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CHAPTER 9
INTERNATIONAL ADJUSTMENT: AGGREGATE DEMAND AND SUPPLY IN AN OPEN
ECONOMY
Chapter Outline
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Aggregate Demand, Aggregate Supply and Net Exports
External Equilibrium
The Effects of Expansionary Monetary Policy
Do Net Exports respond to Changes in the Real Exchange Rate?
The Monetary Approach to the Balance of Payments
Sterilization
The Monetary Approach and the IMF
The Monetary Approach and Depreciation
Exchange Rate Fluctuations and Interdependence
Interdependence
Policy Coordination
Working With Data
Changes from the Previous Edition
Section 9-1 has been completely rewritten and is now much more focused, and retains the
essential elements of previous Sections 9-1 and 9-2. This section now centers on the real exchange rate,
savings and investment and the trade balance, so that there is a natural tie in with earlier chapters. There
is also a section on the empirical relationship between the real exchange rate and net exports.
Learning Objectives
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Students should understand the relationship between the nominal exchange rate, the domestic and
foreign price levels and the real exchange.
Students should understand how the open economy demand curve differs from the closed economy
demand curve.
Students should understand how purchasing power parity can be demonstrated through the open
economy aggregate demand-aggregate supply model.
Students should understand the monetary approach to the balance of payments.
Students should understand the implications of spillover (interdependence) effects.
Achieving the Objectives
Chapter 9 extends the discussion of issues of the open economy to the aggregate demand
aggregate supply model. We begin by discussing the real exchange rate and the open economy aggregate
demand curve. This is particularly relevant given the recent (nominal) appreciation of the Canadian
foreign exchange rate. In late 2003 and into 2004 the Bank of Canada has been particularly obsessed with
the effects this appreciation on aggregate demand. For those instructors who used Chapter 5, a discussion
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centering on Figure 9-2, and the equilibrium determination of the real exchange rate would be of
particular interest to students.
The long run predictions of the quantity theory of money have been discussed at several points in
this book. As an extension of these discussions, the purchasing power parity predictions of expansionary
monetary policy are discussed using Figure 9-3. As long as disturbances are caused primarily by
monetary factors, the exchange rate will eventually adjust by exactly the right amount to maintain the
purchasing power of domestic goods in terms of foreign goods. The purchasing power parity theory of the
exchange rate argues that exchange rate movements are primarily a reflection of a divergence in the
inflation rates between two countries, and that exchange rates behave in such a way as to leave the terms
of trade constant. This theory may provide a relatively plausible explanation of the trends in exchange
rates in the long run. However, the purchasing power parity theory is not very useful in explaining the
behaviour of exchange rate movements among major countries over the last few decades. First, not all
disturbances come from the monetary sector. Second, even a monetary disturbance affects the real
exchange rate in the short run. Data show that nominal exchange rate movements affect unit labour costs
measured in dollars and competitiveness on global markets.
It is also very helpful for students to understand the empirical relations between the real exchange
rate and net exports, which is discussed centering on Figure 9-4.
The process by which a currency devaluation (or depreciation) may actually have a negative
effect on the trade balance in the short run is known as the J-curve effect. Depreciation has two
consequences: first, since the relative prices of imports rise while the volume of imports remains
unchanged, the value (measured in domestic currency) of imports increases, worsening the trade balance.
Then, after some time has passed, exports will rise (since domestic goods are cheaper for foreigner
consumers) and imports will fall (since foreign goods are more expensive for domestic consumers),
bringing about an improvement in the terms of trade. If shown in a diagram, this response of the trade
balance to the depreciation of the domestic currency looks like the letter J, thus the name. The validity of
the J-curve effect has been questioned, and this material has been moved to Box 9-2.
The monetary approach asserts that persistent balance of payments deficits are purely a reflection
of excessive monetary growth. In other words, balance of payments deficits exist because the central bank
can, through sterilization, maintain a level of money supply that is too high to achieve an external
balance. In the absence of sterilization, a balance of payments deficit that arises from a monetary
disequilibrium will eventually always be self-correcting. However, this can be a very painful process
involving a period of high unemployment.
The monetary approach to the balance of payments has been used extensively by the IMF in
designing policies for countries with balance of payments problems. A plan for stabilization drawn up by
the IMF typically involves a balance of payments target. It also suggests domestic credit ceilings to keep
money supply from growing excessively. This monetary approach rightfully suggests that under a fixed
exchange rate system the economy will achieve internal and external balance in the long run, as prices
and money supply adjust. However, its assertion that exchange rate policies may not affect a country’s
competitiveness in the short run, is incorrect.
