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									International Economics

 Chapter 8

         Balance of Payments
             Adjustments
Chapter 8 Balance of Payments Adjustments


     8.1 Elasticities Approach

     8.2 Multiplier Approach

     8.3 Absorption Approach

     8.4 Monetary Approach
8.1 Elasticities Approach
 As a traditional approach to the balance of payments,
  elasticities approach assumes that capital flows occur only
  as a means of financing current account transactions.
 Derivation of the Demand for Foreign Exchange:
   The quantity of a currency demanded in the foreign
     exchange market is derived from the country’s demand
     for imports.
8.1 Elasticities Approach

                   PI                                                                   S
                                                                                        S




                                                             Spot Exchange Rate (¥/$)
                  ¥800                B                                                 8.00
                                                                                        8.00                 B
  Price of iPod




                  ¥700                         A                                        7.00
                                                                                        7.00                        A



                                                   DI                                                                        D$

                   O                                    QI                                  O                                  Q$
                                  8       10                                                           800       1000
                         iPod Imports (in millions)                                             Demand for dollars (in millions)

                                      (a)                                                                    (b)


                  China’s Import Demand Curve and the Demand for dollar
8.1 Elasticities Approach
   Elasticity of
               Import Demand and the Elasticity of
    Foreign Exchange Demand.
                      PI                                                                       S e
                                                                                               S




                                                                    Spot Exchange Rate (¥/$)
                     ¥800        B’       B                                                    8.00       B’      B
                                                                                               8.00
     Price of iPod




                     ¥700                          A                                           7.00
                                                                                               7.00                       A


                                                        D I’                                                                          D$’
                                                                                                                                 D$
                                                       DI
                      O                                        QI                                O                                     Q$
                                 6    8       10                                                         600   800      1000
                            iPod Imports (in millions)                                                Demand for dollars (in millions)

                                          (a)                                                                     (b)
8.1 Elasticities Approach
   Derivation of the Supply of Foreign Exchange
    The supply of foreign exchange to a country results
      from its exports of goods and services.
                      PT                                                                e                                     S$
                                                   ST                                   S




                                                             Spot Exchange Rate (¥/$)
                     ¥80                     B                                          8.00
                                                                                        8.00                   B
      Price of Toy




                     ¥70          A                                                     7.00
                                                                                        7.00           A




                      O                                 QT                                  O                                      Q$
                                  60     80                                                            600         800
                           Toy Exports (in millions)                                            Supply of dollars (in millions)

                                       (a)                                                                   (b)
8.1 Elasticities Approach
   Elasticity of Export Supply and the Elasticity of Foreign
    Exchange Supply
                      PT                                                                         e                                     S$
                                                     ST                                          S
                                                          ST ’                                                                              S$’




                                                                      Spot Exchange Rate (¥/$)
                     ¥80                     B   C                                               8.00                   B         C
      Price of Toy




                     ¥70          A                                                              7.00           A




                      O                                          QT                                  O                                      Q$
                                  60     80 100                                                                 600     800       1000
                           Toy Exports (in millions)                                                     Supply of dollars (in millions)

                                       (a)                                                                            (b)
8.1 Elasticities Approach

   The elasticities approach centers on changes in the
    prices of goods and services as the determinant of
    a country’s balance of payments and the exchange
    value of its currency.

    a change in              the domestic                  the quantity
    the exchange             currency price of             of foreign
    rate                     goods and services            exchange


                   country’s balance              the quantity
                   of payments and                of goods and
                   exchange value                 services
8.1 Elasticities Approach

   The Current Account Deficit
            e
                                        S$

                                                    S$’
          8.00


          7.50


          7.00
                                                      D$’
                                                     D$


            0       600   700   800   900    1000         Q$
8.1 Elasticities Approach
   The Role of Elasticity
     The elasticities of the supply of and demand for
      foreign exchange are fundamental determinants of
      adjustment to a balance-of-payments deficit.
8.1 Elasticities Approach
   The Marshall-Lerner Condition
    The Marshall-Lerner condition specifies the necessary
      condition for a positive effect of depreciation of
      domestic currency on the balance of payments.
8.1 Elasticities Approach
  Assumption
      Capital flows occur only as a means of financing
      current account transactions.
     Trade balance exclusively represents the current
      account.
8.1 Elasticities Approach
  CA    in domestic currency:        CA  PX  eP * M
                                      dCA    dX                dM
     Derivate it with e:                 P     P * M  eP *
                                       de    de                 de
                                     eP * M
     Initial CA in equilibrium:             1
                                       PX
                                 dCA      eP * M dX                dM
     Then:                           P             P * M  eP *
                                  de        PX de                   de
     Rearrange it:              dCA         dX e dM e
                                      P*M (           1)
                                  de         de X de M
     Finally:
          dCA                                    dX e
               P * M (x  m  1)   (   x           , m   dMe
                                                                       )
           de                                    de X           de M
8.1 Elasticities Approach
  A    depreciation to improve CA:   dCA
                                          0
                                       de
     So:      x  m  1

