Bài giảng International Economics - Chapter 13: Economic Policy in an Open Economy

Economic Policy in an Open EconomyHow many more fiascos will it take before responsible people are finally convinced that a system of pegged exchange rates is not a satisfactory financial arrangement? (Milton Friedman, 1992)The Goals of This ChapterIllustrate why it is difficult to keep exchange rates constant.Explain how foreign exchange market intervention works and why it cannot permanently fix exchange rates.Introduce purchasing power parity (PPP) and review the evidence on how well it explains long-run exchange rates.Introduce the aggregate demand/aggregate supply (AD/AS) macroeconomic model, which determines price levels. Combine the AD/AS model, purchasing power parity, and the interest parity condition into a general exchange rate model.Explain the trilemma and show how attempts to defy the trilemma has caused recent financial crises. Floating Versus Fixed Exchange RatesFloating Exchange Rate: An exchange rate that permitted to vary in accordance with the changes in the supply and demand for foreign exchange.Fixed Exchange Rate: An exchange rate that is intentionally prevented from changing by means of specific government policies that influence the supply and demand for foreign exchange.Why It Is Hard to Fix the Exchange Rate The interest parity condition, et = Etet+n[(1 + r*)/(1 + r)]n, suggests that the spot exchange rates will remain the unchanged if all variables on the right-hand side of the equation stay the same, that is if: Expectations about future exchange rates, Etet+n, do not change; Rates of return on assets are the same at home and abroad, that is r = r*.Why It Is Hard to Fix the Exchange Rate The spot exchange rate can also remain unchanged, even when one of the right-hand variables changes, provided that:Policy makers immediately adjust domestic policies when expectations change. This latter condition requires a country’s policy makers to stay attuned to exchange rates and adjust their economic policies to satisfy the interest parity condition, regardless of any other policy objectives they might have.Using Intervention To Fix the Exchange Rate Suppose that the equilibrium exchange rate is $.10, as shown in the Figure.Suppose also that policy makers in the U.S. or Mexico seek to keep the the exchange rate fixed at $.08 per peso.How can they keep the exchange rate at $.08 if the supply and demand curves are as shown? Using Intervention To Fix the Exchange Rate The exchange rate e = $.08 can be established by the U.S. or Mexican central banks intervening in the foreign exchange market.The Banco de México could create pesos and sell them on the foreign exchange market, or the U.S. Federal Reserve Bank could sell reserves of pesos.In either case, the supply of pesos would increase from S to S’ and the exchange rate would fall to $.08.Using Intervention To Fix the Exchange Rate From the Mexican perspective, the equilibrium exchange rate is e = $.10, or q/e = 10 pesos.The required intervention to keep the exchange rate at e = .08, or 1/e = 12.5 pesos, appears as an intentional increase in the supply of dollars by the central banks.Intervention is Not a Long-run ToolThe weakness of using intervention to fix exchange rates is that central banks can seldom continue supplying the necessary amounts of foreign exchange for long periods of time.Another problem is that foreign exchange market intervention alters countries’ money supplies, and such de facto monetary policy may conflict with other macroeconomic goals.Purchasing Power Parity (PPP)The PPP theory assumes that the foreign exchange rate’s fundamental role is balancing international trade, and that arbitrage equalizes the prices everywhere.The PPP theory is normally interpreted to imply that the exchange rate reflects the overall price levels in each country.If P represents a general price index for the home economy and P* is a similar general price index overseas, then the PPP theory says that: e = P/P*.The Evidence on Purchasing Power ParityIn the short run, there is virtually no correlation between price movements and exchange rate movements.In the long run, exchange rates do reflect purchasing power parity.The adjustment of exchange rates toward their purchasing power parities is very slow.Therefore, countries’ relative inflation rates are not helpful in explaining how an exchange rate will move during the next week or month, but it does describe long-run exchange rate movements very well. The Aggregate Demand/Aggregate Supply ModelPurchasing Power Parity’s success in explaining long-run exchange rates does not make it a useful exchange rate model.A complete exchange rate model needs to go one step further and explain what determines national price levels.Fortunately, macroeconomics has a well-established model to explain price levels: the aggregate demand/aggregate supply (AD/AS) macroeconomic model.This model lets us highlight the many variables that affect an economy’s price level and, hence, also distinguishes the variables that influence long-run exchange rates. The Aggregate Demand/Aggregate Supply Model: The Demand Side of the EconomyThe economy’s demand for output, Y, can be divided into consumer demand, C, investment, I, government goods and services, G, and net exports minus imports, X ! IM: Y = C + I + G + X ! IM.We can then focus on the determinants of each of these categories of demand.For example, consumer income depends on the value of income, Y, taxes, T, and transfers, Tr: C = f(Y, T, Tr).The function f(.) reflects people’s preferences about how to allocate their income.The Aggregate Demand/Aggregate Supply Model: The Demand Side of the EconomyThe demand for investment goods (capital) depends on the returns to investment at home and abroad, r and r*, the opportunity cost of alternative uses of the resources used for investment (the interest rate on loanable funds), and the overall level of output that capital helps to produce, Y.Real money supplies matter for interest rates, which implies that M/P and M*/P*, the latter the foreign real money supply, also matter.Hence, an economy’s investment function may look like: I = f(Y, r, r*, M/P, M*/P*). The Aggregate Demand/Aggregate Supply Model: The Demand Side of the EconomyGovernment expenditures, G, are usually a function of political forces, POL.They also depend on taxes, T, which in turn depend on overall income and output, Y, in the economy.Monetary policies at home and abroad affect the costs of borrowing, and transfers, Tr, affect a government’s spending constraints and borrowing needs.Therefore, the government expenditure function may look like: G = f(POL, Y, T, Tr, M/P, M*/P*). The Aggregate