AnIntroductiontoInternationalEconomics

SecondEditionAutomaticAdjustmentswithFlexibleandFixedExchangeRatesCHAPTERTHIRTEEN1FocusofthechapterHowisatradedeficitautomaticallyclosedbypriceandincomechanges?Inthischapterprivateinternationalcapitalflowsareassumedtobepassiveresponsestocovertemporarytradeimbalances.2ExchangerateadjustmentAssume(1)onlytwonations(theU.S.andEMU)and(2)nocapitalflows.UndertheseassumptionsthedemandforeurowillbedrivenbyU.S.demandforEMUgoodsandservices,orimports.€/day$/€D€3ExchangerateadjustmentAssume(1)onlytwonations(theU.S.andEMU)and(2)nocapitalflows.UndertheseassumptionsthedemandforeurowillbedrivenbyU.S.demandforEMUgoodsandservices,orimports.

ThesupplyofeurowillbedrivenbyEMUdemandforU.S.goodsandservices,orexports.€/day$/€D€S€4ExchangerateadjustmentIftheexchangerateisatlevelA,theU.S.willhaveatradedeficit.€/day$/€D€S€A5ExchangerateadjustmentIftheexchangerateisatlevelA,theU.S.willhaveatradedeficit.IfexchangeratesintheU.S.areflexible,overtimetheexchangeratewillmovetoitsequilibriumvalueofB.€/day$/€ABD€S€6ExchangerateadjustmentIftheexchangerateisatlevelA,theU.S.willhaveatradedeficit.IfexchangeratesintheU.S.areflexible,overtimetheexchangeratewillmovetoitsequilibriumvalueofB.AstheexchangerateadjuststoB,thetradedeficitwillclose.€/day$/€ABD€S€7ExchangerateadjustmentIfinsteadoftheoriginalsupplyanddemandcurves,supplyanddemandaregivenbyS€

*andD€

*,adepreciationofthedollarwillstilloccur.However,thedepreciationwillbemuchgreaterinthiscase(tolevelC).€/day$/€ABCD€S€S€*D€*8ExchangerateadjustmentThemoresignificantdepreciationofthedollar(fromAtoC)willhavemoresevereinflationaryeffectsontheU.S.economy.Thisimplicationpointstotheimportanceofknowingtheelasticityofthesupplyanddemandcurves.€/day$/€ACD€S€*S€D€*9ElasticitySincethedemandforforeigncurrencydependsonthedemandforimports,theelasticitydependsonthepriceelasticityofthedemandforimports(ηM).ηM=%ΔQM÷%ΔPM

Similarly,theelasticityofsupplydependsonthepriceelasticityofsupplyforexports(ηX).ηX=%ΔQX÷%ΔPX10UnstableforeignexchangemarketIfthesupplyofforeigncurrencyisnegativelyslopedandmoreelasticthanthedemandforforeigncurrency,theforeignexchangemarketwillbeunstable.€/day$/€S€D€11UnstableforeignexchangemarketIfthesupplyofforeigncurrencyisnegativelyslopedandmoreelasticthanthedemandforforeigncurrency,theforeignexchangemarketwillbeunstable.Inthiscase,atradedeficitoccursatanexchangerateabovetheequilibriumvalue.A€/day$/€S€D€12UnstableforeignexchangemarketAtlevelA,thequantitydemandedofforeignexchange(Z)exceedsthequantitysupplied(Y).AYZ€/day$/€S€D€13UnstableforeignexchangemarketAtlevelA,thequantitydemandedofforeignexchange(Z)exceedsthequantitysupplied(Y).Theexcessdemandputsupwardpressureontheexchangerateandpushestheexchangemarketfurtherfromequilibrium.AYZ€/day$/€S€D€14TheMarshall-LernerconditionTheunstableconditionjustdepictedwillbeavoidediftheMarshall-Lernerconditionholds.TheMarshall-LernerconditionisthatηM+ηX

