Macroeconomics in Open Economies: European Perspective on Trade Balance and Exchange Rates, Apuntes de Economía

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Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 II.1 ECONOMIC POLICY IN AN OPEN ECONOMY Ch. 18 in Blanchard-Amighini-Giavazzi a) Domestic demand in Open Economies b) Exchange rate depreciation and trade balance c) Policy analysis in an Open Economy with flexible exchange rates d) Policy analysis in an Open Economy with Fixed exchange rates Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 18.2 • Recall that the real exchange rate is given by : that is, equal to the nominal exchange rate E times the domestic price level P, divided by the foreign price level P*. • A change in the real exchange affects net exports in three ways: • Volume of exports X, • Volume of imports IM, • the relative price of foreign goods in terms of domestic goods, 1/ε. * EP P ε ≡ ( , ) ( , ) /NX X Y IM Yε ε ε∗= − II.1a Domestic demand in an Open Economy Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 18.5 Increases in Foreign Demand For given price level, expectations and interest rates, an increase in foreign demand (e.g. in foreign income) leads to: • an increase in aggregate demand for domestic goods, • a trade surplus (exports increase, imports increase with income but less than exports). Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 18.6 • Shocks to demand in one country affect other countries (the stronger the trade links, the stronger the interaction and comovements). • Trade deficits mean a country borrows from the rest of the world, increasing its foreign debt; so countries prefer increases in foreign demand to increases in domestic demand. • Thus, countries may be reluctant to take expansionary measures for domestic demand, waiting for the others to increase their demand, and this e.g. can delay the recovery from a common recession. Implications Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 18.7 • But if all countries wait for others to take measures to increase domestic demand, nothing happens and recessions may last longer. • Coordination would avoid the problem: when all countries coordinate their macroeconomic policies to increase domestic demand simultaneously, equilibrium output increases in all countries without increasing trade deficit. • However, evidence shows that macro-coordination is very limited because of: • disagreements on how to share the adjustment (countries that are not in recession or that have large budget deficits want others to do more); • incentives to deviate from the promises once an agreement is reached. Coordination Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 18.10 Saving, Investment and the Trade Balance • Goods market equilibrium condition for the open economy is: /Y C I G IM Xε= + + − + /S I G T IM Xε= + − − + ( )NX S T G I= + − − • The alternative way of looking at equilibrium from the point of view of investment and saving: subtract C and T from both sides and use the fact that private saving is given by S = Y – C – T to get NX X IM≡ − /ε• Using the net exports definition, and reorganizing terms, we get: • It follows that a trade surplus corresponds to an excess of saving over investment, and a trade deficit an excess of investment over saving. Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 18.11 The trade balance in equilibrium is equal to the difference between total saving (private and public) and investment: trade surplus if S+(T-G)>I, trade deficit if S+(T-G)<I. • An increase in investment must be reflected in either an increase in private saving or public saving, or in a deterioration of the trade balance. • An increase in the budget deficit must be reflected in an increase in either private saving, or a decrease in investment or a deterioration of the trade balance. • A country with a high saving rate must have either a high investment rate or a large trade surplus. ( )NX S T G I= + − − Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 18.12 • A real depreciation has ambiguous effects on net exports and trade balance: • For the trade balance to improve following a depreciation, the increase in exports and the decrease in imports must be enough to compensate for the increase in the price of imports. • This is the so-called Marshall-Lerner condition: –(dX/dε) (ε /X) +(dM/dε) (ε /M) –1 > 0→ dNX/dε <0 • Example: 1% real depreciation → 0,9% increase in exports, 0,8% decrease in imports → dNX/X = 0,9% – (– 0,8%) – 1% = 0,7% (i.e. net exports increase) • Note that the quantity of imports IM decreases but its value IM/ε increases. ( , ) ( , ) /NX X Y IM Yε ε ε∗= − II.1b Exchange Rate Depreciation and Trade Balance Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 18.15 Figure 18.5 The J-curve A real depreciation leads initially to a deterioration and then to an improvement of the trade balance Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 18.16 Figure 18.6 The real exchange rate and the ratio of the trade deficit to GDP: USA, 1980–1990 • The real appreciation and depreciation of the dollar in the 1980s were reflected in increasing and then decreasing trade deficits. • There were, however, substantial lags in the effects of the real exchange rate on the trade balance. Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 18.17 Combining Exchange Rate and Fiscal Policies • How to reduce trade deficit leaving output unchanged? To achieve two targets, the government needs two instruments. • Example: output at the natural level, large trade deficit; How to improve trade balance without increasing demand? • Combining a depreciation with a contractionary fiscal policy. • Depreciation to increase net exports and eliminate the trade deficit. • Reducing domestic demand to compensate for the increase in foreign demand. • If instead the economy is in a recession with trade deficit, a depreciation would help on both targets (reducing the trade deficit and increasing output). Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 6.20 • In general, given expectations of future exchange rates, an increase in domestic interest rates (relative to foreign interest rates) will attract capital inflows. • The higher demand for domestic currency will cause its appreciation (an increase in the nominal exchange rate Et). ↑i (rel. to i*) → ↑demand for dom. assets → ↑demand for dom. currency → ↑E (exchange rate appreciation) • Vice versa, a decrease in domestic interest rates (relative to foreign interest rates) will cause capital outflows and a depreciation (a decrease in the nominal exchange rate Et). Interest Rates and Exchange Rates Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 6.21 The effects of an increase in government spending: IS curve to the right → interest rate increases → exchange rate appreciation → net exports decrease → output increases in short run but less than in closed economy Fiscal Policy with Flexible Exchange Rates Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 6.22 • Fiscal policy is less effective in an open economy with flexible exchange rates: • An expansionary fiscal policy (an increase in G or a decrease in T) increasing aggregate demand (shifting the IS to the right), also increases interest rates (r and i), attracting capital inflows and causing an appreciation of the nominal exchange rate, which leads to a higher real exchange rate (higher relative price of domestic goods), which decreases net exports: ↑G → ↑Y, ↑r, ↑i → not only ↓I, but also ↑capital inflow → ↑E (exchange rate appreciation) → ↑ε (real exchange rate appreciation) → ↓NX (also for ↑Y – smaller multiplier) • The negative effect on net exports reduces the expansionary effect on aggregate demand. • A contractionary fiscal policy would also be less effective, leading to a lower i and a depreciation which increases net exports. Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 18.25 • Central banks act under implicit and explicit exchange rate targets, and use monetary policy to achieve those targets. • Some countries operate under fixed exchange rates. These countries maintain a fixed exchange rate in terms of some foreign currency (e.g. they peg their currency to the dollar or to the euro) • Some countries operate under a crawling peg: they typically have inflation rates that exceed the one in the reference country (e.g. the US) and choose a predetermined rate of depreciation. II.1d Policy Analysis in an Open Economy with Fixed Exchange Rates Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 18.26 • Some countries maintain their bilateral exchange rates within some bands. The most prominent example is the European Monetary System (EMS). • Under the EMS rules, member countries agreed to maintain their exchange rate vis-á-vis the other currencies in the system within narrow limits or bands around a central parity. • Some countries moved further, agreeing to adopt a common currency, the euro, in effect, adopting a ‘fixed exchange rate’. Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 18.27 The interest parity condition is: 1+it = (1+it*) (Et/E e t+1). • Suppose the country decides to peg its exchange rate at some chosen value Et = Eº. If credible, E e t+1= Eº, implying it = it*: → with fixed exchange rates and perfect capital mobility, the domestic interest rate has to be equal to the foreign interest rate. • But then any change in money demand must be matched by a change in the money supply to maintain the interest rate constant: → the central bank loses control of monetary policy as an autonomous instrument. Monetary Policy under Fixed Exchange Rates