Ch2/ER 1

Transition from chapter 1 to chapter 2

Ch2/ER 2

• 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 (+)}

Ch2/ER 3

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

Ch2/ER 4

Short term adjustment through foreign exchange market:

1. Means that demand for foreign currency (FC)

2. Means that supply of $ held by foreigners$/FC

S

D

Q of FC Q of $

FC/$S

D

Depreciation of $ equivalent to Appreciation of FC

D’

S’

Ch2/ER 5

Then US demand for Import

while foreign demand for US goods i.e. X

hence CA = X - IM

Ch2/ER 6

Fixed exchange rateSame situation but the $ ______ depreciate

$/FCS

D

Q of FC Q of $

S

DD’

S’

FC/$

Fixed ER

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)

Ch2/ER 7

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.

Ch2/ER 8

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) _________.

Ch2/ER 9

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.

Ch2/ER 10

Medium run adjustment - classical (P flexible)M and P are proportional - economy ______ at FEAs 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.

Ch2/ER 11

Adjustment Mechanismwith Various Exchange Rate

Arrangements

Flexible Exchange Rate

Fixed Exchange Rate

Ch2/ER 12

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 _______________.

Ch2/ER 13

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 servicesUS _____ who must pay dividends to foreigners

holding their stocksThe US _________ planning to send money to the

victims of the tsunami

Ch2/ER 14

In the financial account:US ____________ who reshuffle their

portfolio into Canadian bondsUS ___________ who plan to carry out some

FDI into Indian ITUS ___________ rebuilding some destroyed

schools you know whereUS ___________ in the process of rebuilding

its foreign reservesThe demand for foreign currency is a

_________ demand.

Ch2/ER 15

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.

Ch2/ER 16

When E increases, the demand for FC _____.

$/FC

Q of FC

D

Ch2/ER 17

The determinants of the supply of foreign currency

In the current account: US ______ - receipts for exports of US goods

and servicesUS _______ receiving dividend income on

their foreign stock holdings.______ by the sheik of Arabia to Harvard

University to endow a professorship.

Ch2/ER 18

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.

Ch2/ER 19

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 PXFC = PX$ / E.

Ch2/ER 20

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.

Ch2/ER 21

When E increases, the supply of FC _________

$/FC

Q of FC

S

Assuming high elasticities cf Marshall Lerner conditions

Ch2/ER 22

Foreign Exchange Market Equilibrium

$/FC

Q of FC

S

D

E

The intersection of the supply and the demand for foreign currency determines the ____________ exchange rate E and the ________ of FC traded.

Ch2/ER 23

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).

Ch2/ER 24

Impact of a shift in demand with a flexible exchange rate arrangement

$/FC

Q of FC

S

D

ED’

E’

The $ ___________ from E to E’ to restore equilibrium in the FC market while the quantity of FC traded ___________.

Ch2/ER 25

Impact of a shift in supply with a flexible exchange rate arrangement

$/FC

Q of FC

S

D

ES’

E’

The $ ____________ from E to E’ to restore equilibrium in the FC market while the quantity of FC traded ___________.

Story: Dubai decides to buy a fleet of Boeing for their national airline.

Ch2/ER 26

Fixed Exchange RateAdjustment 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.

Ch2/ER 27

Foreign Exchange Market Equilibrium

$/FC

Q of FC

S

D

Ef

Fixed exchange rate Ef : market is in equilibrium at the fixed ER Ef

Ch2/ER 28

Case 1Increase in demand of FC and intervention by CB

$/FC

Q of FC

S

D

EfD’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 $

E

Goal: to keep ER at Ef

Ch2/ER 29

Case 2Increase in supply of FC and intervention by CB

$/FC

Q of FC

S

D

Ef

S’

To stop the $ from __________ to E, the Fed must _____ quantity ED of FC at the fixed ER Ef thus ________ the FC and _________ the $E

ES

Goal: to keep ER at Ef

Ch2/ER 30

Intervention and the money supply: case 1To 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.

Ch2/ER 31

Impact of Intervention on the Central Bank Balance Sheet

Assets Liabilities

Domestic assets Domestic BondsForeign Assets Foreign Bonds Foreign Currency Gold

CurrencyCommercial 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 supply (M) ________.

Ch2/ER 32

SterilizationSince 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 33

Impact of Intervention followed by Sterilization on the Central Bank Balance Sheet

Assets Liabilities

Domestic assets Domestic BondsForeign Assets Foreign Bonds Foreign Currency Gold

CurrencyCommercial 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 34

Exercise: rework slides 30 to 33 in the case of excess supply of FC (Case 2)

Ch2/ER 35

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 36

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 producedand the subscript f corresponds to imported.

Ch2/ER 37

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:Z = Cd + Cf + Id + If + Gd + Gf + X

- Cf - If - Gf

and - Cf - If - Gf = - IM

Ch2/ER 38

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

Ch2/ER 39

Marshall-Lerner conditionIn 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

Ch2/ER 40

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 41

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 = EThe balance of trade X - *IM becomes X - E*IMA depreciation is an _________ in E

X - volume of exports __________IM - volume of imports ________

E*IM may _______ or __________

Ch2/ER 42

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

Ch2/ER 43

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 _________________.

Ch2/ER 44

Elasticities are defined as:% change in quantity/% change in priceLow 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

Ch2/ER 45

Example:

E PX X PM

$PM=

EPM

MBT =

PX *X - EPM*M

1$1= FC1

2 FC1 $1 2 2 - 2 = 0

2$1=

FC0.53 FC1 $2 1.9 3 - 3.8 = -0.8

Ch2/ER 46

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

Ch2/ER 47

Example: Calculate whether M-L is fulfilled

E PX X PM

$PM=

EPM

MBT =

PX *X - EPM*M

1$1= FC1

2 FC1 $1 2

2$1=

FC0.54 FC1 $2 .5

Ch2/ER 48

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 49

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

Ch2/ER 50

The J-Curve

BT

tt t+3

At time t+3 quantities start to adjust to the depreciation