Open Economy Macro: Exchange Rate And Trade Policy

1. Open Economy Macro: Exchange Rate And Trade Policy Chapter 16

2. Laugher Curve A party of economists was climbing in the Alps. After several hours they became hopelessly lost.

3. Laugher Curve One of them studied the map for some time, turning it up and down, sighting on distant landmarks, consulting his compass, and finally the sun.

4. Laugher Curve Finally, he said, “OK, see that big mountain over there?”

5. The Balance of Payments The balance of payments is a country’s record of all transactions between its residents and the residents of all foreign countries.

6. The Balance of Payments The current account is the part of the balance of payments account in which all short-term flows of payments are listed.

7. The Balance of Payments The capital account is the part of the balance of payments account in which all long-term flows of payments are listed.

8. The Balance of Payments The government can influence the exchange rate by buying and selling official reserves—government holdings of foreign currencies.

9. The Balance of Payments The buying and selling of official reserves is recorded in the official transactions account.

10. The Balance of Payments The buying and selling of official reserves is recorded in the official transactions account.

11. The Current Account The difference between the import and export of goods is sometimes called the balance of merchandise trade.

12. The Current Account Although the popular press often uses this measure, the merchandise trade balance is not a good summary because services are an important component of trade.

13. The Current Account Trade in services is just as important as trade in goods.

14. The Current Account There is no reason that the goods and services sent into a country must equal the goods and services sent out in a particular year.

15. The Current Account The last component of the current account is net transfers, which include foreign aid, gifts, and other payments to individuals not exchanged for goods and services.

16. The Capital Account In order to buy U.S. assets foreigners need dollars , so net capital inflows represent a demand for dollars.

17. The Capital Account In thinking about what determines a currency’s value, it is important to remember both the demand for dollars to buy goods and services and the demand for dollars to buy assets.

18. The Capital Account Because the balance of payments consists of both the capital account and the current account, if the capital account is in surplus and the trade account is in deficit, there can still be a balance of payments surplus.

19. The Capital Account In the 1980s, the inflow of capital into the U.S. greatly exceeded the outflow of capital from the U.S., and this trend has continued into the late 1990s.

20. The Capital Account As a consequence, the U.S. is a net debtor nation—the amount foreigners own in the U.S, is greater than the amount U.S. citizens own abroad.

21. The Official Transactions Account The current account and the capital account measure the private and non-U.S. government supply of and demand for dollars.

22. The Official Transactions Account The net amount of the current account and the capital account is called:

23. The Official Transactions Account A balance of payments deficit will put downward pressure on the value of a nation’s currency.

24. The Official Transactions Account When a government buys its own currency to hold up the currency’s price, we say that the government has supported its currency.

25. The Official Transactions Account When it sells its currency, it is attempting to depress the value of its currency.

26. The Official Transactions Account Because they are an accounting identity, the current, capital, and official transactions accounts must sum to zero.

27. The Official Transactions Account The supply of currency, including government’s, must equal the demand for currency, including government’s.

28. 1987 Balance of Payments Accounts

29. 1987 Balance of Payments Accounts

30. 1999 Balance of Payments Accounts

31. 1999 Balance of Payments Accounts

32. Exchange Rates Supply and demand play a central role in any discussion of exchange rates. When comparing the currencies of two countries, the supply of one currency equals the demand for another currency.

33. Exchange Rates In order to demand one currency, you must supply another.

34. Exchange Rates and the Balance of Payments A deficit in the balance of payments means that the private quantity supplied of a currency exceeds the private quantity demanded. A surplus in the balance of payments means the opposite.

35. Exchange Rates and the Balance of Payments Equilibrium is where the quantity supplied a currency equals the quantity demanded.

36. The Supply of and Demand for Francs

37. Fundamental Forces Determining Exchange Rates Fundamental analysis is a consideration of the fundamental forces that determine the supply of and demand for currencies.

38. Fundamental Forces Determining Exchange Rates These fundamental forces include a country’s income, changes in a country’s prices, and the interest rate in a country.

