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Economic Environment Lecture 8 Joint Honours 2003/4 Professor Stephen Hall The Business School Imperial College London Page 1 © Stephen Hall, Imperial College London Revision A Note on the Natural Rate Hypothesis • Graphically, the natural rate of output can be seen as that associated with the intersections of constantly rising aggregate supply and demand curves. S1 P S0 D1 D0 Natural Rate of output Page 2 © Stephen Hall, Imperial College London The short-run aggregate supply schedule P0 Suppose the economy is initially at Yp in fullemployment equilibrium at A, with price P0 SAS In response to a fall in aggregate demand, A SAS1 firms in the short run B vary labour input, thus moving along SAS to B. SAS2 P2 A2 Yp Page 3 Output In time, the firm is able to negotiate lower wages, and the SAS shifts to SAS1 and then to SAS2, until equilibrium is restored at A2. © Stephen Hall, Imperial College London A fall in nominal money supply AS SAS P P' P'' P3 E E' E3 MDS' Page 4 Starting from long-run equilibrium at E: a fall in nominal money supply shifts MDS to MDS' SAS' Given wage levels, firms SAS3 adjust to E' in the short run With price at P' but wages unchanged, the real wage rises bringing involuntary MDS unemployment. As the labour market (wage) adjusts SAS shifts e.g. to SAS' Yp Output Equilibrium is eventually reached at E3, back at Yp. © Stephen Hall, Imperial College London An adverse supply shock: e.g. an increase in the price of oil Higher oil prices force SAS' firms to charge more for their output, so SAS SAS shifts to SAS' P equilibrium from E to E' E' P' P E MDS Y' Page 5 Yp' Output Higher prices cause a move along MDS, and output falls to Y' In time, unemployment reduces wages and SAS gradually shifts back to SAS, so Yp is restored. © Stephen Hall, Imperial College London Trade and Exchange rates Page 6 © Stephen Hall, Imperial College London Open economy macroeconomics • … is the study of economies in which international transactions play a significant role – international considerations are especially important for open economies like the UK, Germany or the Netherlands • Domestic macroeconomic policy in such countries cannot ignore the influence of the rest of the world – especially via the exchange rate. Page 7 © Stephen Hall, Imperial College London Trade and the International environment • Globalisation • Growing trading blocks • Trade disputes tariffs and protectionism Page 8 © Stephen Hall, Imperial College London Exports as % of GDP 80 1967 1998 60 % 40 20 Page 9 Ja pa n U SA ly Ita U K Fr an ce Be l gi um N ' la nd s 0 © Stephen Hall, Imperial College London Destination of world exports, 1996 North America 17% Africa Other 2% 7% EU 38% Latin America 5% Middle East 3% Asia 28% Source: Direction of Trade Statistics Page 10 © Stephen Hall, Imperial College London The composition of world exports 100% 80% 60% 40% 20% 0% 1955 Food, ag Page 11 Fuels 1995 Other primary Manufactures © Stephen Hall, Imperial College London Comparative advantage • Trade offers benefits when there are international differences in the opportunity cost of goods. • Opportunity cost of a good – the quantity of other goods sacrificed to make one more unit of that good • The law of comparative advantage – states that countries should specialize in producing and exporting the goods that they produce at a lower relative cost than other countries. Page 12 © Stephen Hall, Imperial College London The source of comparative advantage • An important difference between countries is in factor endowments • which will be reflected in different relative factor prices – e.g. if the UK has relatively abundant capital but relatively scarce labour as compared with India, – then the UK would tend to specialize in capital-intensive goods, – and India would tend to specialize in labour-intensive products • Comparative advantage may also reflect a relative advantage in technology Page 13 © Stephen Hall, Imperial College London Gainers and losers • Countries may gain from specialization and trade – but not all countries may gain equally • Commercial policy – is government policy that influences international trade through taxes or subsidies • e.g. tariffs – or through direct restrictions on imports and exports. Page 14 © Stephen Hall, Imperial College London The effect of a tariff SS DD and SS show the domestic demand and supply for a good. If the world price is Pw, and there is free trade, domestic firms supply Qs Pw + T domestic demand is Qd Pw and the difference is imported. DD A tariff can stimulate domestic supply and restrict imports Qs Qs ' Qd' Qd Quantity At a domestic price Pw + T, where T is the size of the tariff Domestic demand falls to Qd', domestic supply rises to Qs' and imports fall. Page 15 © Stephen Hall, Imperial College London The welfare costs of a tariff SS The tariff leads both to transfers and net social losses. The government raises revenue – i.e. there is a transfer to the government Pw+ T Pw DD Qs Qs ' and there is a transfer in the form of extra profits to producers Qd' Qd Quantity There is a social cost from production inefficiency, given that the good could be imported at