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Lecture 10 Nicolas Coeurdacier [email protected] Understanding the World Economy Master in Economics and Business Open economy macroeconomics and exchange rates – Part I
Lecture 10Nicolas Coeurdacier
Understanding the World Economy
Master in Economics and Business
Open economy macroeconomics and
exchange rates – Part I
1. Balance of payments (BOP)
2. Exchange rate in the long run: PPP
3. BOP Theory of Exchange Rates
Lecture 10 : Open economy macroeconomics
and exchange rates – Part I
Open economy national income identities
National Accounting
Y= C + I + G + EX - IM
• Y: GDP
• C: Consumption
• I: Investment
• G: public spending
• EX: Exports of goods and services
• IM: Imports
• Current account (sometimes net exports): CA= EX-IM
National Revenue = National Output
National output (Y) is:
Y ≡ I + C + G + [EX – IM]
with EX – IMP = CA = Current Account Balance
The use of national revenues : Y ≡ C + SP + T
Then: (I – SP) + (G – T) + (EX – IMP) ≡ 0
Introducing Public Savings (Fiscal Surplus): SG=T-G
CA ≡≡≡≡ SP + SG- I ≡≡≡≡ S-I
The Fundamental Balance of Payments Identity
The Fundamental Balance of Payments Identity
•Accounting identity (no behaviour, no explanation, no theory
here)
•A country whose savings exceed national investment tends to
run a current account surplus : the country is lending to the rest
of the world
•A current account deficit can reflect:
- Small saving rate (high consumption) (US from 2000)
- High investment (US 1995-2000)
- Budget deficit (US since 2001)
CA ≡≡≡≡ SP + SG- I ≡≡≡≡ S-I
(SP – I) and (SG) in the US
-8,0
-6,0
-4,0
-2,0
0,0
2,0
4,0
6,0
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
US Private Savings Investment Gap (% of GDP) US Fiscal Surplus (% of GDP)
Balance of Payments (BOP)
- Registers all transactions with foreign economic agents
- 3 main sorts of transactions:
- exports and imports of goods and services
current account (CA)
- sale and purchase of financial assets
financial account (FA)
- certain transfers of wealth (small)
capital account (KA)
A bit more of accounting…
The Balance of Payments
The Balance of Payments (BOP)
= Current Account + Financial Account+ Capital Account
The Balance of Payments has to balance:
BOP = 0
(abstracting from errors and omissions)
Why does the balance of payments have to balance?
•Essentially an accounting trick - every credit needs to be matched by a
debit: double entry book keeping principle!
•The current account shows overall situation in transactions of goods
and services. The capital and financial account shows how this is
financed.
•Consider the case of the U.K running a current account deficit, in
other words the U.K cannot pay its import bill from exports alone.
•One solution is for the U.K to sell any overseas assets and use the
money to pay the import bill. Another option would be to sell some U.K
companies which would count as Inward Direct Investment. This would
create a financial account surplus equal to the current account deficit.
The Current Account
• Trade Balance = Exports of Goods and Services - Imports of
Goods and Services = (X-M)
• Current Account =Balance on Goods and Services + Net Foreign
Workers Remittances + Net International Aid+ Net Royalties + Net
Investment Income = (X-M+NFI)
The Financial & Capital Accounts
• Financial account (FA): records flow of financial assets.
These are Foreign Direct Investment, Net Portfolio Flows
and Net Other (mainly bank loans and trade credits)
• Capital account (KA): records flow of non-financial
assets between countries – debt forgiveness, purchase of
royalty rights
• However because of measurement error also a category
called “errors and omissions”
Capital Account 1 813
Current
Account
-30 277 Financial Account 14 185
Balance of
Trade
-42 516 Net FDI 5 136
Balance of
Services
18 267 Net Portfolio 69 834
Primary &
secondary
income bal.
