Chapter 13 Economic Policy in an Open Economy

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Chapter 13Economic Policy in an Open Economy

• How many more fiascos will it take before
  responsible people are finally convinced that a
  system of pegged exchange rates is not a
  satisfactory financial arrangement?
• (Milton Friedman,
  1992)

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The Goals of This Chapter

• Illustrate why it is difficult to keep exchange
  rates constant.
• Explain how foreign exchange market intervention
  works and why it cannot permanently fix exchange
  rates.
• Introduce purchasing power parity (PPP) and
  review the evidence on how well it explains
  long-run exchange rates.
• Introduce the aggregate demand/aggregate supply
  (AD/AS) macroeconomic model, which determines
  price levels.
• Combine the AD/AS model, purchasing power parity,
  and the interest parity condition into a general
  exchange rate model.
• Explain the trilemma and show how attempts to
  defy the trilemma has caused recent financial
  crises.

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Floating Versus Fixed Exchange Rates

• Floating Exchange Rate An exchange rate that
  permitted to vary in accordance with the changes
  in the supply and demand for foreign exchange.
• Fixed Exchange Rate An exchange rate that is
  intentionally prevented from changing by means of
  specific government policies that influence the
  supply and demand for foreign exchange.

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Why It Is Hard to Fix the Exchange Rate

• The interest parity condition, et Etetn(1
  r)/(1 r)n, suggests that the spot exchange
  rates will remain the unchanged if all variables
  on the right-hand side of the equation stay the
  same, that is if
• Expectations about future exchange rates, Etetn,
  do not change
• Rates of return on assets are the same at home
  and abroad, that is r r.

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Why It Is Hard to Fix the Exchange Rate

• The spot exchange rate can also remain
  unchanged, even when one of the right-hand
  variables changes, provided that
• Policy makers immediately adjust domestic
  policies when expectations change.
• This latter condition requires a countrys
  policy makers to stay attuned to exchange rates
  and adjust their economic policies to satisfy the
  interest parity condition, regardless of any
  other policy objectives they might have.

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Using Intervention To Fix the Exchange Rate

• Suppose that the equilibrium exchange rate is
  .10, as shown in the Figure.
• Suppose also that policy makers in the U.S. or
  Mexico seek to keep the the exchange rate fixed
  at .08 per peso.
• How can they keep the exchange rate at .08 if
  the supply and demand curves are as shown?

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Using Intervention To Fix the Exchange Rate

• The exchange rate e .08 can be established by
  the U.S. or Mexican central banks intervening in
  the foreign exchange market.
• The Banco de México could create pesos and sell
  them on the foreign exchange market, or the U.S.
  Federal Reserve Bank could sell reserves of
  pesos.
• In either case, the supply of pesos would
  increase from S to S and the exchange rate would
  fall to .08.

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Using Intervention To Fix the Exchange Rate

• From the Mexican perspective, the equilibrium
  exchange rate is e .10, or q/e 10 pesos.
• The required intervention to keep the exchange
  rate at e .08, or 1/e 12.5 pesos, appears
  as an intentional increase in the supply of
  dollars by the central banks.

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Intervention is Not a Long-run Tool

• The weakness of using intervention to fix
  exchange rates is that central banks can seldom
  continue supplying the necessary amounts of
  foreign exchange for long periods of time.
• Another problem is that foreign exchange market
  intervention alters countries money supplies,
  and such de facto monetary policy may conflict
  with other macroeconomic goals.

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Purchasing Power Parity (PPP)

• The PPP theory assumes that the foreign exchange
  rates fundamental role is balancing
  international trade, and that arbitrage equalizes
  the prices everywhere.
• The PPP theory is normally interpreted to imply
  that the exchange rate reflects the overall price
  levels in each country.
• If P represents a general price index for the
  home economy and P is a similar general price
  index overseas, then the PPP theory says that
• e P/P.

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The Evidence on Purchasing Power Parity

• In the short run, there is virtually no
  correlation between price movements and exchange
  rate movements.
• In the long run, exchange rates do reflect
  purchasing power parity.
• The adjustment of exchange rates toward their
  purchasing power parities is very slow.
• Therefore, countries relative inflation rates
  are not helpful in explaining how an exchange
  rate will move during the next week or month, but
  it does describe long-run exchange rate movements
  very well.

