open economy macro: exchange rate and trade policy

© 2003 McGraw-Hill Ryerson Limited.

Open Economy Open Economy Macro: Exchange Macro: Exchange Rate And Trade Rate And Trade

PolicyPolicy

Chapter 16Chapter 16

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The Balance of The Balance of PaymentsPayments The balance of payments is a

country’s record of all transactions between its residents and the residents of all foreign countries.

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The Balance of The Balance of PaymentsPayments The current account is the part of the

balance of payments account in which all short-term flows of payments are listed. It includes exports and imports of

both goods and services; net investment income; and net transfers.

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The Balance of The Balance of PaymentsPayments The capital and financial accounts

are the part of the balance of payments account in which all long-term flows of payments are listed. When Canadian citizens buy foreign

securities or when foreigners buy Canadian securities, they are listed here as outflows and inflows, respectively.

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The Balance of The Balance of PaymentsPayments The government can influence the

exchange rate by buying and selling official reserves—government holdings of foreign currencies.

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The Current AccountThe Current Account

The difference between the value of goods exported and the value of goods imported is sometimes called the balance of merchandise trade.

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Although the popular press often uses this measure, the merchandise trade balance is not a good summary because services are an important component of trade.

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Trade in services is just as important as trade in goods.

The key statistic for economists is the balance of goods and services which is the difference between the value of goods and services exported and imported.

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There is no reason that the goods and services sent into a country must equal the goods and services sent out in a particular year.

The current account includes payments from past investments and net transfers.

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The last component of the current account is net transfers, which include foreign aid, gifts, and other payments to individuals not exchanged for goods and services.

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The Capital and The Capital and Financial AccountFinancial Account The capital and financial account

consists of The capital account The financial account.

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The Capital and The Capital and Financial AccountFinancial Account The capital account measures

transactions such as international inheritances, federal debt forgiveness and the transfer of intangible assets.

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The Capital and The Capital and Financial AccountFinancial Account The financial account measures

transactions in financial assets and liabilities.

It includes Canadian portfolio investment abroad and foreign investment in Canadian stocks and bonds.

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The Capital and The Capital and Financial AccountFinancial Account

The reason for this are statistical discrepancies – many transactions have to be estimated.

Current account balance is not completely offset by the capital and financial account balance.

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The Capital and The Capital and Financial AccountFinancial Account In thinking about what determines a

currency’s value, it is important to remember both the demand for dollars to buy goods and services and the demand for dollars to buy assets.

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Balance of Payments Balance of Payments EquilibriumEquilibrium Because the balance of payments

consists of both the capital account and the current account, if the capital account is in surplus and the trade account is in deficit, there can still be a balance of payments surplus.

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2001 Balance of Payments 2001 Balance of Payments Account, Account, Table 16-1, p 383Table 16-1, p 383

1 Current Account2 Merchandise3 Exports 412,5104 Imports -351,0035 Balance of Trade 61,5076 Services7 Exports 55,0958 Imports -61,9269 Balance of Services -6,831

10 Balance of Goods and Services 54,676

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2001 Balance of Payments 2001 Balance of Payments Accounts, Accounts, Table 16-1, p 383Table 16-1, p 38311 Net Investment Income -27,44612 Net Transfers 1,87013 Investment Transactions Balance -25,57614 Balance of Current Account 29,10015 Capital Account16 Inflows 6,48217 Outflows -80418 Balance of Capital Account 5,67819 Financial Account20 Assets -107,38821 Liabilities 80,88922 Net Financial Account -26,49923 Total Capital and Financial Account Balances -20,82124 Statistical Discrepancy -8,27925 Total 0

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Balance of Payments Balance of Payments EquilibriumEquilibrium By definition, current account and the

capital and financial account must sum to zero, because they are an accounting identity.

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Balance of Payments Balance of Payments EquilibriumEquilibrium If the currencies are freely

exchangeable, the quantity of currency demanded must equal the quantity supplied.

Any deficit in the balance of payments, then, must be offset by an equal surplus in official reserve transactions.

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Exchange RatesExchange Rates

Exchange rate is the rate at which one currency can be traded for another.