In a freely flexible exchange rate system, the government takes no action in the foreign exchange
market. Such a system is practically unheard of, since central banks often see the need to intervene in an
effort to stabilize exchange rates. A flexible exchange rates system is, in practice, a system of dirty
floating. While government intervention can help to smooth out temporary fluctuations, it tends to be
fairly problematic since governments can never be sure whether a disturbance is transitory and has arisen
from speculation or is of a more fundamental and persistent nature.
Whatever the exchange rate system (fixed or flexible), large spillover effects among countries
exist due to the increased interdependence. For example, the appreciation of the U.S. dollar in the early
1980s, caused by a combination of fiscal stimulation and monetary restriction, resulted in a decrease in
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U.S. competitiveness. While the U.S. experienced a trade imbalance, the rest of the world was able to
profit from this loss in competitiveness by increasing their exports.
To avoid unwanted spillover effects, countries may try to coordinate policies. Unless policies are
synchronized among countries, large exchange rate fluctuations may occur, posing a potential threat to
free trade. A foreign country may feel compelled to respond to a domestic policy change in a way that
limits foreign trade. The establishment of target zones to limit the fluctuation of exchange rates among all
industrial nations has been repeatedly proposed. However, unwillingness to relinquish sovereignty often
stands in the way, since target zones would involve the synchronization of both fiscal and monetary
policy.
Suggestions and Pitfalls
Students tend to be eager to discuss current international issues and instructors should have ample
opportunity to capture students’ interest by relating the theoretical framework presented in this chapter to
real world events. Recent examples are plentiful and include the creation of a new European currency, the
Asian crisis of 1997, issues related to NAFTA, and the potential for an international debt crisis.
Chapter 9 provides excellent opportunities for classroom discussion of the implications of the
increased globalization of economic activity. These discussions remind students that a good
understanding of macroeconomic principles can help them understand important current issues and
reemphasizes the fact that there are no clear-cut answers to these increasingly complex problems.
Instructors should point out that not all economists, and certainly not all politicians, believe in free trade.
While there are undoubtedly great benefits from increased trade, the free flow of capital, and direct
foreign investments, it is important to remember that there are also costs. The globalization of economic
activity has made it easier for firms to shift production to low wage countries, leading to job insecurity,
the loss of non-wage benefits, and even loss of tax revenue for the government. Therefore, protectionism
is always tempting. Students should also realize that free trade is an important contributor to economic
growth in some developing countries, a lesson that was already learned in Chapter 4.
Economic issues that deal with Mexico will also interest students, particularly as it relates to
NAFTA. Despite the hype that NAFTA received from many economists and politicians before its
implementation, students should be able to distinguish between fact and fiction. How much did it really
hurt Canadian workers, as labour unions proclaimed? Was NAFTA implemented more for economic or
political reasons?
Students are well aware of the increased globalization of economic activity, but may not be aware
of the extent of the spillover effects of domestic policies or disturbances on other countries. Before the
potential benefits of the synchronization of policies among countries (and the reasons for an apparent lack
of policy coordination) can be discussed, however, students need to have a clear understanding of the
workings of the freely floating exchange rate system. Assigning a few problems to determine how the
value of a currency adjusts to a specific disturbance is always helpful in making students more aware of
the workings of the foreign exchange market.
In the discussion of the adjustment processes in a flexible exchange rate system, it is important to
stress that the assumptions of capital mobility and flexible wages and prices will ensure a return to a fullemployment equilibrium and a trade balance in the long run. In other words, monetary policy is still
neutral in the long run, even in an open economy. However, it does affect relative prices and thus
competitiveness in the short run.
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Solutions to the Problems in the Textbook:
Discussion Questions:
1.a. A loss of export markets leads not only to an external deficit but also to a decrease in the level of
output. Since a policy dilemma between an external and an internal balance exists, a combination of
expenditure-switching and expenditure-raising policies is required. The levying of tariffs helps to
achieve an external balance, while an increase in government spending helps to achieve an internal
balance.
1.b. A reduction in saving and an increase in the demand for domestic goods will lead to an increase in
national income. As a result, imports will increase, leading to a balance of payments deficit. This is
not a dilemma situation and an expenditure-reducing policy (a cut in spending) will remedy the
situation.
1.c. An increase in government spending will lead to an increase in national income and the level of
imports. This will cause a balance of payments deficit. This is not a dilemma situation and an
expenditure-reducing policy (a cut in spending) will suffice to reestablish an internal and external
balance.