>1.Empiricalevidenceindicatesthatthisconditiondoeshold.15J-curveeffectAcurrencydepreciationisexpectedtolessenacountry’stradedeficit.Thisimprovementmaytaketimetooccur.Initially,thedepreciationmayworsenthetradedeficitsinceimportpriceswillrisemorequicklythantheimprovementinexports.ThisgeneratesaJ-shapedpatterntoexchangeratemovements.16ThegoldstandardThegoldstandardgeneratesasystemoffixedexchangerates.17ThegoldstandardThegoldstandardgeneratesasystemoffixedexchangerates.Thegoldstandardfortheinternationalmonetarysystemoperatedfrom1880to1914.Thissystemissimilartothepost-WWIIBrettonWoodsmonetarysystemthatcollapsedin1971.18ThegoldstandardThegoldstandardgeneratesasystemoffixedexchangerates.Thegoldstandardfortheinternationalmonetarysystemoperatedfrom1880to1914.Underthegoldstandard,eachnationspecifiedthegoldcontentofitscurrency.￡1goldcoincontained113.0016grainsofgold$1goldcoincontained23.22grainsofgoldThisentailsanexchangerateof113.0016÷23.22or$4.87/￡.19ThegoldstandardThegoldstandardgeneratesasystemoffixedexchangerates.Thegoldstandardfortheinternationalmonetarysystemoperatedfrom1880to1914.Underthegoldstandard,eachnationspecifiedthegoldcontentofitscurrency.Theexchangerateof$4.87/￡isknownasmintparity.20ThegoldstandardAsthecostofshippinggoldfromNewYorktoLondonwasapproximately3cents,theactualexchangeratewouldalwaysliebetween$4.84/￡and$4.90/￡.$4.84/￡isthegoldimportpoint.$4.90/￡isthegoldexportpoint.21AdjustmentunderthegoldstandardAdjustmenttoequilibriumunderthegoldstandardoccursviatheprice-specie-flowmechanism.Theconceptoftheprice-specie-flowmechanismwasinitiallyintroducedin1752byDavidHume.22AdjustmentunderthegoldstandardAdjustmenttoequilibriumunderthegoldstandardoccursviatheprice-specie-flowmechanism.Ifatradeimbalanceexists,goldwillflowfromthecountrywithatradedeficittothecountrywithatradesurplus.23AdjustmentunderthegoldstandardAdjustmenttoequilibriumunderthegoldstandardoccursviatheprice-specie-flowmechanism.Ifatradeimbalanceexists,goldwillflowfromthecountrywithatradedeficittothecountrywithatradesurplus.Thefallingoldsuppliesinthetradedeficitcountryreducesitsmoneysupplyandpushesitspricelevellower;theincreaseingoldsuppliesinthetradesurpluscountryincreasesitsmoneysupplyandraisesitspricelevel.24AdjustmentunderthegoldstandardThepricelevelmovementisseenviatheequationofexchange:M?V=P?Y(whereMisthemoneysupply,Visthevelocityofmoney,Pisthepricelevel,andYisrealoutput).Asthepricelevelfallsinthecountrywithatradedeficit,exportsofitsgoodsandserviceswillbeencouraged;asthepricelevelincreasesinthecountrywithatradesurplus,exportsofitsgoodsandserviceswillbediscouraged.25AdjustmentunderthegoldstandardThesechangesintradewilldecreaseboththetradedeficitandsurplusleavingasituationofbalancedinternationaltrade.26IncomedeterminationinaclosedeconomyInaclosedeconomy(withoutinternationaltrade)withoutagovernmentsector,equilibriumoutputisdeterminedby:Y=C+S=C+I whereYisincome,Cisplannedconsumptionexpenditures,Iisplannedbusinesssavings,andSissavings.27IncomedeterminationinaclosedeconomyInaclosedeconomy(withoutinternationaltrade)withoutagovernmentsector,equilibriumoutputisdeterminedby:Y=C+S=C+I whereYisincome,Cisplannedconsumptionexpenditures,Iisplannedbusinesssavings,andSissavings.Thisyieldsanequilibriumconditionof:S–I=0.28IncomedeterminationinaclosedeconomyThisyieldsanequilibriumconditionof:S–I=0.Inwords,thisentailsthatatequilibriumleakagesfromtheeconomy(S)mustbebalancedbyinjectionsintotheeconomy(I).29IncomedeterminationinaclosedeconomyInwords,thisentailsthatatequilibriumleakagesfromtheeconomy(S)mustbebalancedbyinjectionsintotheeconomy(I).Ifplannedinvestmentisautonomousbutsavingsisdeterminedbythemarginalpropensitytosave(s),then:ΔS=sΔY.Themarginalpropensitytosave(s)isamountofadditionalsavingsthatflowsfromeachadditionaldollarofincome.30IncomedeterminationinaclosedeconomyIfplannedinvestmentisautonomousbutsavingsisdeterminedbythemarginalpropensitytosave(s),then:ΔS=sΔY.SinceS=Iatequilibrium,thisentailsthat:ΔI=sΔYor1÷s=ΔY÷ΔI.31IncomedeterminationinaclosedeconomySinceS=Iatequilibrium,thisentailsthat:ΔI=sΔYor1÷s=ΔY÷ΔI.Ifk=1÷s,thenΔY=k?ΔI.kisthemultiplier.Anychangeininvestmentwillinduceamultipliedchangeinincomeasgivenbytheaboveformula.32IncomedeterminationinaclosedeconomyIfk=1÷s,thenΔY=k?ΔI.Anexamples=0.25ΔI=300Whatisthevalueofk?k=1÷0.25=4Whatisthechangeinincome?ΔY=4?300=1,20033IncomedeterminationinanopeneconomyInanopeneconomy,equilibriumisstilldeterminedbytheconditionthatleakagesmustequalinjections.Inanopeneconomy,imports(M)areanewleakage.Inanopeneconomy,exports(X)areanewinjection.34IncomedeterminationinanopeneconomyInanopeneconomy,equilibriumisstilldeterminedbytheconditionthatleakagesmustequalinjections.Thenewequilibriumequationis:S+M=I+XorΔS+ΔM=ΔI+ΔX.35IncomedeterminationinanopeneconomyThenewequilibriumequationis:S+M=I+XorΔS+ΔM=ΔI+ΔX.IfΔM=mΔY,thenthemultiplier(k*)becomes:k*=1÷(s+m)Wheremisthemarginalpropensitytoimport.36IncomedeterminationinanopeneconomyThenewequilibriumequationis:S+M=I+XorΔS+ΔM=ΔI+ΔX.IfΔM=mΔY,thenthemultiplier(k*)becomes:k*=1÷(s+m)Wheremisthemarginalpropensitytoimport.ThisleavesΔY=k*?ΔIorΔY=k*?ΔX.37IncomedeterminationinanopeneconomyThisleavesΔY=k*?ΔIorΔY=k*?ΔX.

