Lecture Highlights All countries are linked internationally through trade in goods and through financial markets. The exchange rate (ER) is the price of a foreign currency in terms of domestic currency (ringgit). A high exchange rate a week ringgit reduces imports and increases exports, stimulating AD. Under fixed exchange rates, CB buys and sells foreign currency to fix the exchange rate. Under floating exchange rates, the market determines the value of one currency in terms of another. If a country wishes to maintain a fixed ER in the presence of a BP deficit, the CB must buy back domestic currency, using its reserves of foreign currency and gold or borrowing reserves from abroad. In the LR, ER adjust so as to equalize the real cost of goods across countries. With perfect capital mobility and fixed ER, fiscal policy is effective. With perfect capital mobility and floating ER, monetary policy is effective. 2 International Linkages Any economy is linked to the rest of the world through two broad channels: (i) Trade (in goods & services) (ii) Finance The trade linkage means that some of a countrys production is exported to foreign countries, whole some goods that are consumed/ invested at home are produced abroad and imported. The basic IS-LM model of income determination must be amended to include international effects. 3 Contd. The prices of Malaysian goods relative to those of our competitors have direct impacts on demand, output and employment. A decline in the ringgit prices of our competitors, relative to the prices at which Malaysian firms sell, shifts demand away from Malaysian goods toward goods produced abroad. e.g. exchange rate from US$1 = RM3 to US$1 = RM2 Our imports Our exports 4 International links in the area of finance Malaysian citizens whether households, banks, or corporations, can hold Malaysian assets such as Treasury bills or corporate bonds or they can hold assets in foreign countries. International investors shift their assets around the world, they link asset markets here and abroad affect income, exchange rates, and the ability of monetary policy to influence interest rates. 5 The balance of payments and exchange rates The balance of payments (BP) is the record of the transactions of the residents of a country with the rest of the world. 2 main accounts in BP: (i) The current account - Records trade in goods and services, as well as transfer payments. Services include freight, royalty payments, and interest payments. Transfer payments consist of remittances, gifts, and grants. trade balance records trade in goods + trade in services and net transfers current account balance 6 Contd. (ii) The capital account records purchases and sales of assets, such as stocks, bonds, and property. net capital inflow capital account surplus. External accounts must balance if a country runs a deficit in its current a/c the deficit needs to be financed by selling assets or by borrowing abroad. These sales of assets or borrowing the country is running a capital a/c surplus. Current a/c deficit + net capital inflow = 0 Capital a/c has 2 components: (i) The transactions of the countrys private sector (ii) Official reserve transactions the CBs activities 7 Contd. A current a/c deficit can be financed by private residents selling off assets abroad or borrowing abroad or Current a/c deficit can be financed by the government, which runs down its reserves of foreign exchange, selling foreign currency in the foreign exchange market. The increase in official reserves the overall BP surplus BP surplus = increase in official exchange reserves = current a/c surplus + private net capital inflow 8 Exchange rates and the market for foreign exchange Demand for foreign currencies by domestic residents DD for foreign exchange Foreign exchange market - The market in which national currencies are traded for one another. The link between the BP a/c and transactions in the foreign exchange market. - All expenditures by all Malaysian on foreign goods, services or assets represent DD for foreign currencies. 9 Contd. - Malaysian buying a computer from US pays it in ringgit, but the American exporter will expect to be paid in dollar. So ringgit must be exchanged for dollar in the foreign exchange market. - Malaysian exporters will expect to be paid in ringgit, and to buy our goods, foreigners must sell their currency and buy ringgit. 