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1、20-1,20-2,20,International Adjustment and Interdependence,Item ItemItemEtc.,20-3,Introduction,Countries are interdependentBooms 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 movem
2、ents in other countriesIn this chapter we explore the issues of international interdependence further:Mechanisms through which a country with a fixed exchange rate adjusts to balance of payments problemsAspects of behavior of the current flexible exchange rate system,20-4,Adjustment Under Fixed Exch
3、ange Rates,Adjustment to a balance-of-payments problem can be achieved in two ways:Change in economic policyMonetary policyFiscal policyTariffsDevaluations Automatic adjustment mechanismsMoney supply spendingUnemployment wages and prices competitiveness,20-5,The Role of Prices in the Open Economy,Th
4、e real exchange rate is expressed as:(1)assume that exchange rate and foreign prices are givenHow does the openness of the economy 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
5、Given the exchange rate,our goods are more expensive to foreigners and their goods are relatively cheaper for us to buy exports decrease and imports increase,20-6,The Role of Prices in the Open Economy,Figure 20-1 shows the downward sloping AD curve where and the NX=0 curve At point E the home count
6、ry has a trade deficitTo achieve trade balance equilibrium,we would have toBecome more competitive(exporting more and importing less)Reduce our level of income in order to reduce import spending,Insert Figure 20-1 here,20-7,The Role of Prices in the Open Economy,What should the country do?The centra
7、l bank could use its reserves to finance temporary imbalances of paymentsCan borrow foreign currencies abroadMay be troublesome if the 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
8、 for long periods of time,Insert Figure 20-1 here,20-8,The Role of Prices in the Open Economy,Automatic adjustmentWhen the central bank sells 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 fore
9、ign exchange to keep the exchange rate from depreciatingOver time the AD schedule,which is drawn for a given money supply,will be shifting downward and to the left,Insert Figure 20-1 here,20-9,The Role of Prices in the Open Economy,Automatic adjustmentPoint E is also a point of unemploymentUnemploym
10、ent leads to declines in wages and costsOver time,the SR equilibrium point,E,moves downward as the AS and AD shiftProcess continues until reach point EPoint E is a LR equilibrium point and there is no need for exchange market equilibrium automatic adjustment,Insert Figure 20-1 here,20-10,Policies to
11、 Restore Balance,The classical adjustment process may take time alternative is policies to restore external balanceBecause of their side effects,policies to restore external balance must generally be combined with policies to achieve full employmentPolicies to create employment will typically worsen
12、 the external balancePolicies to create a trade surplus will affect employment,Necessary to combine expenditure-switching policies,which shift demand between domestic and imported goods,and expenditure-reducing/increasing policies in order to cope with the two targets of internal balance and externa
13、l balance.,20-11,Policies to Restore Balance,Can use policies to reduce aggregate demand expenditure reducing policiesThe trade deficit is expressed as(2)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
14、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 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,t
15、hus need a more complete model to explain how budget cuts affect external balance,20-12,Devaluation,The unemployment that accompanies automatic adjustment suggests the need for an alternative policy for restoring internal and external balanceThe major policy instrument for dealing with payment defic
16、its is devaluation=an increase in the domestic currency price of foreign exchangeGiven the nominal prices in the two countries,devaluation:Increases the relative price of imported goods in the devaluing countryReduces the relative price of exports from the devaluing country,Devaluation is primarily
17、an expenditure switching policy.,20-13,Exchange Rates and Prices,The price level typically changes with the exchange rate(including after a devaluation)The essential issue when a country devalues is whether it can achieve a real devaluationA real devaluation occurs when it reduces the price of the c
18、ountrys 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 the exchange rate increases by more than the price level,20-14,The Monetary Approach to the Balance of Payments,There is a link between the money su
19、pply 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 adjustment process can be suspended is through sterilization operationsCentral banks frequently offset the impact of foreign exchange market
20、 intervention on the money supply through OMOA deficit country that is selling foreign exchange and correspondingly reducing its money supply may offset this reduction by open market purchases of bonds that restore the money supplyPersistent deficits are possible CB actively maintaining the stock of
21、 money too high for external balance,STERILIZATION,STERILIZATION,20-15,Interest Differentials and Exchange Rate Expectations,In our model of exchange rate determination international capital mobility was assumedWhen capital markets are sufficiently integrated,we expect interest rates to be equated a
22、cross countriesFigure 20-9 shows the U.S.federal funds rate and the money market rate in GermanyThese rates are not equal,Insert Figure 20-9 here,How do we square this fact with our theory?,20-16,Exchange Rate Expectations,Have assumed that capital flows internationally in response to nominal intere
23、st differentialsTheory is incomplete when exchange rates can and are expected to changeMust extend our analysis to incorporate expectations of exchange rate changesTotal return on foreign bonds measured in our currency is the interest rate on the foreign currency plus whatever earned from the apprec
24、iation of the foreign currency,OR(5),20-17,Exchange Rate Expectations,Investor does not know at the time of investment how much the exchange rate will changeThe term should be interpreted as the expected change in the exchange rateThe balance of payments equation needs to be modifiedNet capital flow
25、s are governed by the difference between our interest rate and the foreign rate adjusted for expected depreciation:The balance of payments equation is:(6),20-18,Exchange Rate Expectations,The adjustment for exchange rate expectations thus accounts for international differences in interest rates that
26、 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 high,
