International Trade Graphic Art
International Trade Graphic Art
dickstanford43@gmail.com
This website contains selected illustrations of international trade graphic art accompanied by descriptive matter. Instructors and students are welcome to use the illustrations and descriptive matter as they wish. Corrections and suggestions are welcome.
2. Factor Substitutability
3. Efficiency
4. Welfare
5. Specialization and Trade
6. Terms of Trade
7. Gains from Trade
8. Qualifications
9. Barriers to Trade
10. External Balance
11. Exchange Rates
12. Payments Deficit
13. Payments Surplus
14. International Disturbance
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International trade theory is based on the principle of specialization according to comparative advantage among regions. It abstracts completely from the international identities of the regions. Even though an aggregate perspective is required, the analysis employs various microeconomic concepts that must be generalized to the level of aggregate or industry behavior.
Factor Intensity
The analysis begins with production isoquants for a product produced in a region. An isoquant is a path in graphic coordinate space along which various combinations of capital (K) and labor (L) yield the same level of output. An isoquant map showing two representative isoquants (among an infinite number of such isoquants that could be shown), all other inputs accommodating the K and L input requirements, is illustrated in Figure 2-1.
In order to increase output from Q14 to Q15 in panel (a), a large amount of additional labor but only a small amount of additional capital would be required. A comparable output increase in panel (b) from Q24 to Q25 would require a much larger amount of additional capital, but only a smaller amount of additional labor. This implies that in a labor intensive technology such as is illustrated in panel (a), the marginal productivity of labor is low while the marginal productivity of capital is high in a relative sense, whereas in a capital intensive technology such as illustrated in panel (b), the marginal productivity of capital is low but the marginal productivity of labor is high.
A labor intensive technology is a labor-using but capital-saving technology, whereas a capital intensive technology is a capital-using but labor-saving technology. Where labor is relatively abundant and cheap but capital is scarce and expensive, a labor intensive technology is called for. Where labor is cheap but capital is expensive, the capital-labor budget line (or isocost) that would be tangent to Q14 at point B is fairly shallowly sloped. In order to increase output, production decision makers would likely choose combinations of labor and capital along a relatively shallowly sloped capital-labor path such as KL1. Such conditions may be typical of many less-developed regions.
In industrially developed regions where capital is more abundant and labor is in shorter supply and relatively costly, a more capital intensive technology is appropriate. The capital-labor budget line (or isocost) that would be tangent to isoquant Q24 at point D is more steeply sloped. In such an environment, production decision makers likely would choose combinations of labor and capital along a relatively steeply-sloped capital-labor path such as KL2. A corollary is that labor-saving technologies developed in capital-abundant industrially advanced regions are likely not appropriate to industrially-primitive regions where capital is scarce but labor is both abundant and cheap.
Both of the technologies illustrated by the isoquants in panels (a) and (b) of Figure 2-1 exhibit a high degree of factor substitutability between labor and capital, subject to the relative factor intensities. The isoquant map illustrated in panel (a) of Figure 2-2 exhibits much more angularity between labor and capital. Along isoquant Q34, capital and labor are highly substitutable for one another only over the short range between points G and H. Production decision makers will likely opt for combinations of capital and labor along capital-labor paths between KL3 and KL4, depending upon the relative costs of capital and labor.
If the isoquant map exhibited such great angularity that the isoquants were L-shaped as illustrated in panel (b) of Figures 2-2, labor and capital would not be substitutable for each other at all. The consequence is that production managers would be limited to a fixed capital-labor ratio passing through the corners of the L-shaped isoquants such as KL5 in panel (b).
If the available technology involves a highly restricted range of capital-labor substitutability such as illustrated in panel (a) of Figure 2-2, production managers would likely select more labor intensive output expansion paths with slopes shallower than KL4 assuming labor is abundant and capital is scarce. However, if circumstances change so that capital becomes much more abundant or labor becomes more expensive (say by organizing itself to exercise monopoly power in the supply of labor), the production decision makers would choose combinations of capital and labor along a production expansion path steeper than KL3, resulting in the phenomenon of "factor intensity reversal." This phenomenon may have occurred in such newly industrialized countries (NICs) as Singapore, Indonesia, Taiwan, and South Korea.
Even if the same technology is available in two regions, production managers in a relatively labor abundant environment would choose a shallowly sloped KL output path that is more labor intensive. But production managers in a relatively capital abundant environment would choose a more steeply sloped KL output expansion path that is more capital intensive. In such a case, the apparently anomalous phenomenon known as the "Leontief Paradox" would occur where labor intensive exports from the labor abundant region are received as imports into the capital abundant region where import substitutes are produced under capital intensive conditions. This is reputed to be a paradox because of a presumption that the goods should be labor intensive because they are produced under labor intensive conditions elsewhere in the
In the preceding discussion we have indicated that the slope of the production output path, also known as the capital labor ratio, may take any of a wide range of values, depending upon the relative capital or labor intensity of the technology and the relative abundances of capital and labor that determine their relative prices. However, we have not yet indicated how a production manager might select a particular capital-labor ratio.
At the microeconomic level of analysis the maximum output combination of labor and capital can be found at the tangency of a capital-labor budget line (or isocost) with the highest output isoquant reached by the budget line. The production manager may find this combination by proceeding iteratively along the budget line purchasing allowable combinations of labor and capital until the marginal rate of technical substitution (MRTS) is just equal to the ratio of the prices of the two inputs. This is also the least cost combination of labor and capital for producing the output represented by the isoquant. The capital-labor ratio associated with this combination can be measured as the slope of a ray from the origin to the point of tangency. Any other combination of labor and capital that can be purchased with the budget would yield less output.
An aggregative version of this analysis is needed for the analysis of interregional specialization and trading possibilities. The conceptual approach is to aggregate all of the producers of a particular item into an industry, and then to presume that "the industry" moves and thinks as one in using all of the resources available to it and to industries producing other items.
The conceptual device that enables this analysis is a so-called box diagram as illustrated in panel (a) of Figure 2-3. The vertical dimension of the box represents all of the capital, Ka available to the two industries, A and B; the horizontal dimension represents all of the labor, La. available to both industries. The fact that the box is wider than it is high indicates that the labor resource endowment available to the two industries is more abundant relative to the capital resource endowment.
The isoquant map for industry A's production process is oriented toward the lower-left origin, 0A. The positive directions of change from origin 0A are as normally expected in bivariate graphic analysis. Because its isoquants are relatively steeply sloped, we can infer that item A is produced with a relatively capital intensive technology.
The isoquant map for industry B's production process is oriented toward the upper-right origin, 0B. The positive directions of change from this origin are the opposite to those of origin 0A. This implies that increased usage of either productive factor by industry B results in decreased usage of the factor by industry A, and vice-versa. In order to understand the nature of the item B isoquant map, it may be helpful to rotate panel (a) of Figure 2-3 180 degrees so that origin 0B is in the lower left corner. When this is done it can be seen that the item B isoquants are relatively shallowly sloped, indicating that the B production technology is relatively labor intensive.
With panel (a) of Figure 2-3 oriented to its original position in the lower left of the box, the meandering path from origin 0A through points R, S, and T to origin 0B is found as the sequence of points at the tangencies of the A and B isoquants. This path is usually referred to as the "maximum efficiency locus" because points along it represent least-cost combinations of capital and labor for producing the two items. Points away from the maximum efficiency locus represent wasteful combinations of labor and capital relative to those along the path; for any point away from the path there is some point on the path that will yield a larger output of either or both items.
The path of the maximum efficiency locus meanders below a diagonal from 0A to 0B because item A is produced with a relatively capital-intensive technology while item B is produced with a relatively labor-intensive technology. Had the factor intensities of the technologies been reversed, the maximum efficiency locus would have followed a path above the diagonal. Had the factor intensities of the technologies been approximately the same, the maximum efficiency locus would have followed a path nearer the diagonal.
In order to determine how the available endowment of capital and labor will be allocated to industries A and B, it is necessary to derive a production possibilities curve (also known as a "production transformation frontier"), points along which are plotted from information contained in the output quantities at the tangencies of the A and B isoquants. The production possibilities curve illustrated in panel (b) of Figure 2-3 is associated with the maximum efficiency locus of the box diagram in panel (a). Points R', S', and T' in panel (b) correspond, respectively, to points R, S, and T in panel (a).
Once the production possibilities curve for items A and B has been derived, a so-called iso-welfare map may be superimposed upon it as illustrated in panel (b) of Figure 2-3. The iso-welfare map is an aggregative analog to a microeconomic iso-utility or indifference curve map. It is truly an heroic leap from the concept of an indifference curve map for a single consumer to that of an iso-welfare map for a whole society (or the portion of it that consumes items A and B), because in a strict sense utilities realized by different persons in the consumption of quantities of two items are neither comparable nor additive. Once the heroic leap is taken, the society is taken to think and act as a single aggregate entity.
The society may find its highest welfare combination of A and B by proceeding iteratively along its production possibilities curve (which also means proceeding along its maximum efficiency locus) while comparing its marginal rate of substitution (MRS) of A for B in consumption with its marginal rate of transformation (MRT) of A for B in production until they coincide. The microeconomic analog to this process may be found in the indifference curve analysis of consumer behavior.
Once point S' has been selected by the society along its production possibilities curve in panel (b) of Figure 2-3, point S may be selected by the two producing industries along the maximum efficiency locus in panel (a). Such a "selection" is accomplished by competitive market interaction among the firms in the industries; however, if significant monopoly or monopsony power is exercised by firms in either industry, some allocation of resources other than that represented by point S will result.
The symbols La and Ka represent "all" of the labor and capital, respectively, that are available to produce products A and B. The L1 quantity of labor and K1 quantity of capital constitute the most efficient combination of the two inputs for producing the A1 quantity by industry A. Correspondingly, the (La-L1) quantity of labor and the (Ka-K1) quantity of capital constitutes the most efficient combination of the two inputs for producing the B1 quantity by industry B. Any other allocation of labor and capital between industries A and B than that represented by point S will result in too much of one item and too little of the other along the maximum efficiency locus, or in a point away from the maximum efficiency locus which implies that resources are being inefficiently used.