10 DD & SS in the Foreign Exchange Market (FOREX) We assume that CBs do not intervene in the FOREX market. We relax this assumption later. We assume that there are only 2 countries Malaysia and the USA. Malaysia ringgit USA dollar The exchange rate the relative price of the two currencies. We express as the price of the dollar in terms of ringgit. e.g. if the price of the dollar is US$1 = RM3.50 OR RM1 = US$0.28 11 Contd. A higher exchange rate means that the price of FOREX has risen. When ex.rate foreign currency has appreciated or the ringgit has depreciated. ex.rate the price of FOREX has declined. The dollar has depreciated while ringgit has appreciated. 12 DD & SS of FOREX Sfe Dfe eo Forex rate SS & DD for FOREX 13 Contd. Malaysian imports are DD for FOREX. DD for FOREX vary with the price of FOREX. Dfe downward-sloping as the price of FOREX Dfe FOREX the cost in terms of ringgit (import prices become more expensive) Imports Less FOREX will be demanded 14 Contd. e.g. Suppose that you are considering the purchase of an American computer that costs US$1,000. If the ex.rate US$1 = RM3.50 The computer will cost RM3,500 If the ex.rate US$1 = RM4.00 The computer will cost RM4,000 The higher the exchange rate, the higher the ringgit cost of imported goods DD for FOREX 15 Contd. The SS schedule for foreign exchange is drawn with a positive slope. The SS of FOREX as ex. Rate As the ex.rate Malaysian goods become less expensive to Americans. Holding all other prices, including the ringgit price of Malaysian exports fixed. e.g. Malaysian product that sell for RM100 would cost US$28 at an ex.rate US$1 = RM3.50 or RM1 = $US0.28 But the product would cost US$25 at ex.rate US$ = RM4.00 or RM1 = US$0.25 DD for Malaysian exports as the ex.rate as the ex.rate 16 Flexible Exchange Rate (floating rate) In a flexible exchange rate system, the central banks allow the exchange rate to adjust to equate the SS and DD for foreign currency. If the ex.rate were US$1 = RM3.50 and American exports to Malaysia DD for dollars by Malaysians. Central banks stand aside completely and allow ex.rates to be freely determined in the FOREX markets. In the above example, the ex.rate could move from RM3.50 per dollar to RM3.55 per dollar Making American goods more expensive in terms of ringgit. DD for American goods by Malaysians. 17 Effect in the FOREX market of an increase in the DD for imports Sfe Dfe eo ex rate SS & DD for FOREX Dfe e An autonomous increase in import DD shifts the DD for FOREX from Dfe to Dfe. At the initial equilibrium exchange rate (eo) excess DD FOREX. The exchange rate to e to re-equilibrate SS and DD in the FOREX. 18 Fixed exchange rates/ pegging the exchange rate In a fixed exchange rate system, foreign central banks stand ready to buy and sell their currencies at a fixed price in terms of other currency. Assume that the central bank of Malaysia (Bank Negara) wishes the exchange rate for the ringgit: US$1 = RM3.50 (RM1= US$0.28) The official fixed exchange rate US$1 = RM3.50 is below the equilibrium exchange rate. (see next slide)
19 DD & SS of FOREX Sfe Dfe 3.60 ex rate SS & DD for FOREX 3.50 XDfe At US$1 = RM3.50 Ringgit overvalued Dollar undervalued 20 Contd. The fixed exchange rate US$1 = RM3.50 is below the market equilibrium rate US$1 = RM3.60 excess DD (XD) for FOREX. To keep the exchange rate at US1 = RM3.50 Bank Negara will buy dollars for RM3.50, the exchange rate cannot fall below that point. To keep the exchange rate from rising, Bank Negara must supply FOREX it must exchange dollars for ringgit. Alternatively, the CB of the USA i.e the Federal Reserve would SS dollars (sell dollars and buy ringgit) to satisfy the excess demand. 21 Real exchange rate The price of the foreign currency in terms of the ringgit e.g. US$1 = RM3.50 Bilateral nominal exchange rate Multilateral or effective exchange rate - The price of a representative basket of foreign currencies, each weighted by its importance to Malaysia in international trade. Real exchange rate R = ePf/P e = nominal exchange rate Pf = foreign prices P = domestic prices R or real depreciation goods abroad more expensive relative to goods at home. R or real appreciation our goods relatively more expensive. 22 Domestic spending and spending on domestic goods Spending by domestic residents A = C + I + G Spending on domestic goods = A + NX = C + I + G + NX Domestic spending depends on i and Y A = A(Y,i) Net exports Net exports depend on income (Y) which affects import; Foreign income (Yf) which affects our exports; also depend on R.
