Balance of payments

Automatic adjustment

Remarks
Balance of payments
1. Trade account (trade) TA 2. Current account (capital) CA

Equilibrium (TA+CA=0) & full equilibrium (TA=0, CA=0) Transactions between residents and non residents Values (domestic currency, thus it depends on quantities, prices and the exchange rate)

Trade account
IMPORTS
1. 2. 3. 4. Domestic price Foreign prices Real exchange rate = p e / pf (PPP) Exchange rate Income (Keynesian [Q]) Domestic price Foreign prices Real exchange rate Exchange rate Foreign income ( foreign income) (Keynesian [Q])

EXPORTS
1. 2. 3. 4.

The real exchange rate

It measure the degree of competitiveness:

pe er = pf
If it increases, competitiveness falls. e is how many euro you need to buy a dollar,

Capital account
Capital inflows
1. Domestic nominal interest rate (UIP) 2. Forward premium (spotforward) (CIP) i.e. the foreign currency tomorrow has an higher value than today.

Capital outflows
1. Foreign nominal interest rate 2. Forward premium

Automatic adjustments
Three cases 1. Price with fixed exchange (p and pf) 2. Price with flexible exchange (e) 3. Quantity (income y and foreign income yf)

First case: Price with fixed exchange

Old version: Humes theory of the gold flows (Gold standard) Modern version: fixed exchange rate. More assumptions but the mechanism is the same.

Hume theory of the gold flows

Assumptions Metallic system (the price of a commodity is its relative price in terms of gold). In such a case the pure gold standard regime holds (price of the currency fixed in terms of gold, i.e. currencies are gold). quantity of gold = price (intuition). For the sake of simplicity we only consider the trade account.

Trade account adjustment: How it works

Deficit (imports>exports) Gold out flow (foreign debts>foreign credits) Prices fall Higher competitiveness Export increases/Import falls Balance

Remark: Nominal vs. real income

Nominal income: YN (money value of the income), a change in the income depends on a change in the price level of in the quantities. Real income: YR (constant prices), a change in the income depends only on a change in the quantities. Relation: YR = YN /P or YN = YR P

In the fixed exchange rate regime the story is more or less the same
Quantitative theory of money: YN = v M or YR P = v M. The velocity of money is constant. The real income is constant (i.e. competitive markets). Thus (YR and v are fixed: v M = YR P): M P

Trade account adjustment

Country 1 Deficit Money out flow Prices fall Higher competitiveness Export increases Import falls Balance Country 2 Surplus In flow Increase Lower Falls Increases Balance

Balance of payment adjstment under a fixed exchange rate regime

Return to balance is automatic: if we start with deficit, money flows out until we get back to balance. Much the same story applies to the financial account: if the domestic interest rate is high (low), capital flows in (out) and the return to balance is automatic.

Financial account adjustment

Deficit (the interest rate is too low) People invests abroad Gold out flow Prices fall Higher competitiveness Export increases/Import falls Until balance CA<0

TA>0 TA+CA=0

However notice that CA+TA=0 but CA<0 and TA>0, i.e. it is not a full equilibrium. Indeed it is more complex.

Summary
Deficit or surplus of the balance of payments are adjusted by changes in the level of price, which stimulates the domestic or foreign trade. Changes occurs until the balance of payments get the equilibrium. Since a disequilibrium of it stimulates further changes. Basic mechanism: Competitiveness that depends on prices and exchange rate, which is here fixed..

Second case: Price with flexible exchange rate

Remark: the nominal exchange rate is a price , i.e. the price of a currency in terms of another one. Hence also this is a price adjustment mechanism. It works as before thought competitiveness, but now competitiveness changes because the nominal exchange rate change instead of prices. In the real world both mechanisms work together and both affect competitiveness in the same direction (if some conditions hold).

The mechanism
Deficit of the balance of payments. Excess of demand of the foreign currency. Domestic currency depreciation (if the market is stable, i.e. supply slope larger than the demand one). More competitiveness Reduction of the deficit until balance

Trade account adjustment

Country 1 Country 2 Deficit Surplus Exchange rate depreciation Appreciation e fall e increase Higher competitiveness Lower Export increases Falls Import falls Increases Balance Balance

Marshall Lerner Condition

Balance of payments is expressed in values (thus it depends on quantities and prices.

qE PUS qI PF/R = BP
qE quantity exported; PUS US price; qI quantity imported; PF Foreign price; R exchange rate (direct quotation: # of foreign currency units needed to buy one dollar.

Marshall Lerner Condition

Balance of payments qE PUS qI PF/R < 0 deficit R depreciation qE and qI (real) qE PUS qI PF/R ok But R (nominal) qE PUS qI PF/R no Real effects (qE, qI) have to dominate the nominal ones (R). Else the deficit increases after a depreciation.

Marshall Lerner Condition

Elast. of export (import) the change of export (import) after a change of 1% in the exchange rate. Elast. of export + Elast. imports > 1 qE PUS qI PF/R Intuition: Real effects (qE, qI) have to dominate the nominal ones (R).

Note on ML and stability

The Marshall-Learner condition implies a stable exchange arte market (see the slides of class 1 second part). The stability of the exchange market is related to the demand and supply slopes. Slopes are measured by the elasticities. Thus if ML holds, the slope of the supply is lager than the slope of the demand of foreign currency and the market is stable.

Summary
Deficit or surplus of the balance of payments are adjusted by changes in the exchange rate, which stimulates the domestic or foreign trade. Changes occurs until the balance of payments get the equilibrium. Since a disequilibrium of it stimulates further changes. Basic mechanism: Competitiveness depends on exchange rate and deficit (surplus) stimulates deprecation (appreciation) if the ML condition holds.

Third Case: The Keynesian Mechanism

As far as the income increase the imports also increase (propensity to import). Thus since a deficit reduce the income it will also reduce the imports, while A surplus will increase them.

A two-country world
Country A Deficit Income Imports Exports Deficit falls Country B Surplus Income Imports Exports Surplus falls

Notice that country A exports = country B imports and vice versa. Thus:

Differences
Price mechanisms are slow but at the end lead to the equilibrium; BP=0. Quantity (Income) mechanism is fast but it leads only in the direction of the equilibrium of the BP. In the real world but works together.