Point S' in panel (b) of Figure 2-3 represents a generalization in consumption by the society in the sense that the society consumes quantities of both items. But it also represents a corresponding generalization of production in the sense that the society produces the same quantities of both items that it consumes.
In an autarchic world of closed frontiers and no trade, point S' in panel (b) of Figure 2-3 represents the best that the society, whose region we shall now refer to as Inland, can do. With combination A1 and B1 of the two items, Inland has achieved the highest level of welfare possible; and with allocation L1 and K1 to industry A and (1-L1) and (1-K1) to industry B, Inland's industries have achieved maximum efficiency in the production of the A1 and B1 quantities of their goods. These welfare and efficiency maxima may not actually be achieved due to imperfections of knowledge or the exercise of monopoly power in the product and resource markets. Assuming that the maxima are achieved, the question is whether Inland's society can do better by opening its frontiers to trade with other societies.
Outland is a prospective trading partner whose box diagram is illustrated in Figure 2-4. The dimensions of its box diagram indicate that Outland is relatively better endowed with capital than is Inland, but that Outland suffers relative to Inland's greater endowment of labor. Correspondingly, Outland's production possibilities curve "stretches" farther up its A axis while not as far out its B axis in comparison to Inland's production possibilities curve. This occurs because Outland's greater endowment of capital enables it to employ its relatively more capital-intensive technology to produce larger quantities of the A item and lower unit costs than can Inland. Outland's meager endowment of labor results in the production of lesser quantities of item B in spite of industry B's use of a labor-saving technology compared to that employed by industry B in Inland. It is also for this reason that industry B production costs tend to be higher in Outland than in Inland.
These quantity and cost considerations are then the bases for concluding that Inland has a comparative advantage in the production of item B while Outland has a comparative advantage in the production of item A. However, even if one of the regions, say Inland, had a cost or output advantage in the production of both goods relative to Outland, we could still designate Inland's and Outland's comparative advantages. Inland's comparative advantage lies with the industry possessing the greatest absolute advantage, while Outland's comparative advantage lies with its industry possessing the least absolute disadvantage.
Competitive market conditions in Inland result in a so-called domestic terms of trade ratio between the prices of items A and B that can be represented by the slope of a tangent drawn to both the production possibilities curve and iso-welfare line W3 at point S' in Figure 2-3. Although this tangent is not illustrated, its slope would be fairly shallow because large quantities of item B must be given up in the exchange for relatively small quantities of item A.
The domestic terms of trade ratio in Outland could be represented by a tangent to both its production possibilities curve and iso-welfare curve W12 in Figure 2-4. Its slope would be rather steep because large quantities of item A must be foregone in exchange for smaller quantities of item B. Because the domestic terms of trade differ between Inland and Outland, commercial interests will discover a potential for mutually beneficial (profitable) exchange between the two societies. Producers of B in Inland will find that they can get more units of item A in Outland than they can get at home from producers of item A. Producers of A in Outland will also discover that they can do better to sell some of their output to Inlanders. The question that must be answered is at what interregional terms of trade to exchange Outland product A for Inland product B.
Panel (a) in Figure 2-5 illustrates a box diagram similar in appearance to those of Figures 2-3 and 2-4, but with some significant differences. While those of Figures 2-3 and 2-4 were for analysis of the allocation of two resources in the production context, the box diagram in panel (a) is for the analysis of the distribution of two goods that are the objects of consumption in two regions.
At the lower-left corner of the box is the origin for Inland; that for Outland is in the upper-right corner. The vertical dimension of the box represents the total amount of item A (quantities A1 plus A11, measured from respective origins) available for distribution in the two regions prior to the opening of trade. The horizontal dimension represents the total amount of item B (quantities B1 plus B11, measured from respective origins) available for distribution prior to trade. The quantities available in the two regions are of also the quantities that they produce. The coordinates of point F represent the initial distribution of A and B between Inland and Outland.
The Inland society's iso-welfare map has been brought forward from panel (b) of Figure 2-3 to be situated in the box relative to Inland's origin in the lower left corner. The Outland society's iso-welfare map has been brought forward from panel (b) of Figure 2-4, rotated 180 degrees, and situated relative to Outland's origin in the upper-right of the box. The tangencies of Inland and Outland iso-welfare curves trace out the path from the Inland origin through points D, G, and E to the Outland origin. This path is referred to as a "contract curve" (not to be confused with the "maximum efficiency locus" in the production box diagram) because negotiation between the Inland and Outland societies can be expected to conclude with a contract for redistribution of A and B at some point along the path.
Points along the contract curve represent the highest levels of welfare that can be realized by distributions of the two goods between the two societies. Points away from the contract represent lower levels of welfare for either or both societies because for any such point away from the curve there are one or more points on the curve that result in more of either or both goods for one society or the other.
The object of the analysis is to discern the most likely interregional terms of trade ratio that might emerge for the two goods traded between the two societies. Ultimately this can be determined by examination of the two curved paths, FGJ and FGH. But the sense of these paths can better be seen in panels (b), (c), and (d) of Figure 2-5. Panel (b) contains a portion of the space from the box in panel (a), that to the "northwest" of point F. This graphic space has been extracted from the box, rotated clockwise 90 degrees, and expanded in scale for representation in panel (b).
The coordinates of point F in panel (a) represent the initial distribution of A and B between the two regions. Iso-welfare curves W4 (for Inland) and W12 (for Outland), which intersect at point F, bound a lens-shaped area within which exchanges of quantities of items A and B may be effected to increase the welfare or either or both societies. In panel (c) all iso-welfare curves outside the bounds of the lens-shaped area have been made invisible so that attention can be focused on the portion of the map within the lens-shaped area.
In the initial contact between members of Inland and Outland societies, someone can be expected to propose a possible terms-of-trade (t-o-t) ratio for interregional exchanges. Outlanders are initially enjoying iso-welfare level W12. In their domestic market, Outland producers of item A can exchange 1 unit of it for 1/10 of a unit of B (a domestic B:A t-o-t ratio of 1/10:1). Suppose that the Outlanders lead off with a t-o-t proposal to exchange one unit of Outland item A for two units of Inland item B (a B:A ratio of 2:1, illustrated in panel (c) as the slope of the ray from the F origin labeled P1). Because this happens to be the domestic t-o-t of B for A in Inland, there is no point in proposing a t-o-t of any more than 2 units of Inland B for each unit of Outland A. Given the domestic B:A t-o-t ratio in Inland, 2 units of B for 1 unit of A is the best that Outland could hope to do in interregional commerce with Inland. Assuming that Inlanders would export as much B as the Outlanders might want to import at 2B:1A, this ratio would allow Outlanders to achieve iso-welfare level W15, which is substantially higher than their W12 no-trade level.
Inland society initially is enjoying is iso-welfare level W4. Inland B producers will not think well of Outland's t-o-t proposal because they can already get 1/2 unit of A from the Inland A industry for each unit of their B (1/2:1 is the A:B reciprocal of the 1:2 ratio of B to A) without the bother of engaging in interregional transactions. Also, acceptance of this t-o-t ratio for interregional exchanges with Outland would lower the Inland iso-welfare level to W3 if they should be willing to export all of the B that the Outlanders might want to import at that ratio. Inlanders therefore propose a counter offer of 1 unit of their B for 10 units of the Outland A, which happens to be the Outland domestic t-o-t ratio (illustrated in panel (c) of Figure 2-5 as the slope of ray P2). An interregional t-o-t ratio of 10A:1B would allow Inland to achieve an iso-welfare level well above W6.
At an interregional t-o-t ratio of 10A:1B, Outlanders would gain nothing from trade with Inland, and would in fact suffer a decrease of welfare if they should export as much A as the Inlanders might wish to import. Outlanders might then counter the Inland-counter offer with a proposal to exchange 1 unit of Outland A for each unit of Inland B, i.e. an interregional t-o-t ratio of 1B:1A, illustrated as the slope of ray P3 in panel (c) of Figure 2-5. This would allow Outlanders to achieve an iso-welfare level above W14, and permit Inlanders an increase to iso-welfare level W4.5. Because ray P3 is tangent to W4.5 at point M, W4.5 is the highest iso-welfare level that can be reached by Inland at the 1B:1A t-o-t ratio.
Even though Inlanders would realized increased welfare at a 1B:1A t-o-t ratio, they will likely perceive the Outlanders to be gaining more in the exchange than they would gain. Inland B producers may therefore counter the counter to the counter offer with a proposal to exchange 1 unit of their B for 3 units of Outland A, an interregional t-o-t ratio of 1/3A:1B. This ratio would allow Inland to achieve an iso-welfare level above W5, and Outlanders could enjoy iso-welfare level W12.5. Because ray P4 is tangent to W12.5 at point N, W12.5 is the highest iso-welfare level that can be reached by Outland at the 1/3A:1B t-o-t ratio.
Negotiations can be expected to proceed in this fashion until the two parties can agree upon an interregional t-o-t ratio. The theory illustrated in Figure 2-5 predicts that with perfect market knowledge, the absence of deception, and no exercise of monopoly power, an interregional t-o-t ratio of about 3 B for 2 A (1B:2/3A or 1A:1.5B, illustrated in panel (c) of Figure 2-5 as the slope of ray P5, will emerge. However, if either side exercises monopoly power or deception, or if there is ignorance on either side of their own or their trading partner's production and welfare realities, some other interregional t-o-t ratio may emerge from the negotiations. As a general rule, each side attempts to achieve an interregional t-o-t ratio that is as different from its own domestic t-o-t ratio as possible.
Panel (d) of Figure 2-5 shows the final result of negotiations without the underlying iso-welfare maps or preliminary t-o-t ratio rays. Path FNGH is referred to as Inland's "interregional offer curve" (also known as a "reciprocal demand curve") because it represents the quantities of B that it would offer in response to various interregional t-o-t ratios proposed by Outlanders. Path FMGJ is Outland's interregional offer curve (or reciprocal demand curve) by similar reasoning. These paths can be seen in panels (a), (b), and (c) as well. They intersect at point G, through which passes ray P5 (or FG), the slope of which measures the resulting interregional t-o-t ratio in the absence of monopoly power, deception, and ignorance.