      Marshall-Lerner condition states that a depreciation
      of domestic currency can improve a country’s balance
      of payments only when the sum of the demand
      elasticity of exports and the demand elasticity of
      imports exceeds unity.
8.1 Elasticities Approach
   J-Curve Effect
    A   depreciation of the domestic currency is unlikely to
      immediately improve a country’s balance-of-payments deficit. It
      is even possible that the depreciation could cause a country’s
      balance of payments to worsen before it improves.
               BP Surplus

                                                C
           0            t0   t1                 t2 Time

                        A
                   e↑

                             B
               BP Deficit
8.1 Elasticities Approach
 Reasons   for J-Curve Effect:
     Recognition lags of changing competitive conditions;
     Decision lags in forming new business connections
      and placing new orders;
     Delivery lags between the time new orders are placed
      and their impact on trade and payment flows is felt;
     Replacement lags in using up inventories and
      wearing out existing machinery before placing new
      orders;
     Production lags involved in increasing the output of
      commodities for which demand has increased.
Chapter 8 Balance of Payments Adjustments


     8.1 Elasticities Approach

     8.2 Multiplier Approach

     8.3 Absorption Approach

     8.4 Monetary Approach
8.2 Multiplier Approach

   The multiplier approach is a modified and
    extended version of the elasticity analysis.
     The exchange rate is assumed fixed. The theory
      is suitable to analyze the adjustment process
      under a pegged regime.
     The only possibility for BP adjustment in this
      model is by changes in national income.
8.2 Multiplier Approach

   Assumptions
     Underemployed resources;

     Rigidity of all prices;
     Absence of capital mobility;
     All exports are made out of current output.
8.2 Multiplier Approach
   National income:     Y  C  I  G  (X  M )
                              C  C0  cY
                              I  I0
                              G  G0
                              X  X0
                             M  M 0  mY
                     1
   Thus:    Y            (C0  I 0  G0  X 0  M 0 )
                  1 c  m
8.2 Multiplier Approach
   An expansionary fiscal policy (a rise in G0), an
    expansionary monetary policy (a rise in I0 resulting from
    lower interest rate), or added exports (a rise in X0) can
    increase national income.
       dY   dY   dY      1
                             0
        dG0 dI 0 dX 0 1  c  m
   While a contractionary fiscal policy, a contractionary
    monetary policy or reduced exports will decrease national
    income.
8.2 Multiplier Approach
   An expansionary fiscal policy or an expansionary
    monetary policy can worsen a country’s current account
    (and then its balance of payments).
       dCA dCA          m
                            0
        dG0   dI 0    1 c  m
   While a contractionary fiscal policy or monetary policy
    will improve its balance of payments.
8.2 Multiplier Approach

   Added exports can improve a country’s current
    account (then its balance of payments).
     dCA     1 c
                     0
       dX 0 1  c  m

   While reduced exports will worsen its balance of
    payments.
8.2 Multiplier Approach

   In conclusion, when an economy has
    underemployed resources, fiscal policy, monetary
    policy and trade policies can be used for adjusting
    its balance of payments.
    Contractionary fiscal or monetary policy can improve
     the balance of payments but at the cost of a decrease in
     national output.
    Added exports resulting from export-encouraging
     policies will improve the balance of payments and
     meanwhile, increase national income.
Chapter 8 Balance of Payments Adjustments



      8.1 Elasticities Approach

      8.2 Multiplier Approach

      8.3 Absorption Approach

      8.4 Monetary Approach
8.3 Absorption Approach
 The absorption approach assumes that prices remain
  constant and emphasizes changes in real domestic
  income.
 Hence, the absorption approach is a real-income theory
  of the balance of payments.
8.3 Absorption Approach
 Absorption:             A  C  I G
 National income:       Y  C  I  G  (X  M )
 Current account:       CA  X  M => CA  Y  A
 Thus                   dCA  dY  dA
    It shows whether a currency depreciation can improve
    the current account (then the balance of payments)
    depends on its effect on national income and on
    domestic absorption.
8.3 Absorption Approach
   The effect of depreciation on absorption can be divided
    into two parts:
     dA  a  dY  dAd
         The induced effect of income changes resulting from
          depreciation on absorption: a  dY
         The direct effect of depreciation on absorption: dAd

   Therefore, the effects of depreciation on the current
    account:
     dCA  (1  a )  dY  dA
                              d


           the income effect: (1  a)  dY
           the absorption effect: dAd
8.3 Absorption Approach