When comparing the currencies of two countries, the supply of one currency equals the demand for another currency.

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Exchange RatesExchange Rates

In order to demand one currency, you must supply another.

Equilibrium is where the quantity supplied equals the quantity demanded.

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Exchange Rates and the Exchange Rates and the Balance of PaymentsBalance of Payments A deficit in the balance of payments

means that the quantity supplied of a currency exceeds the quantity demanded.

A surplus in the balance of payments means the opposite.

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Exchange Rates and the Exchange Rates and the Balance of PaymentsBalance of Payments Equilibrium is where the quantity

supplied a currency equals the quantity demanded.

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The Supply of and The Supply of and Demand for Euros, Demand for Euros, Fig. 16-1, p Fig. 16-1, p

387387

Supply

Demand

QSQD

$1.30

1.201.15

1.10

Quantity of Euros

Price of Euros (in dollars)

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Fundamental Forces Fundamental Forces Determining Exchange Determining Exchange RatesRates Exchange rate analysis is usually

broken down into fundamental analysis and short-run analysis.

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Fundamental Forces Fundamental Forces Determining Exchange Determining Exchange RatesRates Fundamental analysis is a consideration

of the fundamental forces that determine the supply of and demand for currencies.

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Fundamental Forces Fundamental Forces Determining Exchange Determining Exchange RatesRates These fundamental forces include a

country’s income, changes in a country’s prices, and the interest rate in a country.

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Changes in a Country’s Changes in a Country’s IncomeIncome When a country’s income falls, the

demand for imports falls. Then demand for foreign currency to

buy those imports falls.

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Changes in a Country’s Changes in a Country’s IncomeIncome This means that the supply of the

country’s currency to buy the foreign currency falls.

This finally leads to an increase in the price of that country’s currency relative to foreign currency.

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Changes in a Country’s Changes in a Country’s PricesPrices If the Canada has more inflation than

other countries, foreign goods will become cheaper.

Canadian demand for foreign currencies will tend to increase, and foreign demand for dollars will tend to decrease.

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Changes in a Country’s Changes in a Country’s PricesPrices This rise in Canadian inflation will shift

the dollar supply to the right and the dollar demand to the left.

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Changes in Interest Changes in Interest RatesRates A rise in Canadian interest rates relative

to those abroad will increase demand for Canadian assets.

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Changes in Interest Changes in Interest RatesRates Demand for dollars will increase, while

simultaneously the supply of dollars will decrease as fewer Canadians sell their dollars to buy foreign assets.

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Changes in Interest Changes in Interest RatesRates A fall in Canadian interest rates or a rise

in foreign interest rates will have the opposite effect.

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Exchange Rate Exchange Rate Determination Is More Determination Is More Complicated Than It Complicated Than It SeemsSeems Large exchange rate fluctuations in

response to changing expectations make trading difficult and have significant real effect on economic activity.

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Exchange Rate Exchange Rate Determination Is More Determination Is More Complicated Than It Complicated Than It SeemsSeems If the market expects exchange rates to

change, it will become a self-fulfilling prophesy.

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Exchange Rate Exchange Rate Determination Is More Determination Is More Complicated Than It Complicated Than It SeemsSeems The resulting fluctuations serve no real

purpose, and cause problems for international trade and the country’s economy.

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International Trade International Trade Problems From Shifting Problems From Shifting Values of CurrenciesValues of Currencies Large fluctuations make real trade

difficult, and cause serious real consequences.

It is these consequences that have led to calls for government to fix or stabilize their exchange rates.

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How a Fixed Exchange How a Fixed Exchange Rate System WorksRate System Works One way the government can set the

exchange rate is to make its currency nonconvertible.

Most western economies have agreed not to use this approach.

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How a Fixed Exchange How a Fixed Exchange Rate System WorksRate System Works A second way is for government to

adopt a fixed exchange rate policy. A fixed exchange rate policy is one in

which the government commits to holding the exchange rate at a specified rate through direct intervention.

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Fixing the Exchange Fixing the Exchange RateRate The government can fix its exchange

rate by exchange rate intervention. Exchange rate intervention – buying

or selling a currency to affect its price.

