Balance of Payments Adjustment

1. Balance of Payments Adjustment Thorvaldur Gylfason

2. Outline Real versus nominal exchange rates Balance of payments adjustment and welfare The scourge of overvaluation Balance of payments adjustment through economic policy

3. 1 Real versus nominal exchange rates Increase in r means real appreciation r = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad

4. Real versus nominal exchange rates 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

5. 2 Balance of payments and welfare Payments for imports of goods, services, and capital Imports Real exchange rate Equilibrium Earnings from exports of goods, services, and capital Exports Foreign exchange

6. 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

7. Balance of payments adjustment and welfare Deficit Imports Overvaluation Real exchange rate Exports Foreign exchange

8. Balance of payments adjustment and welfare Supply (exports) Overvaluation works like a price ceiling Price of foreign exchange Overvaluation Demand (imports) Deficit Foreign exchange

9. Market equilibrium and economic welfare Price Consumer surplus Supply A Total welfare gain associated with market equilibrium equals producer surplus (= ABE) plus consumer surplus (= BCE) B E Producer surplus Demand C Quantity

10. Market intervention and economic welfare Consumer surplus = AFGH Producer surplus = CGH Price Total surplus = AFGC Welfare loss Supply A F Price ceiling imposes a welfare loss equivalent to the triangle EFG J B E Price ceiling H G Demand C Quantity

11. 3 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

12. Market intervention and economic welfare, again Price Welfare loss Supply A F Price ceiling imposes a welfare loss equivalent to the triangle EFG J B E Price ceiling H G Demand C Shortage Quantity

13. 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

14. Inflation and overvaluation Real exchange rate Suppose inflation is 10 percent per year Devaluation 110 Average 105 100 Time

15. Inflation and overvaluation Hence, increased inflation increases the real exchange rate as long as the nominal exchange rate adjusts with a lag Real exchange rate Suppose inflation rises to 20 percent per year 120 110 Average 100 Devaluation Time

16. 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

17. The Marshall-Lerner condition: Theory Suppose prices are fixed 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

18. 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, Devaluation improves the current account

19. Empirical evidence from industrial countries Elasticity of Elasticity of exports imports Austria 1.0 1.2 Belgium 1.1 1.3 Canada 0.7 1.3 France 1.3 0.9 Germany 1.0 0.8 Italy 1.3 0.8 Japan 1.4 1.0 Netherlands 1.5 0.7 Sweden 1.6 0.9 United Kingdom 1.0 1.3 United States 1.2 1.2 Average 1.2 1.1

20. The importance of appropriate side measures Remember: 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

21. 4 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 GNP Y

22. Experiment: Export boom Price level AS AD GNP

23. Experiment: Export boom Price level AS B Exports increase, so that aggregate demand expands A AD’ AD GNP

24. Experiment: Export boom Price level AS B Excess demand drives prices up A C AD’ AD GNP

25. Experiment: Export boom Price level AS B As the price level rises, so does GNP along the upward-sloping AS curve A AD’ AD GNP

26. 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

27. 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

28. 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

29. 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

30. Monetary expansion shifts AD schedule right Aggregate demand Domestic credit • Y = (1-s)(1-t)Y + k(M/P) + G + • (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

31. 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

32. Macroeconomic equilibrium Price level AS W up M up; G up; t down; e down AD GNP

33. Monetary or fiscal expansion Price level An increase in M or G or a decrease in t increases both Y and P for given W AS B A AD’ M up; G up; t down AD GNP

34. An increase in wages AS’ Price level An increase in W increases P, but reduces Y AS W up B An increase in the price of imported oil has the same effect: stagflation A AD GNP

35. Devaluation Price level 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 raises the price of oil and other imported inputs. AS’ B AS W up AD’ A e down AD GNP

36. 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)

37. Balance of payments adjustment Price level Suppose, at A, there is a deficit in the balance of payments (B  0) Can offset decrease in aggregate demand by increasing e or F AS 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. A e or F up AD M or G down, t up GNP

38. Macroeconomic adjustment and structural reform Price level Start, at A, with a deficit in the balance of payments (B  0) Stimulate supply side by liberalization, stabilization, privatization, etc. AS Then, to reduce deficit, try to stimulate supply (shift AS right) in addition to reducing demand AS’ 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. A AD’ E AD M or G down, t up GNP

39. 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 The End