1.d. A shift in the demand from imports to domestic goods will increase output and lead to a trade
surplus. This is a dilemma situation and a combination of expenditure-switching and expenditurereducing policies should be employed. Lowering tariffs combined with a cut in government spending
will help to achieve an external and internal balance.
1.e. A reduction in imports with a corresponding increase in saving will not affect the level of national
income but it will lead to a trade surplus. An appropriate response is a reduction in income taxes
combined with lower tariffs. This will help to reduce the trade surplus without affecting national
income.
2. Temporary trade imbalances can be easily financed, since the central bank is not likely to run out of
foreign currency reserves rapidly. A country that has a temporary payments imbalance may even
borrow foreign currency from abroad as long as the level of domestic investment spending is
sufficient to increase the level of output, some of which will eventually be exported. A temporary
disturbance in trade patterns can come from a change in exchange rates caused by unstable exchange
rate expectations.
If a country suffers a permanent imbalance, however, the central bank will eventually run out of
foreign currency reserves. A permanent imbalance may be caused by a loss in foreign market share.
The adjustment can happen through the automatic adjustment process, but that could involve long
periods of high unemployment. Therefore, domestic policy changes are required to move the
economy more rapidly toward balance.
3. The answer to this question is student specific. Government intervention can help smooth out
temporary fluctuations in exchange rates. However, this is often problematic since at the time a
currency appreciation occurs, the government can never be sure whether a disturbance is transitory
and soon likely to reverse itself or more persistent and fundamental in nature. If unstable exchange
rate expectations lead to capital flows that cause exchange rate movements and undesired changes in
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domestic output, central bank intervention seems justified. But central banks also often intervene to
try to reduce inflation by preventing import prices from rising. The cost of reducing inflation in this
way is a steady loss in competitiveness, which may even result in a foreign exchange crisis.
Ultimately, inflation has to be stopped by restrictive monetary policy. Central banks may also
intervene to affect trade flows and to bring about desired changes in domestic output. In the long run,
however, governments are better off not opposing strong market forces by intervening in the foreign
exchange market. If a government really wants to bring about change, it should employ domestic
policies. It may supplement its policy by intervening in the foreign exchange market as well to
emphasize its intent.
Government intervention is more effective if it is backed up by credible policies. There is
evidence that non-sterilized intervention affects exchange rates more successfully, since there is a
change in money supply equal to the amount of the intervention. But if the intervention is sterilized,
domestic money supply will remain unchanged and even a massive intervention may not affect the
exchange rate to the desired degree.
4. This is basically a discussion of the points presented in Box 9-3
5. In a system of freely floating exchange rates, domestic monetary policy can be used effectively,
whereas in a system of fixed exchange rates, monetary policy is completely ineffective. A freely
floating exchange rate system is less crisis prone since exchange rates are determined solely by
market forces. It therefore provides a better framework for macroeconomic stability. However,
spillover effects make macroeconomic stabilization policy more difficult in a system of freely floating
exchange rates. These spillover (or interdependence) effects can lead to a loss of competitiveness
among other problems. There is therefore good reason for countries to coordinate their policies.
6. Central banks often intervene to affect exchange rates in the belief that they can affect trade flows and
prevent import prices from rising. They may also believe that exchange rate fluctuations have
occurred simply due to erratic changes in expectations. However, it is often unclear whether exchange
rate movements are transitory or the beginning of a new trend with strong market forces at work. This
makes intervention problematic. While non-sterilized intervention will affect exchange rates because
it will affect the domestic money supply, it is not clear that sterilized intervention will have the
desired effects.
7.
It appears that spillover (or interdependence) effects are much stronger under a system of floating
exchange rates. Therefore, it can be argued that macroeconomic stabilization policy can be just as
difficult under a system of freely floating exchange rates as under a system of fixed exchange rates.
Application Questions:
1. The imposition of a tariff raises the relative price of imports and increases the demand for domestic
goods. This increases the level of domestic output, causing interest rates to rise. Higher domestic
interest rates will lead to an inflow of funds and the domestic currency will begin to appreciate. The
higher value of the domestic currency will lower the relative price of imports again. With perfect
capital mobility, the currency appreciation will progress to the point where the overall change in net
exports is zero. In the end, the levels of output and the interest rate will be back at their original
levels.
2.