Agreement upon the interregional t-o-t ratio represented by the slope of ray P5 allows Inland to reach iso-welfare level W5, which is well above its pre-trade best of W4. Likewise, at the P5 t-o-t ratio, Outland can reach iso-welfare level W13, which is also well above its pre-trade best of W12. These conclusions can further be seen in Figure 2-6. In this analysis, the 2-B production possibilities curves from the two regions have been brought forward from panels (b) in Figures 2-3 and 2-4, and they are superimposed over one another in a common coordinate space. Also shown are the two pertinent iso-welfare curves from the respective iso-welfare maps. Terms of trade ratio P5 has been brought forward from panel (a) of Figure 2-5.
By the same token, once t-o-t negotiations are completed, Outland increases specialized production of its comparative advantaged product, item A, by moving along its production possibilities curve from point L' to point K', and then trades around its trade triangle from point K' to point U to point Z. At point Z it is consuming quantity A3 of item A and quantity B3 of item B, which coincidentally is the same combination that Inland consumes after trade commences. In so doing, Outland exports quantity (A12-A11) of item A in exchange for an import of (B3-B12) of item B from Inland. Outland thus achieves iso-welfare level W13, which is substantially higher than its pre-trade welfare level (W12).
It is purely a coincidence that both regions ended up trading to point Z in Figure 2-6. This was arranged by assumption and graphic design in order to simplify the illustration. In reality it is unlikely that both regions would end up consuming exactly the same combination of the two traded items (i.e., the destination corners of the respective trade triangles will differ).
If there are only two trading partners, the quantity of an item exported by one must coincide with the quantity of the item imported by the other, even if the destination corners of their trade triangles differ. In multilateral trading relationships, it is unlikely that quantities of an item imported and exported by two of the trading partners will match, but the total quantities of imports and exports in the world must surely be the same. Even though any pair of regions in a multilateral trading world may run positive or negative trade balances with each other on any single item, this does not change our conclusion with respect to the potential for gains from trade that was illustrated in a strictly bilateral example.
In the examples illustrated, the comparative advantages were based upon different endowments of the productive resources in the prospective trading partners. Two qualifications must be noted. First, even if two regions have identical resource endowments and share a common set of preferences (i.e., the same iso-welfare map), the use of technologies involving different factor intensities can serve as a basis for comparative advantage specialization and mutually beneficial trade. The reader is invited to imagine the shapes of the production boxes, isoquant maps, production possibilities curves, and iso-welfare maps that would illustrate this circumstance.
Second, even if two regions have identical resource endowments and employ the same technologies, different preferences represented by divergently shaped iso-welfare maps can constitute a basis for mutually beneficial exchange. In such a case, however, the trading partners would tend to generalize in production (in fact, produce the exact same combination of items), but specialize in consumption. One of the ironies of recent world trade data is that the bulk of trade tends to occur among regions that are very similar, a fact that may be explainable by the possibility noted above. Again, the reader is invited to imagine the shapes of the respective boxes, maps, and curves that would illustrate this circumstance.
Ignorance, deceptive negotiating practices, or the exercise of monopoly power by resource owners, producers, or consumers in any of the prospective trading partner regions can be expected to lead to distortions in the allocation of resources, inappropriate production specializations, production inefficiencies, diminished profitability, and sub-maximization of the society's welfare.
An enabling condition to the deduction of all of these conclusions has been assumption of aggregation which allowed us to speak of comparative advantages of countries and the actions of trading partners. In fact, countries at a macroeconomic level do not "trade with one another." Rather, people at the microeconomic level do. Most of these "people" turn out to be corporate persons whose managerial officers must recognize company-specific "competitive advantages." Competitive advantages are both enabled by their countries' possession of comparative advantages, and the means by which their countries' comparative advantages are discovered and exploited.
In Chapter 4 we made the case that specialization by comparative advantages together with free trade among regions can increase and ultimately maximize global welfare. This chapter examines the implications for welfare among trading partners if trade is encumbered by trade barriers. It is therefore necessary to shift our attention from interregional to international trade and assume the existence of governments that are both interested in and capable of imposing barriers to trade with other nations.
The analysis of the effects of the imposition of a tariff begins with a standard demand-supply graph as illustrated in Figure 3-1. In this depiction, Sd represents the domestic supply of a product if none of the product is available from foreign sources, or if the economy is closed to international trade.
The former might be the case in the early phase of a product life cycle while the product is still being produced and consumed only in the so-called "innovator nation." Dd is the domestic demand for the good. We will assume that when any disequilibrium situation occurs, market forces are present to bring the market to the next equilibrium situation, i.e., to the intersection of the demand and supply curves. The quantity Q1 is transacted in the market at the equilibrium price P1. All of the triangular area above the dashed P1 price line and below the demand curve is "consumer surplus" to the society. This is because at points along the demand curve above point A, consumers would have been willing to pay higher prices than P1 for quantities smaller than Q1, but in fact they have to pay only P1 for the entire quantity Q1.
If the economy has been closed to international commerce, opening it to trade will make foreign-made products available to domestic consumers. Or, a foreign-made supply of the product whose market conditions are represented in Figure 3-1 may become available in a second product life-cycle phase as production begins in so-called "imitator countries." Sw in Figure 3-2 depicts an initial small foreign (or "world") supply to a relatively large domestic economy.
This small world supply is fairly inelastic with respect to price. Assuming that no trade barriers are imposed, the total supply available for consumption domestically is represented by the supply curve Sd + Sw, which is located in coordinate space as the horizontal summation of Sd and Sw.
Consequent upon the opening of trade to import of the foreign supply of the good, the domestic market price of the good falls from P1 to a new equilibrium at P2. At the lower price P2, the amount of domestic production falls from Q1 to Q2. The total quantity transacted in the domestic market increases from Q1 to Q3. Domestic producers are unhappy at the opening of foreign trade for import of the product; their sales revenue falls from the area of the rectangle represented by corner points 0Q1AP1 to the area of the rectangle identified by corner points 0Q2BP2. But consumers are happy that they can now purchase the larger Q3 quantity of the good at the lower price P2. Their consumer surplus increases by the amount of the triangular area m.
Not everyone can be expected to be made happier by the opening of trade with prospective international trading partners that have comparative advantages in the production of goods also produced in the domestic market of each. As trading relationships become more open and freer, the specialization of production toward the nation's real comparative advantages can come only at the expense of investments and employments in industries for which the nation does not have comparative advantages relative to prospective trading partners. Jobs will be threatened and businesses in non-comparative advantage industries will suffer declining sales and profits attributable to the ensuing process of comparative advantage specialization. Those who feel threatened can be expected to appeal to their congressional or parliamentary representatives to provide protection for the domestic industry in the form of tariffs or non-tariff barriers to trade.
The effect of the imposition of a tariff by the government is to raise the price of the imported product to domestic consumers, which, if the domestic demand for the import is sufficiently elastic with respect to price, will reduce the volume of the import, thereby providing a modicum of protection to the domestic industry. Domestic producers are all too happy to be able to sell their product at the higher imported price. The increased price of the import has the effect of worsening the nation's terms of trade; since the foreign made product now costs more to domestic consumers, each unit of a domestically produced export can buy only a smaller quantity of the import. However, if the domestic demand for the import is sufficiently inelastic, the tariff may not succeed in decreasing the amount of the import.
Suppose that the government imposes a tariff represented by the vertical amount identified in Figure 3-3, causing the world supply to decrease to Sw + tariff by shifting the world supply curve vertically by the amount of the tariff.
The total supply of the product now reaching the domestic market decreases from Sd + Sw to Sd + Sw + tariff. While Sw + tariff lies above (vertically) Sw by the amount of the tariff, Sd + Sw + tariff lies to the left (horizontally) of Sd + Sw by the amount by which Sw + tariff lies to the left of Sd.
Once the tariff is imposed, the market price rises from P2 to P3. Domestic producers are all too happy to accept the higher price P3 although it is still not as high as the pre-trade price of P1. Domestic production increases from Q2 to Q4. At the higher market price, domestic consumption falls from Q3 to Q5, and domestic consumers of the product suffer a decrease of consumer surplus represented by the small triangular area below line segment FC. The quantity of the product imported decreases from (Q3 - Q2) to (Q5 - Q4). These effects are relatively small since the world supply Sw is fairly inelastic with respect to price, but the effects will become larger as Sw increases and becomes more elastic.
The effect of the worsening terms of trade consequent upon the imposition of a tariff is to diminish the potential for gains from trade for both partners. For example, if in Figure 2-6 of Chapter 2 Inland imposes a tariff on imports of item A from Outland, Inland's t-o-t ratio will be shallower of slope than that of P5. Inland will not specialize its production of B as far as point T', its trade triangle will become smaller than T'VZ, and it will not be able to achieve an iso-welfare level as high as W4. If Inland imports less because of its imposed tariff, it will also export less; its trading partners' trade triangles will therefore diminish in size and all will suffer lower levels of welfare than possible under conditions of free trade. It is even possible that the tariff imposed will be so high as to choke off all international trade in the item, thereby limiting the welfare levels of the trading partners to those of the pre-trade situation.
In the third phase of the product life cycle, as the production process matures and settles into mass production mode, foreign producers will be able to ramp up production. This will enable the world supply of the product, Sw, to increase (shift to the right) and become more elastic with respect to price. The limiting position of the rightward shift and increasing elasticity is illustrated in Figure 3-4 as the perfectly elastic (horizontal) supply curve, Sw, which establishes a market price of P12.
At this market price, domestic output would be Q12, quantity imported would be (Q13 - Q12), and total consumption of the good would be Q13. The opening of trade reduces producer revenue from the area of the rectangle identified by corner points 0Q11AP11 to the area of the rectangle 0Q12BP12, but it enables consumers to enjoy additional consumer surplus in the amount of the sum of areas t, u, and v.
Domestic producers can be expected to appeal for protection. Domestic consumers should oppose any such protection measures on grounds that they will pay a higher price for the product, less of it will be available in the market, and their consumer surplus will shrink. Unfortunately, consumers typically are less well organized than producers who lobby for protection. In the Figure 3-4 illustration, the government could impose a tariff of any magnitude ranging from nearly zero to the full amount of the difference between P11 and P12. A tariff equal to this full difference would be sufficient to choke off all imports of the product. If the same tariff as illustrated in Figure 3-3 is imposed on the horizontal world supply curve in Figure 3-4, the tariffed supply curve will lie in position Sw + tariff, causing market price to rise to P13.
