This document summarizes a chapter on international macroeconomics. It discusses how national economies are interconnected through trade, exchange rates, and interest rates. Under fixed exchange rates, imbalances are automatically adjusted as trade imbalances affect money supply and unemployment affects wages/prices. Flexible exchange rates rely on market forces as the exchange rate moves to balance the economy. Devaluation of a currency can boost exports and help correct a trade deficit by making the country's goods relatively cheaper.
This document summarizes a chapter on international macroeconomics. It discusses how national economies are interconnected through trade, exchange rates, and interest rates. Under fixed exchange rates, imbalances are automatically adjusted as trade imbalances affect money supply and unemployment affects wages/prices. Flexible exchange rates rely on market forces as the exchange rate moves to balance the economy. Devaluation of a currency can boost exports and help correct a trade deficit by making the country's goods relatively cheaper.
This document summarizes a chapter on international macroeconomics. It discusses how national economies are interconnected through trade, exchange rates, and interest rates. Under fixed exchange rates, imbalances are automatically adjusted as trade imbalances affect money supply and unemployment affects wages/prices. Flexible exchange rates rely on market forces as the exchange rate moves to balance the economy. Devaluation of a currency can boost exports and help correct a trade deficit by making the country's goods relatively cheaper.
Chapter 20 (International Adjustment and Interdependence)
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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)
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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