Macroeconomics

Chapter 20 (International Adjustment and Interdependence)

1 | P a g e

Chapter Highlights:
National economies are linked through
trade flows, exchange rates, and interest
rates.
Failure to keep exchange rates in line with
prices ultimately leads to a devaluation
crisis.
The monetary approach to the balance
of payments emphasizes the connection
between the domestic money supply and the
balance of payments.
IS can be shifted by consumption and
government budget.
When there is a government budget deficit,
IS will be shifted to the right because the
government is spending more.
Trade Policies: Tariffs (tax on imported
goods) and quota (limited imported goods)
LM increases and IS increases AD
increases
Exchange rate price of foreign currency
in terms of local currency
ADJUSTMENT UNDER FIXED EXCHANGE
RATES
Adjustment to a balance-of-payments
problem can be achieved in two ways:
One: Change economic policy
Two: Automatic adjustment mechanism
Two automatic mechanisms:
One: payments imbalances affect the
money supply and hence spending
Two: unemployment affects wages and
prices and thereby competitiveness.
Policy measures include monetary and fiscal
policy, and also tariffs or devaluation.
Labour Market wages decrease, price
level decreases, costs decrease, affordability
increases
Fixed exchange rate: trade deficit, Ms
decreases, LM shifts to the left, AD shifts to
the left.
AD = DS (aggregate spending by domestic
residents) + NX




Problem: Trade Deficit and Unemployment
When there is unemployment, wages tend to
fall, AS will shift downward (to the right),
lower prices, lower costs, affordable
Automatic adjustments let it flow as it
is.
Government intervention by using
monetary and fiscal policy to remove trade
deficit and unemployment.
All points in the NX curve implies a balance,
Q=X and NX=0
Net Exports (Figure)


















NX curve is steeper than AD curve
Below BOP trade deficit
Classical Adjustment Process relies on
price adjustments and an adjustment in the
money supply based on the trade balance.
Expenditure-switching policy shifts
demand between domestic and imported
goods
Expenditure-reducing (or expenditure-
increasing) policies copes with the two
targets of internal balance and external
balance.
Devaluation an increase in the domestic
currency price of foreign exchange. (primarily
an expenditure switching policy)
Real Devaluation (Figure)




Change in X change in AD < change in
NX because there are other components in
AD
e increases X increases and Q decreases
(devaluation)
A country achieves a real devaluation
when devaluation reduces the price of the
countrys own goods relative to the price of
foreign goods.
P
Y
Trade
Deficit
Trade
Surplus


Macroeconomics
Chapter 20 (International Adjustment and Interdependence)

2 | P a g e

X is exogenous because Yf is outside the
country
An adverse external shock shifts the NX
curve to the left.
Under crawling peg exchange rate
policy, the exchange rate is depreciated at a
rate roughly equal to the inflation differential
between the country and its trading partners.
THE MONETARY APPROACH TO THE
BALANCE OF PAYMENTS
Sterilization By sterilizing, the central
bank actively maintains the stock of money
too high for external balance.
FLEXIBLE EXCHANGE RATES, MONEY,
AND PRICES
Fixed exchange rate BOP
Flexible exchange rate BB
Only at the interest rate i = if will the
balance of payments be in equilibrium.
Adjustment of Exchange Rates and
Prices (Figure)









Exchange rates (external balance) and
prices (internal balance) do not move at
the same rate.
In long run, no change in income and i
R is a measure of competitiveness.
Y increases, Y>Y*, inflation, increase in P
(M/P decrease LM shifts to the left), loss in
competitiveness (R decreases), X decreases,
IS shifts to the left.
i falls CF falls (capital outflow)
BOP deficit depreciation
e increases (increase in competitiveness, X
increases), Y increases
The adjustment pattern of exchange rate
involves overshooting.
The exchange rate overshoots its new
equilibrium level when, in response to a
disturbance, it first moves beyond the
equilibrium it ultimately will reach and then
gradually returns to the long-run equilibrium
position.
Overshooting means that changes in the
monetary policy produce large changes in
exchange rates.
The PPP theory of the exchange rate
argues that exchange rate movements
primarily reflect differences in inflation rates
between countries.
Nominal exchange rate movements
clearly affect competitiveness.
SUMMARY
A monetary expansion in the long run
increases price level and the exchange rate,
keeping real balances and terms of trade
constant.
In the short run, the monetary expansion
increases the level of output and reduces the
interest rate, depreciating the exchange rate.
External balances can be financed in short
term. In the long run they call for
adjustment.
Under fixed exchange rates, the automatic
adjustment mechanism works through
prices and money. Unemployment leads to
a decline in prices, a gain in competitiveness,
increased net exports, and a gain in
employment. Money responds to trade
imbalances, affecting the level of interest
rates, spending, and hence the payments
deficit.

i
if
Y* Y
II
Deflation
Appreciation
I
Inflation
Appreciation
III
Deflation
Depreciation
IV
Inflation
Depreciation
BB