Lecture 9September 6th, 2010

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Price Adjustment Process: Short Run vs. Long Run

▫When the Marshall-Lerner condition holds, changes in the exchange rate bring about appropriate switches in expenditures between domestic and foreign goods.

▫A home currency depreciation leads to a substitution of domestic goods for imports.

▫A home currency depreciation causes foreigners to switch to home country exports.

1 DmDxM

X

Price Adjustment Process: Short Run vs. Long Run

▫Short-run elasticities of supply and demand tend to be smaller in absolute value than long-run elasticities. Consumers don’t adjust immediately to

relative price changes; it’s not unusual for the quantity demanded of imports and the amount of foreign exchange needed to not respond to changes in the exchange rate.

The supply of exports may not adjust immediately in response to changes in exchange rates due to lags in recognition, decision-making, production, and delivery.

1 DmDxM

X

Price Adjustment Process: The J-Curve

▫If the short-run elasticities are low, the market for foreign exchange may be unstable.

▫A depreciation may initially lead to a further depreciation, since demand for the foreign currency outstrips supply.

▫Therefore the current account deficit worsens.

▫Eventually, the current account deficit shrinks and a new equilibrium is attained.

The J-CurveX-M

time

point of depreciation

(X-M) = f(e,time)

Price Adjustment Mechanism in a Fixed Exchange Rate System

▫Rather than allowing the foreign exchange market to determine the value of foreign exchange, countries sometimes fix or “peg” the value of their currencies.

1 DmDxM

X

Price Adjustment Mechanism with the Gold Standard

▫From 1880 to 1914, countries pegged their currencies to gold.

▫This fixes countries’ exchange rates with each other.

▫For example, if the dollar is fixed at

$100 per ounce The pound is fixed at £50 per ounce The “mint par” exchange rate is $2/£.

▫Governments must be prepared to maintain the gold price by buying and selling gold at the set price.

1 DmDxM

X

Price Adjustment Mechanism with the Gold Standard

▫Since the exchange rate is fixed, some other mechanism must be in force to balance demand for and supply of foreign exchange.

▫These “rules of the game” are assumed to hold: no restraints on buying/selling gold within

countries; gold can move freely between countries,

money supply is allowed to change if a country’s gold holdings change, and

prices/wages are flexible.

1 DmDxM

X

Price Adjustment Mechanism with the Gold Standard

▫Suppose an increase in U.S. income causes an increased demand for pounds.

▫There will be upward pressure on the exchange rate to eliminate the excess demand for pounds.

▫Buyers/sellers know that governments stand ready to buy/sell pounds at mint par, using gold as medium of exchange.

▫Since it is costly to ship gold, the exchange rate can vary slightly from mint par.

1 DmDxM

X

Foreign Exchange Market Under a Gold Standard

e$/£ e$/£

£ £

$2.00

D£

S£

D'£

$1.96$2.00

D£

S£

$2.04Mint par

Assuming transactions costs represent 2% of par value, the

exchange rate can vary between $1.96 and $2.04.

Price Adjustment Mechanism with the Gold Standard

▫Americans never need to pay more than $2.04/£, since an unlimited supply of pounds can be obtained at this price. This price is called the gold export point.

▫The British never need to receive fewer than $1.96/£, since at that point gold will begin to move to the U.S. to be exchanged for dollars. This price is called the gold import point.

Price Adjustment Mechanism with the Gold Standard

▫The exchange rate can vary in between these narrow bands.

▫Prices cannot adjust through exchange rate changes.

▫Instead, prices adjust through changes in the money supply.

Price Adjustment Mechanism with the Gold Standard

▫Assuming the quantity theory holds,

Ms = kPY.

▫If gold leaves the country, Ms falls and prices must fall in response.

▫Assuming demand for tradable goods is elastic, This should reduce spending on imports and

increase receipts from exports.

Price Adjustment Mechanism with the Gold Standard

▫The price adjustment mechanism under the gold standard is triggered by changes in the money supply related to flows of gold.

▫This adjustment depends on flexible wages and prices – any rigidities will hinder adjustment.

▫Other adjustment may occur due the effects of changes in the money supply on interest rates and income.

▫The gold standard works to keep inflation in check.

Price Adjustment Mechanism with a Pegged Rate System

Price Adjustment Mechanism with a Pegged Rate System

▫A country can also fix its exchange rate without reference to the value of gold.

▫The central bank must be ready to buy foreign currency when the domestic currency is strong, and sell foreign currency when the domestic currency is weak.

▫Central banks must hold a sufficient supply of foreign currencies.

Price Adjustment Mechanism with a Pegged Rate System

▫The adjustment effects of such a system are similar to a gold standard.