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Direct Exchange Rate Direct Exchange Rate InterventionIntervention Currency support is the buying of a

currency by a government to maintain its value at above its long-run equilibrium value.

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Direct Exchange Rate Direct Exchange Rate InterventionIntervention A country can maintain a fixed

exchange rate only as long as it has the official reserves (foreign currencies) to maintain this constant rate.

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Direct Exchange Rate Direct Exchange Rate InterventionIntervention Once it runs out of official reserves, it

will be unable to intervene, and then must either borrow or devalue its currency.

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Direct Exchange Policy, Direct Exchange Policy, Fig.16-2, p 392Fig.16-2, p 392

$1.30

1.20

1.10

Supply

Q1

D1

D0

Quantity of eurosQE Q2

Excess supply

Pric

e of

eur

os (

in d

olla

rs)

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Currency StabilizationCurrency Stabilization

A more practical long-run exchange rate policy is currency stabilization.

Currency stabilization – the buying and selling of a currency by the government to offset temporary fluctuations in supply and demand for currencies.

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In currency stabilization, the government is not trying to change the long-run equilibrium.

It is simply trying to keep the exchange rate at that long-run equilibrium.

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Currency stabilization minimizes the possibility that the government will run out of official reserves.

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If a country runs out of official reserves, it must adjust its economy if it wants to maintain a fixed exchange rate.

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Given the small level of official reserves relative to the enormous level of private trading, significant amounts of stabilization are impossible.

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Strategic currency stabilization is often used when a government has a small level of official reserves.

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Strategic currency stabilization is the process of buying and selling at strategic moments to affect the expectations of traders, and hence to affect their supply and demand.

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Stabilizing Fluctuations Stabilizing Fluctuations Versus Deviating From Versus Deviating From Long-Run EquilibriumLong-Run Equilibrium In theory, it is important to distinguish

whether the problem is long- or short-run equilibrium.

In practice, it is difficult to do so.

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Stabilizing Fluctuations Stabilizing Fluctuations Versus Deviating From Versus Deviating From Long-Run EquilibriumLong-Run Equilibrium The long-run equilibrium rate can only

be guessed, since no definitive empirical measure of this rate exists.

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Estimating Long-Run Estimating Long-Run Equilibrium Exchange Equilibrium Exchange RatesRates Purchasing power parity is one way

economists have of estimating the long-run equilibrium rate.

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Estimating Long-Run Estimating Long-Run Equilibrium Exchange Equilibrium Exchange RatesRates Purchasing power parity (PPP) is a

method of calculating exchange rates that attempts to value currencies at rates such that each currency will buy an equal basket of goods.

Those exchange rates may or may not be appropriate long-run exchange rates.

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Criticisms of the Criticisms of the Purchasing Power Parity Purchasing Power Parity MethodMethod The difficulty with purchasing power

parity is the complex nature of trade and consumption.

The purchasing power parity will change as the basket of goods changes.

Because of this there is no single measure of purchasing power parity.

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Criticisms of the Criticisms of the Purchasing Power Parity Purchasing Power Parity MethodMethod Purchasing power parity measures

leave out asset demand for a currency, an important element of demand for currencies.

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Criticisms of the Criticisms of the Purchasing Power Parity Purchasing Power Parity MethodMethod The critics contend that the current

exchange rate is the best estimate of the long-run equilibrium exchange rate.

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Alternative Exchange Alternative Exchange Rate SystemsRate Systems There are three exchange rate regimes:

Fixed exchange rate – the government chooses an exchange rate and offers to buy and sell currencies at that rate.

Flexible exchange rate – determination of exchange rates is left totally up to the market.

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Alternative Exchange Alternative Exchange Rate SystemsRate Systems There are three exchange rate regimes:

Partially flexible exchange rate – the government sometimes affects the exchange rate and sometimes leaves it to the market.

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Advantages of Fixed Advantages of Fixed Exchange RatesExchange Rates They provide international monetary

stability. They force governments to make

adjustments to meet their international problems.

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Disadvantages of Fixed Disadvantages of Fixed Exchange RatesExchange Rates They can become unfixed. When they are expected to become

unfixed, they create enormous monetary instability.

