Download Transition from chapter 1 to chapter 2

Transition from chapter 1 to
chapter 2
Ch2/ER
1
• BoP = + = 0
• FA = private (and Gov’t)
+
CA is balance on
account
FA is balance on (capital and)
account
CB is change in central bank foreign
FA includes the
accounts
i.e US bank balance abroad (in for curr.) {incr (-)}
and For bank balance in US (in $) {incr (+)}
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Flexible exchange rate
start w/ CA + FA =
Assume US demand for IM  CA
(CA< 0)
Immediate adjustment:
US must pay for new imports
either w/
(FC) or w/
1. Either US bank balance abroad (in FC) ( )
2. Or foreign bank balance in US (in $)
( )
So FA turns >0 and BoP still = 0
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Short term adjustment through foreign exchange
market:
1. Means that demand for foreign currency (FC)
2. Means that supply of $ held by foreigners
$/FC
FC/$
S
D’
S’
D
D
Q of $
Q of FC
Depreciation of $
S
equivalent to
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Appreciation of FC
4
Then US demand for Import
while foreign demand for US goods i.e. X
hence CA = X - IM
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Fixed exchange rate
Same situation but the $ ______ depreciate
$/FC
Fixed ER
S
FC/$
D’
S
S’
D
D
Q of $
Q of FC
The bold segment shows excess _______ for foreign currency
on the first graph and excess ______ of dollar on the second
graph at the fixed ER.
Need for ___________ by the Central Bank(s)
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2 possibilities:
Unilateral intervention - the Fed uphold the ER by
_______ FC to the public at the _______ ER.
Concerted intervention - the Fed _____ FC to the
public and the foreign central bank ____ dollars
(to soak out the excess supply of $).
No short run adjustment through the market forces
possible - ___________ remains.
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Intervention and the Central Bank
Assets
Liabilities
Monetary
Base
When the CB sells FC to the public, the public pays with
_________ currency i.e. the liabilities of the CB ________ - the
monetary base (MB) and thus the money supply (M) _________.
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Short run monetary adjustment - Keynesian
(P fixed)
The monetary contraction slows down demand
overall and also demand for _________- thus
__________ the CA.
The opposite effect will happen to the trade partner
- there will be a monetary _________ due to the
increase in FC at their CB which will
__________ the economy and the demand for
import (i.e. the export of the other country) thus
______ their CA.
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Medium run adjustment - classical (P flexible)
M and P are proportional - economy ______ at FE
As the money supply contracts, the price level
________ resulting in a real ___________ (an
__________ in RER) and an _____________ in
the country’s international competitiveness - thus
_________ equilibrium in the CA.
Again the opposite will happen to the trade partner
- the monetary expansion resulting in an ______
in their price level and a ____________ in the
trade partner’s international competitiveness.
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Adjustment Mechanism
with Various Exchange Rate
Arrangements
Flexible Exchange Rate
Fixed Exchange Rate
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Flexible Exchange Rate
Adjustment through supply and demand
for foreign currency.
The S & D equilibrium determines the
equilibrium price of the foreign
currency in terms of the domestic
currency i.e. the _______________.
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The determinants of the demand
for foreign currency
We need to go back to the balance of payments and
find out which agents need foreign currency.
In the current account:
US ____________ - to pay for imports of foreign
goods and services
US _____ who must pay dividends to foreigners
holding their stocks
The US _________ planning to send money to the
victims of the tsunami
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In the financial account:
US ____________ who reshuffle their
portfolio into Canadian bonds
US ___________ who plan to carry out some
FDI into Indian IT
US ___________ rebuilding some destroyed
schools you know where
US ___________ in the process of rebuilding
its foreign reserves
The demand for foreign currency is a
_________ demand.
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To simplify, let’s assume that the demand for
foreign currency has only one determinant - the
demand for imports.
When the exchange rate E increases (the $ ______),
the price of imports PIM$ in $ _______ as
PIM$ = PIMFC * E
so the quantity of import demanded QIM _______
as they become _______ expensive for the US.
