Balance of Payments and Exchange Rates

Balance of Payments and Exchange Rates Alternative Exchange Rate Regimes

ALTERNATIVE EXCHANGE RATE REGIMES Internal and external policy objectives internal balance external balance narrow sense: current account balance broad sense: total currency flow balance 2

Internal and external balance W, J (a) Internal balance W1 J1 O YF Ye1 National income

Internal and external balance S1 by UK D by overseas residents (b) External balance Exchange rate r1 Fixed exchange rate O Quantity of £s

ALTERNATIVE EXCHANGE RATE REGIMES Internal and external policy objectives internal balance external balance narrow sense: current account balance broad sense: total currency flow balance possible conflicts between internal and external objectives 2

Internal and external balance W, J Assume that initially there is internal imbalance: at Ye2 W2 W1 J1 J2 O Ye2 YF Ye1 National income

Internal and external balance W, J Assume that the government increases aggregate demand to achieve internal balance. W2 W1 J1 J2 O Ye2 YF Ye1 National income

Internal and external balance This creates external imbalance: i.e. currency flow deficit S1 by UK S2 by UK Exchange rate r1 Fixed exchange rate D by overseas residents O Quantity of £s

Internal and external balance S1 by UK S2 by UK Exchange rate r1 Or an imbalance in the narrow sense (a current account deficit) under a floating exchange rate r2 D by overseas residents O Quantity of £s

Effects on internal and (narrow) external balance Current account surplus 1 2 Contractionary fiscal policy Lower consumption Exchange rate depreciation Foreign boom Internal balance External balance Recession Boom Exchange rate appreciation Foreign recession Expansionary fiscal policy Higher consumption 3 4 Current account deficit

UK balance of payments as % of GDP, 1970–2007 Source: Financial Statement and Budget Report (H M Treasury, 2005)

ALTERNATIVE EXCHANGE RATE REGIMES Internal and external policy objectives internal balance external balance narrow sense: current account balance broad sense: total currency flow balance possible conflicts between internal and external objectives Nominal and real exchange rates 2

ALTERNATIVE EXCHANGE RATE REGIMES Internal and external policy objectives internal balance external balance narrow sense: current account balance broad sense: total currency flow balance possible conflicts between internal and external objectives Nominal and real exchange rates real exchange rate index RERI = NERI × PX / PM 2

Sterling nominal and real exchange rate indices (1990 = 100) Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)

Sterling nominal and real exchange rate indices (1990 = 100) Nominal exchange rate Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)

Sterling nominal and real exchange rate indices (1990 = 100) Nominal exchange rate Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)

Sterling nominal and real exchange rate indices (1990 = 100) Real exchange rate Nominal exchange rate Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)

Sterling nominal and real exchange rate indices (1990 = 100) Real exchange rate Nominal exchange rate Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)

ALTERNATIVE EXCHANGE RATE REGIMES completely fixed 2

(a) Total currency flow deficit S by UK D from abroad Exchange rate b a Fixed rate O Quantity of £s

(b) Total currency flow surplus S by UK Exchange rate d c Fixed rate D from abroad O Quantity of £s

ALTERNATIVE EXCHANGE RATE REGIMES completely fixed freely floating 2

ALTERNATIVE EXCHANGE RATE REGIMES completely fixed freely floating intermediate 2

ALTERNATIVE EXCHANGE RATE REGIMES Fixed exchange rates foreign exchange intervention effects on the money supply sterilisation correcting a disequilibrium expenditure reducing expenditure switching 3

ALTERNATIVE EXCHANGE RATE REGIMES Free-floating exchange rates automatic correction 4

Adjustment of the exchange rate to a shift in demand and supply Depreciation er2 D1 O Quantity of £s

Adjustment of the exchange rate to a shift in demand and supply Appreciation er1 Exchange rate D1 O Quantity of £s

ALTERNATIVE EXCHANGE RATE REGIMES Free-floating exchange rates automatic correction expenditure switching (the substitution effect) 4

ALTERNATIVE EXCHANGE RATE REGIMES Free-floating exchange rates automatic correction expenditure switching (the substitution effect) the process of adjustment 4

ALTERNATIVE EXCHANGE RATE REGIMES Free-floating exchange rates automatic correction expenditure switching (the substitution effect) the process of adjustment elasticities of currency demand and supply 4

Supply of pounds and the elasticity of demand for imports Exchange rate Elastic demand for imports O Quantity of £s

Supply of pounds and the elasticity of demand for imports Exchange rate Inelastic demand for imports S O Quantity of £s