-6 027 Net Other (incl.
derivatives)
-60 784
Errors and
Omissions
14 278
French Balance of Payments (EUR, millions, 2013)
China Balance of Payments ($bn H1 2009)
Balance of Trade 118 Net FDI, Private and
Official Assets
32
Balance of Services -19 Reserves -186
NFI 31 Statistical Discrepancies 25
Current Account 130 Financial Account -129
Capital Account -1
Total Balance (CA+FA+KA) 0
1. Balance of payments (BOP)
2. Exchange rate in the long run: PPP
3. BOP Theory of Exchange Rates
Lecture 10 : Open economy macroeconomics
and exchange rates – Part I
The nominal exchange rate
Two types of quotation:
• E is the exchange rate of the euro/dollar: price of the foreign currency (dollar) in units of the domestic currency (euro)
1 $ = E €
E increases means euro depreciates (it takes more euros to buyone dollar)
• E is the price of the domestic currency (euro) in units of the foreign currency (dollar)
1 € = E $
• In the following, we use the first (more standard, although not most intuitive) convention:
E increases means the euro depreciates
Price conversion
Pi $ : price of good i in dollar
• E is the exchange rate (nb of euros to make one $)
• Pi € price of good i converted in euro
• Pi € = E. Pi
$
• Remark:
A depreciation of the euro (E ) increases the price in euro of an American good (if the producer price Pi
$
does not react).
Decreases the price in $ of a European good (if the producer price in euro does not change).
Floating and fixed exchange rate regimes
• Floating:
The exchange rate is determined on exchange rate marketswithout interventions of central banks (euro/dollar)
• Fixed :
Central banks intervene on markets to maintain the exchangerate at an announced level or around such a level (Goldstandard at the end of 19th century, FF/DM, Bretton Woodssystem until 1971, certain developing and emergingcountries)
• Many intermediate situations
Mostly focus on floating for now.
Nominal Exchange Rates
80
90
100
110
120
130
140
15031
/07/
1990
31/0
1/19
91
31/0
7/19
91
31/0
1/19
92
31/0
7/19
92
31/0
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93
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94
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31/0
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31/0
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96
31/0
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97
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00
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01
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04
An example of floating exchange rates: Japanese yen per US dollar
over the period 1990-2004
Depreciation of the Yen vis-à-vis the $
Appreciation of the Yen vis-à-vis the $
Nominal Exchange Rates
0
0,5
1
1,5
2
2,5
3
3,5
4
31/0
1/19
92
31/0
7/19
92
31/0
1/19
93
31/0
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94
31/0
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31/0
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31/0
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04
31/0
7/20
04
An example of fixed exchange-rate: the Currency Board in Argentina
Peso per US dollar over the period 1992-2004
Fixed Exchange rate Regime: 1 peso =1 $
Devaluation of the Peso
The law of one price (LOP)
• Long term perspective on exchange rates = when
prices are flexible
• On competitive markets, in absence of transport costs and
tariffs… two identical goods must be sold at the same price
(expressed in the same currency)
• Consider a good indexed by i.
Law of one Price = long term arbitrage mechanism
Pi € = E. Pi $
• If Pi € > E. Pi $ : buy the US produced good, sell it in Europe;
increase demand in US, increase supply in Europe: price
converge
Purchasing power parity (PPP)
• Idea developed initially by Ricardo (1772–1823 )
• The price levels of different countries are equalized when
measured in the same currency:
P € = E x P $
where P € and P $ are price indices of US and euro zone.
• E = P € / P $ : Absolute version of PPP
• An increase in the general level of prices reduces purchasing
power of domestic currency and leads to a depreciation.
• PPP (nominal) exchange rate:
EPPP= P € / P $
The PPP exchange rate: E PPP(€/$) = P € / P $
45
°°°°
Nominal Exchange rate (€/$)
P € / P $
$ undervalued, €
overvalued
$ overvalued, €
undervalued
Relative PPP
• The variation of the exchange rate is equal to
the difference in the variation in prices, the
difference in inflation rates (approximation)
• Et = P €t / P $t ⇒ (Et – Et-1)/Et-1 ≃ π €t - π $t
π €t and π $t: inflation in € zone and US
• π €t = (P€t – P€t-1)/ P€t-1
Empirical validity of the LOP
• LOP fails in short run : not puzzling for non traded goods (haircuts); but also for traded goods.
• Transport costs, trade barriers (tariffs and regulations): make
arbitrage more difficult.
• Imperfect competition: firms segment markets (to have high
prices where price elasticity of demand is low) : “pricing to
market”. “Branding”.