However the foreign price of imports PIMFC
__________.
so the total demand for FC equal to PIMFC * QIM
must _____ resulting in a ________ sloping
demand curve.
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When E increases, the demand for FC _____.
$/FC
D
Q of FC
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The determinants of the supply
of foreign currency
In the current account:
US ______ - receipts for exports of US goods
and services
US _______ receiving dividend income on
their foreign stock holdings.
______ by the sheik of Arabia to Harvard
University to endow a professorship.
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In the financial account:
Foreign ____________ who reshuffle their
portfolio into US bonds.
Foreign ____________ who plan to set up
new factories in the US.
Foreign __________ remodeling their
embassy in Washington.
Foreign __________ selling $ back to the US.
The supply of foreign currency is a
___________ supply.
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To simplify, let’s assume that the supply of foreign
currency has only one determinant - the supply of
___________.
This case is more complicated because we are now
2 steps removed from the __________ of foreign
currency.
Indeed the supply of export is really the
_____________ for our goods and services.
When the exchange rate E increases (the $
___________), the price of export PX$ in $ does
_____ change, but, for the foreign importers, the
price of our goods converted into their currency
i.e. in FC _____ as Ch2/ER
PXFC = PX$ / E. 19
so the quantity of export supplied QX
________ as they become _____ expensive
for the foreigners.
The question is what happens to the _______
supply of FC which is equal to PXFC * QX
Indeed PXFC ______ while QX _______ so the
result is ambivalent.
Assuming high elasticities, the percentage
change (increase) in quantities is _______
than the percentage change (drop) in price,
thus resulting in an ________ in the supply
of FC i.e. an _______ sloping supply curve.
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When E increases, the supply of FC _________
$/FC
S
Q of FC
Assuming high elasticities cf Marshall Lerner conditions
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Foreign Exchange Market Equilibrium
$/FC
S
E
D
Q of FC
The intersection of the supply and the demand for foreign
currency determines the ____________ exchange rate E
and the ________ of FC traded.
Ch2/ER
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Impact of a change
in the demand or in the supply of FC
The demand curve or the supply curve may shift
due to a change in _______
or to a change in __________
in anyone of the trade partner.
For instance US consumers are told that bananas
are very good for their health and the demand for
bananas shots up (the US does not produce
bananas). This triggers an ___________ in the
demand for FC (to buy the
bananas).
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Impact of a shift in demand
with a flexible exchange rate arrangement
$/FC
S
E’
E
D’
D
Q of FC
The $ ___________ from E to E’ to restore
equilibrium in the FC market while the
quantity of FC traded ___________.
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Impact of a shift in supply
with a flexible exchange rate arrangement
$/FC
S
S’
E
E’
D
Story: Dubai
decides to
buy a fleet of
Boeing for
their national
airline.
Q of FC
The $ ____________ from E to E’ to restore
equilibrium in the FC market while the
quantity of FC traded ___________.
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Fixed Exchange Rate
Adjustment through intervention by
Central Bank (CB or Fed in the US) in
the market for foreign currency.
The CB commits itself into upholding a
specific ER and adds its own supply
or its own demand to the market to
keep the exchange rate fixed.
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Foreign Exchange Market Equilibrium
Fixed exchange rate Ef :
market is in equilibrium at the fixed ER Ef
$/FC
S
Ef
D
Q of FC
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Case 1
Increase in demand of FC and intervention by CB
Goal: to keep ER at Ef
$/FC
S
E
Ef
D’
ED
To stop the $ from
________ to E, the Fed
must _______ (sell)
quantity ED of FC at
the fixed ER Ef thus
________ the FC and
__________ the $
D
Q of FC
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Case 2
Increase in supply of FC and intervention by CB
Goal: to keep ER at Ef
S
$/FC
Ef
S’
ES
E
D
To stop the $ from
__________ to E,
the Fed must _____
quantity ED of FC at
the fixed ER Ef thus
________ the FC
and _________ the $
Q of FC
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Intervention and the money supply: case 1
To prevent the $ from depreciating, the Fed
must __________ the excess _______ of
FC to the public (the importers mainly).