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The Aggregate Demand/Aggregate Supply Model

• Purchasing Power Paritys success in explaining
  long-run exchange rates does not make it a useful
  exchange rate model.
• A complete exchange rate model needs to go one
  step further and explain what determines national
  price levels.
• Fortunately, macroeconomics has a
  well-established model to explain price levels
  the aggregate demand/aggregate supply (AD/AS)
  macroeconomic model.
• This model lets us highlight the many variables
  that affect an economys price level and, hence,
  also distinguishes the variables that influence
  long-run exchange rates.

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The Aggregate Demand/Aggregate Supply Model The
Demand Side of the Economy

• The economys demand for output, Y, can be
  divided into consumer demand, C, investment, I,
  government goods and services, G, and net exports
  minus imports, X - IM Y C I G X - IM.
• We can then focus on the determinants of each of
  these categories of demand.
• For example, consumer income depends on the value
  of income, Y, taxes, T, and transfers, Tr C
  f(Y, T-, Tr).
• The function f(.) reflects peoples preferences
  about how to allocate their income.

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The Aggregate Demand/Aggregate Supply Model The
Demand Side of the Economy

• The demand for investment goods (capital) depends
  on the returns to investment at home and abroad,
  r and r, the opportunity cost of alternative
  uses of the resources used for investment (the
  interest rate on loanable funds), and the overall
  level of output that capital helps to produce, Y.
• Real money supplies matter for interest rates,
  which implies that M/P and M/P, the latter the
  foreign real money supply, also matter.
• Hence, an economys investment function may look
  like I f(Y, r, r, M/P, M/P).

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The Aggregate Demand/Aggregate Supply Model The
Demand Side of the Economy

• Government expenditures, G, are usually a
  function of political forces, POL.
• They also depend on taxes, T, which in turn
  depend on overall income and output, Y, in the
  economy.
• Monetary policies at home and abroad affect the
  costs of borrowing, and transfers, Tr, affect a
  governments spending constraints and borrowing
  needs.
• Therefore, the government expenditure function
  may look like G f(POL, Y, T, Tr, M/P, M/P).

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The Aggregate Demand/Aggregate Supply Model The
Demand Side of the Economy

• In an open economy, exports and imports depend on
  all of the domestic and foreign variables that
  influence domestic and foreign C, I, and G.
• Thus, the trade balance is a function of all the
  variables in the C, I, and G equations X-IM
  f(C, C, I, I, G, G,P/P, e).

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The Aggregate Demand/Aggregate Supply Model The
Demand Side of the Economy

• By summing the sources of domestic demand in all
  four categories of demand, total aggregate demand
  for the economys output is YD C I G X -
  IM f(Y,Y,T,T,Tr,Tr,r, r,M/P,
  M/P,POL,POL,P/P, e).
• This equation seems to have a lot of variables,
  but it is still a gross simplification of the
  real world.
• The important point here is that even in a simple
  model it is very difficult to determine precisely
  what aggregate demand will be because there are
  so many variables that influence aggregate demand.

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The Aggregate Demand/Aggregate Supply Model The
Demand Side of the Economy

• In the AD/AS model, the aggregate demand curve is
  a downward-sloping line.
• The position of the line depends on all the
  variables that influence demand.
• In relation to the price level, the AD curve is
  downward-sloping because prices effect the real
  money supply, M/P, and a countrys competitive
  position in international trade the lower the
  price level, the higher M/P and (EX IM).

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The Aggregate Demand/Aggregate Supply Model The
Supply Side of the Economy

• In the short run, given the level of technology,
  the steady state level of output depends on the
  depreciation rate,d and the saving rate, s.
• In the long-run, the supply side of the economy
  is determined by economic growth, which is driven
  by technological progress.

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The Aggregate Demand/Aggregate Supply Model The
Supply Side of the Economy

• Aggregate supply, AS, is a function of both the
  short-run variables of the Solow model and the
  long-run variables of the Schumpeterian model
• AS g(K, L, d, s, p, ß, i, R)
• A prediction of an economys long-run productive
  capacity should focus on the Schumpeterian
  variables, of course.