• Many goods considered to be highly traded contain nontraded
components. Retail and wholesale costs (distribution costs)
account for around 50% of final consumer price.
Empirical validity of PPP
• Studies overwhelmingly reject PPP as a short-run relationship, better as long term.
• The variance of floating nominal exchange rates is an order of magnitude greater than the variance of relative price indices.
• The failure of short-run PPP can be attributed partly to the stickiness in nominal prices (short run).
• Works much better in the long term.
Price differentials in Europe for identical car
models (exc. taxes); 2009
France Germany UK Lowest
VW Passat 115% 124% 82% UK
Renault Clio 3
130% 131% 98% Hungary 93%
NISSAN Micra
113% 110% 77% Poland 71%
FIAT Panda 116% 126% 94% Hungary 92%
Source: EU commission
What is the exchange
rate of country i
consistent with LOP for
the Big Mac?
Required appreciation or
depreciation to satisfy
LOP?
EBig Mac = PUS/Pi
The Economist - Oct. 2010
Long term real exchange rate
• Real exchange rate (RER) defined as the relative price
index of goods and services between two countries:
q = E x P $ / P €
A real depreciation of € vis-à-vis the $ (q ) can come
from nominal depreciation (E ), an increase in P $ or a
fall in P €
• Relative PPP ⇒⇒⇒⇒ RER is constant !
PPP: (Et – Et-1)/Et-1 = π €t - π $t
(qt – qt-1)/qt-1 = (Et – Et-1)/Et-1 - π €t + π $t = 0
Long Run PPP: $/£ real exchange rate (in logs)
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
0.2
0.3
0.4
0.517
91
1803
1815
1827
1839
1851
1863
1875
1887
1899
1911
1923
1935
1947
1959
1971
1983
1995
Note: Higher values means a (real) dollar depreciation (or a £ appreciation)
£ overvalued relative to PPP
£ undervalued relative to PPP
The mean reversion of real exchange rates
The Yen/$ exchange rate and the relative price ratio over the long term
Empirical test of relative PPP in the long-run
Looking across countries over a long time period [1960;2001],run the following regression where (i) is a country:
Relative PPP assumption: β is expect to be = 1 (and α = zero).
Can inflation differentials over 41 years explain exchange ratevariations over the same period?
β is fairly close to one for this sample of countries.
Convergence towards PPP: slow reversion towards PPP (from 3 to5 years to eliminate half of the gap).
11960
2001
1960
2001
1960/
2001/
logloglog ++++++++
−−−−
++++====
tus
us
i
i
usi
usi
PP
PP
SS εεεεββββαααα
Remember relative PPP:
(Et – Et-1)/Et-1 = π €t - π $t
-40
-23
-7
10
27
43
60
-40 -20 0 20 40 60I n fl a ti o n d i ffe re n tia l
-10
-3
3
10
17
23
30
-20 -10 0 10 20 30
-6
-3
0
3
6
9
12
-10 -5 0 5 10 15Infla tion Diffe re ntia l
Relative PPP prevails in the very long-run but fails in the short-run
1 Year Window
5 Year Window
Inflation Differential
20 Year Window
%Depreciation
%Depreciation
%Depreciation
Why are prices higher in rich countries?
• Same question as: why E x P rich > P poor?
• Obvious deviation from PPP.
• Related question: why does the real exchange rate of
countries that grow relative to rest of world
appreciate? (q = E x Pworld / P ↓)
Examples: Japan, South Korea, Ireland, today China?
• One theory relies on the presence of non-traded
goods together with productivity differences
between rich and poor in the traded (manufacturing)
sector = Balassa Samuelson effect
• Key distinction: Tradable goods (manufactured goods) and non
tradable (services)
• Around 75% of the consumption basket in industrialized
countries is non tradable (health, education, most services…)
even if definition of a tradable good/service becomes blurred
(internet)
• Productivity differences between rich and poor countries is
much larger for tradables than for non tradables: it is very large
for example in manufacturing (of an order of 10 or more), but
much smaller in services (think of haircuts: technology is not
hugely different across countries).
Balassa-Samuelson effect
Workers can be hairdressers (non-traded) or work in
the textile industry (traded). Workers can produce
haircuts or T-shirts.
