International Macroeconomics: Slides For Chapter 10

Slides for Chapter 10:
Aggregate Demand Shocks and the Real Exchange Rate
International Macroeconomics
Schmitt-Grohé Uribe Woodford
Columbia University
April 17, 2018
1
International Macroeconomics, Chapter 10 Schmitt-Grohé, Uribe, Woodford
Motivation
• The Balassa-Samuelson model emphasizes technological factors

affecting the real exchange rate. A country becomes more expensive
relative to others when it the difference in technical progress in its
traded sector relative to its nontraded sector is larger than in the
other countries. Because technological progress occurs slowly over
time, the model is best suited to understand long-run movements in
the real exchange rate.
• However, real exchange rates, also experience sizable movements

in relatively short periods of time, which are unlikely to be due to
changes in technologies.
• An example of such episodes is given by sudden stops, to which

we turn next.
2
Sudden Stops
A sudden stop is a situation in which a country that is running

current account deficits, that is, is borrowing from the rest of
the world, experiences a sudden and large increase in the cost of
external borrowing. Foreign lenders either start charging a much
larger country premium or stop lending altogether. As a result,
the current account reverts quickly from deficit to surplus, as the
country is cut from international financial markets.
In addition sudden stops are characterized by sharp depreciations of

the real exchange rate (the country becomes suddenly much cheaper
relative to other countries) and by severe contractions in aggregate
activity (collapses in output, consumption, and investment).
3
Case Study: The Argentine Sudden Stop of 2001
At the end of 2001, Argentina suffered a crisis that had all the signs
of a sudden stop.
In the second half of 2001, foreign lenders begin in increase the

Argentine interest rate premium to extremely high levels. In Decemer,
Argentina defaults on its foreign debt, which leads to a cutoff from
international capital markets.
The following slides look at what happened to the interest-rate

premium, the current, output, and the real exchange rate around
the Argentine Sudden Stop of 2001.∗
∗ All
graphs are taken from: “The IMF and Argentina, 1991-2001,” prepared by a
team headed by Shinji Takagi, Washington, D.C.: International Monetary Fund,
Independent Evaluation Office, 2004.
4
The Argentine Interest-Rate Premium

During the Sudden Stop of 2001
5
Current Account Reversal in Argentine Sudden Stop
The next graph displays capital inflows in Argentina over the period
1991 to 2002.
Capital inflows represent the change in a countries net liability position.

In terms of the notation of the two-period model of chapter 3, capital
inflows are given by
capital inflows= −(B1∗ − B0∗ )
Now recalliing the relationship between changes in the net asset
position and the current account
CA1 = B1∗ − B0∗
We have that the graph shows −CAt
In the graph we see:

• current account deficits until the year 2000.
• drastic current account reversal beginning in 2001 with current
account surpluses in 2001 and 2002
6
7
Large Contraction in GDP During the Argentine Sudden

Stop
8
Large Real Exchange Rate Depreciation in the

Argentine Sudden Stop
The next graph displays the inverse of the peso/dollar real exchange
rate:
1 P Arg
=
epeso/dollar S peso/dollar P U S
where P Arg denotes the price level in Argentina, P U S the price level
in the United States, S peso/dollar the nominal exchange rate, defined
1
as the peso price of one U.S. dollar. and peso/dollar is the peso/dollar
e
real exchange rate.
The figure shows that the real exchange rate increased (that is,
depreciated) by about 200 percent in 2002. This means that the
Argentina becomes much cheaper relative to the United States in a
very short period of time. This cannot be explained by technological
progress as suggested by the Balassa-Samuelson model. Also, Argentina
did not apply tariffs of 200 percent at that time, so it was not trade
barriers either.
9
10
Why did the Real Exchange Rate Depreciate so Much?

Recall
peso/dollar S peso/dollarP U S peso/dollar φ(PTU S , PN

U S)
e = =S arg arg
P Arg φ(PT , PN )
φ(1, PNus /P us )
= T
arg arg
φ(1, PN /PT )
Suppose that φ(PN , PT ) = PT1−α PNα and that α = 0.75 (so that households allocate
75 percent of thier expenditute to nontradables,
us ausplausible
α number). Then
PN /PT
epeso/dollar = arg
PN /PTarg
Taking log differences
peso/dollar us us arg arg
h i
%∆e = α %∆(PN /PT ) − %∆(PN /PT )
arg arg
' 0% − α %∆(PN /PT )
arg arg
200% ' −0.75 %∆(PN /PT )
So the question of why did the real exchange rate depreciate so much becomes:
Why did the relative price of nontradables fall so much during the Sudden
Stop?
11
What happens in a Sudden Stop?
Narrative: Argentina had a large trade deficit before the Sudden