Unstable equilibrium Exchange rate r S D O Quantity of £s

Unstable equilibrium Exchange rate r S D O Quantity of £s

ALTERNATIVE EXCHANGE RATE REGIMES Free-floating exchange rates automatic correction expenditure switching (the substitution effect) the process of adjustment elasticities of currency demand and supply the Marshall–Lerner condition 4

ALTERNATIVE EXCHANGE RATE REGIMES Free-floating exchange rates automatic correction expenditure switching (the substitution effect) the process of adjustment elasticities of currency demand and supply the Marshall–Lerner condition expenditure changing (the income effect) 4

ALTERNATIVE EXCHANGE RATE REGIMES Free-floating exchange rates automatic correction expenditure switching (the substitution effect) the process of adjustment elasticities of currency demand and supply the Marshall–Lerner condition expenditure changing (the income effect) a rise in income 4

The income effect (stable prices) Y E1 Y1 Current account deficit of a – b Expenditure (E), exports (X), imports (M) (X – M)1 b a O Y

The income effect (stable prices) Y E1 Exchange rate depreciates Expenditure (E), exports (X), imports (M) a O Y1 Y b (X – M)1

The income effect (stable prices) Y E1 Exports rise; imports fall Expenditure (E), exports (X), imports (M) a O Y1 Y b (X – M)1

The income effect (stable prices) Y E1 Expenditure rises Expenditure (E), exports (X), imports (M) a O Y1 Y b (X – M)1

The income effect (stable prices) Y E1 Income effect Exports fall back somewhat; imports rise back somewhat Expenditure (E), exports (X), imports (M) a O Y1 Y b (X – M)1

The income effect (stable prices) Y E2 E1 Y2 Eventual equilibrium (Y2) Positive substitution effect: c – b Negative income effect: c – a Net balance of payments effect: a – b Expenditure (E), exports (X), imports (M) (X – M)2 c a O Y1 Y b (X – M)1

ALTERNATIVE EXCHANGE RATE REGIMES Free-floating exchange rates automatic correction expenditure switching (the substitution effect) the process of adjustment elasticities of currency demand and supply the Marshall–Lerner condition expenditure changing (the income effect) a rise in income a rise in prices 4

ALTERNATIVE EXCHANGE RATE REGIMES Intermediate exchange rate regimes adjustable peg dirty floating crawling peg 5

The crawling peg within exchange rate bands $1.60 $1.40 Exchange rate O Time No intervention Central bank buys domestic currency No intervention Central bank sells domestic currency No intervention

ALTERNATIVE EXCHANGE RATE REGIMES Intermediate exchange rate regimes adjustable peg dirty floating crawling peg joint float 5

ALTERNATIVE EXCHANGE RATE REGIMES Intermediate exchange rate regimes adjustable peg dirty floating crawling peg joint float exchange rate bands 5

ALTERNATIVE EXCHANGE RATE REGIMES Intermediate exchange rate regimes adjustable peg dirty floating crawling peg joint float exchange rate bands exchange rate bands under the old ERM 5

Balance of Payments and Exchange Rates Fixed Exchange Rates

FIXED EXCHANGE RATES Response to contractionary internal shock short-run effect assumption: relatively inflexible wages & prices effects of reduced aggregate demand current account surplus reduced interest rates  financial account deficit financial account effect likely to be the bigger to prevent exchange rate falling, the interest rate must thus not be allowed to fall so far money supply must be allowed to contract to match the fall in demand for money internal imbalance will persist 6

FIXED EXCHANGE RATES Response to contractionary internal shock long-run effect assume: greater flexibility of wages & prices this allows internal balance to be restored external effects of reduced AD large current account surplus from fall in real exchange rate reduced somewhat by the rise again in aggregate demand from higher exports and lower imports overall external balance restored current account surplus may persist 7

FIXED EXCHANGE RATES Response to contractionary external shock short-run effect assumption: fall in exports current account deficit fall in X  fall in AD  fall in M financial account fall in AD  fall in r if r is allowed to fall  financial account deficit money supply must be reduced to prevent this happening  this allows r to rise rise in r makes recession worse 6

FIXED EXCHANGE RATES Response to contractionary external shock long-run effect assumption: fall in exports reduction in AD reduces inflation this reduces real exchange rate current account deficit is eliminated flexible prices restore internal balance too but the ‘long term’ may be very long in coming! 7

