1. TWO-COUNTRY STOCK- FLOW-CONSISTENT MACROECONOMICS GODLEY AND LAVOIE MONETARY ECONOMICS (2007) CHAPTER 12 AND AFTER

2. Outline Notes on the open economy model, in particular price elasticities of exports and imports Experiments in two closures: What happens when domestic exports fall exogenously:  In the fixed exchange rate regime with endogenous foreign reserves  In the flexible exchange rate regime

3. A complex model with several endogenous variables Import prices, export prices, domestic sales deflator, GDP deflator, (exchange rate); Exports, imports, output, consumption, domestic sales, disposable income Taxes, interest payments, money stock, holdings of bills and money (portfolios), wealth Trade balance, current account balance, capital account balance, (foreign reserves)

4. … but still elementary model The simplifying assumptions are enormous.  There is no domestic or foreign investment in fixed or working capital  No holdings of financial assets by firms;  No wage inflation  No commercial banking  No “hot money”.  The treatment of expectations is rudimentary. Yet the model contains nearly 90 equations!

5. HHFirmGovtCentral bank +H$-H$ +B$£.xr£ +B$$-B$+Bcb$ +or$.pg$ -V$-NWg$=+B$0 000 Cash # Bills $ Bills Gold Balance Sum Balance sheet of US country The net worth of the US central bank has to be zero (all profits are distributed to government, and the price of gold in dollars is assumed constant).

6. HHFirmsGovtCentral bank B1Cash+H£-H£ B2# Bills+B££-B£+Bcb£ B3$ Bills+B£$.xr$+Bcb£$.xr$ B4Gold+or£.pg£ B5Balance-V£-NWg£ = +B£-NWcb£ B6Sum000 Balance sheet of the UK country The net worth of the UK central bank may become positive, because The central bank can achieve a capital gain when the $ currency appreciates, that is when the number of pounds per dollar xr$ goes up

7. A fully-consistent stock-flow model Here we skip the behavioural equations tied to portfolio choices, as well as the explanations about asset supplies. The main dynamic equation is the one that ties consumption to disposable income and wealth. We also skip the transactions-flow matrix, which records the accounting flows arising from the model. One also needs a revaluation matrix, to take capital gains into account. For each closure, one can identify an accounting redundant equation, which is not part of the simulation model, but which must be satisfied for the model to be fully coherent.

8. Trade prices pm£ = 0 − 1.xr£ + (1 − 1 ).py£ + 1.py$ 0 < 1 nu < 1 px£ =  0 −  1.xr£ + (1 −  1 ).py£ +  1.py$ 0 <  1 upsilon < 1 where pm is import prices, px is export prices, py is the GDP deflator, while bold characters denote natural logs of these variables.

9. Why? (1 − 1 ).py£ + 1.py$ If there were a simultaneous addition of some given amount to domestic inflation in both countries with no change in the exchange rate, then there would be an equivalent addition to export and (therefore) import prices in each country – hence the constraint that the coefficients on domestic and foreign inflation sum to unity.

10. Why ? − 1.xr£ + (1 − 1 ).py£ If depreciation were exactly paralleled by a simultaneous and equal addition to domestic inflation, it is reasonable to expect that import prices would rise by the full amount of the depreciation – hence the sum of the coefficients on the (negative of the) exchange rate and domestic inflation must also sum to unity

11. Trade flows x£ =  0 −  1 (pm$ -1 − py$ -1 ) +  2.y$ im£ = μ 0 − μ 1 (pm£ -1 – py£ -1 ) + μ 2.y£ First equation says that the volume of UK exports (x£) responds with an elasticity of  1 (epsilon1) with respect to US import prices relative to US domestic prices, and  2 with respect to US domestic output (y$). Second equation says that UK imports (im£) respond with elasticities μ 1 (mu1) with respect to UK import prices (pm£) relative to UK domestic prices (py£), and μ 2 with respect to UK domestic output (y£).

12. Marshall-Lerner conditions It is usually asserted that the sum of the elasticities with respect to relative prices (here, ε 1 + μ 1 ) must sum to at least one if the trade balance is to improve following devaluation (the Marshall-Lerner condition). This however is based on the assumption that import prices in domestic currency will fall by the full amount of the devaluation (a full pass-through), while export prices in domestic currency won’t change.

13. A modified Marshall-Lerner condition In verity the sum of these elasticities need be no greater than the elasticity of terms of trade with regard to devaluation. For instance if, following a devaluation of 10%, terms of trade were to decrease by 2% (as is assumed in our simulations, with ν 1 −  1 = 0.2), then the sum of the price elasticities need be no more than 0.2. If there were no change at all in the terms of trade following devaluation – not an impossible outcome – the sum of the elasticities need be no greater than positive for the balance of trade to improve.