Stop. With the default it has no more access to international
capital markets. The CA must swing into balance, or surplus,
CA ≥ 0 and there must be a trade balance reversal from deficits
to surplus, T B => 0. With a trade balance reversal domestic
demand for traded goods falls, and absent any relative price changes
domestic demand for nontraded goods also falls. Weak domestic
demand for nontradables will lead to a decline in the relative price
of nontradables bringing about a real depreciation.
We will embed this narrative into a theoretical model next.
12
The TNT Model
2 goods: QT and QN
QT = traded output
QN = nontraded output
PT = domestic currency price of traded good
PN = domestic currency price of nontraded good
Law of one price holds for traded goods: PT = SPT∗
13
Production
Production of Tradables:
QT = FT (LT ); FT0 (·) > 0; ; FT00 (·) < 0;
LT = labor input in the traded sector
Production of Nontradables:
QN = FN (LN ); 0 (·) > 0; ;

FN 00 (·) < 0;
FN
LN = labor input in the nontraded sector
14
Labor Supply
Fixed Labor Supply: L = LT + LN
L = total labor supply
Increase in labor input in the traded sector must be compensated

one for one by decreases in the nontraded sector
dLT = −dLN (1)
15
Construct the Production Possibility Frontier
dQT = FT0 (LT )dLT (2)
0
dQN = FN (LN )dLN (3)
[insert graph]
What is the slope of the PPF?
Divide (3) by (2) and use (1) to obtain:

dQN 0 (L )
FN N
=− 0
dQT FT (LT )
16
This equations says that the slope of the PPF is equal to the
marginal rate of transformation between traded and nontraded goods.
Suppose we move down the PPF, producing more tradables. Then

LT must rise and LN must fall. This raises the marginal product
of labor in the nontraded sector, FN 0 (L ), and lowers the marginal
N
product of labor in the traded sector, FT0 (LT ). This is so because
we are assuming that the production functions display decreasing
returns to scale, which is to say we assume that the marginal product
of labor is decreasing with labor.
This assumption then implies that the PPF becomes steeper as QT

rises. It follows that the PPF is concave towards the origin,
Our argument is that a Sudden Stop moves the economy down

its PPF, reallocating production from the nontraded sector to the
nontraded sector. The above relation says that the sudden stop
causes the economy to produce at a point where the PPF is steeper.
But we want to link the Sudden Stop to a real exchange depreciations.
Is there a link between the slope of the PPF and the relative price
of nontradables in terms of tradables? We will show that link in the
next slide.
Traded Goods Sector

Firms choose QT and LT to maximize profits
profits = PT QT − W LT .
subject to
QT = FT (LT ).
Eliminate QT
profits = PT FT (LT ) − W LT
Choose LT to maximize profits
∂profits
= 0 ⇒ PT FT0 (LT ) = W (*)
∂LT
17
Nontraded Goods Sector

Firms choose QN and LN to maximize profits
profits = PN QN − W LN .
subject to
QN = FN (LN ).
Eliminate QN
profits = PN FN (LN ) − W LN
Choose LN to maximize profits
∂profits 0 (L ) = W
= 0 ⇒ PN F N N (**)
∂LN
18
Combining (*) with (**) yields
PT 0 (L )
FN
= 0 N (4)
PN FT (LT )
As we move down the PPF its slope becomes steeper and steeper
implying that the relative price of nontradables relative to tradables
falls.
19
A Sudden Stop is a situation in which the production of nontradables

must fall and the production of tradables must rise. That is a move
down the production possibility frontier. What will induce firms to
shift production out of the nontraded sector and into the traded
sector? The relative price of nontraded goods must fall.
Hence a Sudden Stop leads to a real exchange rate depreciation.
20
In 2008 Iceland experienced a Sudden Stop
1. Interest rates spike
2. Large trade balance reversal
3. Output suddenly stops growing
and ...
as in the case of Argentina in 2001, the sudden stop is associated

with a large real exchange depreciation
Let’s look at the data for Iceland
21
Interest rates spike
Here we look at Credit Default Swap (CDC) rates.
What is a Credit Default Swap.
Suppose the government of Iceland issues a 10-year bond for $100

with an annual coupon rate of 5 percent. This means that Iceland
must make a payment to the lender of $5 every year and in year 10
must also pay the principal of $100.
In a CDS contract the seller of that contract offers insurance against

default by the debtor (= Iceland). This insurance contract (the
CDS contract) works as follows. Every year that the debtor does
not default the creditor pay the CDS rate, denoted c, to the insurer,
that is, every year the creditor pays c × 100. Now suppose the debtor
defaults. Then the insurer buys from the creditor the defaulted debt
22
at face value, that is, in our example the insurer buys the defaulted
debt from the lender for $100.
CDS rates are often used to measure how borrowing costs increase
for a given country because they are easily available.
The next graph shows Iceland’s CDS spreads between September 1