▫Upward pressure on the exchange rate caused by an increase in demand for foreign exchange will cause the central bank to sell foreign exchange.

▫This reduces the money supply, thereby triggering adjustments to interest rates, income, and prices.

Price Adjustment Mechanism with a Pegged Rate System

▫Similarly, downward pressure on the exchange rate caused by an increase in the supply of foreign exchange will cause the central bank to buy foreign exchange.

▫This increases the money supply, thereby triggering adjustments to interest rates, income, and prices.

Price Adjustment Mechanism with a Pegged Rate System

▫For these adjustments to occur, the central bank must allow the actions taken in the foreign exchange markets to affect the domestic money supply.

▫Bottom line: when a country adopts a fixed exchange rate system, its central bank loses effective control over the money supply as a policy tool.

Current Account and National Income

The Current Account and National Income•Aggregate spending is the focus of the

Keynesian income model.•Prices and interest rates are assumed to

be constant.•The economy is assumed to not be at full

employment.

The Keynesian Income Model•Desired aggregate expenditures (E) can

be written as

E = C + I + G + X – M

•where▫C is consumption▫I is investment spending by firms▫G is government spending▫X is export spending by foreigners▫M is domestic import spending

The Keynesian Income Model: Consumption•Consumption is assumed to be a function of

disposable income (Yd), which is the difference between national income (Y) and taxes (T).

•More generally, we could write this as

C = a + b(Yd)•where

▫a is autonomous consumption spending ▫b is the marginal propensity to consume (MPC).

•For example, C = 200 + 0.8Yd

The Keynesian Income Model: Consumption• The MPC is ΔC/ΔYd, where Δ means “change in.”

• The marginal propensity to save (MPS) is ΔS/ΔYd.• Since changes in income can only be allotted to

consumption and saving

MPC + MPS = 1

• If the MPC = 0.8, the MPS = 0.2• The saving function, then, is

S = -a + sYd

• where ▫ s is the MPS.

• In our case▫ S = -200 + 0.2Yd

The Keynesian Income Model: I, G, T, and X• Investment (I)•Government spending (G)•Taxes (T)•Exports (X) •Are all assumed to be independent of

income in the simplest Keynesian model.•We’ll assume for example

▫I = 300▫G = 700▫T = 500▫X = 150

The Keynesian Income Model: Imports

•Imports (M) are assumed to be a function of income: M = f(Y)

•More generally,

•where ▫m is the marginal propensity to import.

•For exampleM = 50 + 0.1Y

mYMM

The Keynesian Income Model: Imports

•MPM = ΔM/ΔY•Also,

▫Average propensity to import is APM = M/Y

•A final concept is the income elasticity of demand for imports (YEM), recall the YEM formula

YEM = MPM/APM

Equilibrium National Income•Recall our example•C = 200 + 0.8Yd•Yd = Y – T•T = 500•I = 300•G = 700•X = 150•M = 50 + 0.1Y

Equilibrium National Income•This means that desired expenditures (E)

can be calculated as follows:

•E = 200+0.8(Y-500)+300+700+150-(50+0.1Y)

•E = 200+0.8Y-400+300+700+150-50-0.1Y

•E = 900+0.7Y

•We can plot this relationship on a graph.•Also, let us plot a 45-degree line

▫This represents points where Y = E.

Equilibrium National Income

Income or production (Y)

Desi

red

sp

en

din

g (

C+

I+G

+X

-M)

45°

900

Equilibrium National Income•Equilibrium occurs where desired

spending (E) equals production (Y).•In the graph, this occurs where the lines

cross.•Mathematically, we can solve for

equilibrium▫E = Y▫900 + 0.7Y = Y▫900 = 0.3Y▫Y = 3,000

Equilibrium National Income

Income or production (Y)

Desi

red

sp

en

din

g (

C+

I+G

+X

-M)

45°

900

3,000

Equilibrium National Income•At income levels below equilibrium,

spending exceeds production.▫As firms’ inventories decline, they will

increase production levels.▫Eventually Y = 3,000.

•At income levels above equilibrium, production exceeds spending.▫As firms’ inventories expand, they will

decrease production levels.▫Eventually Y = 3,000.

Leakages and Injections•We can think of saving, imports, and taxes

as “leakages” from spending.•Investment, government spending, and

exports can be seen as “injections” into spending.

•In equilibrium, leakages must equal injections:

S + M + T = I + G + X

Leakages and Injections•In our example, •S = -200 + 0.2(Y - T)•M = 50 + 0.1Y•T = 500•I = 300•G = 700•X = 150

Leakages and Injections•S + M + T = I + G + X

• -200+0.2(Y-500)+50+0.1Y+500=300+700+150

• -200+0.2Y-100+50+0.1Y+500=300+700+150

•250+0.3Y=1,150

•0.3Y=900

•Y = 3,000

Equilibrium Income and the Current Account Balance•Recall,

▫X – M represents the current account balance.