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Disadvantages of Fixed Disadvantages of Fixed Exchange RatesExchange Rates They force governments to make

adjustments to meet their international problems.

Notice that this is an advantage as well as a disadvantage.

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Fixed Exchange Rates Fixed Exchange Rates and Monetary Stabilityand Monetary Stability If the government picks an exchange

rate that is too high, its exports lag and the country loses official reserves.

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Fixed Exchange Rates Fixed Exchange Rates and Monetary Stabilityand Monetary Stability If the government picks an exchange

rate that is too low, it is paying more for its imports than it needs to and is building up official reserves.

Some other country is losing official reserves.

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Fixed Exchange Rates Fixed Exchange Rates and Monetary Stabilityand Monetary Stability At times fixed exchange rates can

become highly unstable because expectations of a change in the exchange rate can force the change to occur.

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Fixed Exchange Rates Fixed Exchange Rates and Policy Independenceand Policy Independence Fixed exchange rates provide

international monetary stability and force governments to make adjustments to meet their international problems.

If they become unfixed, they create monetary instability.

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Fixed Exchange Rates Fixed Exchange Rates and Policy Independenceand Policy Independence Because most countries’ official

reserves are limited, a country with fixed exchange rates is limited in its ability to conduct expansionary monetary and fiscal policies.

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Fixed Exchange Rates Fixed Exchange Rates and Policy Independenceand Policy Independence Many countries run out of official

reserves when a recession hits. They choose expansionary monetary

policy to achieve their domestic goals rather than contractionary monetary policy to maintain fixed exchange rates.

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Advantages of Flexible Advantages of Flexible Exchange RatesExchange Rates They provide for orderly incremental

adjustment of exchange rates, rather than large, sudden jumps.

They help government in conducting domestic monetary and fiscal policies.

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Disadvantages of Disadvantages of Flexible Exchange RatesFlexible Exchange Rates They allow speculation to cause large

jumps in exchange rates, which do not reflect market fundamentals.

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Disadvantages of Disadvantages of Flexible Exchange RatesFlexible Exchange Rates They allow government to be flexible in

conducting domestic monetary and fiscal policies.

Notice that this is an advantage as well as a disadvantage.

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Flexible Exchange Rates Flexible Exchange Rates and Monetary Stabilityand Monetary Stability Proponents argue: why not treat

currency markets like any other market and let private market forces determine a currency’s value?

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Flexible Exchange Rates Flexible Exchange Rates and Monetary Stabilityand Monetary Stability Opponents argue that flexible exchange

rates allow far too much fluctuation in exchange rates, making trade difficult.

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Flexible Exchange Rates Flexible Exchange Rates and Policy Independenceand Policy Independence Flexible exchange rate regimes allow

governments to be flexible in conducting domestic monetary and fiscal policy.

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Flexible Exchange Rates Flexible Exchange Rates and Policy Independenceand Policy Independence Some argue that flexible exchange

rates do not provide sufficient discipline for macro policy.

They are, however, open to private speculation.

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Partially Flexible Partially Flexible Exchange RatesExchange Rates Most nations have opted for a policy,

partially flexible exchange rates, that stands between these two extremes.

Sometimes, these are referred to as “managed” exchange rates or a “dirty” float.

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Partially Flexible Partially Flexible Exchange RatesExchange Rates If policy makers believe there is a

fundamental misalignment in a country’s exchange rate, they allow market forces to determine it.

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Partially Flexible Partially Flexible Exchange RatesExchange Rates If they believe the currency’s value is

falling because of speculation, they step in and fix the exchange rate, either supporting or pushing down their currency’s value.

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Partially Flexible Partially Flexible Exchange RatesExchange Rates Partially flexible exchange rate regimes

combine the advantages and disadvantages of fixed and flexible exchange rates.

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Which View Is Right?Which View Is Right?

Which view is correct is much in debate. In order to decide, it is necessary to go

beyond the arguments and look at the history of the various regimes.

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The View of Foreign The View of Foreign Exchange TradersExchange Traders Most foreign-exchange traders feel their

take on the market is better than that of governments’.