2008 and October 29, 2008. The units of the vertical axis are basis
points. The horizontal axis measures time. The graph shows that
betwen Sept 1, 2008 and October 11, 2008 the Icelandic CDS spread
increased from 2 percent (200 basis points) to over 14 percent (1400
basis points). This large increase in CDS spreads indicates that
interest rates at which Iceland would have been able to borrow must
have increased significantly.
The interest rate increase is accompanied by a dramatic trade balance

reversal
The units on the vertical axis are percent of GDP.
The trade balance goes from a deficit of 15 percent of GDP in 2006

to a surplus of 10 percent of GDP in 2010.
23
... and output stops growing
24
... And what happens to the real exchange rate? The real exchange
rate depreciates!
25
To sum up, Iceland in 2008 represents another example in which a

sudden stop lead to a large real exchange rate depreciation in the
short run.
26
Third Example of observing a large Real Exchange

Rate depreciation after a Sudden Stop
Case Study: Chile 1979-1985
In 1982 (after the default of Mexico in August) credit dries up for

highly indebted developing countries, particularly in Latin America.
These countries were running large current account deficits. The
Sudden Stop forces them to run TB surpluses to service their existing
debts.
What is the required external adjustment?
QT ↑ and QN ↓
This adjustment caused a large real exchange rate depreciation (and

with it costly reallocations of production away from the nontraded
sector towards the traded sector)
27
Chile, Real Exchange Rate Depreciation and Trade Balance

Reversal, 1979-1985
∆e TB
GDP
Year % %
1979 -1.7
1980 -2.8
1981 -8.2
1982 20.6 0.3
1983 27.5 5.0
1984 5.1 1.9
1985 32.6 5.3
cumulative RER depreciation of close to 90 percent.
28
Add other examples of sudden stops...
29

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Slides for Chapter 10:

Aggregate Demand Shocks and the Real Exchange Rate

Schmitt-Grohé Uribe Woodford

April 17, 2018

• The Balassa-Samuelson model emphasizes technological factors

• However, real exchange rates, also experience sizable movements

• An example of such episodes is given by sudden stops, to which

A sudden stop is a situation in which a country that is running

In addition sudden stops are characterized by sharp depreciations of

Case Study: The Argentine Sudden Stop of 2001

In the second half of 2001, foreign lenders begin in increase the

The following slides look at what happened to the interest-rate

The Argentine Interest-Rate Premium

Current Account Reversal in Argentine Sudden Stop

Capital inflows represent the change in a countries net liability position.

In the graph we see:

Large Contraction in GDP During the Argentine Sudden

Large Real Exchange Rate Depreciation in the

Why did the Real Exchange Rate Depreciate so Much?

peso/dollar S peso/dollarP U S peso/dollar φ(PTU S , PN

What happens in a Sudden Stop?

Narrative: Argentina had a large trade deficit before the Sudden

We will embed this narrative into a theoretical model next.

The TNT Model

Law of one price holds for traded goods: PT = SPT∗

QT = FT (LT ); FT0 (·) > 0; ; FT00 (·) < 0;

LT = labor input in the traded sector

QN = FN (LN ); 0 (·) > 0; ;

LN = labor input in the nontraded sector

Fixed Labor Supply: L = LT + LN

L = total labor supply

Increase in labor input in the traded sector must be compensated

dLT = −dLN (1)

Construct the Production Possibility Frontier

dQT = FT0 (LT )dLT (2)

What is the slope of the PPF?

Divide (3) by (2) and use (1) to obtain:

Suppose we move down the PPF, producing more tradables. Then

This assumption then implies that the PPF becomes steeper as QT

Our argument is that a Sudden Stop moves the economy down

Traded Goods Sector

Nontraded Goods Sector

Combining (*) with (**) yields

A Sudden Stop is a situation in which the production of nontradables

Hence a Sudden Stop leads to a real exchange rate depreciation.

In 2008 Iceland experienced a Sudden Stop

1. Interest rates spike

2. Large trade balance reversal

3. Output suddenly stops growing

as in the case of Argentina in 2001, the sudden stop is associated

Let’s look at the data for Iceland

Interest rates spike

Here we look at Credit Default Swap (CDC) rates.

What is a Credit Default Swap.

Suppose the government of Iceland issues a 10-year bond for $100

In a CDS contract the seller of that contract offers insurance against

The next graph shows Iceland’s CDS spreads between September 1