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Macroeconomic Themes:10 1

Balance of Payment and Exchange Rate


Overshooting
Thre approaches to the balance of payment
Keynesian or Absorption (UK Experience 1970-90)
Monetary approach (German and Japanese Experience)
Elasticity (Marshall-Lerner-Robinson conditions)
Internal and External Balance and Tinbergenian Assignment Problem
Exchanger Rate Overshooting
Balance Of Payment:
0 = +
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KA M
M
P X
x
P
Macroeconomic Themes:10 2
Balance of Payment analysis: Graphical approach
Labour Market Goods and Money Money market Domestic bonds Foreign Bonds Foreign Exchange
LD LS IS AS LM MD MS BS BD
Wage i i i* i
Interest rt
L Y M/P DB FB exchange rate
Output
Y P Price
Employment Output Real money balance Portfolio allocation e
Open Economy Model: Equilibrium in Six
Different Markets
Macroeconomic Themes:10 3
Internal and External Balance Under the Fixed
Exchange Rate Regime
analysis of internal and external stability using IS-LM and international financial integration line can be
conducted using this diagram.
Analysis of Internal and External Stability Convergence process to macro equilibrium
Interest ESM ESM ESG
Rate BOP + BOP+ EDG ESG EDM
Unempl. Inflation/Boom BOP+ BOP+ BOP+
K inflow K-inflow
*
i i =
BOP= X-M=0 BOP=0
BOP- BOP-
Unemployment Boom ESM EDM EDM
K-outflow K-Outflow EDG EDG ESG
BOP- BOP- BOP-
YF
Notes: YF full employment output, BOP = Balance of Payment, K= capital, ESG =Excess supply of
goods, EDG =Excess demand for goods, ESM =excess supply of money, EDM=excess demand for
money
Macroeconomic Themes:10 4
Policy Spill-over Effects in Interdependent
Economies
Answer: Use a two country Mundell-Fleming Model
In fixed exchange rate with perfect capital mobility:
0 >
c
c
g
Y
; 0
*
>
c
c
g
Y
;
0 >
c
c
g
R
;
0
*
<
c
c
g
R
Expansionary fiscal policy in country 1 Impact in country 2
i2=i2*
i1=i1* BOP
LM2
LM1 LM2 LM2 IS2 IS2
IS1
IS1
O y0 y1 y2 o y0 y2 y1
Macroeconomic Themes:10 5
BOP: Keynesian Approach
Capital account Exports, imports and trade balance to Income
KA+ Imports
CA
exports
trade balance
Interest rate Income
KA-
Interest
Rate interest rate External balance
Interest rate Income
Macroeconomic Themes:10 6
Monetary Approach to BOP
Money demand |
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\
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= r Y pf
d
M ,
Money supply
D R
s
M + =
Growth rate of reserves:
d
g
y
g
y r
g
1 0
o q o =
Growth of income raises reserves and favourable to BOP
Has just opposite result than the Keynesian Model.
Macroeconomic Themes:10 7
BOP: Elasticity Approach
Trade balance: ( ) 0 = + KA M P X P
M x
Country 1 Country 2
PD PM E
A B C S I J K
O
E Export F O G H Home Import
P*
L M
P* V W
PP* N P Q
O R S Foreign import O T U Foreing Exoport
Macroeconomic Themes:10 8
BOP: Elasticity Approach (Marshall-Lerner
Condition)
- Net export function
eM X NX =
( ) ( ) e Y eM e Y X NX , ,
*
=
For simplicity assume that
eM X NX =
. Then three are three sources of changes in the
net exports:
1. Exports 2. Imports and 3. Exchange rate
e M M e X NX A A A = A
Divide each term by X ,
X
e
M
X
M
e
X
X
X
NX A

A
=
A
Now using the fact that
eM X =
when the trade is balanced (
0 = NX
);
M X
e 1
=
and
e X
M 1
=
.
e
e
M
M
X
X
X
NX A

A
=
A
=>
1 0 =
A A

A A
=> =
A
e
e
M
M
e
e
X
X
X
NX
Macroeconomic Themes:10 9
Exchange Rate Overshooting
Goods and Money market equilibrium and the exchange rate Exchange Rate Overshooting
Goods market
Goods market eq.
Price Price
Level c