At the higher price P13 after imposition of the tariff, domestic output of the product will increase from Q12 to Q14. Domestic consumption of the product will fall from Q13 to Q15 as imports shrink to (Q15 - Q14). Consumer surplus falls by the amount of t + u. The government captures tariff revenue represented by the area (s + t). Consumer surplus diminishes by the amount of the area (t + v). Domestic producer revenue increases from the area represented by the corner points of the rectangle 0Q12BP12 to rectangle 0Q14EP13. Unfortunately, the area u is lost consumer surplus; it is a so-called "deadweight loss" to society since it is not captured by domestic producers, domestic consumers, or the government in the form of tariff revenue.
While domestic producers can be expected to push for a maximum tariff, (P11 - P12), and domestic consumers will hope for a zero tariff, the government has to decide whether the tariff should serve domestic producers, domestic consumers, or its own revenue needs. The government will realize no revenue at either extreme. If the government's goal is to maximize tariff revenue, it should specify a tariff between the extremes that will maximize the area (s + t) in Figure 3-4.
A tariff enables market determination of market price, domestic output, and the amount of imports as illustrated in Figures 3-3 and 3-4. Producers may push for the imposition of a quota in lieu of a tariff. A quota imposes an absolute limit on the amount of product that may be imported, although the market still works to determine the market price. Producers can be expected to push for a zero quota while consumers might hope for a maximum quota of (Q13 - Q12) in Figure 3-4. Suppose that in Figure 3-5 the government opts for a quota that yields results equivalent to the effects of the tariff imposed in Figure 3-4.
The market supply curve in Figure 3-5 is now Sd + quota, and all of the production, consumption, revenue, and deadweight loss effects noted in Figure 3-4 can be seen in Figure 3-5. This illustrates the principle that for any tariff that can be imposed, a quota can be determined that has effects that are equivalent to the tariff.
A quota is one type of "non-tariff barrier" (NTB) to trade. Other forms of NTB include performance, national origin, packaging, safety, and health requirements. If any NTB is imposed upon imports from a trading partner, the dimensions of the trade triangles in Figure 2-6 of Chapter 2 will be decreased. The result is that lower levels of welfare than those at point Z will be attained by both trading partners.
A subsidy is another form of NTB. A subsidy is a benefit, usually in financial form, that is provided by the government of a region to local producers of a good or service. The intent of a subsidy is to offset a foreign comparative advantage by defraying some of the costs of production of the product incurred by local producers. In a sense, a subsidy is the conceptual opposite of a tariff except that instead of shifting the foreign supply curve upward by the amount of the tariff, the subsidy shifts the domestic supply curve downward by the amount of the subsidy. The reader is invited to imagine revisions of Figures 3-3 and 3-4 to illustrate the trade effects of a subsidy.
The advocacy of trade barriers constitutes one of those conundrums in which what might be good for domestic producers turns out to be bad for both the economy of the region and the global economy. The obvious managerial conclusion is that every business firm engaged in international commercial activity should seek any and all forms of protection by its government from foreign competition. But such petitions inevitably will impair world welfare.
Domestic producers' pleas to their government to "level the playing field" with foreign competitors is a de facto admission that the domestic producers lack competitive advantages relative to foreign competitors, and that the region may lack comparative advantage in the production of the product relative to other regions. Rather than acquiesce in pleas by domestic firms for protection, governments should encourage efforts by domestic firms to discover local competitive advantages or to engage in research to develop (R&D) competitive advantages that can be implemented by capital investments. In so doing, domestic producers may be able to acquire competitive advantages that confer comparative advantages upon their regions.
Trade liberalization involves decreasing or eliminating tariffs and non-tariff barriers to trade. Trade liberalization may be expected to open potentials for mutually beneficial trading relationships that yield welfare gains to the trading partners if they can discover their true comparative advantages and successfully specialize according to them. This is the principle that underlay the drive for the passage and ratification of the North American Free Trade Agreement (NAFTA), the elimination of trade barriers within the European Union, and the multilateral reductions of tariffs and elimination of non-tariff barriers to trade under the auspices of the General Agreement on Tariffs and Trade (GATT) and its successor, the World Trade Organization (WTO).
The persistence of protectionism throughout the world, though serving the narrow interests of domestic producers in each region, can only impair global welfare by leading to inappropriate international specializations, autarchistic generalization in production, and distortions in the allocation of the world's resources.
Earlier chapters have explored the so-called "real" aspects of international commerce. With this chapter we begin an examination of the financial dimensions of international commercial activity. In a barter-economy world, real things (goods and services) would be exchanged for other real things as implied in Chapter 2. However, in a money-using world where regions and nations may use different currencies, most international transactions involving real things elicit a counterflow of value denominated in the currency units of one or the other of the trading partners. This chapter considers the financial flows that offset the real flows involved in international trade and investment transactions. It also entertains the possibility of transactions that involve exchanging one type of financial instrument for another.
"External Balance" refers to a nation's trade, investment, and official reserves transactions with the rest of the world. A nation with an absolutely closed economy, i.e., one that is perfectly isolated from the rest of the world, would have no external transactions to balance. The external balance for an open economy that enjoys substantial private sector trade and investment discretion is indicated by its Balance of Payments.
Balance of Payments (BoP) accounting, strictly speaking, is not part of the process of accounting for National Income and Product, but BoP accounting information feeds into the NIPA process of compiling GDP. Table 7-1 has been designed to illustrate the structure of the BoP accounts. Table 7-1, showing information for years 2003 through 2008, was downloaded from the Bureau of Economic Analysis website (http://www.bea.gov/international/), but the information has been reorganized and reformatted to exhibit a structure that is more easily interpreted.
Table 7-1.
U. S. International Transactions, by Type of Transaction: 2003 to 2009 [In millions of dollars
(1,340,353 represents $1,340,353,000,000). Minus sign (-) indicates debits.]
CURRENT ACCOUNT 2003 2004 2005 2006 2007 2008 2009
A. Exports of goods and services
and income receipts..............1,340,353 1,572,315 1,816,449 2,135,004 2,478,267 2,635,540 2,159,000
1. Exports of goods and services......1,019,897 1,158,576 1,281,186 1,452,783 1,648,665 1,839,012 1,570,797
Goods, balance of payments basis. 728,258 819,870 909,016 1,035,868 1,160,366 1,304,896 1,068,499
Services ........................ 291,639 338,707 372,171 416,916 488,299 534,116 502,298
2. Income receipts ................... 320,456 413,739 535,263 682,221 829,602 796,528 588,203
Income receipts on U. S.-owned
assets abroad ................. 317,643 413,379 532,373 679,338 826,632 793,484 585,256
Direct investment receipts ...... 186,417 250,606 294,538 324,816 370,712 403,225 346,073
Other private receipts .......... 126,529 157,313 235,120 352,122 453,687 385,353 234,458
U. S. Government receipts ....... 4,697 2,998 2,715 2,400 2,233 4,906 4,724
Compensation of employees ....... 2,813 2,822 2,890 2,883 2,971 3,044 2,977
B. Imports of goods and services
and income payments.............-1,789,227 -2,114,441 -2,458,268 -2,846,159 -3,080,813 -3,182,368 -2,412,489
1. Imports of goods and services.....-1,514,080 -1,767,921 -1,995,362 -2,212,023 -2,350,763 -2,537,814 -1,945,705
Goods, balance of payments basis-1,269,802 -1,485,501 -1,692,817 -1,875,324 -1,983,558 -2,139,548 -1,575,443
Services......................... -244,278 -282,420 -302,546 -336,700 -367,206 -398,266 -370,262
2. Income payments ................... -275,147 -346,519 -462,905 -634,136 -730,049 -644,554 -466,783
Income payments on foreign-owned
assets in the U. S............. -266,635 -337,556 -453,615 -624,646 -719,983 -634,190 -456,027
Direct investment payments ...... -73,750 -99,754 -121,333 -150,770 -129,134 -115,538 -94,010
Other private payments .......... -119,051 -155,266 -228,408 -338,897 -426,501 -352,053 -218,020
U. S. Government payments ....... -73,834 -82,536 -103,874 -134,979 -164,348 -166,599 -143,997
Compensation of employees ....... -8,512 -8,963 -9,290 -9,490 -10,066 -10,364 -10,757
C. Unilateral current transfers, net ..... -71,794 -88,362 -105,772 -91,481 -115,548 -122,026 -124,943
U. S. Government grants.............. -22,173 -23,823 -33,647 -27,733 -34,437 -36,003 -41,638
U. S. Government pensions
and other transfers ............... -5,341 -6,264 -6,303 -6,508 -7,323 -8,390 -8,874
Private remittances and other
transfers ......................... -44,280 -58,275 -65,822 -57,240 -73,788 -77,633 -74,431
D. Balance on current account (A + B + C). -520,668 -630,488 -747,590 -802,636 -718,094 -668,854 -378,432
1. Balance on goods................... -541,544 -665,631 -783,801 -839,456 -823,192 -834,652 -506,944
2. Balance on services................ 47,361 56,286 69,625 80,216 121,093 135,850 132,036
3. Balance on trade................... -494,183 -609,345 -714,176 -759,240 -702,099 -698,802 -374,908
4. Balance on income.................. 45,309 67,219 72,358 48,085 99,553 151,974 121,419
CAPITAL ACCOUNT 2003 2004 2005 2006 2007 2008 2009
E. Foreign assets in the U. S., excluding
Financial derivatives,
(increase/financial inflow (+)) ..... 858,303 1,533,201 1,247,347 2,065,169 2,107,655 454,722 305,736
1. Foreign official assets in the U. S. 278,069 397,755 259,268 487,939 481,043 550,770 450,030
U. S. Government securities ..... 224,874 314,941 213,334 428,401 269,897 591,381 441,056
U. S. Treasury securities ..... 184,931 273,279 112,841 208,564 98,432 548,653 561,125
Other ......................... 39,943 41,662 100,493 219,837 171,465 42,728 -120,069
Other U. S. Government liabilities -723 -134 -421 2,816 5,436 8,912 57,971
U. S. liabilities reported by
U. S. banks, n. i. e. 1 ....... 48,643 69,245 26,260 22,365 109,019 -153,423 -70,851
Other foreign official assets ... 5,275 13,703 20,095 34,357 96,691 103,900 21,854
2. Other foreign assets in the U. S... 580,234 1,135,446 988,079 1,577,230 1,626,612 -96,048 -144,294
Direct investments in U. S. ..... 63,750 145,966 112,638 243,151 271,210 328,334 134,707
U. S. Treasury securities ....... 91,455 93,608 132,300 -58,229 66,845 161,411 22,781
U. S. securities other than
U. S. Treasury securities ..... 220,705 381,493 450,386 683,245 605,414 -166,490 59
U. S. currency flows............. 10,591 13,301 8,447 2,227 -10,675 29,187 12,632
U. S. liabilities to unaffiliated
foreigners reported by U. S.