39. Changes in a Country’s Income When a country’s income falls, the demand for imports falls. Then demand for foreign currency to buy those imports falls.

40. Changes in a Country’s Income This means that the supply of the country’s currency to buy the foreign currency falls.

41. Changes in a Country’s Prices If the U.S. has more inflation than other countries, foreign goods will become cheaper. U.S. demand for foreign currencies will tend to increase, and foreign demand for dollars will tend to decrease.

42. Changes in a Country’s Prices This rise in U.S. inflation will shift the dollar supply to the right and the dollar demand to the left.

43. Changes in Interest Rates A rise in U.S. interest rates relative to those abroad will increase demand for U.S. assets.

44. Changes in Interest Rates Demand for dollars will increase, while simultaneously the supply of dollars will decrease as fewer Americans sell their dollars to buy foreign assets.

45. Changes in Interest Rates A fall in U.S. interest rates or a rise in foreign interest rates will have the opposite effect.

46. Exchange Rate Determination Is More Complicated Than It Seems Large exchange rate fluctuations in response to changing expectations make trading difficult and have significant real effect on economic activity.

47. Exchange Rate Determination Is More Complicated Than It Seems If the market expects exchange rates to change, it will become a self-fulfilling prophesy.

48. Exchange Rate Determination Is More Complicated Than It Seems The resulting fluctuations serve no real purpose, and cause problems for international trade and the country’s economy.

49. International Trade Problems From Shifting Values of Currencies Large fluctuations make real trade difficult, and cause serious real consequences. It is these consequences that have led to calls for government to fix or stabilize their exchange rates.

50. How a Fixed Exchange Rate System Works One way the government can set the exchange rate is to make its currency nonconvertible. Most western economies have agreed not to use this approach.

51. How a Fixed Exchange Rate System Works A second way is for government to adopt a fixed exchange rate policy.

52. Fixing the Exchange Rate The government can fix its exchange rate by exchange rate intervention. Exchange rate intervention – buying or selling a currency to affect its price.

53. Direct Exchange Rate Intervention Currency support is the buying of a currency by a government to maintain its value at above its long-run equilibrium value.

54. Direct Exchange Rate Intervention A country can maintain a fixed exchange rate only as long as it has the official reserves (foreign currencies) to maintain this constant rate.

55. Direct Exchange Rate Intervention Once it runs out of official reserves, it will be unable to intervene, and then must either borrow or devalue its currency.

56. Direct Exchange Policy

57. The Supply of and Demand for Francs

58. How a Fixed Exchange Rate System Works

59. Currency Stabilization A more practical long-run exchange rate policy is currency stabilization. Currency stabilization – the buying and selling of a currency by the government to offset temporary fluctuations in supply and demand for currencies.

60. Currency Stabilization In currency stabilization, the government is not trying to change the long-run equilibrium. It is simply trying to keep the exchange rate at that long-run equilibrium.

61. Currency Stabilization In currency stabilization, the government is not trying to change the long-run equilibrium.

62. Currency Stabilization Currency stabilization minimizes the possibility that the government will run out of official reserves.

63. Currency Stabilization If a nation runs out of official reserves, it must adjust its economy if it wants to maintain a fixed exchange rate.

64. Currency Stabilization Given the small level of official reserves relative to the enormous level of private trading, significant amounts of stabilization are impossible.

65. Currency Stabilization Strategic currency stabilization is often used when there a government has a small level of official reserves.

66. Currency Stabilization Strategic currency stabilization is the process of buying and selling at strategic moments to affect the expectations of traders, and hence to affect their supply and demand.

67. Stabilizing Fluctuations Versus Deviating From Long-Run Equilibrium In theory, it is important to distinguish whether the problem is long- or short-run equilibrium. In practice, it is difficult to do so.

68. Stabilizing Fluctuations Versus Deviating From Long-Run Equilibrium The long-run equilibrium rate can only be guessed at since no definitive empirical measure of this rate exists.

69. Estimating Long-Run Equilibrium Exchange Rates Purchasing power parity is one way economists have of estimating the long-run equilibrium rate.

