It’s Wednesday and I just finished a ‘Conversation’ with the Economics Society of Australia, where I talked about Modern Monetary Theory (MMT) and its application to current policy issues. Some of the questions were excellent and challenging to answer, which is the best way. You can view an edited version of the discussion below and…
I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text by the end of this year. Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.
Chapter 15 International Trade, Capital Flows and the Exchange Rate
[Note: This is the first rough layout and will evolve over the next few weeks]
In Chapter 8, we introduced trade into the income-expenditure model. The representation was simplistic, in the sense, that we assumed that exports were determined by the income levels prevailing in the rest of the world (that is, they were exogenous to the domestic economy) and that imports were a simple proportion of the national income of the homeeconomy. This proportion was termed the marginal propensity to import.
In this Chapter we extend our understanding of the way in which the economy behaves once it becomes open to the World. We will continue to consider the price level to be fixed, which means we are assuming that firms respond to an increase in aggregate demand by increasing real output. Later in the Chapter we will consider price level movements in the open economy context.
We will the consider the concept of an exchange rate and examine how movements in exchange rates influence exports and imports and financial transactions between nations.
For an economy as a whole, imports are real goods and services coming into the nation from abroad and as such represent a real benefit to residents. Conversely, exports are real goods and services that are sold to foreigners.
Exports represent a real cost to residents because they represent real resources (labour, capital and other productive inputs) that the residents are unable to utilise themselves.
It is obvious that the only motivation for a nation to export, and incur the real costs involved in exporting goods and services abroad, is to gain foreign currencies, which, in turn, allow the nation to purchase other goods and services that it does not produce itself.
If imports exceed exports then a nation is able enjoy higher material living standard by consuming more goods and services than it produces for foreign consumption. We will consider how this conception of trade interacts with a flexible exchange rate.
You will already appreciate that the transactions between nations involve both real goods and services and financial flows. The financial transactions represents currency flows in and out of a nation and have significant implications for movements in the exchange rate and other macroeconomic aggregates, such as interest rates, the inflation rate and real GDP.
All transactions between a nation and the rest of the world are recorded in the Balance of Payments. We will initially examine the way the national statistician accounts for the external economy via the Balance of Payments, which is a framework that is closely related to the National Accounts.
15.2 The Balance of Payments
National Statistical agencies regularly publish statistics relating to a nation’s economic interaction with the rest of the world using what is known as the balance of payments and international investment position framework. While there are variations in terminology used by different nations the principles are universal. Most nations use the International Monetary Funds’s http://www.imf.org/external/pubs/ft/bop/2007/pdf/bpm6.pdf (BPM6), augmented by the System of National Accounts 2008 (2008 SNA), “as the standard framework for statistics on the transactions and positions between an economy and the rest of the world” (IMF, 2011: 1).
The IMF define the balance of payments as:
… a statistical statement that summarizes transactions between residents and nonresidents during a period. It consists of the goods and services account, the primary income account, the secondary income account, the capital account, and the financial account.
The differentiating feature of these difference accounts relates to “the nature of the economic resources provided and received” by the nation (IMF, 2011: 9).
The Current Account (IMF, 2011: 9):
… shows flows of goods, services, primary income, and secondary income between residents and nonresidents.
The goods and services or balance of trade records “transactions in items that are outcomes of production activities” (IMF, 2011: 149) and considers the exchanges between the local economy and the rest of the world.
[NOTE THIS SECTION IS TO BE WRITTEN AND IS DESCRIPTIVE – IT OUTLINES THE BALANCE OF PAYMENTS AND RELATED INTERNATIONAL ACCOUNTS]
15.3 Essential concepts
Before we consider a more complex income and expenditure model (to incorporate exchange rates) we need to understand the basic nomenclature.
The following essential concepts are used in open economy macroeconomics:
- Nominal exchange rates
- Foreign exchange markets
- Exchange rate determination mechanisms – fixed and flexible
- Real or effective exchange rates, unit labour costs and competitiveness
We will consider the history of exchange rate systems in a later section of this Chapter.