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The View of Foreign The View of Foreign Exchange TradersExchange Traders When these traders know that

government might enter the market, they stop focusing on fundamentals and switch to trying to guess what the regulators will do.

Such guessing-games tend to destabilize the market, not stabilize it.

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The View of Central The View of Central Banks EconomistsBanks Economists Economists at central banks maintain

that government intervention helps to stabilize currency markets.

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Monetary Union in North Monetary Union in North AmericaAmerica Should Canada and the United States

adopt a common currency? Twelve members of the European

Union replaced their national currencies by euro – a common currency in Europe.

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Monetary Union in North Monetary Union in North AmericaAmerica Possible options for North America:

Moving back to fixed exchange rates. Creating a new North American

currency (the amero). Adopting the U.S. dollar.

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Fixed Exchange RatesFixed Exchange Rates

Fixing the value of the Canadian dollar to the U.S. dollar makes sense from a practical stand-point.

There are potential benefits and costs of such an action.

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Benefits: A fixed exchange rate would force

Canadian firms to be competitive - Steady decline in the value of the Canadian dollar has postponed cost-cutting decisions of firms, as Canadian products became relatively cheap.

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Costs: Any advantages of a flexible rate vis-

à-vis other nations would be lost.

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A New CurrencyA New Currency

If a common currency could be agreed, we have to decide the rate at which the two economies would enter the monetary union.

Which central bank gets to determine monetary policy?

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A New CurrencyA New Currency

A common currency is beneficial when states respond in similar fashion to

disturbances An economy is relatively open.

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Adopting the U.S. DollarAdopting the U.S. Dollar As long as Canada benefits from a

separate currency and floating exchange rate, it is not feasible to consider either the adoption of a common currency, nor adoption of the U.S. dollar.

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Adopting the U.S. DollarAdopting the U.S. Dollar

Canadian and U.S. economy differ in important aspects - Canada is a net exporter of primary commodities. As such, it benefits from a flexible exchange.

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Trade PolicyTrade Policy

Trade policy involves government creating trade restrictions on imports in order to meet the balance of payments constraint without using traditional macro policy or exchange rate policy.

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Trade PolicyTrade Policy

Economists generally oppose such trade restrictions. They prevent competition. They lower world welfare. They lead other countries to retaliate.

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Varieties of Trade Varieties of Trade RestrictionsRestrictions The most common trade restrictions are

tariffs and quotas. Other trade restrictions are voluntary

restraint agreements, embargoes, regulatory trade restrictions, and nationalistic appeals.

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TariffsTariffs

Tariffs, also called customs restrictions, are taxes governments place on internationally traded goods—generally imports.

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TariffsTariffs

Tariffs are the most-used and most-familiar type of trade restriction.

Tariffs operate in the same way a tax does.

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TariffsTariffs

They make imported goods relatively more expensive than they otherwise would have been and thereby encourage the consumption of domestically produced goods.

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The Impact of Tariffs on The Impact of Tariffs on Imported Goods, Imported Goods, Fig. 16-3, p403Fig. 16-3, p403

P0

S1

S0

Tariff

D0

Q1

P1

Quantity of imported goods

Price of imported

goods

Q0

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TariffsTariffs

International organizations promoting free trade: The General Agreement on Tariffs

and Trade (GATT) – a regular international conference to reduce trade barriers.

World Trade Organization (WTO) - a successor to GATT.

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QuotasQuotas

Quotas are quantity limits placed on imports.

Quotas differ from tariffs in the distribution of revenue.

Foreign producers prefer quotas to tariffs.

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QuotasQuotas

In a tariff, the government receives the tariff payment.

In a quota, revenues accrue as additional profits to producers of the protected good.

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QuotasQuotas

With quotas, an increase in domestic demand will be met by the less-efficient domestic producers.

Under a tariff, part of any increase in domestic demand will be met by more-efficient foreign producers.

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Voluntary Restraint Voluntary Restraint AgreementsAgreements To avoid imposing new tariffs on their

goods, countries often enter into voluntary restraint agreements.

Voluntary restraint agreements are those in which countries voluntarily restrict their exports.