Pw. Page 16 © Stephen Hall, Imperial College London There is also a loss of consumer surplus. Tariffs • The deadweight burden of a tariff suggests that society suffers from this method of restricting trade. • This is the case for free trade. • Tariffs have fallen substantially under the GATT – General Agreement on Tariffs and Trade Page 17 © Stephen Hall, Imperial College London The case for tariffs – good arguments • Optimal tariff – a first-best argument – only valid where the importing country is large enough to affect the world price • This policy fulfils the principle of targeting – which says that the most efficient way to attain a given objective is to use a policy that influences that activity directly. – Policies that attain the objective, but also influence other activities are second-best, because they distort those other activities. Page 18 © Stephen Hall, Imperial College London The case for tariffs – second-best arguments • Way of life – an attempt to preserve ‘traditional’ ways – a production subsidy would be better • Suppressing luxuries – an attempt to curb consumption patterns of the rich in a poor society – better achieved by a consumption tax • Infant industries – an attempt to nurture new activities via learning by doing – a temporary production subsidy probably better • Revenue – tariffs raise government revenue – but there are better ways • Cheap foreign labour – a non-argument – denies benefits of comparative advantage Page 19 © Stephen Hall, Imperial College London Other commercial policies • Although tariff rates have fallen under GATT, there has been a proliferation of other trade restrictions – quotas – non-tariff barriers • administrative regulations that discriminate against foreign goods – export subsidies Page 20 © Stephen Hall, Imperial College London The foreign exchange market - the international market in which one national currency can be exchanged for another. Exchange rate ($/£) The price at which two currencies exchange is the exchange rate. DD shows the demand for Suppose 2 countries: UK & USA pounds by Americans wanting to buy British goods/assets. SS SS1 e0 Equilibrium exchange rate is e0 e1 DD Quantity of pounds Page 21 SS shows the supply of pounds by UK residents wishing to buy American goods/assets. If UK residents want more $ at each exchange rate, the supply of £ moves to SS1 New equilibrium at e1. © Stephen Hall, Imperial College London Warning!! • Exchange rates can be defined in two ways • Dollars to the pound 1.4 • Pounds to the dollar 0.71 • • • • Devaluation means the currency buys less 1.4 -> 1.3 or 0.71 -> 0.79 Revaluation means it buys more 1.4 ->1.5 or 0.71 -> 0.66 Page 22 © Stephen Hall, Imperial College London Two Basic Exchange Rate Theories • Purchasing Power Parity • Uncovered Interest Parity Page 23 © Stephen Hall, Imperial College London Purchasing Power Parity • Basic trade relationship • Law of one price. If a car costs £1000 in the UK and DM3000 in Germany then the exchange rate should be 3DM/£. • Qualification; Transportation costs, Tarrifs, Taxes • A long term relationship Page 24 © Stephen Hall, Imperial College London Uncovered Interest Parity • Basic speculative model • If interest rates in the UK are 5% and in Germany they are 4% then an investor must expect the DM/£ rate to devalue by 1% • Expected change in exchange rate= interest diff. • Qualification: Risk aversion • Dominates exchange rates in the short run Page 25 © Stephen Hall, Imperial College London Alternative exchange rate regimes • In a fixed exchange rate regime – the national governments agree to maintain the convertibility of their currency at a fixed exchange rate. • In a flexible exchange rate regime – the exchange rate is allowed to attain its free market equilibrium level without any government intervention using exchange reserves. Page 26 © Stephen Hall, Imperial College London Intervention in the forex market e1 E A Suppose the government is committed to maintaining the SS exchange rate at e1 ... If the demand for pounds is DD1 C there is excess demand AC. DD The Bank of England must DD1 supply AC £s in return for $, which are added to reserves. DD2 Quantity of £s The reverse occurs if demand is at DD2. When demand is DD, no intervention is needed ... there is a balance in transactions between the countries. Page 27 © Stephen Hall, Imperial College London The balance of payments • … a systematic record of all transactions between residents of one country and the rest of the world • Current account – records international flows of goods, services, income and transfer payments • Capital account – records transactions involving fixed assets • Financial account – records transactions in financial assets Page 28 © Stephen Hall, Imperial College London £ billion at current prices The UK balance of payments, 1980-1998 25 20 15 10 5 0 -5 -10 -15 -20 -25 1980 Current Capital Financial Err & om 1983 1986 1989 1992 1995 1998 Source: Economic Trends Annual Supplement Page 29 © Stephen Hall, Imperial College London Floating exchange rates and the balance of payments • If the exchange rate is free to move to its equilibrium, there is no need for intervention • any current account imbalance