balance of payments adjustments international economics chapter 8

Balance of Payments Adjustments

International Economics

Chapter 8

Chapter 8 Balance of Payments Adjustments

8.1 Elasticities Approach

8.2 Multiplier Approach

8.3 Absorption Approach

8.4 Monetary 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 ex

change market is derived from the country’s demand for imports.



China’s Import Demand Curve and the Demand for dollar

1000 800 10 8

B

Q$ O

7.00

8.00

S

A

D$

B 8.00

7.00

O

B

A

PI

O

￥700

￥800

QI

8.00

7.00

S

O

DI

iPod Imports (in millions) Demand for dollars (in millions)

Pric

e of

iPod

Spot

Exc

hang

e R

ate

(￥/$

)

(a) (b)


Elasticity of Import Demand and the Elasticity of Foreign Exchange Demand.

DI

800 1000 10 8

B

Q$ O

7.00

8.00

S

A

D$

B 8.00

7.00

O

B

A

PI

O

￥700

￥800

QI

8.00

7.00

S

O

iPod Imports (in millions) Demand for dollars (in millions)

Pric

e of

iPod

Spot

Exc

hang

e R

ate

(￥/$

)

(a) (b)

6 600

B’

DI’

B’

D$’

e

Derivation of the Supply of Foreign ExchangeThe supply of foreign exchange to a country results

from its exports of goods and services.


800 600 80 60 Q$ O

7.00

8.00

S

A

S$

B 8.00

7.00

O

B

A

PT

O

￥70

￥80

QT

8.00

7.00

e

O

ST

Toy Exports (in millions) Supply of dollars (in millions)

Pri

ce o

f To

y

Spo

t Exc

hang

e R

ate

(￥/$

)

(a) (b)


Elasticity of Export Supply and the Elasticity of Foreign Exchange Supply

800 600 80 60 Q$ O

7.00

8.00

S

A

S$

B 8.00

7.00

O

B

A

PT

O

￥70

￥80

QT

8.00

7.00

e

O

ST

Toy Exports (in millions) Supply of dollars (in millions)

Pri

ce o

f To

y

Spo

t Exc

hang

e R

ate

(￥/$

)

(a) (b)

ST’ S$

’

B’ B’

100 1000


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.

country’s balance of payments and exchange value

the quantity of foreign exchange

the quantity of goods and services

a change in the exchange rate

the domestic currency price of goods and services




The Current Account Deficit

S$

S$’

D$

D$’

Q$

e

8.00

7.50

7.00

800700600 10009000


The Role of ElasticityThe elasticities of the supply of and demand for foreig

n exchange are fundamental determinants of adjustment to a balance-of-payments deficit.


The Marshall-Lerner ConditionThe Marshall-Lerner condition specifies the necessary

condition for a positive effect of depreciation of domestic currency on the balance of payments.


Assumption Capital flows occur only as a means of financing

current account transactions.Trade balance exclusively represents the current

account.


CA in domestic currency:

Derivate it with e:

Initial CA in equilibrium:

Then:

Rearrange it:

Finally:

( , )

*CA PX eP M

* *dCA dX dM

P P M ePde de de

*1

eP M

PX

** *

dCA eP M dX dMP P M eP

de PX de de

* ( 1)dCA dX e dM e

P Mde de X de M

* ( 1)x m

dCAP M

de x

dX e

de X

m

dM e

de M


A depreciation to improve CA:

So:

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 1.

0dCA

de

1x m


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

BP Deficit

t0 t1 t20 Time

e↑

A

B

C


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.


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.


Assumptions Underemployed resources; Rigidity of all prices; Absence of capital mobility; All exports are made out of current output.


National income:

Thus:

( )Y C I G X M

0C C cY

0I I

0G G

0X X

0M M mY

0 0 0 0 0

1( )

1Y C I G X M

c m


An expansionary fiscal policy (a rise in G0), an expansionary monetary policy (a rise in I0 resulting from lower interest rates), or added exports (a rise in X0) can increase national income.

While a contractionary fiscal policy, a contractionary monetary policy or reduced exports will decrease national income.

0 0 0

10

1

dY dY dY

dG dI dX c m


An expansionary fiscal policy or an expansionary monetary policy can worsen a country’s current account (and then its balance of payments).

While a contractionary fiscal policy or monetary policy will improve its balance of payments.

0 0

01

dCA dCA m

dG dI c m


Added exports can improve a country’s current account (then its balance of payments).

While reduced exports will worsen its balance of payments.

0

10

1

dCA c

dX c m


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 t

he 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.


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.


Absorption: National income: Current account: => Thus

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.

A C I G

( )Y C I G X M

CA Y A

dCA dY dA

CA X M


The effect of depreciation on absorption can be divided into two parts:

The induced effect of income changes resulting from depreciation on absorption:

The direct effect of depreciation on absorption:

Therefore, the effects of depreciation on the current account:

the income effect:

the absorption effect:

a dY

ddA

ddA a dY dA

(1 ) ddCA a dY dA

(1 )a dY

ddA


Indirect 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.


Direct Effects of Depreciation on Absorption Real cash balance effect

e↑e↑ cash balance↓

expenditure↓

withdraw financial assets

Price of financial assets↓

P↑

r↑

require Ms↓to guarantee

C↓, I↓

C↓

ddA


Income redistribution effect

e↑e↑ Income redistribution from wage earners to profit earners

P↑

C↓

Wprofit earners have lower MPC

ddA


Taxation effect

e↑e↑ Enter higher taxation levels

expenditure↓

Nominal Y↑

C↓

Require G↓/ T↑ to guarantee

ddA


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 condit

ion;the government fulfills contractionary fiscal or

monetary policy along with depreciation.


Leaning with or against the Wind If a 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.


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 reservesSterilization of the sale of foreign exchange reserves requires

an equally-sized expansion of domestic credit.


Monetary Equilibrium ConditionIn equilibrium, the actual money stock equals the

quantity of money demanded.

Md=kPy

m(D+F)=keP*y Ms=Md

Ms=m(D+F)

*

Pe

P

Md=keP*y


A Change in Domestic Credit under Fixed Exchange Rates If the central bank increases domestic credit through an open m

arket purchase of securities, the open market purchase causes the country’s money stock to rise. m(D’+F)>keP*y

Under fixed exchange rates, 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 fixed exchange rates, an increase in domestic credit generates BP deficit, while a decrease in domestic credit results in BP surplus.


A Change in Md under Fixed Exchange Rates 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.


A Change in Domestic Credit under Flexible Exchange Rates Suppose the domestic central bank increases domestic credit thr

ough 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 flexible exchange rates, 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.


A Change in Md under Flexible Exchange Rates If the foreign price level or domestic real income increases, cau

sing 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 flexible exchange rates, 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.

balance of payments adjustments international economics chapter 8

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