So the Fed _____ FC in the foreign exchange
market and receives payments in ___.
The FC were part of its assets so the Fed’s
assets _____ while the $ payments from the
public to the Fed correspond to a
__________ of the Fed’s liabilities towards
the public.
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Impact of Intervention on the Central Bank
Balance Sheet
Assets
Domestic assets
Domestic Bonds
Foreign Assets
Foreign Bonds
Foreign Currency
Gold
Liabilities
Currency
Commercial Bank
Reserves
Monetary
Base
When the CB sells FC to the public, the public
pays with domestic currency i.e. the liabilities of
the CB ________ - the monetary base (MB) and
thus the money supplyCh2/ER (M) ________. 31
Sterilization
Since a decrease in the money supply is
____________, the government may wish
in certain circumstances (a recession for
instance) to avoid worsening the state of the
economy.
In this case the government can __________
the impact of intervention on the money
supply by performing an
________________ of the same size but in
the __________ direction to cancel out
(sterilize) the effect on the money supply.
Ch2/ER
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Impact of Intervention followed by Sterilization
on the Central Bank Balance Sheet
Assets
Domestic assets
Domestic Bonds
Foreign Assets
Foreign Bonds
Foreign Currency
Gold
Liabilities
Currency
Commercial Bank
Reserves
Monetary
Base
As the CB sells FC to the public, it also _____ domestic
bonds from the public thus putting back in circulation the
currency wiped by the sale of FC to the public. The
monetary base (MB) and thus the money supply (M) thus
_____________________. Ch2/ER
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Exercise: rework slides 30 to 33 in the case of
excess supply of FC (Case 2)
Ch2/ER
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National Income Accounting in the
Open Economy
It is clear that exports are foreign demand for ____
goods and services and so ________ to the total
demand for domestic output.
On the other hand, imports are domestic demand for
goods produced ______ so they will detract from
total demand for domestically produced output as
they are income earned domestically that does not
add to demand for domestically produced output.
Ch2/ER
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Demand Z for domestic production Y
is defined as:
Z = C + I + G + X - IM
C, I and G are total demand from _________, _______ and
the ________, so Zt can be broken down into demand for
_________ produced goods and services and demand for
________ goods and services. X is export, IM import and
 the real exchange rate.
With
C = Cd +  Cf
I = Id +  If
and G = Gd +  Gf
The subscript d corresponds to domestically produced
and the subscript f corresponds to imported.
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The imported goods and services are expressed in
baskets of __________ goods. So they must be
converted into baskets of ________ goods using
the ______ exchange rate  = EP*/P
Since Z is defined as the demand for domestically
produced goods and C, I and G also include the
demand for imported goods, the latter has to be
_________ away from Z.
So we have:
and
Z = Cd +  Cf + Id +  If + Gd +  Gf + X
-  Cf -  If -  Gf
- Cf -  If -  Gf = - IM
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Definitions - Summary
• Z is the total demand - domestic and foreign for domestically produced goods and services.
• C + I + G is the domestic demand for ____
goods - produced domestically or abroad
it is called __________
• X - IM is the net foreign demand for domestic
goods - the balance of ____ - net ______
• IM are the imports expressed in _______ units
(baskets) - so imports must be converted into
domestic units (baskets) using the real ER 
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Marshall-Lerner condition
In principle, one would think that a depreciation
(or a devaluation) should result in an
______________ in the balance of trade.
A cheaper $ means that US goods will be ______
for the foreign buyers of our goods and they will
________ their purchases,
 _______ exports from our point of view
More expensive FC means that foreign goods will
be ______ expensive for us and we will buy ___
 _______ imports from our point of view
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However we were referring to _______ or _________ of
imports and exports. The balance of trade will actually
improve only if there is an _________ in the $ value of
export minus the $ value of import.
