.8
1.0
0.7
0.9
1.3
1.2
Average
1.2
1.1
The importance of appropriate
side measures
Remember:
eP
r
P*
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
Balance of payments
adjustment and economic policy
Price level
Aggregate supply
An increase in prices induces
producers to produce more, so
that aggregate supply increases
Equilibrium
P
An increase in prices induces
consumers to buy less, so that
aggregate demand decreases
Aggregate demand
Y
GNP
Experiment: Export boom
Price level
AS
AD
GNP
Experiment: Export boom
Price level
B
A
AS
Exports increase, so that
aggregate demand expands
AD’
AD
GNP
Experiment: Export boom
Price level
B
A
AS
Excess demand
drives prices up
C
AD’
AD
GNP
Experiment: Export boom
Price level
B
AS
As the price level rises,
so does GNP along the
upward-sloping AS curve
A
AD’
AD
GNP
Comments on experiment
An export boom stimulates aggregate demand
because Y = C + I + G + X - Z
Therefore, 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 policy
Economic policy instruments
Exogenous 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 targets
Endogenous variables




GNP level or growth
Price level or inflation
Employment, unemployment
BOP, exchange rate (if flexible), external debt
Aims of economic policy
Apply policy instruments to attain given
economic objectives
External balance: conduct monetary, fiscal, and
exchange rate policy so as to make the
balance of payments position sustainable
Key to financial programming
Not only crisis management in short run
Internal balance: conduct policy so as to foster
rapid, sustainable economic growth with low
inflation and unemployment
Key to economic and social prosperity
Aggregate demand
Y=C+I+G+X–Z
C = c(Y-T) = (1-s)(1-t)Y
where s = saving rate and t = tax rate
I = k(M/P)
through interest rates
G = exogenous
X = aY* - br
Z = mY + cr
where r = eP/P* (real exchange rate) and
increase in r means appreciation, as before
Monetary expansion shifts
AD schedule right
Aggregate demand
Domestic
Y = (1-s)(1-t)Y + k(M/P) + G + credit
(aY* - b(eP/P*)) – (mY + c(eP/P*))
which means:
Y = F(P; M, G, t, e; Y*, P*)
- + + - - +
+
Aggregate demand schedule slopes down
via real balances and the real exchange rate
... and shifts in response to changes in
exogenous variables, including policy
AD schedule slopes down
Devaluation shifts AD schedule right
Aggregate supply
Y = 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 up
through real wages
... and shifts in response to changes in exogenous
variables, including nominal wages and other
costs, e.g., price of imported oil
Macroeconomic equilibrium
Price level
AS
W up
M up; G up; t down; e down
AD
GNP
Monetary or fiscal expansion
Price level
AS
B
A
An increase in M or
G or a decrease in t
increases both Y
and P for given W
AD’
M up; G up; t down
AD
GNP
An increase in wages
AS’
Price level
AS
W up
B
An increase in W
increases P, but
reduces Y
An increase in the
price of imported
oil has the same
effect: stagflation
A
AD
GNP
Devaluation
Price level
B
W up
A
AS’
AS
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
AD’ raises the price of
e down
oil and other
imported inputs.
AD
GNP
Balance of payments
B=X–Z+F
X = aY* - br
Z = mY + cr
r = eP/P*
F = exogenous
B = 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)
Balance of payments adjustment
Price level
Can offset decrease
in aggregate demand
by increasing e or F
A
M or G down, t up
Suppose, at A, there is a deficit
in the balance of payments (B  0)
AS
e or F up
AD
Then, to reduce deficit, must
reduce M or G or raise t to
reduce demand (shift AD left)
End result is still point A, but
now with balance of payments
equilibrium (B = 0). Level of
GNP is unchanged, but its
composition has changed.
GNP
Macroeconomic adjustment and
structural reform
Price level
Stimulate supply side
by liberalization,
stabilization,
privatization, etc.
AD’
Start, at A, with a deficit in the
balance of payments (B  0)
AS
Then, to reduce deficit, try to
stimulate supply (shift AS right)
AS’ in addition to reducing demand
A
E
M or G down, t up
AD
End result is point E
with balance of payments
equilibrium (B = 0). Level of
GNP is unchanged, but its
composition has changed.
Price level is lower.
GNP
Conclusion
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 growth