International Economics

Chapter 8 Balance of Payments Adjustments

Chapter 8 Balance of Payments Adjustments

8.1 Elasticities Approach

8.2 Multiplier Approach 8.3 Absorption Approach 8.4 Monetary Approach

8.1 Elasticities Approach

As a traditional approach to the balance of payments, elasticities approach assumes that capital flows occur only as a means of financing current account transactions. Derivation of the Demand for Foreign Exchange: The quantity of a currency demanded in the foreign exchange market is derived from the countrys demand for imports.

8.1 Elasticities Approach

PI

S S B

Price of iPod

800 700

Spot Exchange Rate (/$)

8.00 8.00 7.00 7.00

B A

DI O 8 10 QI

D$ O 800 1000 Q$

iPod Imports (in millions) (a)

Demand for dollars (in millions) (b)

Chinas Import Demand Curve and the Demand for dollar

8.1 Elasticities Approach

Elasticity

of Import Demand and the Elasticity of Foreign Exchange Demand.

PI S e S
B

Spot Exchange Rate (/$)

Price of iPod

800 700

8.00 8.00 7.00 7.00

B A

D I

DI O
6

D$ O
600

D$

10

QI

800

1000

Q$

iPod Imports (in millions) (a)

Demand for dollars (in millions) (b)

8.1 Elasticities Approach

Derivation of the Supply of Foreign Exchange The supply of foreign exchange to a country results from its exports of goods and services.
PT ST B

e
S

S$

Price of Toy

80 70

Spot Exchange Rate (/$)

8.00 8.00 7.00 7.00 A

60

80

QT

600

800

Q$

Toy Exports (in millions) (a)

Supply of dollars (in millions) (b)

8.1 Elasticities Approach

Elasticity of Export Supply and the Elasticity of Foreign Exchange Supply

PT ST B B

e
S

S$ S$

Spot Exchange Rate (/$)

ST

Price of Toy

80 70

8.00 8.00 7.00 7.00 A

60

80 100

QT

600

800

1000

Q$

Toy Exports (in millions) (a)

Supply of dollars (in millions) (b)

8.1 Elasticities Approach

The elasticities approach centers on changes in the prices of goods and services as the determinant of a countrys balance of payments and the exchange value of its currency.
a change in the exchange rate the domestic currency price of goods and services the quantity of foreign exchange

countrys balance of payments and exchange value

the quantity of goods and services

8.1 Elasticities Approach

The Current Account Deficit

e S$ S$ 8.00 7.50 7.00 D$ D$ 0 600 700 800 900 1000 Q$

8.1 Elasticities Approach

The Role of Elasticity The elasticities of the supply of and demand for foreign exchange are fundamental determinants of adjustment to a balance-of-payments deficit.

8.1 Elasticities Approach

The Marshall-Lerner Condition The Marshall-Lerner condition specifies the necessary condition for a positive effect of depreciation of domestic currency on the balance of payments.

8.1 Elasticities Approach

Assumption

Capital flows occur only as a means of financing current account transactions. Trade balance exclusively represents the current account.

8.1 Elasticities Approach

CA

in domestic currency:

CA PX eP * M

Derivate it with e:
Initial CA in equilibrium:

dCA dX dM P P * M eP * de de de
eP * M 1 PX dCA eP * M dX dM P P * M eP * de PX de de

Then:
Rearrange it:

Finally:

dCA dX e dM e P*M ( 1) de de X de M
x
dX e de X

dCA P * M (x m 1) de

, m dM

e de M

8.1 Elasticities Approach

A

depreciation to improve CA:

x m 1

dCA 0 de

So:

Marshall-Lerner condition states that a depreciation of domestic currency can improve a countrys balance of payments only when the sum of the demand elasticity of exports and the demand elasticity of imports exceeds 1.