nonbanking concerns ........... 96,526 165,872 69,572 244,793 182,355 -36,522 -1,460
U. S. liabilities reported by
U. S. banks, n. i. e. 1 ....... 97,207 335,206 214,736 462,043 511,463 -411,968 -313,013
F. U. S. assets abroad, excluding financial
derivatives
(increase/financial outflow (-))... -325,424 -1,000,870 -546,631 -1,285,729 -1,475,719 156,077 -140,465
1. U. S. private assets, net.......... -327,484 -1,005,385 -566,266 -1,293,449 -1,453,324 690,540 -629,552
Direct investments abroad ....... -149,564 -316,223 -36,235 -244,922 -413,993 -351,141 -268,680
Foreign securities............... -146,722 -170,549 -251,199 -365,129 -366,512 197,897 -208,213
U. S. claims on unaffiliated
foreigners reported by U. S.
nonbanking concerns............ -18,184 -152,566 -71,207 -181,299 -23,089 421,153 124,428
U. S. claims reported by U. S.
Banks and securities brokers... -13,014 -366,047 -207,625 -503,099 -649,730 422,631 -277,087
2. U. S. Govt. assets, other than
official reserve assets, net... 537 1,710 5,539 5,346 -22,273 -529,615 541,342
U. S. credits and other long-term
assets ........................ -7,279 -3,044 -2,255 -2,992 -2,475 -2,202 -4,069
Repayments on U. S. credits and
other long- term assets ....... 7,981 4,716 5,603 8,329 4,104 2,202 2,133
U. S. foreign currency holdings and
U. S. short- term assets, net -165 38 2,191 9 -23,902 -529,766 543,278
G. Financial derivatives, net............. 29,710 6,222 -32,947 50,804
H. Balance on Capital Account (E + F + G). 532,879 532,331 700,716 809,150 638,158 577,852 216,075
OFFICIAL RESERVES TRANSACTIONS: 2003 2004 2005 2006 2007 2008 2009
I. U. S. official reserve assets, net...... 1,523 2,805 14,096 2,374 -122 -4,848 -52,256
Gold.................................. 0 0 0 0 0 0 0
Special drawing rights ............... 601 -398 4,511 -223 -154 -106 -48,230
Reserve position in the
International Monetary Fund......... 1,494 3,826 10,200 3,331 1,021 -3,473 -3,357
Foreign currencies ................... -572 -623 -615 -734 -989 -1,269 -669
DISCREPANCY 2003 2004 2005 2006 2007 2008 2009
J. Discrepancy (D + H + I, with sign
reversed) ........................... -13,734 95,352 32,778 -8,888 80,058 95,850 21,613
1 Not included elsewhere.
Transactions are possible, but all data are not available.
Source: U. S. Bureau of Economic Analysis, http://www.bea.gov/international/.
A nation's Balance of Payments statement must always balance, in principle by the requisites of double-entry bookkeeping when there are no errors or omissions, but in practice by inclusion of a Discrepancies line in the amount by which the Current Account total is not fully offset by the sum of the Capital Account and Official Reserves Transactions totals. Since the Balance of Payments always balances, an imbalance in the nation's external payments can be detected only by examining some parts of the statement in comparison to other parts of it. By convention, this has been accomplished by figuratively (if not literally) drawing a line across the Balance of Payments statement at a selected place, and then comparing totals "above the line" and "below the line."
For purpose of conceptual analysis, a nation's BoP presentation requires only three sections, a Current Account section, a Capital Account section, and an Official Reserves section. Table 7-1 exhibits a fourth section, Discrepancy.
Early in the twenty-first century, the line is most commonly drawn below the Balance on Current Account (line D in Table 7-1). Abstracting from the Discrepancy line (i.e., assuming that the Discrepancy line total is zero), the Current Account is in surplus or in deficit depending upon whether the sum of the nation's imports, gifts by citizens to foreigners, and incomes earned by foreigners in the nation (all of which involve fund outflows) is greater or lesser than the sum of the nation's exports, gifts by foreigners to citizens, and incomes earned by citizens overseas (all of which involve fund inflows). True balance of a nation's Current Account occurs only when these two sums are equal and the Discrepancy line amount is zero.
It is the Balance on Trade (line D3) in the Current Account that becomes part of the GDP compilation each year as exports less imports, (X - M). The positive signs and increasing values of the entries for Balance on Services (line D2) through 2009 indicate that services trade has been increasingly favorable for the U.S. since services exports have been increasing faster than have services imports. However, the negative signs and the increasing values of the entries for Balance on Goods through 2009 mean that the trade deficit on tangible goods worsened as goods imports have increased at a faster rate than have goods exports. The trade deficit began to decrease in 2009. The favorable growth of trade in services has been swamped by the worsening deficit on trade in goods. The negative signs and increasing values of all of the line D3 entries in Table 7-1 mean that the overall trade balance has been in continuing deficit, and the trade deficits increased until 2006 and decreased thereafter. The negative (X - M) values have the effect of depressing GDP from what it would have been had the economy been closed to trade or had the economy enjoyed a trade balance or surplus.
In principle, for a nation that allows its exchange rates to freely flex or float in response to changing market forces, the BoP presentation needs only two sections, Current Account and Capital Account. In the long run and in equilibrium, the totals for these two sections should perfectly offset each other because exchange rates should adjust to stimulate trade and capital flows to offset market induced changes. If in long-run equilibrium the Current Account balance has a positive sign, the Capital Account balance would be of equal magnitude but have a negative sign, and vice versa. In the short run, discrepancies (adjustment rather than statistical) might occur between the magnitudes of the two section balances until exchange rate changes bring the magnitudes of the two sections into equivalence (though with opposite signs).
The BoP presentation might have a third section, Official Reserves Transactions, even if the nation allows its exchange rates perfect flexibility. But the balance totals would be zeros since no government agency would be using the official reserves to manipulate or fix the exchange rates. Since the demise of the Bretton Woods international exchange system in 1971, the global economy nominally has been on a flexible or floating exchange rate system, although it has never been a so-called "clean-float" system because governments, singly or in concert with other nations (like the G7 or G10 ad hoc groupings of nations), occasionally have attempted to manipulate exchange rates or prevent further changes of them. That the Official Reserves Transactions totals (Line I) in Table 7-1 are not zeros betrays the fact that the federal government of the United States has engaged in occasional efforts to cause exchange rates between the dollar and other currencies to change in desired directions, or to prevent further undesirable changes.
In Table 7-1, the Current Account balances (line D) and Capital Account balances (line E) do have opposite signs, but do not precisely offset each other in magnitude. This implies either that exchange rates do not change (or not fast enough) to balance the Current and Capital accounts totals, or that the government is using its Official Reserves (line I) to manipulate or fix some exchange rates. The non-zero Official Reserves Transactions totals imply the existence of government activity to exert some control over exchange rates, but they can account for only part of the discrepancy between the Current and Capital account balance totals.
The non-zero "Discrepancy" balances (line J) in Table 7-1 are attributable to at least three causes. One is of course the possibility that they represent only short-term disequilibria in the interim between when some market phenomena occur and exchange rates have changed by enough to bring the Current and Capital Account balance totals into opposite-sign equivalence. A second possible cause is that governmental efforts to manipulate or fix exchange rates prevent exchange rates from accomplishing equilibration.
A third possible explanation lies in the imperfections in the procedures by which BoP data are collected and aggregated. Nominally, BoP accounting is accomplished by double-entry bookkeeping procedures that ensure that debit entries are always fully offset by credit entries. This should also ensure that the nation's Balance of Payments actually balances, i.e., that the sum of its Current Account, Capital Account, and Official Reserves Transactions totals net out to zero. While double-entry bookkeeping is a reliable process at the microeconomic level of the firms engaged in international transactions, data for BoP totals are aggregated from tax reports that are, in effect, single-entry sources. Since there are literally tens of thousands of such single-entry sources of BoP information that have to be aggregated into the totals, it is very likely that some information is missed and other information is double counted.
Unfortunately, it is not possible to distinguish the portions of the Discrepancy totals that are attributable to information reporting, collection, and aggregation problems from those that are attributable to interim disequilibria or to governmental efforts to manipulate or fix exchange rates.
Several aggregates listed in Table 7-1 are notable for their relative stability. Although the U.S. Trade Balance has been in continuous deficit during the years shown (line D3), both imports and exports have been growing steadily. Since imports have been growing at a faster rate than have exports, the trade deficits also have been growing and at a relatively steady pace. In the U.S. Capital Account, both direct investment by Americans abroad and direct investment by foreigners in the U.S. have been growing steadily, with the latter outpacing the former. As the so-called "Great Recession" ensued after 2008, both exports and imports fell. Imports decreased more than exports in 2009 compared to 2008 so that the 2009 trade deficit diminished relative to that in 2008.
As can be seen in line I of Table 7-1, the discrepancies between U.S. Capital Account, Current Account, and Official Reserves Transactions totals exhibit a great deal more year-to-year variability than can be accounted for in the Current Account alone. Discrepancy totals often are small, but occasionally become quite large. The principal source of this variability appears to lie in the Capital Account, particularly in both private and official holdings of U.S. Treasury securities by foreign interests, and in American holdings of foreign securities. This fact suggests that short-term capital flow volatility may be a more significant source of payments instability than inflation rates and employment levels in trading partner economies. Short term capital flow volatility may be associated with central bank activity in regard to interest rate changes.
