1. © Stephen Hall, Imperial College LondonPage 1 Economic Environment Lecture 8 Joint Honours 2003/4 Professor Stephen Hall The Business School Imperial College London

2. © Stephen Hall, Imperial College LondonPage 2 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. Natural Rate of output P S0S0 S1S1 D1D1 D0D0

3. © Stephen Hall, Imperial College LondonPage 3 The short-run aggregate supply schedule Output Price level YpYp SAS P0P0 SAS 1 SAS 2 In time, the firm is able to negotiate lower wages, and the SAS shifts to SAS 1 and then to SAS 2, A A2A2 P2P2 until equilibrium is restored at A 2. Suppose the economy is initially at Y p in full- employment equilibrium at A, with price P 0 B In response to a fall in aggregate demand, firms in the short run vary labour input, thus moving along SAS to B.

4. © Stephen Hall, Imperial College LondonPage 4 MDS' a fall in nominal money supply shifts MDS to MDS' Output Price level YpYp SAS P E MDS AS A fall in nominal money supply Starting from long-run equilibrium at E: E' P' Given wage levels, firms adjust to E' in the short run With price at P' but wages unchanged, the real wage rises bringing involuntary unemployment. P3P3 SAS 3 E3E3 Equilibrium is eventually reached at E 3, back at Y p. SAS' As the labour market (wage) adjusts SAS shifts e.g. to SAS' P''

5. © Stephen Hall, Imperial College LondonPage 5 An adverse supply shock: e.g. an increase in the price of oil Yp'Yp' MDS Output P P SAS E SAS' Higher oil prices force firms to charge more for their output, so SAS shifts to SAS' Y' Higher prices cause a move along MDS, and output falls to Y' P' E' equilibrium from E to E' In time, unemployment reduces wages and SAS gradually shifts back to SAS, so Y p is restored.

6. © Stephen Hall, Imperial College LondonPage 6 Trade and Exchange rates

7. © Stephen Hall, Imperial College LondonPage 7 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.

8. © Stephen Hall, Imperial College LondonPage 8 Trade and the International environment Globalisation Growing trading blocks Trade disputes tariffs and protectionism

9. © Stephen Hall, Imperial College LondonPage 9 Exports as % of GDP

10. © Stephen Hall, Imperial College LondonPage 10 Destination of world exports, 1996 Source: Direction of Trade Statistics

11. © Stephen Hall, Imperial College LondonPage 11 The composition of world exports

12. © Stephen Hall, Imperial College LondonPage 12 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.

13. © Stephen Hall, Imperial College LondonPage 13 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

14. © Stephen Hall, Imperial College LondonPage 14 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.

15. © Stephen Hall, Imperial College LondonPage 15 The effect of a tariff DD SS Quantity Price DD and SS show the domestic demand and supply for a good. PwPw If the world price is P w, and there is free trade, QsQs domestic firms supply Q s QdQd domestic demand is Q d A tariff can stimulate domestic supply and restrict imports P w + T At a domestic price P w + T, where T is the size of the tariff Qs'Qs' Qd'Qd' Domestic demand falls to Q d ', domestic supply rises to Q s ' and the difference is imported. and imports fall.

16. © Stephen Hall, Imperial College LondonPage 16 The government raises revenue – i.e. there is a transfer to the government There is a social cost from production inefficiency, given that the good could be imported at P w. There is also a loss of consumer surplus. and there is a transfer in the form of extra profits to producers The welfare costs of a tariff DD SS Quantity Price PwPw QsQs QdQd P w + T Qs'Qs' Qd'Qd' The tariff leads both to transfers and net social losses.

17. © Stephen Hall, Imperial College LondonPage 17 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

18. © Stephen Hall, Imperial College LondonPage 18 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.

19. © Stephen Hall, Imperial College LondonPage 19 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

20. © Stephen Hall, Imperial College LondonPage 20 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

21. © Stephen Hall, Imperial College LondonPage 21 The foreign exchange market - the international market in which one national currency can be exchanged for another. The price at which two currencies exchange is the exchange rate. DD DD shows the demand for pounds by Americans wanting to buy British goods/assets. Quantity of pounds Exchange rate ($/£) Suppose 2 countries: UK & USA SS SS shows the supply of pounds by UK residents wishing to buy American goods/assets. e0e0 Equilibrium exchange rate is e 0 SS 1 If UK residents want more $ at each exchange rate, the supply of £ moves to SS 1 e1e1 New equilibrium at e 1.

22. © Stephen Hall, Imperial College LondonPage 22 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

23. © Stephen Hall, Imperial College LondonPage 23 Two Basic Exchange Rate Theories Purchasing Power Parity Uncovered Interest Parity

24. © Stephen Hall, Imperial College LondonPage 24 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

25. © Stephen Hall, Imperial College LondonPage 25 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

26. © Stephen Hall, Imperial College LondonPage 26 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.

27. © Stephen Hall, Imperial College LondonPage 27 Intervention in the forex market Quantity of £s $/£ SS DD e1e1 Suppose the government is committed to maintaining the exchange rate at e 1... When demand is DD, no intervention is needed... there is a balance in transactions between the countries. The Bank of England must supply AC £s in return for $, which are added to reserves. DD 1 If the demand for pounds is DD 1 there is excess demand AC. AC DD 2 The reverse occurs if demand is at DD 2. E

28. © Stephen Hall, Imperial College LondonPage 28 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

29. © Stephen Hall, Imperial College LondonPage 29 The UK balance of payments, 1980-1998 Source: Economic Trends Annual Supplement

30. © Stephen Hall, Imperial College LondonPage 30 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.

31. © Stephen Hall, Imperial College LondonPage 31 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

32. © Stephen Hall, Imperial College LondonPage 32 Relative prices and the nominal exchange rate, UK & USA Relative price (UK/USA) Exchange rate ($/£)

33. © Stephen Hall, Imperial College LondonPage 33 The real £/$ exchange rate The real exchange rate is the nominal rate multiplied by the ratio of domestic to foreign prices

34. © Stephen Hall, Imperial College LondonPage 34 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

35. © Stephen Hall, Imperial College LondonPage 35 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.

36. © Stephen Hall, Imperial College LondonPage 36 Shocks may move an economy away from internal and external balance: Boom Slump Surplus Deficit More saving, tighter fiscal & monetary policy Foreign boom, lower real exchange rate Foreign slump, higher real exchange rate Less saving, easier fiscal & monetary policy

37. © Stephen Hall, Imperial College LondonPage 37 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.

38. © Stephen Hall, Imperial College LondonPage 38 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

39. © Stephen Hall, Imperial College LondonPage 39 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.

40. © Stephen Hall, Imperial College LondonPage 40 Monetary policy under floating exchange rates Time e e1e1 Suppose the economy begins in equilibrium with the nominal exchange rate at e 1. t A At time t, nominal money supply is halved... e2e2 e 2 will be the new equilibrium exchange rate once the economy has adjusted But prices are sluggish, so in the short run, real money supply falls and domestic interest rates rise e3e3 B To maintain equilibrium in the forex market, the exchange rate overshoots to e 3 C, adjusting along BC with wages & prices.

41. © Stephen Hall, Imperial College LondonPage 41 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

42. © Stephen Hall, Imperial College LondonPage 42 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.

43. © Stephen Hall, Imperial College LondonPage 43 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