0 = t
a b

( ) p p e e =
u
1
money market eq.
Exchange Rate Exchange Rate
Macroeconomic Themes:10 10
Internal and External Balance and Tibergenian Target-
Instrument Assignment Problem
Fiscal and Monetary Policies for Stability
Budget Budget
Surplus surplus
Excess supply BOP surplus
Excess Recession BOP
demand deficit
Boom
Inflation
Internal balance External balance
Interest rate Interest rate
Budget
Surplus
Deflation and BOP surplus
Fiscal Policy
Inflation and BOPdeficit EB IB
Interest rate
monetary policy
Macroeconomic Themes:10 11
Assuring Internal and external stability using the fiscal and monetary policies
Under imperfect Capital Mobility Scenario
LM2
LM1
Interest rate
b
a
BOP
IS2
IS1
Y*
Income
Originally the internal equilibrium is at point a where both goods and money
market are in equilibrium but the external account is imbalance by amount
ab. Money supply is reduced to raise the interest by shifting LM1 to LM2.
However, this policy action will create an internal imbalance and
unemployment will result because economy is operating under full capacity
at point c. Accommodating fiscal policy can shift IS1 to IS2 at point b where
both internal and external account are balances and stability is achieved.
How does this curve look like under a perfect capital mobility condition?
Assignment Problem in the Mundel-Fleming Model
Macroeconomic Themes:10 12
Exchange Rate in the Long Run
Purchasing power parity:
*
EP p=
Money demand at home
o
KY
p
M
=
Money demand abroad:
|
* *
*
*
Y K
p
M
=
*
P
p
E=
*
* *
M
Y K
KY
M
E
|
o
=
Long run exchange rate
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\
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+ + = y y k k m m e o |
* * *
Macroeconomic Themes:10 13
J-curve hypothesis:
- devaluation of a currency deteriorates the trade
balance condition in the short run because
imports can not decrease and export cannot
increase immediately.
- However over time adjustments will take place
so that exports increase and imports can decrease
Impact of devaluation on net exports
Net Exports
Time
Macroeconomic Themes:10 14
Preference (CD orCES): ) , ( M D U U = (1) Total
expenditure: M
M
P D
D
P PY + = (2)
Transformation function (CET) :

) , ( D E T T =
(3)
Total Income:
E
E
P D
D
P PY + =
(4)
D = domestically produced and consumed good
M= imports
E = exports
From optimizing behaviour on the demand side,
Real exchange rate:
) 1 ( t
M
P
D
P
M
U
D
U
+
=
;
D
P
E
P
D
T
E
T
=
A Small open economy model of trade
Macroeconomic Themes:10 15
Economy wide income, I, trade balance and market
clearing conditions:
Domestic sales exports and Tariff:
R E
E
P D
D
P I + + =
(6)
Trade Balance condition:
B E
E
P M
M
P =
(7)
Demand and supply of domestic goods:
S
D
D
D =
(8)
M
P
and
E
P
world prices of imports and exports.
Domestic economy is too small to change the world price.
Economy wide Income and Trade Balance in
a Small Open Economy
Macroeconomic Themes:10 16
Global Trade model
Production :
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\
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=
r
r i
L
r
r i
K
r j i
a
r i j
INT
r i
Y
| | 1
, ,
,
, ,
, ,
min
,
(1)
Domestic Supply and exports:
r i
r i
r i
X
r i
r i
r i
YD
r i r i
Y
,
1
,
,
)
,
1 (
,
, , ,
q
q
o
q
o
|
|
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|

\
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+ =
(2)
Armington:
r i
r i
r i
M
r i
r i
r i
YD
r i r i
A
,
1
,
,
)
,
1 (
,
, , ,
o
o

|
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.
|

\
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+ =
(3)
Transportation:
s r i
M
s r i s r i
T
, , , , , ,
t =
(4)
Preferences: [
=
r i
r i
C
r
U
,
,

(5)
Household Income: r
RV
r i
K
r
r
r
r i
L
i
r
w
r
I +

=
, ,
(6)
Public sector:
G GD
r i r
i r
=
[
,
,

(7)
Revenue:
r i j
INT
r i
P
r N r i
Y
r i
P
r i
r L
r
w
w
r K
r
r
k
r
G
, , , , , , ,
t t t t + + + =
(8)
Macroeconomic Themes:10 17
Equilibrium in the Global Trade Model
Goods Market:

=
j rr
r j i
INT
r j i
a
r
r i
C
r i
Y
,
, , , , , ,
(9)
Capital Market

r i
ri r
K
r
r
K
,
,
(10)
Labour Market:
=
i
r i
LS
r
LS
,
(11)
Equilibrium in the global trade model:
A competitive equilibrium in this global economy is such that, given the prices of commodities
and factors, demands for good and supply of goods are equal at the regional as well as the global level;
factor market clears for each region and at the world level; consumers of each region maximise their utility
subject to their income constraints; and the government budget and trade are balanced for each region.
Macroeconomic Themes:10 18
Dornbusch (1976) Model of Exchange Rate Overshooting
Interest rate parity condition: x r r + =
*
(1)
Adjustment of the interest to the deviation of the exchange rate:
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\
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= e e x u
(2)
Money demand: y r p m u + = (3)
By substituting (1) and (2) in (3)
y e e r p m u u + =
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\
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*

y e e r m p u u + =
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\
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\
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*
(4)
In the long run,
0 = e e

y r m p u =
*
(5)
Using this in (4)
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\
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+ = e e m p m p u
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\
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= p p e e
u
1

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\
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= p p e e
u
1
(6)
Thus the current exchange rate depends on the long run exchange
rate plus the deviation of current price from its trend.
Macroeconomic Themes:10 19
Now suppose the aggregate demand function of the economy is given by an IS curve in
the open economy model
( ) r y p e u D o o + + =
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\
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1 ln
(7)
Increase in the price is proportional to the excess demand
( )
(
(

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\
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\
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+ + = = r y p e u
Y
D
p o o t t 1 ln

(8)
In the long
run
0 = p

.
( ) 0 1 = + +
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\
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t o o r y p e u

( ) u r y p e + =
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\
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t o o 1
u y p e + + =
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\
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ot
o
1
1
(9)
Simplify (8) using (9)
( )
(
(

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\
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\
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+ + = = r y p e u
Y
D
p o o t t 1 ln


(
(
(

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\
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\
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(
(

|
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\
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+ + + + = r y u r y p p u p o o
o
o o t 1
*
1
1


(
(
(

|
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\
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.
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\
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=
*
r r p p u p o o t

Macroeconomic Themes:10 20
Using the relation from (2) and (3)
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\
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= e e r r u
*
and
|
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\
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= p p e e
u
1
(
(

|
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.
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\
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\
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= e e p p p ou o t


(
(
(

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\
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.
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\
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= p p p p p
u
ou
o t


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.
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\
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(
(
(

= p p p
u
ou
o t


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.
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\
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= p p v p

where
(
(
(

=
u
ou
o t v
The time path of the price level thus is
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\
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.
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\
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\
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+ = vt p p p t p exp
0
.
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.
|

\
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= p p e e
u
1

|
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.
|

\
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= p p e e
u
1
exp(-vt)
From (6) the time path of the exchange rate is
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\
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\
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\
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+ = vt e e e t e exp
0
Macroeconomic Themes:10 21
References
K. A.Chrystal and Simon Price (1994) Controversies in Macroeconomics, Harvester Wheatsheaf, chapter 6.
Dornbusch Rudiger (1976) Expectations and Exchange Rate, Journal of Political Economy, vol. 84, no.6,
pp. 1161-1176.
Fleming J. Marcus (1962) Domestic financial policies under fixed and under floating
exchange rates, IMF staff paper 9, November , 369-379.
Krugman Paul (1979) A Model of Balance of Payment Crisis, Journal of Money Credit and Banking, 11,
Aug.
Krugman P. and L. Taylor (1978) Contractionary Effects of Devaluation Journal of International
Economics, 445-56.
Miller, Marcus; Salmon, Mark When Does Coordination Pay? Journal of Economic Dynamics and Control,
July-Oct. 1990, v. 14, iss. 3-4, pp. 553-69
Mundell R. A (1962) Capital mobility and stabilisation policy under fixed and flexible exchange rates,
Canadian Journal of Economic and Political Science, 29, 475-85.
Sebastian E (1986) Are Devaluations Contractionary? Review of Economics and Statistics, vol. 68, 3, 501-
508.
G.K.Shaw, M. J. McCrostie and D. Greenaway (2001) Macroeconomics: Theory and Policy in the UK,
Blackwell.
Taylor Mark (1995) The Economics of Exchange Rates, Journal of Economic Literature, March, vol 33,
No. 1, pp. 13-47.