So will the $ value of export ________ and
will the $ value of import ________
as a result of a depreciation (or devaluation)?
We will show that the $ value of exports increases
____________ while the $ value of imports may
_______ or _______.
Finally if the value of imports increases and this increase is
greater than the increase in the value of exports, then the
balance of trade will definitely _______ as a result of a
depreciation.
Ch2/ER
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Let’s be more rigorous.
Assumptions:
short run - prices are fixed and the nominal and real
ER are proportional so we can focus on E only.
Assume P = P* = 1 then  = E
The balance of trade X -  *IM becomes X - E*IM
A depreciation is an _________ in E
X - volume of exports __________
IM - volume of imports ________
E*IM may _______ or __________
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Assume that all the prices remain fixed in term of
their own currency.
PX is the price of export (in $) and PM the price of
imports (in FC)
So the balance of trade is PX*X - EPM*IM
EPM is the foreign price of imports converted into $
The depreciation does not affect PX but X increases
so the value of exports [PX*X]
However EPM the price of imports converted into $
________ while IM ________,
so the value of imports in $ [EPM*IM] may or
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If the deterioration on the import side is greater than the
improvement on the export side, the balance of trade will
__________.
How can we predict whether there will be an increase in
the value of imports?
If the increase in price of imports results in a ________
reduction in the quantity demanded i.e. import demand
is _______, then the value of imports will _________.
Moreover if the decrease in the price of export results only
in a _______ increase in the value of export i.e. export
supply (foreign demand for our exports) is ________.
The increase in the value of exports may not be large
enough to _____ the increase in the value of imports and
the balance of trade will _________________.
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Elasticities are defined as:
% change in quantity/% change in price
Low elasticities 1 correspond to __________
demand or supply.
Marshall-Lerner conditions
A depreciation/devaluation will improve the
balance of trade only if the sum of the absolute
value of the elasticities of supply of exports ex
(i.e. foreign demand for our exports) and
domestic demand for imports em are
ex + em <1
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Example:
E
PX
X
PM
$PM=
EPM
1
$1=
FC1
2
FC1
$1
2
2-2=0
2
$1=
FC0.5
3
FC1
$2
1.9
3 - 3.8 = -0.8
Ch2/ER
M
BT =
PX *X - EPM*M
45
Let’s approximate the elasticities in this example:
em = %change in IM / % change in PM
= [(1.9-2)/1.95]/[(2-1)/1.5] = - 0.0769 _______
The elasticity of export supply is the elasticity of
foreign import demand for our good. To calculate
it we must convert the domestic price of export
into FC
ex = %change in X / % change in PX/E
= [(3-2)/2.5] / [(.5-1)/.75] = - 0.6
______
The sum of the 2 absolute values is 0.6769 < 1
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Example: Calculate whether M-L is fulfilled
E
PX
X
PM
$PM=
EPM
1
$1=
FC1
2
FC1
$1
2
2
$1=
FC0.5
4
FC1
$2
.5
Ch2/ER
M
BT =
PX *X - EPM*M
47
Let’s approximate the elasticities in this example:
em = %change in IM / % change in PM
= [(
)/ ]/[(2-1)/1.5] =
The elasticity of export supply is the elasticity of
foreign import demand for our good. To calculate
it we must convert the domestic price of export
into FC
ex = %change in X / % change in PX/E
= [(
)/ ] / [(.5-1)/.75] =
The sum of the 2 absolute values is
Ch2/ER
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The J-curve
• Why does the balance of trade worsens
immediately after a depreciation?
• Because quantities do not adjust ____________
(orders are placed in advance - several months)
• Immediate effect of the depreciation (in $):
• PM ___________ but QM ____________
• PX and QX are ______ affected
– So PXQX - PMQM _______
• Effect on monetary expansion: more overshooting
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The J-Curve
BT
t
t+3
t
At time t+3 quantities start to adjust to the depreciation
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