70. Estimating Long-Run Equilibrium Exchange Rates Purchasing power parity (PPP) is a method of calculating exchange rates that attempts to value currencies at rates such that each currency will buy an equal basket of goods.

71. Criticisms of the Purchasing Power Parity Method The difficulty with purchasing power parity is the complex nature of trade and consumption. The purchasing power parity will change as the basket of goods changes. Because of this there is no single measure of purchasing power parity.

72. Criticisms of the Purchasing Power Parity Method Purchasing power parity measures leave out asset demand for a currency, an important element of demand for currencies.

73. Criticisms of the Purchasing Power Parity Method The critics contend that the current exchange rate is the best estimate of the long-run equilibrium exchange rate.

74. Alternative Exchange Rate Systems There are three exchange rate regimes: Fixed exchange rate – the government chooses an exchange rate and offers to buy and sell currencies at that rate. Flexible exchange rate – determination of exchange rates is left totally up to the market.

75. Alternative Exchange Rate Systems There are three exchange rate regimes: Partially flexible exchange rate – the government sometimes affects the exchange rate and sometimes leaves it to the market.

76. Advantages of Fixed Exchange Rates They provide international monetary stability. They force governments to make adjustments to meet their international problems.

77. Disadvantages of Fixed Exchange Rates They can become unfixed. When they are expected to become unfixed, they create enormous monetary instability.

78. Disadvantages of Fixed Exchange Rates They force governments to make adjustments to meet their international problems.

79. Fixed Exchange Rates and Monetary Stability If the government picks an exchange rate that is too high, its exports lag and the country loses official reserves.

80. Fixed Exchange Rates and Monetary Stability If the government picks an exchange rate that is too low, it is paying more for its imports than it needs to and is building up official reserves.

81. Fixed Exchange Rates and Monetary Stability At times fixed exchange rates can become highly unstable because expectations of a change in the exchange rate can force the change to occur.

82. Fixed Exchange Rates and Policy Independence Fixed exchange rates provide international monetary stability and force governments to make adjustments to meet their international problems. If they become unfixed, they create monetary instability.

83. Fixed Exchange Rates and Policy Independence Because most countries’ official reserves are limited, a country with fixed exchange rates is limited in its ability to conduct expansionary monetary and fiscal policies.

84. Fixed Exchange Rates and Policy Independence Many countries run out of official reserves when a recession hits.

85. Advantages of Flexible Exchange Rates They provide for orderly incremental adjustment of exchange rates, rather than large, sudden jumps. They help government in conducting domestic monetary and fiscal policies.

86. Disadvantages of Flexible Exchange Rates They allow speculation to cause large jumps in exchange rates, which do not reflect market fundamentals.

87. Disadvantages of Flexible Exchange Rates They allow government to be flexible in conducting domestic monetary and fiscal policies.

88. Flexible Exchange Rates and Monetary Stability Proponents argue: why not treat currency markets like any other market and let private market forces determine a currency’s value?

89. Flexible Exchange Rates and Monetary Stability Opponents argue that flexible exchange rates allow far too much fluctuation in exchange rates, making trade difficult.

90. Flexible Exchange Rates and Policy Independence Flexible exchange rate regimes allow governments to be flexible in conducting domestic monetary and fiscal policy.

91. Flexible Exchange Rates and Policy Independence Some argue that flexible exchange rates do not provide sufficient discipline for macro policy.

92. Partially Flexible Exchange Rates Most nations have opted for a policy, partially flexible exchange rates, that stands between these two extremes.

93. Partially Flexible Exchange Rates If policy makers believe there is a fundamental misalignment in a country’s exchange rate, they allow market forces to determine it.

94. Partially Flexible Exchange Rates If they believe the currency’s value is falling because of speculation, they step in and fix the exchange rate, either supporting or pushing down their currency’s value.

95. Partially Flexible Exchange Rates Partially flexible exchange rate regimes combine the advantages and disadvantages of fixed and flexible exchange rates.