Assume a $10 billion balance of payments deficit occurs:
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The central bank's balance sheet before sterilization:
Assets
foreign exchange - 10
other reserves
0
Liabilities
member bank deposits - 10
currency
0
monetary base
monetary base
- 10
- 10
The central bank's balance sheet after sterilization:
Assets
foreign exchange - 10
govt. securities + 10
Liabilities
member bank deposits
currency
0
0
monetary base
monetary base
0
0
3. After a currency depreciation, exports should rise and imports should decline, both in the short run
and in the long run. However, empirical evidence suggests that in the short run the volume effects are
too small to overcome the price effect. Only in the long run, when consumers and producers have had
time to adjust to the change in relative prices, will the volume effects be large enough to overcome
the price effect.
Additional Problems:
1. "A trade imbalance can persist as long as the central bank wants it to." Comment.
Under a system of fixed exchange rates, the central bank of a country with a balance of payments deficit
has to sell foreign currency. This will reduce high-powered money and therefore domestic money supply,
which will result in a recession, a reduction in domestic prices, and an improvement in the trade balance.
This adjustment process can only be suspended through sterilization (the central bank offsets the decrease
in high-powered money through simultaneous open market purchases). A persistent balance of payments
deficit can only exist if the central bank actively keeps money supply above the level that would ensure an
external balance. Under a system of flexible exchange rates, a central bank can maintain an imbalance
through intervention in the foreign exchange market.
2. "A balance of payments surplus may lead to inflation, while a balance of payments deficit may
lead to unemployment." Comment on this statement.
A country that has a large balance of payments deficit (surplus) may intervene in the foreign exchange
market by selling (buying) foreign currency. Unless the intervention is sterilized, this will lead to a
reduction (increase) in the monetary base and thus money supply. But a reduction (increase) in money
supply may ultimately cause a recession (increase in inflation).
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3. Should a country ever borrow from abroad to finance a balance of trade deficit? Explain.
When deciding whether to finance a balance of trade deficit by borrowing from abroad, it is important to
know if the imbalance appears to be temporary or permanent. A temporary imbalance can be financed by
borrowing from abroad, if a country feels confident that it will be able to repay its debt. As long as there
is sufficient domestic investment to produce and export additional output, there should be relatively little
concern about borrowing from abroad.
However, a permanent imbalance cannot be financed by borrowing from abroad, since a country
cannot indefinitely spend more than its income. When a country runs a balance of payments deficit, the
demand for foreign exchange is by definition larger than the amount being supplied, and the central bank
has to sell the difference. Unless the central bank sterilizes its foreign exchange market intervention, this
will result in a reduction in high-powered money and thus money supply. This may ultimately lead the
domestic economy into a recession with high unemployment. To avoid this situation, the government may
instead decide on a combination of expenditure-reducing and expenditure-switching policies.
4. True or False? Why?
"If a country has a balance of payments deficit and its central bank wants to manipulate
exchange rates, it can sterilize the intervention by undertaking open market sales of bonds."
False. The central bank of a country with a balance of payments deficit may intervene in foreign exchange
markets by selling some of its foreign currency holdings. The resulting reduction in the amount of highpowered money can only be offset by an open market purchase of bonds (not sales). Such sterilized
intervention serves to maintain a constant level of domestic money supply.
5. True or False? Why?
"A country that has high unemployment and a balance of payments surplus needs a
combination of expenditure-reducing and expenditure-switching policies."
False. There is no policy conflict when the economy is faced with unemployment and a surplus in the
balance of payments. Expansionary fiscal policy will reduce unemployment and increase the interest rate.
Higher domestic interest rates will attract funds from abroad, which will result in an appreciation of the
home currency and a reduction in the payments surplus. A country that has high unemployment and a
balance of payments surplus need only employ an expenditure-increasing policy to bring the economy
back to a situation of internal and external balance.
6. Under a fixed exchange rate system there is a direct link between the balance of payments and
the domestic money supply. Does such a direct link also exist under a system of freely floating
exchange rates?
Under a system of freely floating exchange rates, there is no direct link between the balance of payments
and domestic money supply, since there are no changes in international reserves to affect the monetary
base (high-powered money). Only if the central bank decides to manipulate exchange rates by actively
intervening in foreign exchange markets will the monetary base and money supply be affected. But a
central bank always has the option to sterilize its intervention in foreign exchange markets through
appropriate open market operations, leaving money supply unchanged.
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7. Discuss the possibility that an exchange rate depreciation may actually worsen the trade
balance.