An exchange rate is the price of one currency expressed in terms of another currency. During part of the twentieth century, the exchange rates of many countries' currencies were relatively stable during some periods, but more volatile during other periods. What causes exchange rates to change, and how do changing exchange rates affect macroeconomies?
Under a fixed exchange regime, exchange rates are determined by government fiat. Exchange values are fixed or stabilized either by intervention of a government agency in exchange markets, or by exercise of the police power of the state to dictate official rates and punish transactions at rates other than the official rates. Under a flexible exchange regime, exchange rates are determined in foreign exchange ("forex") markets by interaction of suppliers and demanders. Exchange rates vary in response to changes of demand for and supply of foreign exchange (i.e., shifts of demand and supply curves). We shall first examine the macroeconomic implications of market determination of exchange rates. Later in the chapter we shall return to the implications of governmental determination of exchange rates.
Although any exchange rate can be expressed as either the foreign currency price of the domestic currency (e.g., the euro price of a dollar, e/$) or its reciprocal, the domestic currency price of the foreign currency (e.g., the dollar price of a euro, $/e), the former should be used in order to make sense of appreciation and depreciation of the domestic currency. Figure 13-1 is a hypothetical illustration of the foreign exchange (forex) market for dollars priced in euros at e0.85 per dollar ($1.17 per euro) at the inception of the euro in January, 1999. In following discussion, the subscript U refers to the U.S. and the subscript E refers to Europe.
In Figure 13-1, the demand for the domestic currency on the forex market varies inversely with price, e/$, as its principal determinant. The demand for the domestic currency derives from two sources, citizens of the nation and foreigners. Citizens of the nation may demand their own currency on the forex market if they have acquired foreign currencies in trade, as earnings on investments, or as gifts. The foreign demand for the domestic currency is equivalent to the foreign supply of the foreign currency. Foreigners may supply their own currencies to purchase the nation's domestic currency on the forex market in order to make gifts to citizens of the nation, import goods and services from the nation, or invest in the nation.
The principal non-price determinants of the total demand (domestic and foreign) for the domestic currency on the forex market are foreign incomes, YE, foreign preferences, prefE, relative rates of inflation, PE/PU, comparative interest rates, (iU - iE), and domestic trade barriers, TariffsU, and non-tariff barriers, NTBU. This may be expressed in functional format as
(1) D$ = f ( e/$ | YE, prefE, PE/PU, (iU - iE), TariffsU, NTBU),
where e/$ is the euro price of a dollar. All of the non-price determinants of demand are assumed constant (ceteris paribus) in order to specify the locus of the demand curve illustrated in Figure 13-1. A change of any of the non-price determinants of demand shifts the demand curve. The demand for dollars on the forex market might increase from D1 to D2 in Figure 13-2 if European incomes rise, European preferences for American goods improve, European price levels rise relative to the U.S. price level, or U.S. interest rates rise relative to European interest rates. The forex demand for dollars might also increase if U.S. trade barriers were to decrease.
Assuming that the supply of dollars does not change, the increased demand for dollars on the forex market induces the price of the dollar to rise. This means that the dollar appreciates relative to the value of the euro, or the euro depreciates relative to the value of the dollar. A change in any of the non-price determinants of demand in the opposite directions to those specified above would decrease the forex demand for dollars. Again, assuming that the supply of dollars does not change, the demand decrease would induce the euro price of the dollar to fall. This means that the dollar depreciates relative to the euro, or the euro appreciates relative to the dollar.
The assumption that the supply of dollars does not change is unnecessarily stringent. The same conclusion obtains in each case if the supply of dollars changes in the same direction as the demand for dollars, but by a smaller amount, or if the supply of dollars changes in the opposite direction to the change in the demand for dollars.
In Figure 13-1, the supply of the domestic currency on the forex market varies directly with price, e/$, as its principal determinant. The principal non-price determinants of the domestic supply of the domestic currency to the forex market (i.e., the domestic demand for the foreign currency) are domestic incomes, YU, domestic preferences, prefU, relative rates of inflation, PU/PE, comparative interest rates, (iE - iU), and foreign trade barriers, TariffsE, and non-tariff barriers, NTBE. This may be expressed in functional format as
(1) S$ = g ( e/$ | YU, prefU, PU/PE, (iE - iU), TariffsE, NTBE,
A change of any of the non-price determinants of supply would shift the supply curve. The supply of dollars to the forex market might increase, i.e., shift to the right, if U.S. incomes increase, U.S. preferences for European goods improve, the U.S. price level rises relative to European price levels, or European interest rates rise relative to U.S. interest rates. Decreases of European trade barriers also might increase the supply of dollars to the forex market. If any of these non-price determinants of supply should change in the opposite direction to those specified above, the supply of dollars to the forex market would decrease. The supply shift in Figure 13-3 illustrates dollar depreciation from e1.20 toward e1.00 per dollar (i.e., from $0.83 per euro toward $1.00 per euro).
It is important to note that the demand for exchange on the forex market is not coincident with the demand for money. Nor is the supply of exchange on the forex market coincident with a nation's supply of money. Only a part of the global quantity of the money supply denominated in units of a nation's currency will be offered on the global forex market at any one point in time, and only a portion of the money supply denominated in units of the nation's currency will be demanded for international transactions purposes. However, during any particular forex trading period (such as a trading day), the total volume of transactions denominated in units of a particular national currency may exceed the nominal amount of the of the nation's money supply by virtue of the fact that the same quantities may be traded many times over during the trading period.
While the demand for and supply of a nation's money are not coincident, respectively, with the demand for and supply of the domestic currency on the global forex market, they are linked by what eighteenth century economist David Hume called the price-specie flow mechanism. Hume was concerned with inflows and outfows of gold and silver (specie) from a nation. Modern money supplies are more diverse, consisting not only of coin and paper currencies but also of balances on deposit at financial institutions. These balances, though physically resident as liability accounting entries "on the books" of financial institutions within the nation, may be owned by foreigners as well as by citizens of the nation.
This section describes the process of adjustment to a Current Account deficit (i.e., a Capital Account surplus). An emerging or growing Current Account deficit is likely to increase the supply of domestic money to the forex market (i.e., increase the demand for the foreign currency). Assuming that the demand for domestic money has not changed, the resulting excess supply likely will induce depreciation of the domestic currency on the forex market. The depreciation of the domestic currency makes the nation's exportables look cheaper to foreigners and imports from abroad appear more expensive to citizens, thereby alleviating the Current Account deficit.
Following is an illustration with graphic models of a scenario which, starting from an initial equilibrium, eventually result in a balance of payments deficit.
Panel (a) of Figure 13-4 illustrates a scenario in which the initiating change occurs in the private sector rather than by macropolicy. Starting from a situation of equilibrium in all markets, assume that the demand for money to hold decreases as illustrated in panel (a) by the leftward shift of the money demand schedule from MD to MD'. The horizontal bracket indicates an excess supply of money in the sense that at interest rate i1 there is more money in circulation than people wish to hold.
A similar scenario, but one for which the initiating factor occurs as a matter of macropolicy, is illustrated in panel (aa) of Figure 13-5. Here the central bank, in an effort to implement an expansionary (or “loose”) monetary policy, increases the money supply from MS to MS’ by conducting open market purchases of treasury bonds. As in panel (a), the horizontal bracket in panel (aa) represents an excess supply of money at interest rate i1.
Panel (b) in Figure 13-4 illustrates the Keynesian conclusion that people can rid themselves of their excess money balances by buying “bonds” (a Keynesian euphemism for all kinds of financial instruments) to hold in their portfolios of assets. This is illustrated in panel (b) as the rightward shift of the bond demand curve from DB to DB’. Other things remaining the same, bond prices will rise above PB, causing bond yields to fall below i1 in panel (a) or in panel (aa).
Monetarists suggest that the bond market is not the only place where people can rid themselves of excess money balances. They may do so by increasing their consumption spending relative to the flow of their incomes so as to decrease their saving. Panel (c) illustrates that when people increase their consumption spending the aggregate demand curve shifts right (increases) from AD to AD’. Other things remaining the same for aggregate supply, AS, the increased spending will induce output (and income) to rise above Y1, and the price level to rise above P1 as illustrated in panel (c).
In a closed economy, the adjustment to an excess supply of money will be played out completely in the bond and real markets. When the economy is open to international transactions, both current account (goods and services) and capital account (short term instruments like bank account balances and currencies as well as portfolio investments and direct investments) responses may result as well. Panel (d) illustrates that when there is an excess supply of money as illustrated in panel (a) or in panel (aa), the supply of dollars to the foreign exchange market may increase from S$ to S$’. This shift results in an excess supply of dollars on the foreign exchange market at exchange rate e1. This excess supply may be interpreted as a Balance of Payments (BoP) deficit because the supply of dollars to buy “things” (merchandise, services, dollar-denominated bank balances, treasury bonds, stock shares, plant and equipment, etc.) from foreign sources exceeds the demand for dollars to purchase “things” domestically. The same result might have been illustrated in panel (d) as a decrease (leftward shift) of the D$ schedule as people attempt to exchange less of the foreign currencies (i.e., to acquire fewer dollars) in the effort to eliminate the excess supply of money.
If exchange rate flexibility is permitted, a BoP deficit causes the foreign currency ("euro" as illustrated) price of the local currency ("dollar" as illustrated) to fall, i.e., the dollar depreciates (or the euro appreciates). The adjustment process plays out in the form of rising domestic output and price level (panel (c)), increasing bond prices (panel (b)), and falling interest rates (panel (a) or panel (aa)). The domestic adjustment process occurs just as it would in a closed economy. In a cleanly floating exchange rate system, there are no international flows of reserves or changes of the domestic money supply.
