International Business Chapter 18 Tbe The Trade Balance Illustrated Function The Real Exchange Rate Shown Figure

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18 Balance of Payments II: Output, Exchange Rates, and

Macroeconomic Policies in the Short Run

Notes to Instructor

Chapter Summary

This chapter develops a standard short-run macroeconomic model for the open economy.

It begins with an overview of the components of demand and their determinants, then

derives a goods market equilibrium using the Keynesian cross. The next two sections

Comments

This chapter is very dense because it combines material that would easily take several

weeks to cover in an intermediate macroeconomics course. For those classes in which

intermediate macroeconomic theory is a prerequisite, this material can be taught

relatively quickly, emphasizing the richer role of the trade balance in equilibrium

outcomes. For these students, Sections 1 through 4 probably can be condensed, treating

1. Demand in the Open Economy

a. Preliminaries and Assumptions

b. Consumption

i. Marginal Effects

c. Investment

d. The Government

e. The Trade Balance

f. Exogenous Changes in Demand

i. Side Bar: Barriers to Expenditure Switching: Pass-Through and the J

Curve

2. Goods Market Equilibrium: The Keynesian Cross

a. Supply and Demand

3. Goods and Forex Market Equilibria: Deriving the IS Curve

a. Equilibrium in Two Markets

4. Money Market Equilibrium: Deriving the LM Curve

a. Money Market Recap

5. The Short-Run IS‒LM‒FX Model of an Open Economy

a. Macroeconomic Policies in the Short Run

6. Stabilization Policy

a. Application: The Right Time for Austerity

b. Problems in Policy Design and Implementation

i. Policy Constraints

ii. Incomplete Information and the Inside Lag

c. Application: Macroeconomic Policies in the Liquidity Trap

7. Conclusions

Lecture Notes

This chapter connects exchange rate movements to the national economy using the IS‒

LM model. By combining the theories of exchange rate determination with the balance of

payments accounting, we can better understand how exchange rate movements affect key

1 Demand in the Open Economy

In previous chapters, we took the level of output as a given, allowing us to abstract from

fluctuations in the goods market. This assumption is acceptable for long-run economic

analysis because the level of output is determined by the factors of production. In the

Preliminaries and Assumptions

■ Home and foreign price levels, and , are constant so expected inflation is

■ GDP is taken as equivalent to GNDI.

Consumption

Consumption, C, is a function of disposable income, Yd = Y − :

Marginal Effects The slope of the consumption function is the marginal propensity to

Investment

Firms engage in capital investment projects only when the real return on the project

exceeds the cost of borrowing. The firm’s borrowing cost is the expected real interest

This relationship is illustrated in the investment function, Figure 18-2.

The Government

The government collects taxes, T, from households and spends government

The government’s tax revenue may not exactly equal its government consumption

spending.

■ G > T: Budget deficit

Fiscal policy refers to decisions about taxes and government consumption. Based on our

assumptions, these values are taken as given:

The Trade Balance

The quantities of exports and imports, and therefore the trade balance, are all directly

affected by exchange rates. We need to study the variables that influence the trade

balance so we can make it endogenous. Those variables include the real exchange rate,

the level of home income, and the level of foreign income.

The Role of the Real Exchange Rate The change in spending patterns in response to

exchange rate fluctuations is known as expenditure switching (between foreign and

home purchases).

Recall that the real exchange rate is defined as

We can use this expression to understand how expenditure switching works:

■ ↑ q → real depreciation of the home currency ‒ foreign goods are relatively more

■ ↓ q → real appreciation of the home currency ‒ home goods are relatively more

The Role of Income Levels When income rises, people generally buy more of

everything, including imports. But we need to realize that our exports are other countries’

imports. And, of course, our imports are their exports. That means an increase in home

income increases home imports and foreign exports. Similarly, an increase in foreign

income increases foreign imports and home exports.

The home country’s income also affects the trade balance:

Finally, the foreign country’s income affects the trade balance:

■ ↑ Y* → foreign country increases spending on all goods → home country exports

In summary, the trade balance is a function of three variables:

The trade balance is illustrated as a function of the real exchange rate shown in Figure

H E A D L I N E S

The Curry Trade

In 2009, the British pound weakened dramatically vis-à-vis the euro. That led to some

interesting changes in trade across the English Channel.

Discussion Questions:

■ Shipping French food products to the United Kingdom, then shipping them back

to France is costly. Given these high transportation costs, explain how it is

possible for customers in France to buy those products from the United Kingdom

moved after 2009.

Here’s a graph of the pound‒euro exchange rate from 1999 through November 2010.

The effect of a change in output on the trade balance can be thought of in terms of the

marginal propensity to consume. Let MPCF denote the marginal propensity to consume

foreign imports and MPCH denote the marginal propensity to consume home goods and

services:

APPLICATION

The Trade Balance and the Real Exchange Rate

Figure 18-4 reports the real effective exchange rate relative to the trade balance in the

United States, 1975 to 2006. The real effective exchange rate measures real depreciation

and appreciation in the United States relative to a basket of other countries (weighted by

how much the United States trades with each country). This provides a comprehensive

Exogenous Changes in Demand

This section considers the sources of exogenous shocks to demand:

■ An exogenous change in consumption shifts the consumption function. Panel (a)

of Figure 18-6 shows an exogenous increase in consumption. When there is an

exogenous increase in consumption, the consumption function shifts up. For any

■ An exogenous change in investment shifts the investment function. Figure 18-6,

panel (b), shows an exogenous increase in investment. An exogenous increase in

investment shifts the investment function to the right. For any given interest rate,

■ An exogenous change in the trade balance shifts the trade balance function. Panel

exogenous increase in the trade balance shifts the trade balance function up. For

any given real exchange rate, the trade balance is higher. An exogenous decrease

S I D E B A R

Barriers to Expenditure Switching: Pass–Through and the J Curve

There are two key mechanisms at work when the real exchange rate changes.

