Basic Theories of the Balance of Payments Three Approaches.
-
Upload
nathanael-stormes -
Category
Documents
-
view
252 -
download
0
Transcript of Basic Theories of the Balance of Payments Three Approaches.
![Page 1: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/1.jpg)
Basic Theories of the Balance of Payments
Three Approaches
![Page 2: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/2.jpg)
Three Approaches
The Elasticities Approach to the Balance of Trade
The Absorption Approach to the Balance of Trade
The Monetary Approach to the Balance of Payment (MABOP)
![Page 3: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/3.jpg)
The Elasticities Approach to BOT
d = elasticity of demand
= the responsiveness of quantity
demanded to changes in price
d = (%Qd)/(%P)
which is usually negative
![Page 4: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/4.jpg)
Elasticities
| d | > 1 the demand is elastic | d | < 1 the demand is inelastic If the demand is elastic, the 1% rise in
price leads to more than 1% decline in quantity demanded.
If the demand is inelastic, the 1% rise in price leads to less than 1% decline in quantity demanded.
![Page 5: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/5.jpg)
Devaluation and BOT
Does the devaluation of a currency improve the country’s balance of trade?
Consider EPs/$ = the Mexican peso price of the dollar
![Page 6: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/6.jpg)
Devaluation and BOT (cont’d)
(1) If the demand curve for the dollar slopes downward and the supply curve of the dollar slopes upward, then the devaluation of the peso leads to an excess supply of the dollar, which causes the Mexican trade deficit to decrease.
![Page 7: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/7.jpg)
Devaluation and BOT
(2) If the demand curve for the dollar is steep and the supply curve of the dollar is negatively sloped, then the devaluation of the peso leads to an excess demand for the dollar, which causes the Mexican trade deficit to increase.
![Page 8: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/8.jpg)
Devaluation and BOT (cont’d)
(1): stable FX market equilibrium (2): unstable FX market equilibrium The case (2) could occur when Mexican demand
for US imports and US demand for Mexican exports are both very inelastic.
The greater the elasticities of both country’s demand for the other country’s goods, the greater the improvement in Mexico trade balance after a peso devaluation.
![Page 9: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/9.jpg)
Devaluation and BOT
The condition that guarantees the case (1) is called Marshall-Lerner Condition.
![Page 10: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/10.jpg)
J Curve Effect
After the devaluation, it is often observed that the trade balance initially deteriorates for a while before getting improved.
![Page 11: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/11.jpg)
Elasticities and J-Curves
Why do we have a J-Curve? The initial demands tend to be inelastic. Suppose Mexico imports good X from the
US and exports good Y to the US. Devaluation Eps/$
PXPs & PY
$
QXd & QY
d
![Page 12: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/12.jpg)
Elasticities and J-Curves
But if Mexican demand for X is inelastic, the % decrease in QX
d would be smaller than the % increase in PX
Ps so that Imports = PXPs QX
d would increase.
Further, if US demand for Y is inelastic, the % increase in QY
d would be smaller than the % decline in PY
$ so that Exports = PY$ QY
d would fall.
![Page 13: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/13.jpg)
Pass Through
Devaluation Import prices in the home country and export prices in foreign countries.But prices do not adjust instantaneously.
Persistent BOP deficit devaluation Home demand for imports and foreign demand for exports an improvement in BOP in the L-R
![Page 14: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/14.jpg)
Pass-through Analysis
How do prices adjust to exchange rate changes in the S-R?
Differences in the pass-through effect across countries Producers adjust profit margins
Example: When the yen appreciated against the dollar substantially during late 1980s, Japanese auto-makers limited the pass-through of higher prices by reducing the profit margins on their products.
![Page 15: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/15.jpg)
Pass-though analysis (cont’d)
In general, Depreciation of the dollar Foreign
sellers cut their profit margins Appreciation of the dollar Foreign
sellers increase their profit margins
![Page 16: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/16.jpg)
Absorption Approach to BOT
Recall the national income identity:
Y = C + I + G + (X – M)
So
Y – A = X – M
where A = C + I + G is the total domestic spending or absorption.
![Page 17: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/17.jpg)
Absorption approach to BOP (cont’d)
If Y > A, then X – M > 0 or BOT > 0.If Y < A, then X – M < 0 or BOT < 0.
Does devaluation always improve BOT? Recall: If Y = Y* Full employment level of
output, then all resources are already employed and hence, X – M needs A .