FIXED EXCHANGE RATES Effectiveness of government policies monetary policy relatively ineffective fiscal policy relatively effective Causes of balance of payments problems under fixed rates different rates of inflation different rates of growth income elasticities of demand for imports higher than for exports long-term structural changes 8

FIXED EXCHANGE RATES Advantages of fixed exchange rates certainty no speculation (if rate is absolutely fixed) automatic correction of monetary errors prevents ‘irresponsible’ government policies 9

FIXED EXCHANGE RATES Disadvantages of fixed exchange rates new classical view make monetary policy ineffective anti free market Keynesian view balance of payments deficits can lead to recession possibility of competitive deflation problems of international liquidity inability to adjust to shocks speculation 9

Balance of Payments and Exchange Rates Free-floating Exchange Rates

FREE-FLOATING RATES Response to shocks internal shocks external shocks purchasing-power parity theory limitations of theory in short run changes in interest rates affect financial account this affects current account in opposite direction external shocks changes in exchange rate help to insulate domestic economy from such shocks the path to long-run equilibrium 10

Exchange rate path to long-run equilibrium after a shock at time t1 er1 Exchange rate path Nominal exchange rate erL t1 O Time

Exchange rate path to long-run equilibrium after a shock at time t1 er1 Exchange rate path Nominal exchange rate erL t2 O t1 Time

FREE-FLOATING RATES Speculation stabilising speculation 10

Stabilising speculation D3 D2 er1 People believe that exchange rate change is only temporary. er3 Exchange rate er2 D1 O Quantity of £s

FREE-FLOATING RATES Speculation stabilising speculation destabilising speculation 10

Destabilising speculation er1 People believe that exchange rate change indicates a trend. er2 Exchange rate er3 D1 O Quantity of £s

FREE-FLOATING RATES Speculation stabilising speculation destabilising speculation overshooting 10

FREE-FLOATING RATES Effectiveness of government policy monetary policy relatively effective direct effect on aggregate demand reinforced by a change in the exchange rate effect of speculation fiscal policy relatively ineffective offset by effect on interest rates & exchange rate 10

FREE-FLOATING RATES Advantages of free-floating rates automatic correction no problem of international liquidity and reserves insulation from external events governments free to pursue domestic policy Disadvantages of free-floating rates unstable exchange rates 11

Fluctuations between the euro and the dollar

Fluctuations between the euro and the dollar US interest rate

Fluctuations between the euro and the dollar US interest rate ECB interest rate

Fluctuations between the euro and the dollar US interest rate ECB interest rate

Fluctuations between the euro and the dollar US interest rate $ / € ECB interest rate

FREE-FLOATING RATES Advantages of free-floating rates automatic correction no problem of international liquidity and reserves insulation from external events governments free to pursue domestic policy Disadvantages of free-floating rates unstable exchange rates speculation 11

FREE-FLOATING RATES Advantages of free-floating rates automatic correction no problem of international liquidity and reserves insulation from external events governments free to pursue domestic policy Disadvantages of free-floating rates unstable exchange rates speculation uncertainty for business 11

FREE-FLOATING RATES Advantages of free-floating rates automatic correction no problem of international liquidity and reserves insulation from external events governments free to pursue domestic policy Disadvantages of free-floating rates unstable exchange rates speculation uncertainty for business lack of discipline on economy 11

Balance of Payments and Exchange Rates Exchange Rate Systems in Practice

EXCHANGE RATE SYSTEMS IN PRACTICE The Bretton Woods system (1943–73) the system role of the IMF correction through deflation or reflation correction through devaluation or revaluation Problems of adjustment disruption of devaluations J-curve effect of devaluation 14

The J-curve effect t1 X - M Devaluation takes place at t1 Surplus Deficit t1 Time

EXCHANGE RATE SYSTEMS IN PRACTICE The Bretton Woods system (1943–73) the system role of the IMF correction through deflation or reflation correction through devaluation or revaluation Problems of adjustment disruption of devaluations J-curve effect of devaluation stop–go policies 14

EXCHANGE RATE SYSTEMS IN PRACTICE The Bretton Woods system (1943–73) the system role of the IMF correction through deflation or reflation correction through devaluation or revaluation Problems of adjustment disruption of devaluations J-curve effect of devaluation stop–go policies speculation 14

EXCHANGE RATE SYSTEMS IN PRACTICE The Bretton Woods system (cont.) problems of international liquidity over-reliance on US dollar problem of US deficits and excess liquidity decline in confidence in the system the collapse of the system 15