Demand/Aggregate Supply Model: The Demand Side of the EconomyIn an open economy, exports and imports depend on all of the domestic and foreign variables that influence domestic and foreign C, I, and G.Thus, the trade balance is a function of all the variables in the C, I, and G equations: X!IM = f(C, C*, I, I*, G, G*,P/P*, e).The Aggregate Demand/Aggregate Supply Model: The Demand Side of the EconomyBy summing the sources of domestic demand in all four categories of demand, total aggregate demand for the economy’s output is: YD = C + I + G + X ! IM = f(Y,Y*,T,T*,Tr,Tr*,r, r*,M/P, M*/P*,POL,POL*,P/P*, e). This equation seems to have a lot of variables, but it is still a gross simplification of the real world.The important point here is that even in a simple model it is very difficult to determine precisely what aggregate demand will be because there are so many variables that influence aggregate demand.The Aggregate Demand/Aggregate Supply Model: The Demand Side of the EconomyIn the AD/AS model, the aggregate demand curve is a downward-sloping line.The position of the line depends on all the variables that influence demand.In relation to the price level, the AD curve is downward-sloping because prices effect the real money supply, M/P, and a country’s competitive position in international trade; the lower the price level, the higher M/P and (EX – IM).The Aggregate Demand/Aggregate Supply Model: The Supply Side of the EconomyIn the short run, given the level of technology, the steady state level of output depends on the depreciation rate *, and the saving rate, F.In the long-run, the supply side of the economy is determined by economic growth, which is driven by technological progress.The Aggregate Demand/Aggregate Supply Model: The Supply Side of the EconomyAggregate supply, AS, is a function of both the short-run variables of the Solow model and the long-run variables of the Schumpeterian model: AS = g(K, L, *, F, B, $, i, R)A prediction of an economy’s long-run productive capacity should focus on the Schumpeterian variables, of course. The Aggregate Demand/Aggregate Supply Model: Shifts in the AD and AS CurvesSuppose that economic growth causes the AS curve to shift to the right.All other things equal, the shift in the AS curve will cause the level of output to increase and the price level to decline.The Aggregate Demand/Aggregate Supply Model: Shifts in the AD and AS CurvesA shift in aggregate demand will have similar, but opposite effects on the price level. All other things equal, the outward shift in the AD curve will cause the price level to increase. Long-Run Changes in the Price LevelSuppose that economic growth pushes the economy’s AS curve continually to the right.The price will remain unchanged only if the AD curve also shifts to the right at the exact same rate as the AS curve shifts. Long-Run Changes in the Price LevelSuppose that economic growth pushes the economy’s AS curve continually to the right.The price level will fall if aggregate demand shifts out more slowly than aggregate supply. Long-Run Changes in the Price LevelSuppose again that economic growth pushes the economy’s AS curve continually to the right.If aggregate demand shifts out more rapidly than aggregate supply, then prices will rise.The Relative Shifts in AD and ASThe AD curve will tend to automatically shift to the right when the AS curve shifts to the right because increasing output also increases income, and income is an important determinant of consumption, investment, and government expenditures. But, the relationship between output and demand is not a neat one-for-one relationship. There are many determinants of consumption, investment, government expenditures, and net exports, other than income, as shown in the functions for each of the components of aggregate demand.Hence, it is not clear whether the two sets of curves will shift out at the same rate.A Simple Exchange Rate Model The logical model that results from the combination of the AD/AS macroeconomic model, the purchasing power parity (PPP) theory, and the interest parity (IP) condition can be summarized as follows:The interest parity condition relates spot exchange rates to the expected future exchange rates.Exchange rates are expected to reflect countries’ relative price levels, as the PPP theory predicts.The AD/AS macroeconomic model details the variables that determine an economy’s price level and, therefore, relates the expected future exchange rate to the variables that determine future aggregate demand and aggregate supply.A Simple Exchange Rate ModelThe spot exchange rate therefore depends on expectations of future price levels across all countries of the world.If expectations about any one country’s future price level changes, all exchange rates will tend to change because triangular arbitrage links all exchange rates.The task of accurately forecasting individual exchange rates is therefore likely to be subject to large errors given the enormous number of variables likely to influence price levels.Frequent revisions of expectations are also likely as the enormous data set is continually revised and updated.In the words of the international economist Maurice Obstfeld:A country cannot simultaneously maintain fixed exchange rates and an open capital market while pursuing a monetary policy oriented toward domestic goals.Governments may choose only two of the above. The impossibility of simultaneously achieving these three goals is known as the trilemma. The Trilemma and Recent Exchange Rate CrisesThere are obvious parallels between the 1994 Mexican crisis, 1997 Asian crisis, and the 2001 Argentine crisis.All of the countries concerned had made substantial economic policy changes, among which were the opening to international trade and international investment.After financial account transactions were liberalized (globalized), foreign loans and investment had grown rapidly.All the governments were openly committed to maintaining fixed or tightly controlled exchange rates.That is, the countries had all picked globalization and fixed exchange rates from the trilemma menu.The Trilemma and Recent Exchange Rate CrisesThus, when external economic conditions or domestic policies shifted and became incompatible with the fixed exchange rate, speculation moved against the currencies.Central banks were unable to intervene to the extend necessary to keep exchange rates constant, and the fixed exchange rates were eventually abandoned in favor of floating rates.The resulting sharp fall in the currencies’ values triggered financial crises because foreign debt was contracted in terms of dollars.The financial crises forced the countries to endure severe recessions and long adjustment periods.