If Y < Y*, then X – M obtains through increasing Y with A unchanged, i.e. by producing more to sell to foreigners.
![Page 18: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/18.jpg)
Absorption approach
So, when Y < Y*, devaluation would improve BOT.
But when Y > Y*, devaluation would increase X – M but create inflation.
![Page 19: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/19.jpg)
Monetary Approach to BOP
Recall
Current account
Non-reserve capital account
--------------------------------------
Official reserve account money
supply
![Page 20: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/20.jpg)
Fed’s Balance Sheet
Assets Liabilities Domestic Credit Currency (Treasury securities, (Fed reserve notes Discount loans, etc ) outstanding)
International Bank reserves reserves (Gold, SDR, other foreign
currencies denominated deposits and bonds)
![Page 21: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/21.jpg)
Monetary base
DC + IR = CU + R MB (1)
where DC = domestic credit
IR = international reserves
CU = currency
R = bank reserves
MB = monetary base
![Page 22: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/22.jpg)
FX intervention again
Suppose the Fed sells $1 billion of its foreign assets in exchange for $1 billion of US currency.Fed’s balance sheet Assets Liabilities
Foreign assets -$1 billion Currency -$1 billion
So, MB by $1 billion.
![Page 23: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/23.jpg)
Money Supply
Recall: MS = m•MB (2)where m = money multiplier
M = CU + D where D = deposits
MB = CU + RSo, M/MB = (CU + D)/(CU + R)
= (1 + c)/(c + r) mwhere c = currency-deposit ratio
r = reserve ratio
![Page 24: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/24.jpg)
Money supply and Money demand
Substituting (2) in (1), we obtainMS = m (DC + IR) (3)
Consider Money demand function:Md = k•P•L (4)
where P = price level at home and L is the liquidity preference function, which depends on income and the interest rate. k is a constant.
![Page 25: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/25.jpg)
PPP again
Now assume PPP
P = E•P* (5)where E = home currency price of the
foreign currency
P* = price level in the foreign country
Substituting (5) into (4), we have
Md = k•E•P*•L (6)
![Page 26: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/26.jpg)
Monetary equilibrium
In equilibrium, Md = MS. So, from (3) and (6), we have
k•E•P*•L = m (DC + IR) In terms of “% changes” (or growth rates),
E^ + P*^ + L^ = w•DC^ + (1-w)•IR^
where k^ = m^ =0 because they are constants. w = DC/(DC + IR).
![Page 27: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/27.jpg)
Finally,
Rearranging, we obtain
(1-w)• IR^ - E^ = P*^ + L^ - w•DC^ (7)
![Page 28: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/28.jpg)
Monetary approach to Balance of payments (MABOP)
With a fixed exchange rate (E^ = 0),
BOP^ = IR^ = [1/(1-w)]•(P*^ + L^)
- [w/(1-w)]•DC^ (8) Fed increases MS (Excess money supply)
DC IR BOP Fed decreases MS
DC IR BOP
![Page 29: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/29.jpg)
Monetary approach to exchange rate (MAER)
With a flexible exchange rate (BOP=0),
-E^ = P*^ + L^ - w•DC^ (9)
Fed increases MS
DC E (depreciation) Fed decreases MS
DC E (appreciation)
![Page 30: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/30.jpg)
Managed float
Although exchange rates are market determined in principle, central banks intervene at times to peg the rates at some desired level.
When MS or Md changes, the central bank can choose either E^ or IR^ to adjust.
![Page 31: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/31.jpg)
Implication of PPP
Recall PPP again: P = EP*. With a fixed ex rate, E^ = 0, so
P^ = P*^
In other words, when the foreign price level is increasing rapidly, then the home price must follow if we are to maintain the fixed E. Imported Inflation
![Page 32: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/32.jpg)
Implication of PPP (cont’d)
With flexible rates, E is free to vary so that even when P*^ > 0, P^ can be zero by letting E^ = - P*^, or letting the home currency to appreciate by the same amount as the foreign inflation rate.
![Page 33: Basic Theories of the Balance of Payments Three Approaches.](https://reader033.fdocuments.in/reader033/viewer/2022061604/551c59ad550346a66a8b5046/html5/thumbnails/33.jpg)
Views based on MABOP
BOP disequilibria are essentially monetary phenomena.
Devaluation is a substitute for reducing the growth of domestic credit.
Appreciation is a substitute for increasing domestic credit growth.