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The Aggregate Demand/Aggregate Supply Model
Shifts in the AD and AS Curves

• Suppose that economic growth causes the AS curve
  to shift to the right.
• All other things equal, the shift in the AS curve
  will cause the level of output to increase and
  the price level to decline.
• A shift in aggregate demand will have similar,
  but opposite effects on the price level.
• All other things equal, the outward shift in the
  AD curve will cause the price level to increase.

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Long-Run Changes in the Price Level

• Suppose that economic growth pushes the economys
  AS curve continually to the right.
• The price will remain unchanged only if the AD
  curve also shifts to the right at the exact same
  rate as the AS curve shifts.

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Long-Run Changes in the Price Level

• Suppose that economic growth pushes the economys
  AS curve continually to the right.
• The price level will fall if aggregate demand
  shifts out more slowly than aggregate supply.

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Long-Run Changes in the Price Level

• Suppose again that economic growth pushes the
  economys AS curve continually to the right.
• If aggregate demand shifts out more rapidly than
  aggregate supply, then prices will rise.

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The Relative Shifts in AD and AS

• The AD curve will tend to automatically shift to
  the right when the AS curve shifts to the right
  because increasing output also increases income,
  and income is an important determinant of
  consumption, investment, and government
  expenditures.
• But, the relationship between output and demand
  is not a neat one-for-one relationship.
• There are many determinants of consumption,
  investment, government expenditures, and net
  exports, other than income, as shown in the
  functions for each of the components of aggregate
  demand.
• Hence, it is not clear whether the two sets of
  curves will shift out at the same rate.

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A Simple Exchange Rate Model

• The logical model that results from the
  combination of the AD/AS macroeconomic model, the
  purchasing power parity (PPP) theory, and the
  interest parity (IP) condition can be summarized
  as follows
• The interest parity condition relates spot
  exchange rates to the expected future exchange
  rates.
• Exchange rates are expected to reflect countries
  relative price levels, as the PPP theory
  predicts.
• The AD/AS macroeconomic model details the
  variables that determine an economys price level
  and, therefore, relates the expected future
  exchange rate to the variables that determine
  future aggregate demand and aggregate supply.

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A Simple Exchange Rate Model

• The spot exchange rate therefore depends on
  expectations of future price levels across all
  countries of the world.
• If expectations about any one countrys future
  price level changes, all exchange rates will tend
  to change because triangular arbitrage links all
  exchange rates.
• The task of accurately forecasting individual
  exchange rates is therefore likely to be subject
  to large errors given the enormous number of
  variables likely to influence price levels.
• Frequent revisions of expectations are also
  likely as the enormous data set is continually
  revised and updated.

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In the words of the international economist
Maurice Obstfeld

• A country cannot simultaneously maintain fixed
  exchange rates and an open capital market while
  pursuing a monetary policy oriented toward
  domestic goals.
• Governments may choose only two of the above.
• The impossibility of simultaneously achieving
  these three goals is known as the trilemma.

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The Trilemma and Recent Exchange Rate Crises

• There are obvious parallels between the 1994
  Mexican crisis, 1997 Asian crisis, and the 2001
  Argentine crisis.
• All of the countries concerned had made
  substantial economic policy changes, among which
  were the opening to international trade and
  international investment.
• After financial account transactions were
  liberalized (globalized), foreign loans and
  investment had grown rapidly.
• All the governments were openly committed to
  maintaining fixed or tightly controlled exchange
  rates.
• That is, the countries had all picked
  globalization and fixed exchange rates from the
  trilemma menu.

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The Trilemma and Recent Exchange Rate Crises

• Thus, when external economic conditions or
  domestic policies shifted and became incompatible
  with the fixed exchange rate, speculation moved
  against the currencies.
• Central banks were unable to intervene to the
  extent necessary to keep exchange rates constant,
  and the fixed exchange rates were eventually
  abandoned in favor of floating rates.
• The resulting sharp fall in the currencies
  values triggered financial crises because foreign
  debt was contracted in terms of dollars.
• The financial crises forced the countries to
  endure severe recessions and long adjustment
  periods.