EXCHANGE RATE SYSTEMS IN PRACTICE Managed floating: 1972 onwards forms of managed flexibility extent of intervention forms of intervention justification of managed floating focus on long-term equilibrium exchange rate adjustment is less disruptive Problems with managed floating predicting the long-term equilibrium rate speculative financial movements conflicts with internal policy 16

Exchange rate indices averages for each period (1995 = 100) Based on data in European Economy Statistical Annex (Commission of the European Union)

EXCHANGE RATE SYSTEMS IN PRACTICE UK experience of managed floating 17

$ / £ exchange rate and £ exchange rate index: 1976–2005

$ / £ exchange rate and £ exchange rate index: 1976–2005

$ / £ exchange rate and £ exchange rate index: 1976–2005 1990=100 $ / £

$ / £ exchange rate and £ exchange rate index: 1976–2005 1990=100 $ / £

EXCHANGE RATE SYSTEMS IN PRACTICE UK experience of managed floating effects of first oil crisis: 1973–6 6 17

EXCHANGE RATE SYSTEMS IN PRACTICE UK experience of managed floating effects of first oil crisis: 1973–6 second oil crisis and the rise in monetarism 17

$ / £ exchange rate and £ exchange rate index: 1976–2005 1990=100 $ / £

EXCHANGE RATE SYSTEMS IN PRACTICE UK experience of managed floating effects of first oil crisis: 1973–6 second oil crisis and the rise in monetarism effects of growing US budget and trade deficits in the 1980s 17

EXCHANGE RATE SYSTEMS IN PRACTICE UK experience of managed floating effects of first oil crisis: 1973–6 second oil crisis and the rise in monetarism effects of growing US budget and trade deficits in the 1980s the 1985 exchange crisis 17

$ / £ exchange rate and £ exchange rate index: 1976–2005 1990=100 $ / £

EXCHANGE RATE SYSTEMS IN PRACTICE UK experience of managed floating effects of first oil crisis: 1973–6 second oil crisis and the rise in monetarism effects of growing US budget and trade deficits in the 1980s the 1985 exchange crisis joining and leaving the ERM 17

EXCHANGE RATE SYSTEMS IN PRACTICE UK experience of managed floating effects of first oil crisis: 1973–6 second oil crisis and the rise in monetarism effects of growing US budget and trade deficits in the 1980s the 1985 exchange crisis joining and leaving the ERM sterling in the mid 1990s 17

$ / £ exchange rate and £ exchange rate index: 1976–2005 1990=100 $ / £

EXCHANGE RATE SYSTEMS IN PRACTICE UK experience of managed floating effects of first oil crisis: 1973–6 second oil crisis and the rise in monetarism effects of growing US budget and trade deficits in the 1980s the 1985 exchange crisis joining and leaving the ERM sterling in the mid 1990s recent experience 17

$ / £ exchange rate and £ exchange rate index: 1976–2005 1990=100 $ / £

EXCHANGE RATE SYSTEMS IN PRACTICE UK experience of managed floating effects of first oil crisis: 1973–6 second oil crisis and the rise in monetarism effects of growing US budget and trade deficits in the 1980s the 1985 exchange crisis joining and leaving the ERM sterling in the mid 1990s recent experience problems of a high pound 17

EXCHANGE RATE SYSTEMS IN PRACTICE UK experience of managed floating effects of first oil crisis: 1973–6 second oil crisis and the rise in monetarism effects of growing US budget and trade deficits in the 1980s the 1985 exchange crisis joining and leaving the ERM sterling in the mid 1990s recent experience problems of a high pound exchange rate effects of inflation targeting 17

EXCHANGE RATE SYSTEMS IN PRACTICE The volatility of exchange rates causes of volatility money supply and inflation targets growth in financial movements abolition of exchange controls growth in IT growth in speculative activity growing belief that governments are powerless to prevent speculation 17

Balance of Payments and Exchange Rates The Open Economy and ISLM Analysis

THE OPEN ECONOMY AND ISLM ANALYSIS The BP curve 12

The BP curve r BP SURPLUS r1 DEFICIT O Y

The BP curve r Y1 SURPLUS BP DEFICIT O Y

The BP curve r BP a r1 Y1 O Y

The BP curve r Assume that national income rises BP a r1 O Y1 Y1 Y

Deficit if rate of interest The BP curve r Assume that national income rises BP a b r1 Deficit if rate of interest remains at r1 O Y1 Y1 Y

The BP curve r BP r2 r1 Rate of interest must rise to r2 to restore balance of payments O Y1 Y1 Y

THE OPEN ECONOMY AND ISLM ANALYSIS The BP curve Analysis under a fixed exchange rate 12