is exactly matched by an offsetting balance in capital/financial accounts • if there is intervention, it is recorded as part of the financial account. Page 30 © Stephen Hall, Imperial College London International competitiveness • The competitiveness of UK goods in international markets depends upon: – the nominal exchange rate – relative inflation rates • Overall competitiveness is measured by the real exchange rate – which measures the relative price of goods from different countries when measured in a common currency Page 31 © Stephen Hall, Imperial College London 3 $/£ 2.5 1.1 Relative price (UK/USA) 1 0.9 2 0.8 1.5 0.7 Exchange rate ($/£) 1 0.6 0.5 0.4 19 71 19 73 19 75 19 77 19 79 19 81 19 83 19 85 19 87 19 89 19 91 19 93 19 95 19 97 0.5 Relative price (UK/USA) Relative prices and the nominal exchange rate, UK & USA Page 32 © Stephen Hall, Imperial College London The real £/$ exchange rate The real exchange rate is the nominal rate multiplied by the ratio of domestic to foreign prices 2.5 £/$ 2 1.5 1 0.5 19 71 19 73 19 75 19 77 19 79 19 81 19 83 19 85 19 87 19 89 19 91 19 93 19 95 19 97 0 Page 33 © Stephen Hall, Imperial College London Components of the balance of payments • The current account is influenced by: – competitiveness – domestic and foreign income • The capital & financial accounts are influenced by: – relative interest rates • which affect international capital flows. • Perfect capital mobility – occurs when there are no barriers to capital flows, and investors equate expected total returns on assets in different countries Page 34 © Stephen Hall, Imperial College London Internal and external balance • Internal balance – a situation for a country when aggregate demand is at the full-employment level • External balance – a situation for a country when the current account of the balance of payments just balances • The combination of internal and external balance is the long-run equilibrium for the economy. Page 35 © Stephen Hall, Imperial College London Shocks may move an economy away from internal and external balance: Surplus More saving, tighter fiscal & monetary policy Foreign boom, lower real exchange rate Slump Boom Less saving, easier fiscal & monetary policy Foreign slump, higher real exchange rate Deficit Page 36 © Stephen Hall, Imperial College London Macroeconomic policy under fixed exchange rates • Under fixed exchange rates, there is a crucial link between external imbalance and domestic money supply. • When the government intervene to maintain the exchange rate, there is a direct effect on money supply. • Sterilization – an open market operation between domestic money and domestic bonds to neutralize the tendency of balance of payments surpluses and deficits to change domestic money supply. Page 37 © Stephen Hall, Imperial College London Monetary policy under fixed exchange rates Assume: perfect capital mobility, sluggish prices • An increase in nominal money supply – tends to reduce interest rates – leads to a capital outflow – reducing money supply as the government seeks to maintain the exchange rate • so monetary policy is powerless – the government cannot fix independent targets for both money supply and the exchange rate – domestic and foreign interest rates cannot diverge Page 38 © Stephen Hall, Imperial College London Fiscal policy under fixed exchange rates Assume: perfect capital mobility, sluggish prices • An increase in government expenditure; • in the short run – stimulates output – but also increases interest rates – which leads to a capital inflow – money supply expands to maintain the exchange rate – there is no crowding-out – as interest rates cannot rise • in the long run: – wages and prices adjust, affecting competitiveness – the economy returns to potential output. Page 39 © Stephen Hall, Imperial College London Monetary policy under floating exchange rates e e3 e2 Suppose the economy begins in equilibrium with the nominal exchange rate at e1. At time t, nominal money B supply is halved... C e will be the new equilibrium 2 e1 exchange rate once the economy has adjusted A t Time But prices are sluggish, so in the short run, real money supply falls and domestic interest rates rise To maintain equilibrium in the forex market, the exchange rate overshoots to e3 , adjusting along BC with wages & prices. Page 40 © Stephen Hall, Imperial College London Monetary policy under floating exchange rates (2) • This analysis suggests that with floating exchange rates, • monetary policy is highly effective in the short run • but the effect is only transitional Page 41 © Stephen Hall, Imperial College London Fiscal policy under floating exchange rates • Following an increase in government expenditure ... • the crowding-out effect of higher interest rates is enhanced by appreciation of the exchange rate – which dampens export demand • so fiscal policy is less effective under floating exchange rates. Page 42 © Stephen Hall, Imperial College London Conclusion • Trade is important and growing • Exchange rate regimes affect the working of economic policy • A major issue in policy is the overall way of determining exchange rates and trade Page 43 © Stephen Hall, Imperial College London