NX = X(Yf,R) M(Y,R) 23 Contd. Yf improves the home countrys trade balance AD R real depreciation improves the trade balance AD Y M worsen the trade balance 24 Contd. IS curve: Y = A(Y,i) + NX(Y,Yf,R) X IS shifts to the right X IS shifts to the left R or real depreciation IS shifts to the right and raises net exports Y
25 Effects of disturbance on Y and NX ________________________________________ Home spending Yf Real depreciation ________________________________________ Y + + + NX - + + ________________________________________
26 Capital mobility One element in the international economy High degree of linkage among financial or capital markets. In most industrial countries there are no restrictions on holding assets abroad. Malaysians or residents in other countries can hold their wealth either at home or abroad. They search around for the highest return. In reality tax differences among countries; exchange rate can change; restrictions on capital outflows differences in interest rates among countries. 27 Perfect capital mobility Capital is perfectly mobile internationally when investors can purchase assets in any country, quickly, with low transaction costs, and in unlimited accounts - One countrys interest rates cannot get too far from the world level. - E.g. if Malaysian yields less than Singaporean yields capital outflow from Malaysia Interest rates affect capital flows & the BP Monetary & fiscal policies affect interest rates The policies affect capital account & BP 28 The Balance of Payments and Capital Flows
Balance of payments surplus, BP: BP = NX(Y,Yf,R) + CF(i if) CF: capital flow; if: world interest rate; i = domestic interest rate Y worsen the trade balance i where i > if capital inflow improves the capital account The trade deficit would be financed by a capital inflow BP in equilibrium (BP = 0) When BP = 0 a flat line i = if Points above BP = 0 surplus BP Points below BP = 0 deficit BP 29 Fiscal policy with a fixed exchange rate (Contd.) BP LM LM IS IS Yo Y Y 1 i = if i 1 30 Policy effects under fixed exchange rates Fiscal policy with a fixed exchange rate F shifts IS to the right from IS to IS Domestic interest rate, i > if Resulting in a massive capital inflow Central bank intervention to maintain the fixed exchange rate causes Ms LM shifts to the right from LM to LM Domestic interest rate is brought back into equality with if Y from Yo to Y1 (see next slide) 31 Monetary policy with a fixed exchange rate Ms shifts the LM curve to the right from LM to LM. Domestic interest rate below if BP deficit Massive capital outflow Central bank intervention to maintain the fixed exchange rate by selling foreign reserve assets & buys domestic currencies domestic Ms Domestic interest rate is restored to equality with if Y is back at its initial level Monetary policy is completely ineffective (see next slide)
32 Monetary policy with a fixed exchange rate (Contd.) BP LM LM IS Yo
i = if i 1 33 Policy effects under flexible exchange rate monetary policy with a flexible exchange rate BP LM LM IS IS Yo Y 1 i = if i 1 Ms causes the LM shifts to the right from Lm to LM donestic interest rate, i fall below if massive outflow of capital BP deficit the exchange rate NX IS shifts to the right from IS to IS domestic interest rate = if Y from Yo to Y1 monetary policy is highly effective with perfect capital mobility and flexible exchange rates. 34 Fiscal policy with a flexible exchange rate BP LM IS IS Yo
i = if i 1 G causes the IS shifts to the right from IS to IS donestic interest rate, i above if massive capital inflow BP surplus the exchange rate NX IS shifts back to the left from IS to IS domestic interest rate = if Y to its initial level (Yo) fiscal policy is completely ineffective under flexible exchange rate