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Voluntary Restraint Voluntary Restraint AgreementsAgreements The effect of voluntary restraint

agreements is the same as the effect of quotas.

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Voluntary Restraint Voluntary Restraint AgreementsAgreements In the case of the voluntary quotas

imposed on Japanese auto manufacturers, consumers lost since they paid higher prices both for domestic and imported cars.

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EmbargoesEmbargoes

An embargo is an all-out restriction on import or export of a good.

Embargoes are usually created for international political reasons rather than for primary economic reasons.

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Regulatory Trade Regulatory Trade RestrictionsRestrictions Regulatory trade restrictions are

indirect methods of imposing governmental procedural rules that limit imports. An example: limiting or prohibiting

foodstuffs to be imported if certain pesticides are used.

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Regulatory Trade Regulatory Trade RestrictionsRestrictions A second type of restriction involves

making import and customs restrictions so detailed and time consuming that importers simply give up.

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Nationalistic AppealsNationalistic Appeals

Given two products of equal quality and appeal, Canadians prefer to “Buy Canadian.”

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Economist Dislike Trade Economist Dislike Trade Restriction PoliciesRestriction Policies Despite the political popularity of trade

restrictions, most economists support free trade.

A free trade policy allows unrestricted trade among countries.

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Economist Dislike Trade Economist Dislike Trade Restriction PoliciesRestriction Policies Trade restrictions lower aggregate

output. One nation benefits while most other

nations are hurt. They work only if there is no

retaliation, and retaliation is the rule.

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Economist Dislike Trade Economist Dislike Trade Restriction PoliciesRestriction Policies Trade restrictions lower international

competition. This competition is necessary to keep

domestic firms on their toes, keeping costs and prices down.

Domestic companies become less efficient.

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Economist Dislike Trade Economist Dislike Trade Restriction PoliciesRestriction Policies They often result in harmful trade wars

that hurt everyone.

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Strategic Trade PoliciesStrategic Trade Policies

Strategic trade policies are threats to implement tariffs to bring about a reduction in tariffs or some other concession from the other country.

The threats must be credible.

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International Trade International Trade Agreements Affecting Agreements Affecting CanadaCanada Those are:

The Canada-U.S. Free Trade Agreement (FTA)

The North American Free Trade Agreement (NAFTA)

Free Trade Areas of the Americas (FTAA)

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The Canada-U.S. Free The Canada-U.S. Free Trade Agreement (FTA)Trade Agreement (FTA) FTA was signed in 1987, and it came

into effect in 1989. It set into motion a process that

removed most tariff and non-tariff barriers between the two countries over a 10-year period.

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The Canada-U.S. Free The Canada-U.S. Free Trade Agreement (FTA)Trade Agreement (FTA) Who are the winners and losers of tariff

reduction? The elimination of tariffs would

decrease domestic price, benefiting consumers.

Some high-cost firms will have to leave the industry, and domestic production will decline.

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The Benefits of Tariff The Benefits of Tariff Reduction, Reduction, Fig. 16-4, p 408Fig. 16-4, p 408

PT

PWD

SP

QQ1 Q2 Q3 Q4

A B

16 - 123


The North American The North American Free Trade Agreement Free Trade Agreement (NAFTA)(NAFTA) In 1993 Canada, U.S. and Mexico

signed the North American Free Trade Agreement (NAFTA).

It extended the FTA to eliminate other impediments to international trade.

Among other goals, it promoted free trade in services.

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The North American The North American Free Trade Agreement Free Trade Agreement (NAFTA)(NAFTA) NAFTA brought as many critics as the

FTA. The critics believed that Canadian

economy will be “Americanized”.

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Free Trade Areas of the Free Trade Areas of the Americas (FTAA)Americas (FTAA) Free Trade Areas of the Americas

(FTAA) agreement includes all economies of the Americas.

The problem with free trade is that it is not necessarily a fair trade, so some observers believe that rich nations may be dictating the terms and taking advantage of the small developing nations.


Open Economy Open Economy Macro: Exchange Macro: Exchange Rate And Trade Rate And Trade

PolicyPolicy

End of Chapter 16End of Chapter 16

open economy macro: exchange rate and trade policy

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