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1、1Chapter20International Adjustment and InterdependenceItem ItemItemEtc.McGraw-Hill/IrwinMcGraw-Hill/IrwinMacroeconomics, 10eMacroeconomics, 10e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.2IntroductionCountries are interdepende
2、ntBooms or recessions in one country spill over to other countries through trade flowsChanges in interest rates in any major country cause immediate exchange or interest rate movements in other countriesIn this chapter we explore the issues of international interdependence further:Mechanisms through
3、 which a country with a fixed exchange rate adjusts to balance of payments problemsAspects of behavior of the current flexible exchange rate system3Adjustment Under Fixed Exchange RatesAdjustment to a balance-of-payments problem can be achieved in two ways:Change in economic policyMonetary policyFis
4、cal policyTariffsDevaluations Automatic adjustment mechanismsMoney supply spendingUnemployment wages and prices competitiveness 4The Role of Prices in the Open EconomyThe real exchange rate is expressed as: (1) assume that exchange rate and foreign prices are givenHow does the openness of the econom
5、y affect the aggregate demand curve?An increase in the price level reduces demandHigher price level implies lower real balances, higher interest rates, and reduced spending Given the exchange rate, our goods are more expensive to foreigners and their goods are relatively cheaper for us to buy export
6、s decrease and imports increase5The Role of Prices in the Open EconomyFigure 20-1 shows the downward sloping AD curve where and the NX = 0 curve At point E the home country has a trade deficitTo achieve trade balance equilibrium, we would have toBecome more competitive (exporting more and importing
7、less)Reduce our level of income in order to reduce import spendingInsert Figure 20-1 here6The Role of Prices in the Open EconomyWhat should the country do?The central bank could use its reserves to finance temporary imbalances of paymentsCan borrow foreign currencies abroadMay be troublesome if the
8、countrys ability to repay the debt is in questionCountry must find a way of adjusting the deficitCannot maintain and finance current account deficits indefinitely or for long periods of timeInsert Figure 20-1 here7The Role of Prices in the Open EconomyAutomatic adjustmentWhen the central bank sells
9、foreign exchange, it reduces domestic high powered money and the money stockThe deficit at E implies the central bank is pegging the exchange rate, selling foreign exchange to keep the exchange rate from depreciatingOver time the AD schedule, which is drawn for a given money supply, will be shifting
10、 downward and to the leftInsert Figure 20-1 here8The Role of Prices in the Open EconomyAutomatic adjustmentPoint E is also a point of unemploymentUnemployment leads to declines in wages and costsOver time, the SR equilibrium point, E, moves downward as the AS and AD shiftProcess continues until reac
11、h point EPoint E is a LR equilibrium point and there is no need for exchange market equilibrium automatic adjustmentInsert Figure 20-1 here9Policies to Restore BalanceThe classical adjustment process may take time alternative is policies to restore external balanceBecause of their side effects, poli
12、cies to restore external balance must generally be combined with policies to achieve full employmentPolicies to create employment will typically worsen the external balancePolicies to create a trade surplus will affect employmentNecessary to combine expenditure-switching policies, which shift demand
13、 between domestic and imported goods, and expenditure-reducing/increasing policies in order to cope with the two targets of internal balance and external balance.10Policies to Restore BalanceCan use policies to reduce aggregate demand expenditure reducing policiesThe trade deficit is expressed as (2
14、)A balance-of-trade deficit can be reduced by reducing spending (C+I+G) relative to income through restrictive monetary and/or fiscal policyThe link between the external deficit and budget deficits is shown in equation (2a): (2a)If S and I are constant, changes in the budget would translate one for
15、one into changes in the external balance Budget cutting would bring about equal changes in the external deficit but budget cutting will affect S and I, thus need a more complete model to explain how budget cuts affect external balance 11DevaluationThe unemployment that accompanies automatic adjustme
16、nt suggests the need for an alternative policy for restoring internal and external balanceThe major policy instrument for dealing with payment deficits is devaluation = an increase in the domestic currency price of foreign exchangeGiven the nominal prices in the two countries, devaluation:Increases
17、the relative price of imported goods in the devaluing countryReduces the relative price of exports from the devaluing countryDevaluation is primarily an expenditure switching policy.12Exchange Rates and PricesThe price level typically changes with the exchange rate (including after a devaluation)The
18、 essential issue when a country devalues is whether it can achieve a real devaluationA real devaluation occurs when it reduces the price of the countrys own goods relative to the price of foreign goodsUsing the definition of the real exchange rate: A real devaluation occurs when e/P rises or when th
19、e exchange rate increases by more than the price level13The Monetary Approach to the Balance of PaymentsThere is a link between the money supply and the external balance the adjustment process must ultimately lead to the right money stock so that external payments will be in balanceThe only way the
20、adjustment process can be suspended is through sterilization operationsCentral banks frequently offset the impact of foreign exchange market intervention on the money supply through OMOA deficit country that is selling foreign exchange and correspondingly reducing its money supply may offset this re
21、duction by open market purchases of bonds that restore the money supplyPersistent deficits are possible CB actively maintaining the stock of money too high for external balance STERILIZATIONSTERILIZATION14Interest Differentials and Exchange Rate ExpectationsIn our model of exchange rate determinatio
22、n international capital mobility was assumedWhen capital markets are sufficiently integrated, we expect interest rates to be equated across countriesFigure 20-9 shows the U.S. federal funds rate and the money market rate in GermanyThese rates are not equalInsert Figure 20-9 hereHow do we square this
23、 fact with our theory?15Exchange Rate ExpectationsHave assumed that capital flows internationally in response to nominal interest differentialsTheory is incomplete when exchange rates can and are expected to changeMust extend our analysis to incorporate expectations of exchange rate changesTotal ret
24、urn on foreign bonds measured in our currency is the interest rate on the foreign currency plus whatever earned from the appreciation of the foreign currency, OR (5) 16Exchange Rate ExpectationsInvestor does not know at the time of investment how much the exchange rate will changeThe term should be
25、interpreted as the expected change in the exchange rateThe balance of payments equation needs to be modifiedNet capital flows are governed by the difference between our interest rate and the foreign rate adjusted for expected depreciation: The balance of payments equation is: (6)17Exchange Rate Expe
26、ctationsThe adjustment for exchange rate expectations thus accounts for international differences in interest rates that persist even when capital is freely mobile among countriesWhen capital is completely mobile, we expect interest rates to be equalized, after adjusting for expected depreciation: (6a)Expected depreciation helps account for differences in interest rates among low and high-inflation countriesWhen inflation in a country is high, its exchange rate is expected to depreciate and nominal interest rates will be high18