14. The modified condition itself questioned In reality, things are more complicated, as the recovery in the trade balance implies larger domestic income, and hence income effects on the trade balance. The conditions are thus stricter than indicated in the previous slide. For instance, in our simulations, with our parameters, the trade balance improved only when the sum of the price elasticities exceeded 0.35 (when terms of trade went down by 0.2). In addition, while the trade balance may keep improving, the current account may deteriorate due to interest payments on foreign debt

15. Devaluation as a response to a drop in exports, when the sum of price elasticities are only 0.70: the trade balance recovers after a lag (J-curve) Shock Devaluation

16. The fixed exchange rate closure (with endogenous foreign reserves) The non-US central bank must settle any residual discrepancy between the country’s current account balance and net private purchases of foreign issued assets by accumulating reserves in the form of US Treasury bills. Alternatively expressed, it describes the purchases of US Treasury bills which the non- US central bank must make in order to prevent its exchange rate from floating up.

17. Effect of an increase in the US propensity to import on UK variables, within a fixed exchange rate regime with endogenous foreign reserves:

18. Effect of an increase in the US propensity to import, within a fixed exchange rate regime with endogenous foreign reserves, on the UK current account balance and elements of the balance sheet of the Bank of England (the UK central bank): change in foreign reserves, stock of money, holdings of domestic Treasury bills

19. Comparision with simplest SFC model Similarities There are no Rules of the game: the money stock does not change with a BP surplus or deficit A twin surplus arises in the steady state There is a compensation mechanism at work: the rise in CB reserves is compensated by the fall in domestic credit Differences The current account surplus and the govt budget surplus are not constant anymore They both grow at the rate of the interest rate In the case of the deficit country, the US, there is no limit to this process: there is no fall in the Fed reserves, since the US dollar is the international currency

20. Contradicting received wisdom Alan Greeenspan and others have been saying that Chinese accumulation of US Treasury bills is making it difficult for them to manage their monetary policy; but the above analysis strongly suggests that they are mistaken. Mainstream authors would say that the UK (or Chinese) central bank of our model is “sterilizing” foreign reserves, by selling domestic Treasury bills on the open market. In a way, it is true. But this is not the result of any intentional policy, where central bankers are actively intervening in financial markets. The UK (Chinese) central bank, just like the US one, is simply attempting to keep interest rates constant. Bills are provided to those who demand them at the set rate of interest. The central bank provides cash on demand to its citizens.

21. The Chinese situation In reality, compensation is mainly done in China either through commercial banks reducing their debt vis-à-vis the People’s Bank of China (a reduction in domestic credit compensating for the increase in credit to foreigners), or with banks purchasing central bank bills (issued by the People’s Bank of China).

22. Flexible exchange rates closure To transform the model into a flexible exchange rate model, we must inverse or « bump » a small series of equations, because reserves cannot change anymore. Eventually one equation becomes: xr£ = B$£d/B$£s The endogeneity of the exchange rate only finds itself expressed in one single equation. But the effect works its way round so that the supply and demand for all internationally-traded assets are all brought into equivalence at (and by) the new exchange rate, until all stock changes revert to zero. The equation will also be found to satisfy all the trade equations.

23. Effect of a decrease in the UK propensity to export, within a flexible exchange rate regime, over various UK variables (with high price elasticities): current account balance, trade balance and budget deficit

24. Effect of a decrease in the UK propensity to export, within a flexible exchange rate regime

25. Effect of a decrease in the UK propensity to export, within a flexible exchange rate regime, over UK prices

26. Effect of a decrease in the UK propensity to export, within a flexible exchange rate regime, over UK and US real GDP

27. The real GDP of UK is higher in the long run This is because the exchange rate brings the current account into equilibrium But the UK has had a sequence of current account deficits, accumulating foreign debt The trade balance (in £ pounds) is in surplus (near the steady state) The terms of trade have worsened, with exports now relatively cheaper than imports So real net exports are much higher than in the baseline case (where they were zero)

28. Same experiment, but with low export and import price elasticities (sum of which is equal to 0.70) With the same export shock as before and as in the fixed exchange rate model

29. Effect of a decrease in the UK propensity to export, within a flexible exchange rate regime, (with low price elasticities): The trade balance recovers, but the current account balance explodes

30. A large depreciation of the UK currency won’t do (In the fixed exchange rate regime, a fall to $0.65 was enough)

31. Some final lessons The exchange rate is being asked to do too much. The flexible exchange rate regime cannot stabilize this economy, whereas the fixed exchange rate regime could. Countries with low price elasticities should stick to fixed exchange rate regimes