Nominal exchange rate (e)
The nominal exchange rate (e) is the number of units of one currency that can be purchased with one unit of another currency. There are two ways in which we can quote a bi-lateral exchange rate. Consider the relationship between the Australian dollar ($A) and the United States dollar ($US).
- We might be interested in knowing the amount of Australian currency that is necessary to purchase one unit of the US currency ($US1). In this case, the $US is what we call the reference currency and the other currency is expressed in terms of how much of it is required to buy one unit of the reference currency. So $A0.80 = $US1 means that it takes $0.80 (or 80 cents) of Australian currency to buy one $US.
- Alternatively, e can be defined as the amount of US dollars that are needed to by one unit of Australian currency ($A1). In this case, the $A is the reference currency. So, in the example above, this is written as $US1.25= $A1. Thus if it takes $0.80 Australian to buy one $US, then $US1.25 is required to buy one $A.
It is clear that the quotation under the first alternative with the US dollar as the reference currency is the inverse of the second alternative. But to understand exchange rate quotations you must know which is the reference currency. In this Chapter we use the first convention so e is the amount of domestic currency which is required to buy one unit of the foreign currency.
e is the amount of $A which is required to buy one unit of the foreign currency
Change in e – appreciation and depreciation
Imagine that an Australian resident wishes to buy a product from a USA supplier who quotes the current US price as $US40 and the $A-$US parity is current at $0.80. Then the equivalent Australian price is $A32 (multiply the foreign price by the nominal exchange rate. This situation is shown in the first row of Figure 15.1.
What happens if the nominal exchange rate falls to 0.70 (as shown in the second row of Figure 15.1)? This means that instead of 80 cents Australian being required to purchase one $US only 70 cents Australian is required.
So, a fall in e means that the $A has appreciated – it is worth more in terms of foreign reference currency. In the example shown in Figure 15.1, this would mean that the price of the product from the USA would now be equal to $A28 (0.7 times $US40).
Thus, even though the quoted US dollar price for the product remains unchanged, the local price equivalent is now lower when the nominal exchange rate appreciates.
The example shows that an appreciation of the $A leads to:
- Cheaper foreign goods in terms of $A and, other things being equal, this should lead to a rise in the quantity of imports demanded.
- Higher prices which foreigners will have to pay for our goods, and other things being equal, this should lead to a fall in the quantity of exports demanded.
Now, assume that the Australian-USA parity rises to 0.80 from 0.90. This means that we now need 90 cents Australian to purchase one $US. So, given our exchange rate definition, a rise in e means that the $A has depreciated.
In the example shown in Figure 15.1, this would mean that the price of the product from US would now be equal to $A36 (0.9 times $US40).
The example shows that an depreciation of the $A leads to:
- Foreign goods more expensive in terms of $A, and other things equal, this should lead to a fall in the quantity of imports demanded.
- The price foreigners have to pay for our goods lower, and other things equal, this should lead to a rise in the quantity of exports demanded.
What determines the exchange rate?
Exchange rates are determined by the supply of and the demand for currencies in the world foreign exchange markets, which could be the local bank foreign currency desk or elsewhere, like a train station kiosk in a city where travellers meet.
Sometimes we refer to foreign exchange in jargon as forex. The supply of and demand for currencies are in turn linked to trade and capital flows between countries.
In Figure 15.2 we consider the foreign exchange market for the $A and the $US. In reality, many currencies are traded in the foreign exchange market.
Consider the supply of Australian dollars to the foreign exchange market. When Australian residents buy foreign goods (imports), buy foreign assets or lend abroad, they need to purchase the relevant foreign currencies in which the transaction is denominated. To buy the currency they desire, they supply $As in exchange.
Alternatively, on the demand side, when foreigners buy Australian goods and services (exports) and/or Australian financial assets they require $A. They purchase them in the forex market by supplying their own currency in exchange.
Like any market determined price, e is in equilibrium when supply equals demand.
If there is an excess demand for $A then there is pressure for the $A to appreciate in price relative to other currencies. As noted, an appreciation means that one unit of a foreign currency buys less $A, that is e declines.