But suppose that the government resolves to prevent depreciation of its currency on the forex market. One way in which to do this is to specify an official exchange rate at euro1, and then to employ the police power of the state to punish transactions at any exchange rate other than euro1. Under this type of fixed exchange regime, a BoP deficit will persist. Imports (M) of “things” (any type, current or capital account) exceed exports (X) of “things” with the result that the (X - M) deficit has to be paid for by an outflow of money. In David Hume’s 19th century discussion of the price-specie flow mechanism, gold would flow out in payment for the imports. In the 21st century, this outflow of money takes the form of foreigners acquiring ownership of domestic currrency denominated bank account balances. The money outflow thus decreases the account balances of local citizens and the reserves of their commercial banks. This outflow of money and reserves has the effect of shifting the money supply curve to the left of MS in panel (a), or to the left of MS’ toward MS in panel (aa). This diminishes the excess supply of money in panel (a) or in panel (aa) and prevents the interest rate from falling below i1. If the outflow of money and reserves is sufficient to eliminate the excess supply of money, bond prices won’t rise (panel (b)), interest rates won’t fall (panel (a) or panel(aa)), output won’t increase (panel (c)), and the price level won’t rise (panel (c)). This implies that in the case of a fixed exchange rate regime (like the 19th century gold standard or the 20th century Bretton Woods regime) the BoP deficit will persist and there is no effective mechanism to relieve international disequilibria.
An alternative implementation of a fixed exchange rate regime is that a designated government agency (central bank or treasury department) enters the open market for foreign exchange when the exchange rate departs too far from the official rate (i.e., above or below specified boundaries on either side of the official rate). The exchange control authority purchases or sells foreign exchange by selling or purchasing the domestic currency. In the foreign exchange market illustrated in panel (d) the excess supply of dollars can be eliminated by a central bank purchase of dollars by selling euros. This amounts to an open market sale in the foreign exchange market, the side effect of which is to destroy money and bank reserves. This has the effect of shifting the MS schedule in panel (a) to the left to eliminate the excess supply of money caused by the leftward shift of MD. The effect in panel (aa) is to shift the money supply schedule leftward from MS’ toward its original locus at MS. If the central bank keeps the local currency from depreciating by selling foreign currency, no domestic changes will occur to domestic bond prices, interest rates, the output level, or the price level. The BoP deficit persists and there is no effective mechanism to alleviate international disequilibria. Since domestic monetary policy has been dedicated to fixing the exchange rate, the central bank cannot use it to address domestic macroeconomic issues such as inflation or unemployment.
Although there is no technical limit to the ability of a central bank to supply its own currency in an effort to relieve a BoP surplus and prevent appreciation of its own currency, the opposite possibility is severely limited. Suppose that a BoP deficit emerges for non-monetary reasons and the prospect is for the currency to depreciate. The central bank can prevent depreciation only as long as it is able to supply the foreign currency to the foreign exchange market in buying back its own currency (thereby reducing the domestic money supply and the reserves of domestic commercial banks). Once the central bank stocks out of the foreign currency, it can no longer prevent depreciation of its currency. Depreciation ensues until the BoP deficit is alleviated. Experience during the post-Bretton Woods era (since 1972) suggests that central banks, singly or in coordination with other central banks, rarely have the will or enough foreign exchange reserves to fully alleviate BoP deficits.
A nominally flexible exchange rate regime has been in place since the early 1970s. Under a flexible exchange regime international adjustment to changing international circumstances is automatic (though not necessarily immediate as claimed by some writers). The exchange rate falls until an emerging BoP deficit is eliminated. This means that the domestic adjustment to an incipient BoP deficit is increase of domestic output, prices, and employment, just as would occur in a closed economy. Of course, these increases may be prevented by exercise of contractionary macropolicy. Unlike a fixed exchange rate regime in which monetary policy must be dedicated to keeping the exchange rate fixed, under a flexible exchange rate regime monetary policy is free to be applied to domestic macropolicy problems.
The possible causes of an emerging or growing Current Account surplus of a nation are the same items which cause appreciation of its domestic currency. Three of the most prominent causes are domestic incomes decreasing or increasing at a slower pace than foreign incomes, foreign inflation at a faster pace than the domestic inflation rate, and domestic interest rates which are higher than foreign interest rates.
An emerging or growing Current Account surplus is likely to increase the demand for domestic money in the forex market (i.e., increase the supply of the foreign currency). Assuming that the supply of the domestic currency to the forex market does not change, the resulting excess demand for the domestic currency likely induces appreciation of the domestic currency. The appreciation of the domestic currency makes the nation's exportables look more expensive to foreigners and imports from abroad appear cheaper to citizens, thereby alleviating the Current Account surplus.
A major source of the increasing demand for the domestic currency on the forex market is foreigners who wish to import goods and services from domestic producers, invest in the nation, or make uniliteral transfers (gifts) to citizens of the nation. Another source of the increasing demand for the domestic currency is citizens of the nation attempting to convert quantities of the foreign currencies into the domestic currency in order to repatriate export earnings or foreign investment income. As the foreign currencies are exchanged for the domestic currency in the forex market, the relevant domestic money supply (that which motivates the behavior of citizens of the nation) increases by the amount not involving citizen-to-citizen or foreigner-to-foreigner transactions.
As described in Chapters 6 and 8, assuming that the domestic money demand does not change, the domestic money supply increase likely results in rising domestic prices, falling domestic interest rates, and increasing domestic employment. The rising domestic prices of tradeables tend to reduce the volume of exports and increase the volume of imports. The falling domestic interest rates tend to increase the volume of investment by citizens in other countries and decrease the volume of investment by foreigners in the nation. The increasing domestic employment increases incomes and thus stimulates imports. These three phenomena supplement the appreciation of the domestic currency in alleviating the Current Account surplus. The burden of adjustment borne by domestic prices, interest rates, and employment is lessened to the extent that currency appreciation occurs. If appreciation of the domestic currency is prevented by government authorities, the full burden of adjustment to the Current Account surplus will descend upon domestic prices, interest rates, employment, and incomes.
Chapter 12 illustrates the effects of macroeconomic phenomena which culminate in balance of payments deficits. The graphic models and exposition of this chapter are revisions to illustrate the effects of macroeconomic phenomena which culminate in balance of payments surpluses.
Panel (a) of Figure 13a-1 illustrates a scenario in which the initiating change occurs in the private sector rather than by macropolicy. Starting from a situation of equilibrium in all markets, assume that the demand for money to hold increases as illustrated in panel (a) by the rightward shift of the money demand schedule from MD to MD'. The horizontal bracket indicates an excess demand for money in the sense that at interest rate i1 people would like to hold more money than is in circulation, MS.
A similar scenario, but one for which the initiating factor occurs as a matter of macropolicy, is illustrated in panel (aa) of Figure 13a-1. Here the central bank, in an effort (for whatever unspecified reason) to implement a contractionary (or “tight”) monetary policy, reduces the money supply from MS to MS’ by conducting open market sales of treasury bonds. As in panel (a), the horizontal bracket in panel (aa) represents an excess demand for money at interest rate i1.
Panel (b) in Figure 13a-1 illustrates the Keynesian conclusion that people can get more money to hold by selling some of the “bonds” (a Keynesian euphemism for all kinds of financial instruments) that they hold in their portfolios of assets. This is illustrated in panel (b) as the rightward shift in the bond supply curve from SB to SB’. Other things remaining the same, bond prices will fall below PB, causing bond yields to rise above i1 in panel (a) or in panel (aa).
Monetarists suggest that the bond market is not the only place where people can get more money to hold. They may do so by decreasing their consumption spending relative to the flow of their incomes so as to increase their saving, and they may then hold their savings in the form of idle money balances to satisfy their excess demand for money to hold. Panel (c) illustrates that when people decrease their consumption spending the aggregate demand curve shifts left (decreases) from AD to AD’. Other things remaining the same for aggregate supply, AS, the increased saving will induce output (and income) to fall below Y1, and the price level to fall below P1 as illustrated in panel (c).
In a closed economy, the adjustment to an excess demand for money will be played out completely in the bond and real markets. When the economy is open to international transactions, both current account (goods and services) and capital account (short term instruments like bank account balances and currencies as well as portfolio investments and direct investments) responses may result as well. Panel (d) illustrates that when there is an excess demand for money as illustrated in panel (a) or in panel (aa), the supply of dollars to the foreign exchange market may decrease from S$ to S$’. This shift results in an excess demand for dollars on the foreign exchange market. This excess demand may be interpreted as a Balance of Payments (BoP) surplus because the demand for dollars to buy “things” (merchandise, services, dollar-denominated bank balances, treasury bonds, stock shares, plant and equipment, etc.) domestically exceeds the supply of dollars to the foreign exchange market to purchase “things” from foreign sources. The same result might have been illustrated in panel (d) as an increase (rightward shift) of the D$ schedule as people attempt to acquire more dollars on the foreign exchange market to meet the excess demand for money to hold illustrated in panel (a) or in panel (aa).
If exchange rate flexibility is permitted, a BoP surplus causes the foreign currency ("euro" as illustrated) price of the local currency ("dollar" as illustrated) to rise, i.e., the dollar appreciates (or the euro depreciates). The adjustment process plays out in the form of falling domestic output and price level (panel (c)), falling bond prices (panel (b)), and rising interest rates (panel (a) or panel (aa)). The domestic adjustment process occurs just as it would in a closed economy. In a cleanly floating exchange rate system, there are no international flows of reserves or changes of the domestic money supply.
One way in which to impose fixed exchange rates is to employ the police power of the state to specify an official exchange rate at euro1, and then to punish transactions at any exchange rate other than euro1. Under this type of fixed exchange regime, a BoP surplus will persist. Exports (X) of “things” (any type, current or capital account) exceed imports (M) of “things” with the result that the (X - M) surplus has to be paid for by an inflow of money. (In David Hume’s 19th century discussion of the price-specie flow mechanism, gold would flow in to pay for the exports.) The inflow of money adds to the account balances of local citizens and the reserves of their commercial banks. This inflow of money and reserves has the effect of shifting the money supply curve to the right of MS in panel (a), or to the right of MS’ toward MS in panel (aa). This shift meets the excess demand for money to hold and prevents the interest rate from rising above i1. If the inflow of money and reserves is sufficient to meet the excess demand for money to hold, bond prices won’t fall (panel (b)), interest rates won’t rise (panel (a) or panel (aa)), output won’t fall (panel (c)), and the price level won’t fall (panel (c)). This implies that in the case of a fixed exchange rate regime (like the 19th century gold standard or the 20th century Bretton Woods regime) the BoP surplus will persist and there is no effective mechanism to relieve international disequilibria.