Anexamples=0.25m=0.25ΔI=400Whatisthevalueofk*?k=1÷(0.25+0.25)=2Whatisthechangeinincome?ΔY=2?200=80038ForeignrepercussionsSupposeNation1experiencesanincreaseinitsplannedautonomousinvestment.TheincreaseinNation1’sincomewillincreaseitsimportsbymΔY.Assumingonlytwocountries,Nation1’sincreasedimportswillincreaseNation2’sexportsleadingtoanexpansioninNation2’sincomebyk2*?ΔX2.TheincreaseinNation2’sincomewillleadtoanincreaseinitsimports,spurringasecondaryexpansioninNation1.39AbsorptionapproachTheabsorptionapproachintegratestheeffectofinducedincomechangesintheprocessofcorrectingabalanceofpaymentsdisequilibriumbyachangeintheexchangerate.40AbsorptionapproachTheabsorptionapproachintegratestheeffectofinducedincomechangesintheprocessofcorrectingabalanceofpaymentsdisequilibriumbyachangeintheexchangerate.Domesticequilibriumisgivenby:Y=C+I+(X–M).41AbsorptionapproachDefineA(domesticabsorption)=C+IandB(foreignabsorption)=X–M.Then:Y=A+BorY–A=B.AdepreciationofthecurrencyisexpectedtoincreaseB.42AbsorptionapproachAdepreciationofthecurrencyisexpectedtoincreaseB.ThiscanonlyoccurifAfallsorYincreases.Iftheeconomyisatfullemployment,Ycannotincrease.Therefore,adepreciationmustresultinafallinA.43AbsorptionapproachThiscanonlyoccurifAfallsorYincreases.Forcesthatleadtoafallindomesticabsorption(A).Incomeisredistributedfromwagestoprofits.T