T-shirts sold 1$ in international markets.
US worker produces 50 T-shirts/hour, Indian worker
only 10.
Both US and Indian hairdressers make 5 haircuts/ hour.
Question: what is the price of an haircut in India and in
the US?
Implications?
Understanding the Balassa-Samuelson effect
Income convergence and exchange rate appreciation (here appreciation is up!)
Source: Reisen , 2009
1. Balance of payments (BOP)
2. Exchange rate in the long run: PPP
3. BOP Theory of Exchange Rates
Lecture 10 : Open economy macroeconomics
and exchange rates – Part I
BOP theory of exchange rates
• Develop a simple framework to examine how the
current account and exchange rate of a country is
affected by various macroeconomic events…
• … to explain some of the medium term deviations
from PPP documented in the section.
The role of exchange rate
•But while the National Accounts show that:
CA = S-I
How does this happen?
•Variations in the real exchange rate ensure that
current account equals net savings.
Focus on flexible exchange rates
Two country model: Europe-US.
CA€ = CA(q, Y€d, Y$
d)
q = E P$/P€ : real exchange rate; relative price of US goods with respect to European goods
q : real depreciation of euro
The Current Account
CA€ = EX€ - IM€ in euros = Net exports in euros
Suppose E ↑ (or equivalently q ↑ ):
How do exports (foreign demand for European goods) and imports
(European demand for foreign goods) react ?
Depends on two main factors:
1) In which currency exporters fix their prices?
How much ‘pass-through’ of exchange rates to consumer prices?
2) How large is the elasticity of substitution between domestic and
foreign goods?
The Current Account
• If q ↑ → volume of imports↓, exports↑: substitution
• But if slow response of volumes (empirically 6 months-1 year):value of imports ↑
• volume versus value effect. In short term, the value effect candominate
• Net effect on the CA of q ?• J curve and the Marshall-Lerner condition such that a
depreciation generates an improvement in CA: the sum ofimport and export elasticities to exchange rate > 1
The Current Account
The J-Curve
J-curve: valueeffect dominatesvolume effect
volume effect dominatesvalue effect
Immediateeffect of real depreciationon the CA
We assume from now on:
€ nominal or real depreciabon (E ↑ or q ↑)
generates an ↑ in demand via an ↑ in net exports :
CA€ (q)= (EX€ - IM€)
The Current Account
+
The Current Account
q
CA=Net Exports0
High real exchange rate means
European goods cheaper so Europe
export more and import less - net
exports increases with q
BOP Theory of Exchange Rates
q
CA=Net Exports
S-I
Real Exchange Rate determined by equality of net savings with net exports
BOP Theory of Exchange Rates
• A depreciation of real exchange rate means domestic goods
are more competitive on international markets.
• Real exchange rate adjusts to ensure net exports equals net
savings.
• If net savings > net exports, then real exchange rate
depreciates which decreases imports and boosts exports.
Eventually net exports equal net savings.
Increase in fiscal deficits (fall in public savings)
q
CA=Net Exports
S-I
Appreciation of the currency and deterioration of the current account
Source : Bureau of Economic Analysis
Reagan and Bush I Deficits
-1
0
1
2
3
4
5
6
1981 1982 1983 1984 1985 1986 1987 1988
% o
f G
DP
Current Account deficit Fiscal deficit
-1
0
1
2
3
4
5
1989 1990 1991 1992
% o
f G
DP
Drop in investment
q
CA=Net Exports
S-I
Depreciation of the currency and improvement of the current account
Argentina 2001-2002 Financial Crisis
-10
-5
0
5
10
15
20
25
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Current Account (% of GDP) Investment rate % of GDP Real GDP Growth
Increase in demand for European goods
q
CA=Net Exports
S-I
• In the long-term, changes in nominal exchange rates
reflect differences in inflation as predicted by relative
purchasing power parity. Failures of PPP are due to
price rigidities, barriers to international trade, pricing-
to-market.
• Due to the Balassa Samuelson effect, poor countries
have lower prices and face appreciating real exchange
rates when catching-up in terms of productivity.
• In the medium to long-term, the real exchange rate will
adjust to a level where the current account
surplus/deficit matches longer term capital flows.
Summary