An alternative implementation of a fixed exchange rate regime is that a designated government agency (central bank or treasury department) commits to enter the open market for foreign exchange if the exchange rate departs too far from the official rate (i.e., above or below specified boundaries on either side of the official rate) to purchase or sell foreign exchange by selling or purchasing the local currency. In the foreign exchange market illustrated in panel (d) the excess demand for dollars can be met by a central bank sale of dollars to purchase euros. This amounts to an open market purchase in the foreign exchange market, the side effect of which is to create money and bank reserves. This newly created money has the effect of shifting the MS schedule in panel (a) to the right to meet the excess demand for money to hold caused by the rightward shift of MD. The effect in panel (aa) is to shift the money supply schedule rightward from MS’ back toward its original locus at MS. If the central bank keeps the local currency from appreciating by buying the foreign currency, no domestic changes will occur to domestic bond prices, interest rates, the output level, or the price level. The BoP surplus persists and there is no effective mechanism to alleviate international disequilibria. Since domestic monetary policy has been dedicated to fixing the exchange rate, the central bank cannot use it to address domestic macroeconomic issues such as inflation or unemployment.
Under a flexible exchange regime, international adjustment to changing international circumstances is automatic (though not necessarily immediate as claimed by some writers). The exchange rate rises until an emerging BoP surplus is eliminated. This means that adjustment to an incipient BoP surplus is decline of domestic output, prices, and employment, just as would occur in a closed economy. Of course, these declines may be prevented by exercise of stimulative macropolicy. Unlike a fixed exchange rate regime in which monetary policy must be dedicated to keeping the exchange rate fixed, under a flexible exchange rate regime monetary policy is free to be applied to domestic macropolicy problems.
In the modern era of nominally floating exchange rates, governments may act singly or in concert with governments of other nations (often in a “group of seven”) to try to prevent change of exchange rates in a direction perceived as undesirable, or to precipitate change of exchange rates in a direction thought to be desirable. Such an exchange regime has been called a “dirty float.” Suppose that the central bank or treasury department can supply some, though not enough, of the appreciating currency to the foreign exchange market (i.e., it can buy some but not enough of the foreign currency). In panel (d) of Figures 13-4 , the excess demand gap for dollars may be partially filled with sales of dollars to purchase euros, thereby slowing but not entirely preventing the appreciation of the dollar. The dollar cannot appreciate far enough to eliminate the BoP surplus, i.e., the increase in the supply of money in panel (a) or panel (aa) is not sufficient to fully satisfy the excess demand for money to hold. Bond prices will fall some in panel (b), the interest rate will rise some in panel (a) or in panel (aa), output will fall some below Y1 in panel (c), and the price level will fall some below P1 in panel (c).
Technically, there is no limit to the ability of a central bank to supply its own currency to the foreign exchange market (i.e., engage in open market purchases of a foreign currency) since in a debt-money using world a central bank can create any amount of its own money in simply buying things from open markets. This means that if the central bank of the dollar-issuing nation illustrated in panel (a) and in panel (aa) wished to do so, it could purchase enough euros (i.e., supply enough dollars) to more than fill the BoP surplus gap and precipitate depreciation of its own currency by fostering a BoP deficit. This would have the effect in panel (a) or in panel (aa) of increasing the domestic money supply to the right beyond MS to create an excess supply of money at interest rate i1. Forcing depreciation in this manner causes the bond supply schedule to decrease (shift left) from SB, precipitating an increase of bond prices in panel (b) and a decrease of domestic interest rates in panel (a) or in panel (aa). The ensuing rightward shift of aggregate demand beyond AD in panel (c) would induce output to increase beyond Y1 (limited by full employment constraints) and the price level to rise above P1.
Can exchange rate flexibility insulate the domestic economy from international disturbances? Suppose that there has occurred an externally sourced (foreign) decrease of demand for domestically produced "things" (anything, including merchandise, services, financial instruments, direct investments, etc.). If this decreased demand impacts primarily the current account (merchandise and services), the result is a decrease of exports (X). Panel (d) of Figure 13-5 illustrates the resulting decrease of the demand for dollars on the foreign exchange market to purchase such things, precipitating an incipient balance of payments (BoP) deficit and portending a depreciation of the exchange rate.
While our objective is to consider the insulating properties of exchange rate flexibility relative to foreign disturbances, we should note that in panel (dd), the same incipient BoP deficit and exchange rate depreciation pressure would results from an internally-sourced increase of the demand for foreign made things which shifts the supply schedule for dollars to the forex market to the right. If the increased demand for foreign things impacts primarily the current account, the result is an increase of imports (M).
In either case illustrated in panels (d) or (dd), net exports (X - M) decreases, causing a decrease of aggregate demand illustrated as a leftward shift of the AD curve in panel (c). To the extent that AD decreases, real output (Y) falls and unemployment rises.
Under a flexible exchange rate regime, if depreciation occurs concurrently with the decreased demand for exports or increased demand for imports, the lower foreign price of the domestic currency makes domestic goods appear cheaper to foreigners and foreign-made goods appear more expensive to domestic consumers. Both effects offset the leftward shift of AD in panel (c), and ideally will prevent any net leftward shift. In this best-case scenario, the exchange rate depreciation serves to insulate the domestic economy completely from the effects of decreased demand for domestically produced things or the effects of increased domestic demand for foreign-made things. Output doesn't fall and unemployment doesn't rise.
Exchange rates respond to a variety of influences other than what is happening in the current account (X - M), and they often respond sluggishly to changing international conditions. If the exchange rate falls too slowly or doesn't fall far enough to prevent a net leftward shift of AD, output and employment may fall, at least temporarily. In such less-than-ideal scenarios, exchange rate flexibility may not be sufficient to completely insulate the domestic economy from foreign disturbances.
In contrast, under a fixed exchange rate regime there is virtual certainty that international disturbances will impact the domestic economy. How they do so depends critically upon the strengths of secondary effects. One way in which exchange rates may be fixed is to specify an official exchange rate at euro1, and then to employ the police power of the state to punish transactions at any exchange rate other than euro1. With an overvalued currency which cannot depreciate, increasing imports or decreasing exports cause a growing current account (X - M) deficit that decreases aggregate demand, shifting the AD curve to the left toward AD'. Output and income falls and unemployment rises.
Secondary effects may ameliorate the contraction. Consequent upon the falling incomes, the demand for money decreases, illustrated as a shift in panel (a) from MD to MD', causing an excess supply of money at interest rate i1. In the Keynesian transmission mechanism, the excess supply of money causes the demand for bonds to increase from DB toward D'B in panel (b), raising bond prices and depressing interest rates in panel (a) below i1. As interest rates fall, interest-sensitive consumer and business investment spending increase. In the monetarist transmission mechanism, some to the excess money supply goes directly to consumption spending, irrespective of interest rates. In either case, the increased spending causes aggregate demand to recover from AD' back toward AD, thereby ameliorating the initial contraction.
But other secondary effects may dampen the amelioration. The emerging BoP deficit has to be paid for by an outflow of money, represented by the excess supply of dollars to the forex market at euro1 in panel (d). In David Hume’s 19th century discussion of the price-specie flow mechanism, gold would flow out in payment for the imports. In the 21st century, the money outflow usually is accomplished by foreigners acquiring ownership of dollar-denominated bank balances in payment for the excess of imports over exports. The money outflow decreases the account balances of local citizens and the reserves of their commercial banks. This outflow of money and reserves has the effect of shifting the money supply curve to the left of MS in panel (a). This diminishes the excess supply of money in panel (a) and may prevent the interest rate from falling below i1. If the outflow of money and reserves is sufficient to eliminate the excess supply of money, bond prices won’t rise (panel (b)), interest rates won’t fall (panel (a)), output won’t increase (panel (c)), and the price level won’t rise (panel (c)). This implies that when exchange rates are fixed an international disturbance is likely to have adverse impact on the domestic economy when all of the secondary effects are taken into account. This also implies that in the case of a fixed exchange rate regime like the 19th century gold standard or the 20th century Bretton Woods regime, the BoP deficit will persist and there is no effective mechanism to relieve international disequilibria.
In the more liberal (market oriented) implementation of a fixed exchange rate regime, a designated government agency (central bank or treasury department) enters the open market for foreign exchange when the exchange rate departs too far from the official rate (i.e., above or below specified boundaries on either side of the official rate). The exchange control authority purchases or sells foreign exchange by selling or purchasing the domestic currency. The decreased net exports decreases aggregate demand, illustrated as the leftward shift toward AD' in panel (c). Output and income falls, and unemployment rises. As income falls, the demand for money decreases, illustrated as the shift to MD' in panel (a). In the foreign exchange market the excess supply of dollars illustrated in panel (d) can be eliminated by a central bank purchase of dollars by selling euros. This amounts to an open market sale in the foreign exchange market, the side effect of which is to destroy money and bank reserves. This has the effect of shifting the MS curve in panel (a) to the left to eliminate the excess supply of money caused by the leftward shift of MD. If the central bank keeps the local currency from depreciating by selling foreign currency, the domestic economy is likely to be impacted adversely by the external disturbance. As long as the BoP deficit persists, there is no effective mechanism to alleviate international disequilibria. And, since domestic monetary policy has been dedicated to fixing the exchange rate, the central bank cannot use it to address domestic macroeconomic issues such as inflation or unemployment.
There is a severe limit to the ability of a central bank to prevent depreciation of its own currency. It can prevent depreciation only as long as it is able to supply the foreign currency to the foreign exchange market in buying back its own currency (thereby reducing the domestic money supply and the reserves of domestic commercial banks). Once the central bank stocks out of the foreign currency, it can no longer prevent depreciation of its currency. Depreciation ensues until the BoP deficit is alleviated. Experience during the post-Bretton Woods era (since 1972) suggests that central banks, singly or in coordination with other central banks, rarely have the will or enough foreign exchange reserves to fully alleviate BoP deficits.
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