Most work in macroeconomics in the past 30 years has been useless at best and harmful at worst.
Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates
(Part E)
by
Charles Lamson
The Effects of Exchange Rates on the Economy
Recall, when exchange rates are fixed, households spend some of their income on imports and the mutiplier is smaller than it would be otherwise. Imports are a "leakage" from the circular flow of the economy, much like taxes and saving. Exports, in contrast, are an "injection" into the circular flow; they represent spending on U.S.-produced goods and services from abroad and can stimulate output. The world is far more complicated when exchange rates are allowed to float. First, the level of imports and exports depends on exchange rates as well as on income and other factors. When events cause exchange rates to adjust, the levels of imports and exports will change. Changes in exports and imports can in turn affect the level of real GDP and the price level. Further, exchange rates themselves also adjust to changes in the economy. Suppose the government decides to stimulate the economy with an expansionary monetary policy. This will affect interest rates, which may affect exchange rates. Exchange Rate Effects on Imports, Exports, and Real GDP When a country's currency depreciates (falls in value), its import prices rise and its export prices (in foreign currencies) fall. When the U.S. dollar is cheap, U.S. products are more competitive with products produced in the rest of the world, and foreign trade goods look expensive to U.S. citizens. A depreciation of a country's currency can serve as a stimulus to the economy. Suppose the U.S. dollar falls in value. If foreign buyers increase their spending on U.S. goods, and domestic buyers substitute U.S.-made goods for imports, aggregate expenditure on domestic output will rise, inventories will fall, and real GDP (Y) will increase. A depreciation of a country's currency is likely to increase its GDP.  Exchange Rates and the Balance of Trade: The J Curve Because a depreciating currency tends to increase exports and decrease imports, you might think it will also reduce a country's trade deficit. In fact, the effect of a depreciation on the balance of trade is ambiguous. Many economists believe that when a currency starts to depreciate, the balance of trade is likely to worsen for the first few quarters (perhaps three to six). After that, the balance of trade may improve. This effect is graphed in Figure 7. The curve in this figure resembles the letter J, and the movement in the balance of trade that it describes is sometimes called the J-curve effect. The point of the J shape is that the balance of trade gets worse before it gets better following a currency depreciation.  How does the J curve come about? Recall that the balance of trade is equal to export revenue minus import costs, including exports and imports of services: balance of trade = dollar price of exports x quantity of exports - dollar price of imports x quantity of imports A currency depreciation affects the items on the right side of this equation as follows. First, the quantity of exports increases and the quantity of imports decreases; both have a positive effect on the balance of trade (lowering the trade deficit or raising the trade surplus). Second, the dollar price of exports is not likely to change very much, at least not initially. The dollar price of exports changes when the U.S. price level changes, but the initial effect of a depreciation on the domestic price level is not likely to be large. Third, the dollar price of imports increases. Imports into the United States are more expensive, because $1 U.S. buys fewer yen, euros, etc. than before. An increase in the dollar price of imports has a negative effect on the balance of trade.  An example to clarify this last point follows: The dollar price of a Japanese car that costs 1,200,000 yen rises from $10,000 to $12,000 when the exchange rate moves from 120 yen per dollar to 100 yen per dollar. After the currency depreciation, the United States ends up spending more (in dollars) for the Japanese car than it did before. Of course, the United States will end up buying fewer Japanese cars than it did before. Does the number of cars drop enough so the quantity effect is bigger than the price effect, or vice versa? Does the value of imports increase or decrease? The net effect of a depreciation on the balance of trade could go either way. The depreciation stimulates exports and cuts back imports, but it also increases the dollar price of imports. It seems that the negative effect dominates initially. The impact of a depreciation on the price of imports is generally felt quickly, while it takes time for export and import quantities to respond to price changes. In the short run, the value of imports increases more than the value of exports, so the balance of trade worsens. The initial effect is likely to be negative; but after exports and imports have had time to respond, the net effect turns positive. The more elastic the demand for exports and imports, the larger the eventual improvement in the balance of trade. Exchange Rates and Prices The depreciation of a country's currency tends to increase its price level. There are two reasons for this. First, when a country's currency is less expensive, its products are more competitive in world markets, so exports rise. In addition, domestic buyers tend to substitute domestic products for the now more expensive imports. This means planned aggregate expenditure on domestically produced goods and services rises, and the aggregate demand curve shifts to the right. The result is a higher price level, higher output, or both. If the economy is close to capacity, the result is likely to be higher prices. Second, a depreciation makes imported inputs more expensive. If costs increase, the aggregate supply curve shifts to the left. If aggregate demand remains unchanged, the result is an increase in the price level. Monetary Policy with Flexible Exchange Rates Let us now put everything in the last several posts together and consider what happens when monetary policy is used first to stimulate the economy and then to contract the economy.  