8.1 Elasticities Approach

J-Curve Effect
A

depreciation of the domestic currency is unlikely to immediately improve a countrys balance-of-payments deficit. It is even possible that the depreciation could cause a countrys balance of payments to worsen before it improves.
BP Surplus C t2 Time

t0 A e

t1

B BP Deficit

8.1 Elasticities Approach

Reasons

for J-Curve Effect: Recognition lags of changing competitive conditions; Decision lags in forming new business connections and placing new orders; Delivery lags between the time new orders are placed and their impact on trade and payment flows is felt; Replacement lags in using up inventories and wearing out existing machinery before placing new orders; Production lags involved in increasing the output of commodities for which demand has increased.

Chapter 8 Balance of Payments Adjustments

8.1 Elasticities Approach

8.2 Multiplier Approach 8.3 Absorption Approach 8.4 Monetary Approach

8.2 Multiplier Approach

The multiplier approach is a modified and extended version of the elasticity analysis. The exchange rate is assumed fixed. The theory is suitable to analyze the adjustment process under a pegged regime. The only possibility for BP adjustment in this model is by changes in national income.

8.2 Multiplier Approach

Assumptions Underemployed resources; Rigidity of all prices; Absence of capital mobility; All exports are made out of current output.

8.2 Multiplier Approach

National income:

Y C I G (X M )

C C0 cY

I I0
G G0
X X0
M M 0 mY

Thus:

1 (C0 I 0 G0 X 0 M 0 ) 1 c m

8.2 Multiplier Approach

An expansionary fiscal policy (a rise in G0), an expansionary monetary policy (a rise in I0 resulting from lower interest rates), or added exports (a rise in X0) can increase national income.

dY dY dY 1 0 dG0 dI 0 dX 0 1 c m

While a contractionary fiscal policy, a contractionary monetary policy or reduced exports will decrease national income.

8.2 Multiplier Approach

An expansionary fiscal policy or an expansionary monetary policy can worsen a countrys current account (and then its balance of payments).

dCA dCA m 0 dG0 dI 0 1 c m

While a contractionary fiscal policy or monetary policy will improve its balance of payments.

8.2 Multiplier Approach

Added exports can improve a countrys current account (then its balance of payments).
dCA

1 c 0 dX 0 1 c m

While reduced exports will worsen its balance of payments.

8.2 Multiplier Approach

In conclusion, when an economy has underemployed resources, fiscal policy, monetary policy and trade policies can be used for adjusting its balance of payments.
Contractionary

fiscal or monetary policy can improve the balance of payments but at the cost of a decrease in national output. Added exports resulting from export-encouraging policies will improve the balance of payments and meanwhile, increase national income.

Chapter 8 Balance of Payments Adjustments

8.1 Elasticities Approach 8.2 Multiplier Approach

8.3 Absorption Approach

8.4 Monetary Approach

8.3 Absorption Approach

The absorption approach assumes that prices remain constant and emphasizes changes in real domestic income. Hence, the absorption approach is a real-income theory of the balance of payments.

8.3 Absorption Approach

A C I G Absorption: Y C I G (X M ) National income: Current account: CA X M => CA Y A Thus dCA dY dA It shows whether a currency depreciation can improve the current account (then the balance of payments) depends on its effect on national income and on domestic absorption.

8.3 Absorption Approach

The effect of depreciation on absorption can be divided into two parts:

dA a dY dAd The

induced effect of income changes resulting from depreciation on absorption: a dY The direct effect of depreciation on absorption: dAd

Therefore, the effects of depreciation on the current account:

dCA (1 a ) dY dA d

the income effect: (1 a) dY the absorption effect: dAd

8.3 Absorption Approach

Indirect Effects of Depreciation on National Income On the supply side, an effective depreciation requires idle resources in the economy. On the demand side, an effective depreciation requires the Marshall-Lerner condition to be met. From the perspective of governments macroeconomic regulation, an effective depreciation requires loosening protective or restrictive trade polices.