■ A nominal depreciation is associated with a real depreciation (because prices are

fixed).

Trade Dollarization, Distribution, and Pass–Through

We assumed that all prices are set in local currency and that these prices are fixed in the

short run. In reality, some home goods may be priced in foreign currency. To understand

how this affects trade, define these two pricing schemes (treating the United States as the

foreign country):

Therefore, we can define the price of foreign goods relative to dollar-priced home goods

and relative to local–currency-priced home goods:

Based on the previous weighting, we can derive the price of goods sold in the home

country relative to those sold in the foreign country (e.g., the real exchange rate):

exchange rates are passed through to real exchange rates. In the model given in the text,

we assume d = 0.

Table 18-1 reports the shares of exports and imports denominated in U.S. dollars and

euros (roughly equivalent to the share d previously). Note that if a large share of the trade

balance is denominated in U.S. dollars, then a depreciation or appreciation of the U.S.

The J Curve

A real depreciation improves a country’s trade balance through boosting exports and

reducing imports. In reality, this process takes time because orders for exports and

imports are placed in advance and the payment occurs much later, at the time of delivery.

It may take time for firms and intermediaries to fully adjust their orders.

Although exports continue to sell, for a time, in the same quantity at the same

domestic price, the domestic price paid for imports will increase (depending on the

degree of pass-through). Thus, the quantity of imports into the country stays the same,

but these goods cost more, increasing total spending on imports. The overall effect is a

decrease in the trade balance. Therefore, before firms adjust their orders, the total

spending on imports rises and total spending on exports remains the same, so the trade

2 Goods Market Equilibrium: The Keynesian Cross

This section uses the traditional Keynesian cross approach to goods market equilibrium.

Supply and Demand

The total aggregate supply of final goods and services is equal to total output, GDP − Y:

We know that the national income accounting identity says the supply of output is equal

to the demand for final goods and services. The demand for goods and services is given

by the previous components:

In equilibrium, demand (D) must equal aggregate output (Y). Substituting Y

for D in the equation for aggregate demand, we obtain the goods market equilibrium

condition:

Determinants of Demand

The factors that can affect demand include

■ The home nominal interest rate (i)

We begin by analyzing the impact of a change in home output. Suppose Y rises by $1.

Consumption spending will rise by +$MPC. And imports will rise by +$MPCF. The trade

balance will change by −$MPCF. The net change in aggregate demand will be $(MPC −

(which, in this case, includes spending on both domestic and foreign goods).

So far our graph includes only aggregate demand:

When demand is graphed against output (income, Y), the slope of the line will be less

than 1.0. This graph shows how demand changes as Y changes. What is the one point at

which spending equals output?

To answer that question, we need another line in our graph, the line showing all

possible points of equilibrium. The equation of that line is D = Y. By a coincidence of

To see why the goods market adjusts to equilibrium, consider the following cases. Let

Y1 denote the equilibrium (point 1 in Figure 18-7).

Factors That Shift the Demand Curve

In the following examples, the first example is illustrated in panel (b) of Figure 18-6 (as

an increase in demand).

■ Government purchases:

↑ ⇒ D shifts upward ⇒ ↑ Y

■ Interest rate: i

↓ i ⇒ ↑ l(i) ⇒ D shifts upward ⇒ ↑ Y

■ Nominal exchange rate: E

↑ E ⇒ ↑ TB(/ , Y − T, Y* − T*) ⇒ D shifts upward ⇒ ↑ Y

Summary

The Keynesian cross is derived from the relationship between the demand for goods and

services, which depends on income, and their supply, or output, Y. Changes in demand

not associated with changes in output (Y) lead to a shift in the demand curve for goods

and services.

3 Goods and Forex Market Equilibria: Deriving the IS Curve

To derive the economy’s general equilibrium, we must consider the equilibrium in three

markets: the goods market, the money market, and the forex market. Students probably

will be familiar with the concept of general equilibrium (even if this term was not

Equilibrium in Two Markets

In the IS‒LM diagram, we study equilibrium in three markets: the goods market, the

forex market (IS), and the money market (LM). This section focuses on the IS curve.

The IS curve shows combinations of output Y and interest rate i in which the goods

and the forex markets are in equilibrium.

The IS curve is plotted with interest rate i on the vertical axis and output Y on the

Forex Market Recap

The forex market equilibrium is given by the uncovered interest parity (UIP) condition:

The return on domestic deposits, the nominal interest rate i, must equal the expected

market equilibrium, we obtain the equilibrium interest rate i and nominal exchange rate

Deriving the IS Curve

This section derives the shape of the IS curve through examining changes in the interest

rate.

Initial Equilibrium Using the diagrams, the equilibrium output and interest rate are

given from the goods market and forex market:

■ Goods market: The level of output from the goods market equilibrium must be a

It may be worthwhile to point out that lining up the diagrams correctly helps students

avoid mistakes because they can check for consistency across the two (eventually, three)

markets.

A Fall in the Interest Rate To derive the IS curve, consider how a change in the interest

rate affects the demand for goods and the forex market. Figure 18-8 illustrates how a

decrease in the interest affects the two markets:

■ Panel (a): ↓ i ⇒ ↑ I(i) ⇒ D shifts upward ⇒ ↑ Y

Note that expenditure switching is a source of demand for goods and services not

present in the closed economy. In the open economy, lower interest rates increase