Suppose the economy is below full employment and the Federal Reserve (Fed) decides to expand the money supply. The volume of reserves in the system is expanded perhaps through open market purchases of U.S. government securities by the Fed. This results in a decrease in the interest rate. The lower interest rate stimulates planned investment spending and consumption spending. This added spending causes inventories to be lower than planned and aggregate output (income) (Y) to rise, but there are two additional effects. One, the lower interest rate has an impact in the foreign exchange market. A lower interest rate means a lower demand for U.S. securities by foreigners, so the demand for dollars drops. Two, U.S. investment managers will be more likely to buy foreign securities (which are now paying relatively higher interest rates), so the supply of dollars rises. Both events push down the value of the dollar. A cheaper dollar is a good thing if the goal of the monetary expansion is to stimulate the domestic economy, because its cheaper dollar means more U.S. exports and fewer imports. If consumers substitute U.S.-made goods for imports, both the added exports and the decrease in Imports mean more spending on domestic products, so the multiplier actually increases. Now suppose inflation is a problem and the Fed wants to slow it down with tight money. Here again, floating exchange rates help. Tight monetary policy works through a higher interest rate. A higher interest rate lowers investment and consumption spending, reducing aggregate expenditure, reducing output, and lowering the price level. The higher interest rate also attracts foreign buyers into U.S. financial markets, driving up the volume of the dollar, which reduces the price of imports. The reduction in the price of imports shifts the aggregate supply curve to the right, which helps fight inflation.  Fiscal Policy with Flexible Exchange Rates The openness of the economy and flexible exchange rates do not always work to the advantage of policymakers. Consider a policy of cutting taxes to stimulate the economy. Suppose Congress enacts a major tax cut designed to raise output. Spending by households rises, but not all this added spending is on domestic products---some leaks out of the U.S. economy, reducing the multiplier. As income rises, so does the demand for money---not the demand for dollars in the foreign exchange market, but the amount of money people desire to hold for transactions. Unless the Fed is fully accommodating, the interest rate will rise. A higher interest rate tends to attract foreign demand for U.S. securities. This tends to drive the price of the dollar up, which further blunts the effectiveness of the tax cut. If the value of the U.S. dollar rises, U.S. exports are less competitive in world markets, and the quantity of exports will decline. Similarly, a strong dollar makes imported goods look cheaper, and U.S. citizens spend more on foreign goods and less on U.S. goods, again reducing the multiplier. Without a fully accommodating Fed, three factors work to reduce the multiplier: (1) A higher interest rate from the increase in money demand may crowd out private investment and consumption; (2) some of the increase in income from the expansion will be spent on imports; and (3) a higher interest rate may cause the dollar to appreciate, discouraging exports and further encouraging imports. Monetary Policy with Fixed Exchange Rates Although most major countries in the world today have a flexible exchange rate (counting for this purpose the euro zone countries as one country), it is interesting to ask what role monetary policy can play if a country has a fixed exchange rate. The answer is, no role. In order for a country to keep its exchange rate fixed to, say, the U.S. dollar, its interest-rate cannot change relative to the U.S. interest rate. If the monetary authority of the country tried to lower its interest rate because it wanted to stimulate the economy, this would lead the country's currency to depreciate (assuming that the U.S. interest rate did not change). People would want to sell the country's currency and buy dollars and invest in U.S. securities, since the country's interest rate would have fallen relative to the U.S. interest rate. In other words, the monetary authority cannot change its interest rate relative to the U.S. interest rate without having its exchange rate change. The monetary authority is at the mercy of the United States and it has no independent way of changing its interest rate if it wants to keep its exchange rate fixed to the dollar.  This restriction means that when the various European countries moved in 1999 to a common currency, the euro, each of the countries gave up its monetary policy. There is now only one monetary policy for all the euro zone countries, and it is decided by the European Central Bank (ECB). The one case in which a country can change its interest rate and keep its exchange rate fixed is if it imposes capital controls. Imposing capital controls means that the country limits or prevents people from buying or selling its currency in the foreign exchange market. A citizen of the country may be prevented, for example, from using the country's currency to buy dollars. The problem with capital controls is that they are hard to enforce, especially for large countries and for long periods of time.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 700-704* end |
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