8.3 Absorption Approach

Direct Effects of Depreciation on Absorption Real cash balance effect

require Msto guarantee e P cash balance

expenditure
withdraw financial assets

C
Price of financial assets r C, I

dAd

8.3 Absorption Approach

Income

redistribution effect
P
W

Income redistribution from wage earners to profit earners

profit earners have lower MPC

dAd

8.3 Absorption Approach

Taxation effect
Require G/ T to guarantee

Nominal Y

Enter higher taxation levels

expenditure

dAd

8.3 Absorption Approach

In conclusion, the absorption approach proposes that depreciation can be effective in improving the balance of payments when the economy has idle resources; the economy meets the Marshall-Lerner condition; the government fulfills contractionary fiscal or monetary policy along with depreciation.

Chapter 8 Balance of Payments Adjustments

8.1 Elasticities Approach

8.2 Multiplier Approach 8.3 Absorption Approach 8.4 Monetary Approach

8.4 Monetary Approach

Leaning with or against the Wind

If

a central bank intervenes to support or speed along the current trend in the value of its countrys currency in the foreign exchange market, then economists say that its interventions are leaning with the wind. In contrast, a central banks interventions intended to halt or reverse a recent trend in the value of its countrys currency are leaning against the wind.

8.4 Monetary Approach

Foreign Exchange Intervention

Central banks

buy or sell financial assets denominated in foreign currencies in an effort to influence exchange rates. A central bank sterilizes foreign exchange interventions when it buys or sells domestic assets in sufficient quantities to prevent the interventions from influencing the domestic money stock. monetary base = domestic credit + foreign exchange reserves Sterilization of the sale of foreign exchange reserves requires an equally-sized expansion of domestic credit.

Sterilization of Intervention

8.4 Monetary Approach

Monetary Equilibrium Condition In equilibrium, the actual money stock equals the quantity of money demanded.
P e P*

Md=kPy

Md=keP*y Ms=Md m(D+F)=keP*y

Ms=m(D+F)

8.4 Monetary Approach

A Change in Domestic Credit under Fixed Exchange Rates

If the central bank increases domestic credit through an open market purchase of securities, the open market purchase causes the countrys money stock to rise. m(D+F)>keP*y Under fixed exchange rates, the countrys monetary authorities must sell foreign exchange reserves to meet the demand for foreign currency. As a result, foreign exchange reserves decline, while the spot exchange rate remains constant. Under fixed exchange rates, an increase in domestic credit generates BP deficit, while a decrease in domestic credit results in BP surplus.

8.4 Monetary Approach

A Change in Md under Fixed Exchange Rates

Suppose

that there is an increase in either the foreign price level or real income, causing an increase in the quantity of money demanded. m(D+F)<ke(P*y) To prevent the domestic currency from appreciating, the domestic monetary authorities must increase the quantity of money supplied so that it equals the quantity of money demanded. A rise in either the foreign price level or domestic real income results in BP surplus. Likewise, a decline in either the foreign price level or domestic real income results in BP deficit.

8.4 Monetary Approach

A Change in Domestic Credit under Flexible Exchange Rates

Suppose the domestic central bank increases domestic credit through a purchase of securities, causing domestic money stock to rise. m(D+F)>keP*y As households increase their expenditures on foreign goods and services, the domestic currency depreciates and BP keeps in equilibrium. Under flexible exchange rates, an increase in domestic credit results in a depreciation of the domestic currency, while a decline in domestic credit results in an appreciation of the domestic currency.

8.4 Monetary Approach

A Change in Md under Flexible Exchange Rates

If

the foreign price level or domestic real income increases, causing an increase in the quantity of money demanded. m(D+F)<ke(P*y) The decrease in demand for foreign goods and services causes the domestic currency to appreciate and BP keeps in equilibrium. Under flexible exchange rates, an increase in the foreign price level or domestic real income results in an appreciation of the domestic currency. In contrast, a decline in the foreign price level or domestic real income results in a depreciation of the domestic currency.