If there is an excess supply of $A, the $A depreciates and one unit of foreign currency buys more $A, so e increases.
These changes in e resolve the supply and demand imbalance. In the case of a depreciation in the Australian dollar, the foreign price of Australian exports is now lower (less $US required to purchase a given $A priced good), and with export demand varying inversely with price (by assumption), the demand for exports and hence $A’s rises.
Assuming a fixed import price in the foreign currency, the $A price of imports has risen which reduces the quantity demanded.
While most currencies float freely against each other, at times the central bank will enter the foreign exchange markets as a buyer or seller of the local currency as a means of influencing the parity determined in that market. This is called Official intervention and we will examine it in more detail later in the chapter.
What happens to the total $A value of imports when the exchange rate depreciates depends upon what economists term the price elasticity of demand. An elasticity is the responsiveness in percentage terms of quantity to price changes.
When demand falls less in percentage terms than the price rises, we consider the commodity to be inelastic. Total revenue (or spending) will rise in this case.
When demand falls more in percentage terms than the price rises, we consider the commodity to be elastic. Total revenue (or spending) will fall in this case.
When price and quantity change by the same proportion the commodity has a unitary elasticity and total revenue (or spending) does not change.
Should the demand for imports be price inelastic (less than one), then the quantity demanded (volume) falls by a smaller percentage than the $A rise in price and total import spending in $A would increase.
However, if the price elasticity of demand for imports is greater than one, then the percentage decline in demand (volume) more than offsets the percentage gain in price and so total import spending in $A falls.
The circumstances under which the trade balance unambiguously improves following a depreciation is referred to as the Marshall-Lerner Condition. It states that net exports will improve following a depreciation as long as the sum of the export and import price elasticities exceeds unity. You do not have to learn the proof underpinning this condition.
In summary, if the Marshall-Lerner condition is satisfied:
- An excess supply of $A in the foreign exchange market leads to a depreciation in e and a rise in net exports. This will reduce the excess supply of $A in the foreign exchange market.
- An excess demand for $A in the foreign exchange market leads to an appreciation in e and a decline in net exports. This will reduce the excess demand for $A in the foreign exchange market.
Another component of the current account is net income, which results from the foreign ownership of domestic assets and vice versa. We consider this component of the current account in more detail later in the chapter.
This pattern of ownership of assets gives rise to a net flow of dividend and interest payments. If the net flow is positive then national income rises, other things being equal. If the net flow is negative then national income falls, other things being equal.
In Australia’s case, the net income flows on the current account are negative. In this case, a depreciation in the $A can lead to a deterioration in net income because the interest payments or dividends may be denominated in a foreign currency. The loss of income through this part of the current account may offset any gains that are made as a result of depreciation on the trade balance.
For simplicity, we shall ignore the possible impact on net income and assume that through the satisfaction of the Marshall-Lerner condition a depreciation of the domestic currency not only improves the trade balance but also the current account balance.
We can define three trade balance outcomes:
- The trade balance is in deficit if the local currency value of its exports is less than the local currency value of its import spending.
- The trade balance is in surplus if the local currency value of its exports is greater than the local currency value of its import spending.
- The trade balance is in balance if the local currency value of its exports is equal to the local currency value of its import spending.
Take Australia, as an example. A trade deficit for Australia means that increasing quantities of Australian dollars are being accumulated by non-Australian residents. In return, the non-Australian residents have supplied goods and services (imports) to Australian residents.
Clearly, the foreigners have allowed Australia to run a trade deficit because they preferred to accumulate financial assets denominated in Australian dollars. The alternative would have been to spend the Australian dollars they acquired through their exports to buy Australian goods and services (that is, to buy Australian imports).
Had the foreigners used their export income, which is denominated in $A to purchase other goods and services from Australia, then there would have been a trade balance.
A trade deficit thus means that the foreigners are increasing their nominal savings (which in this case manifests as Australian dollar denominated financial assets).
[NOTE: I WILL CONTINUE THIS CHAPTER NEXT WEEK]
The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty (-:
That is enough for today!
(c) Copyright 2012 Bill Mitchell. All Rights Reserved.