   Effects of Depreciation on National Income
    On the supply side, an effective depreciation requires
      idle resources in the economy.
    On the demand side, an effective depreciation requires
      the Marshall-Lerner condition to be met.
    From the perspective of government’s macroeconomic
      regulation, an effective depreciation requires loosening
      protective or restrictive trade polices.
8.3 Absorption Approach
   Direct Effects of Depreciation on Absorption
      Real cash balance effect

                                            require Ms↓to guarantee

    e↑           P↑         cash balance↓

         expenditure↓         C↓

         withdraw             Price of financial      r↑       C↓,
         financial assets     assets↓                          I↓


         dAd 
8.3 Absorption Approach
   Income   redistribution effect


    e↑          P↑              Income redistribution from
                                wage earners to profit earners
                 W
                                profit earners have lower MPC



         C↓             dAd 
8.3 Absorption Approach
     Taxation effect
                                             Require G↓/ T↑ to
                                             guarantee

 e↑          Nominal Y↑        Enter higher taxation levels



      expenditure↓        C↓        dAd 
8.3 Absorption Approach

   In conclusion, the absorption approach proposes
    that depreciation can be effective in improving the
    balance of payments when
      the economy has idle resources;

      the economy meets the Marshall-Lerner
       condition;
     the government fulfills contractionary fiscal or
       monetary policy along with depreciation.
Chapter 8 Balance of Payments Adjustments


     8.1 Elasticities Approach

     8.2 Multiplier Approach

     8.3 Absorption Approach

     8.4 Monetary Approach
8.4 Monetary Approach
   Leaning with or against the Wind
     Ifa central bank intervenes to support or speed along the
     current trend in the value of its country’s currency in the
     foreign exchange market, then economists say that its
     interventions are leaning with the wind.
     In contrast, a central bank’s interventions intended to halt or
     reverse a recent trend in the value of its country’s currency are
     leaning against the wind.
8.4 Monetary Approach
   Foreign Exchange Intervention
     Central banks    buy or sell financial assets denominated in foreign
        currencies in an effort to influence exchange rates.
   Sterilization of Intervention
        A central bank sterilizes foreign exchange interventions when it
        buys or sells domestic assets in sufficient quantities to prevent
        the interventions from influencing the domestic money stock.
           monetary base = domestic credit + foreign exchange reserves
           Sterilization of the sale of foreign exchange reserves requires
            an equally-sized expansion of domestic credit.
8.4 Monetary Approach
   Monetary Equilibrium Condition
    In equilibrium, the actual money stock equals the
     quantity of money demanded.
                P
             e
                P*
    Md=kPy            Md=keP*y
                                 Ms=Md    m(D+F)=keP*y

                     Ms=m(D+F)
8.4 Monetary Approach
   Fixed Exchange Rate and A Change in Domestic Credit
      If the central bank increases domestic credit through an open
      market purchase of securities, the open market purchase causes
      the country’s money stock to rise.
         m(D’+F)>keP*y
     Under a fixed exchange rate arrangement, the country’s
      monetary authorities must sell foreign exchange reserves to
      meet the demand for foreign currency. As a result, foreign
      exchange reserves decline, while the spot exchange rate remains
      constant.
     Under a fixed exchange rate arrangement, an increase in
      domestic credit generates BP deficit, while a decrease in
      domestic credit results in BP surplus.
8.4 Monetary Approach
   Fixed Exchange Rate and A Change in Md
     Suppose   that there is an increase in either the foreign price level
      or real income, causing an increase in the quantity of money
      demanded.
         m(D+F)<ke(P*y)’
     To prevent the domestic currency from appreciating, the
      domestic monetary authorities must increase the quantity of
      money supplied so that it equals the quantity of money
      demanded.
     A rise in either the foreign price level or domestic real income
      results in BP surplus. Likewise, a decline in either the foreign
      price level or domestic real income results in BP deficit.
8.4 Monetary Approach
   Flexible Exchange Rate and A Change in Domestic Credit
      Suppose the domestic central bank increases domestic credit
      through a purchase of securities, causing domestic money stock
      to rise.
         m(D’+F)>keP*y
     As households increase their expenditures on foreign goods and
      services, the domestic currency depreciates and BP keeps in
      equilibrium.
     Under a flexible exchange rate arrangement, an increase in
      domestic credit results in a depreciation of the domestic
      currency, while a decline in domestic credit results in an
      appreciation of the domestic currency.
8.4 Monetary Approach
   Flexible-Exchange-Rate and A Change in Md
     If the foreign price level or domestic real income increases,
      causing an increase in the quantity of money demanded.
         m(D+F)<ke(P*y)’
     The decrease in demand for foreign goods and services causes
      the domestic currency to appreciate and BP keeps in
      equilibrium.
     Under a flexible exchange rate arrangement, an increase in the
      foreign price level or domestic real income results in an
      appreciation of the domestic currency. In contrast, a decline in
      the foreign price level or domestic real income results in a
      depreciation of the domestic currency.

								
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