After an exchange rate depreciation, the relative price of imports rises. Initially the trade balance is likely
to worsen since the volume of imports will not change rapidly, while the value of those imports measured
in domestic currency will increase due to the change in relative price. But the increased relative price of
imports increases competitiveness (exports rise as domestic goods become cheaper for foreigners to buy
and imports decline as imports become more expensive for domestic consumers to buy). The short-term
volume effect tends to be fairly small and does not outweigh the price effect. Therefore, the depreciation
will temporarily worsen the trade balance. But after a period of adjustment, the volume effect will become
substantial enough to improve the trade balance. This slow response of trade flows to exchange rate
movements is called the "J-curve effect."
8. "If the Bank of Canada used expansionary monetary policy to lower the value of the Canadian
dollar, the Canadian trade balance would immediately improve." Comment on this statement.
When the Bank uses expansionary monetary policy, domestic interest rates decrease and, eventually, the
rate of inflation increases. Both events lead to a depreciation of the Canadian dollar. After an exchange
rate depreciation, the relative price of imports rises, making Canadian goods more competitive.
Consequently, the trade balance slowly improves, although it may initially actually worsen the trade
balance, since the volume of imports changes gradually, while the value measured in domestic currency
increases more quickly. Eventually, the increased relative price of imports will increase competitiveness,
so exports will rise (as domestic goods are now cheaper for foreigners to buy) and imports will decline (as
foreign goods are more expensive for domestic consumers to buy). The short-term volume effect will be
fairly small and will be outweighed by the price effect in the long run. Therefore, a currency depreciation
will worsen the trade balance at first but improve it in the long run as the volume effect becomes more
substantial. This slow response of trade flows to exchange rate movements is called the "J-curve effect."
9. Comment on the following statement:
"The purchasing power parity theory does a good job of explaining exchange rate movements."
The purchasing power parity theory suggests that exchange rate movements mainly reflect the
differentials in national inflation rates. In the long run, the purchasing power parity theory holds up
reasonably well, especially when inflation rates are high and caused by monetary changes. However, in
the short run, even a monetary disturbance will affect competitiveness, since exchange rates move much
more rapidly than prices. Similarly, when a real disturbance occurs, the purchasing power parity
relationship will no longer hold, since the adjustment will affect the equilibrium terms of trade. Examples
of such real disturbances are changes in technology, shifts in export demand, and shifts in potential output
in different countries.
10. Explain why restrictive monetary policy to control inflation may be unsuccessful if the central
bank pays too much attention to stabilizing the value of the domestic currency.
If the central bank employs restrictive monetary policy, interest rates will increase which will lower the
level of investment, leading to a decline in economic activity and eventually a lower the rate of inflation.
High interest rates will lead to an inflow of funds and appreciate the value of the currency. A higher
currency value will make domestic goods less competitive on world markets, leading to a decrease in net
exports. But if the central bank pays too much attention to the value of the domestic currency, monetary
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policy will not be very effective, since the policy will have to be at least partially reversed as soon as the
value of the currency is affected by the inflow of funds in response to higher interest rates.
11. Comment on the following statement:
"Some foreign countries artificially create a comparative advantage by paying exploitative
wages to their workers; this is why we need to protect domestic industry through tariffs."
One argument used in support of trade restrictions against foreign countries is that other countries either
unfairly subsidize their export industries or allow low wage levels, which enable their industries to sell
their goods cheaply on the world market. According to some people, the Canada should impose trade
restrictions, such as tariffs, to avoid the loss of jobs resulting from trade imbalances. But trade restrictions
by one country will almost certainly cause a reaction from other countries and in the end everybody will
be worse off. Any kind of trade restriction also interferes with the free market system, leading to
inefficiencies.
12. "Either expansionary fiscal policy or a currency depreciation will increase domestic national
income by decreasing the level of foreign output demanded." Comment on this statement.
The central bank can intervene in exchange rate markets by buying foreign currency. If it does so,
domestic money supply and national income increase, while the currency depreciates. The currency
depreciation increases competitiveness and net exports, while income in other countries decreases.
Expansionary fiscal policy, on the other hand, leads to an increase in national income and domestic
interest rates. The increase in interest rates leads to a capital inflow, appreciation of the domestic
currency, and a loss in competitiveness. A trade deficit develops as other countries' exports increase. The
income in other countries therefore increases.
13. "A combination of expansionary fiscal and restrictive monetary policy will lower inflation,
increase investment, and lower the trade deficit." Comment on this statement.
A combination of expansionary fiscal and restrictive monetary policy will lead to an increase in real
interest rates with little or no change in aggregate demand or national income. High interest rates will
either crowd out private investment or lead to an inflow of funds from abroad, which will appreciate the
value of the domestic currency. This will make domestic goods less competitive on world markets, so
trade deficits will develop. The restrictive monetary policy will eventually decrease the rate of inflation.
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