THE OPEN ECONOMY AND ISLM ANALYSIS The BP curve Analysis under a fixed exchange rate equilibrium in the model 12

ISLMBP analysis: fixed exchange rates O Y Full equilibrium in the goods, money and foreign exchange markets

THE OPEN ECONOMY AND ISLM ANALYSIS The BP curve Analysis under a fixed exchange rate equilibrium in the model movement to a new equilibrium 12

THE OPEN ECONOMY AND ISLM ANALYSIS The BP curve Analysis under a fixed exchange rate equilibrium in the model movement to a new equilibrium effects of fiscal policy 12

ISLMBP analysis: fixed exchange rates O Y An expansionary fiscal policy

ISLMBP analysis: fixed exchange rates Balance of payments surplus causes money supply to expand a r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy

ISLMBP analysis: fixed exchange rates Restoration of full equilibrium a Y3 r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy

ISLMBP analysis: fixed exchange rates O Y1 Y An expansionary fiscal policy: BP curve steeper than LM curve

ISLMBP analysis: fixed exchange rates O Y1 Y An expansionary fiscal policy: BP curve steeper than LM curve

ISLMBP analysis: fixed exchange rates Balance of payments deficit causes money supply to contract a r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy: BP curve steeper than LM curve

ISLMBP analysis: fixed exchange rates Restoration of full equilibrium a r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy: BP curve steeper than LM curve

THE OPEN ECONOMY AND ISLM ANALYSIS The BP curve Analysis under a fixed exchange rate equilibrium in the model movement to a new equilibrium effects of fiscal policy effects of monetary policy 12

ISLMBP analysis: fixed exchange rates O Y1 Y An expansionary monetary policy

ISLMBP analysis: fixed exchange rates O Y1 Y An expansionary monetary policy

ISLMBP analysis: fixed exchange rates Balance of payments deficit causes money supply to contract again b r2 IS O Y1 Y2 Y An expansionary monetary policy

ISLMBP analysis: fixed exchange rates Full equilibrium is restored back at point a b r2 IS O Y1 Y2 Y An expansionary monetary policy

THE OPEN ECONOMY AND ISLM ANALYSIS Analysis under free-floating rates effects of exchange rate changes on the BP curve 13

Movements in the BP curve Appreciation SURPLUS BP O Y

Movements in the BP curve Depreciation DEFICIT O Y

THE OPEN ECONOMY AND ISLM ANALYSIS Analysis under free-floating rates effects of exchange rate changes on the BP curve achievement of equilibrium 13

THE OPEN ECONOMY AND ISLM ANALYSIS Analysis under free-floating rates effects of exchange rate changes on the BP curve achievement of equilibrium effects of fiscal policy 13

ISLMBP analysis: floating exchange rates An expansionary fiscal policy

ISLMBP analysis: floating exchange rates Balance of payments surplus causes the exchange rate to appreciate O Y1 Y2 Y An expansionary fiscal policy

ISLMBP analysis: floating exchange rates The appreciation causes the IS curve to shift to the left a r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy

ISLMBP analysis: floating exchange rates Full equilibrium is restored at point c Y3 a r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy

ISLMBP analysis: floating exchange rates An expansionary fiscal policy: BP curve steeper than LM curve

ISLMBP analysis: floating exchange rates Balance of payments deficit causes exchange rate to depreciate a r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy: BP curve steeper than LM curve

ISLMBP analysis: floating exchange rates Depreciation causes the IS curve to shift to the right r2 a r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy: BP curve steeper than LM curve

ISLMBP analysis: floating exchange rates Full equilibrium is achieved at point c b r2 Y3 a r1 IS2 IS1 O Y1 Y2 Y An expansionary fiscal policy: BP curve steeper than LM curve

THE OPEN ECONOMY AND ISLM ANALYSIS Analysis under free-floating rates effects of exchange rate changes on the BP curve achievement of equilibrium effects of fiscal policy effects of monetary policy 13

ISLMBP analysis: floating exchange rates An expansionary monetary policy

ISLMBP analysis: floating exchange rates The balance of payments deficit causes the BP line to shift downward r2 b IS1 O Y1 Y2 Y An expansionary monetary policy

ISLMBP analysis: floating exchange rates The depreciation causes the IS curve to shift to the right r2 b IS1 O Y1 Y2 Y An expansionary monetary policy

ISLMBP analysis: floating exchange rates Full equilibrium is restored at point c IS1 O Y1 Y2 Y An expansionary monetary policy