96. Which View Is Right? Which view is correct is much in debate. In order to decide, it is necessary to go beyond the arguments and look at the history of the various regimes.

97. The View of Foreign Exchange Traders Most foreign-exchange traders feel their take on the market is better than that of governments’.

98. The View of Foreign Exchange Traders When these traders know that government might enter the market, they stop focusing on fundamentals and switch to trying to guess what the regulators will do.

99. The View of Fed Economists Fed economists maintain that government intervention helps to stabilize currency markets.

100. Trade Policy Trade policy involves government creating trade restrictions on imports in order to meet the balance of payments constraint without using traditional macro policy or exchange rate policy.

101. Trade Policy Economists generally oppose such trade restrictions.

102. Varieties of Trade Restrictions The most common trade restrictions are tariffs and quotas. Other trade restrictions are voluntary restraint agreements, embargoes, regulatory trade restrictions, and nationalistic appeals.

103. Tariffs Tariffs, also called customs restrictions, are taxes governments place on internationally traded goods—generally imports.

104. Tariffs Tariffs are the most-used and most-familiar type of trade restriction.

105. Tariffs They make imported goods relatively more expensive than they otherwise would have been and thereby encourage the consumption of domestically produced goods.

106. The Impact of Tariffs on Imported Goods

107. Smoot-Hawley Tariff The most infamous tariff in U.S. history was the 1930 Smoot-Hawley Act. It raised tariffs on imported goods by an average 60 percent. Other nations retaliated, resulting in a collapse in world trade.

108. Smoot-Hawley Tariffs The failure of this legislation brought on the General Agreement on Tariffs and Trade (GATT), the regular international conference to reduce trade barriers.

109. Smoot-Hawley Tariffs GATT has been succeeded by the World Trade Organization (WTO) – an organization committed to getting nations to agree not to impost new tariffs on other trade restrictions.

110. Quotas Quotas are quantity limits placed on imports. Quotas differ from tariffs. Foreign producers prefer quotas to tariffs.

111. Quotas In a tariff, the government receives the tariff payment.

112. Quotas With quotas, an increase in domestic demand will be met by the less-efficient domestic producers.

113. Voluntary Restraint Agreements To avoid imposing new tariffs on their goods, countries often enter into voluntary restraint agreements. Voluntary restraint agreements are those in which countries voluntarily restrict their exports.

114. Voluntary Restraint Agreements The effect of voluntary restraint agreements is the same as the effect of quotas.

115. Voluntary Restraint Agreements In the case of the voluntary quotas imposed on Japanese auto manufacturers, consumers lost since they paid higher prices both for domestic and imported cars.

116. Embargoes An embargo is an all-out restriction on import or export of a good. Embargoes are usually created for international political reasons rather than for primary economic reasons.

117. Regulatory Trade Restrictions Regulatory trade restrictions are indirect methods of imposing governmental procedural rules that limit imports. An example: limiting or prohibiting foodstuffs to be imported if certain pesticides are used.

118. Regulatory Trade Restrictions A second type of restriction involves making import and customs restrictions so detailed and time consuming that importers simply give up.

119. Nationalistic Appeals Given two products of equal quality and appeal, Americans prefer to “Buy American.”

120. Nationalistic Appeals Some manufacturers will have cloth made and cut in a foreign nation, then brought into the U.S. where it is sewn together so that it can be advertised: “Made in U.S.A.”

121. Economist Dislike Trade Restriction Policies Despite the political popularity of trade restrictions, most economists support free trade. A free trade policy allows unrestricted trade among countries.

122. Economist Dislike Trade Restriction Policies Trade restrictions lower aggregate output.

123. Economist Dislike Trade Restriction Policies Trade restrictions lower international competition.

124. Economist Dislike Trade Restriction Policies They often result in harmful trade wars that hurt everyone.

125. Strategic Trade Policies Strategic trade policies are threats to implement tariffs to bring about a reduction in tariffs or some other concession from the other country. The threats must be credible.

126. Open Economy Macro: Exchange Rate And Trade Policy End of Chapter 16