•Starting from the leakages = injections equation we can rearrange

S + M + T = I + G + XS + (T – G) – I = X – M

•Therefore, the difference between total saving (private + government) and investment must equal a country’s current account balance.

Equilibrium Income and the Current Account Balance•In our example, the current account

balance is •X - M = 150 – [50+0.1(Y)]•X – M = 150 – 50 – 0.1(3,000)•X – M = -200•This current account deficit means that

total saving (100) is less than investment (300).

The Autonomous Spending Multiplier•If autonomous spending on C, I, G, or X

changes, by how much will equilibrium income change?

•Suppose autonomous investment rises from 300 to 330.

•Because of the multiplier process, ▫ΔI of 30 will lead to a ΔY of more than 30.

The Autonomous Spending Multiplier•The increase of 30 in I increases

disposable income by 30 (since T does not depend on income).

•Because MPC = 0.8, spending rises by 30 x 0.8 = 24.

•Because MPM = 0.1, M rises by 3.•This leaves a net effect of 21 in this

second round.•This process continues, with spending

increasing incrementally in each round.

The Autonomous Spending Multiplier•The overall effect is•ΔY = (k0)ΔI,

▫where

•k0 is called the open-economy multiplier.

•In our example k0 = 3.3333.•That is, the increase in I of 30 ultimately

increases Y by 100.

MPMMPSk

10

The Current Account and the Multiplier•In our example, national income

equilibrium (Y=3,000) existed along with a current account deficit of 200.

•If policy-makers wish to eliminate the current account deficit by lowering imports, by how much would national income have to fall?

•From the definition of MPM,•ΔY = ΔM/MPM = -200/0.1 = -2,000•To make imports fall by 200, Y must fall

by 2,000.

The Current Account and the Multiplier•If policy-makers wish to eliminate the

current account deficit by increasing exports, could we simply increase X from 150 to 350?

•The multiplier process makes this more complicated (if X rises, Y rises, and as a result M rises, etc.).

Foreign Repercussions and the Multiplier Process•When home country spending and income

change, changes are transmitted to the foreign country through changes in home country imports.

•In our simple model, an increase in I in the U.S. is transmitted in this way:

• ↑IU.S. → ↑YU.S. → ↑MU.S.

Foreign Repercussions and the Multiplier Process•However, in the real world U.S. exports

are linked to incomes in the rest of the world (ROW).

•This means that increased U.S. imports lead to higher incomes in the ROW, and therefore higher U.S. exports.

•This feeds back onto U.S. incomes

↑IUS→↑YUS→↑MUS = ↑YROW→↑MROW→↑MROW→↑XUS

Price and Income Adjustments and Internal and External Balance•External balance refers to balance in the

current account (that is, X = M).•Internal balance occurs when the

economy is characterized by low levels of unemployment and reasonable price stability.

•How does the economy adjust when there are external and internal imbalances?

Price and Income Adjustments and Internal and External Balance• Case I:

▫Deficit in the current account; unacceptably rapid inflation

• Case II: ▫Surplus in the current account; unacceptably high

unemployment• Case III:

▫Deficit in the current account; unacceptably high unemployment

• Case IV: ▫Surplus in the current account; unacceptably rapid

inflation• How should policy-makers respond in each case?

Internal and External Imbalance

•Case I: Deficit in the current account; unacceptably rapid inflation

•The government should pursue contractionary monetary and fiscal policy.

•Effect:▫Price level will fall▫Increasing X and decreasing M.▫The decrease in income will also reduce M

through the MPM.

Price and Income Adjustments and Internal and External Balance•Case II: Surplus in the current account;

unacceptably high unemployment•The government should pursue

expansionary monetary and fiscal policy.•Effect:

▫Price level will rise▫Decreasing X and increasing M.▫The increase in income will increase

employment.

Price and Income Adjustments and Internal and External Balance•Case III: Deficit in the current account;

unacceptably high unemployment•The direction of the effect is unclear.•Expansionary policy to increase

employment will worsen the current account deficit.

•Contractionary policy to reduce the current account deficit will worsen unemployment.

Price and Income Adjustments and Internal and External Balance•Case IV: Surplus in the current account;

unacceptably rapid inflation•The direction of the effect is unclear.•Expansionary policy to reduce the current

account surplus will worsen inflation.•Contractionary policy to reduce the

inflation rate will widen the current account surplus.