Politicas macroeconomicas, handout, Miguel Lebre de Freitas 13/03/2018 https://mlebredefreitas.wordpress.com/teaching-materials/ The real exchange rate Index: The Real Exchange Rate ................................................................................................ 3 14.1 Introduction ........................................................................................ 3 14.2 The purchasing power doctrine.......................................................... 4 14.2.1 The real exchange rate ............................................................................... 4 14.2.2 Actual versus equilibrium .......................................................................... 5 Box 1: The real exchange rate in Portugal ............................................................. 6 14.2.3 The Law of one price ................................................................................. 6 14.2.4 The theory of purchasing power parity ...................................................... 8 Box 2: PPP exchange rates and international comparisons of income .................. 9 14.2.5 The relative PPP hypothesis..................................................................... 11 Box 3: The relative PPP hypothesis in the real world.......................................... 12 14.3 Traded and non-traded goods........................................................... 14 14.3.1 What do we mean by traded and non-traded goods? ............................... 14 14.3.2 What happens when the demand for non-traded goods increases?.......... 16 14.3.3 What happens when the demand for the traded good increases?............. 17 14.3.4 Non-traded good prices and the level of aggregate demand .................... 19 14.3.5 The real exchange rate and non-traded goods.......................................... 19 Box 4: Traded and non-traded goods in Portugal ................................................ 20 14.4 The supply side ................................................................................ 21 14.4.1 Technology and factor endowments ........................................................ 21 14.4.2 The Production Possibility Frontier (PPF)............................................... 22 14.4.3 Numerical example .................................................................................. 22 14.4.4 The Marginal rate of transformation ........................................................ 24 14.4.5 Labour demands ....................................................................................... 25 14.4.6 An arbitrage condition ............................................................................. 26 14.4.7 The supply functions ................................................................................ 27 14.4.8 Measuring Domestic Production.............................................................. 28 14.4.9 Productivity, wages and non-tradable good prices .................................. 28 14.5 Internal and external balance ........................................................... 29 14.5.1 The household’ problem .......................................................................... 29 14.5.2 The Swan diagram ................................................................................... 31 14.6 Why some countries are more expensive than other? ...................... 35 14.6.1 Real exchange rate and productivity ........................................................ 35 14.6.2 The Balassa Samuelson proposition ........................................................ 36 14.6.3 Implications for Purchasing Power Parity ............................................... 39 14.6.1 Nominal avenues ...................................................................................... 39 14.6.2 Demand driven appreciation .................................................................... 40 14.6.3 Comparing the two cases ......................................................................... 43 14.6.4 Does it matter? ......................................................................................... 44
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Politicas macroeconomicas, handout, Miguel Lebre de Freitas
14.2 The purchasing power doctrine..........................................................4
14.2.1 The real exchange rate ...............................................................................4 14.2.2 Actual versus equilibrium..........................................................................5 Box 1: The real exchange rate in Portugal.............................................................6 14.2.3 The Law of one price .................................................................................6 14.2.4 The theory of purchasing power parity......................................................8 Box 2: PPP exchange rates and international comparisons of income ..................9 14.2.5 The relative PPP hypothesis.....................................................................11 Box 3: The relative PPP hypothesis in the real world..........................................12
14.3 Traded and non-traded goods...........................................................14
14.3.1 What do we mean by traded and non-traded goods? ...............................14 14.3.2 What happens when the demand for non-traded goods increases?..........16 14.3.3 What happens when the demand for the traded good increases?.............17 14.3.4 Non-traded good prices and the level of aggregate demand....................19 14.3.5 The real exchange rate and non-traded goods..........................................19 Box 4: Traded and non-traded goods in Portugal ................................................20
14.4 The supply side ................................................................................21
14.4.1 Technology and factor endowments ........................................................21 14.4.2 The Production Possibility Frontier (PPF)...............................................22 14.4.3 Numerical example ..................................................................................22 14.4.4 The Marginal rate of transformation........................................................24 14.4.5 Labour demands.......................................................................................25 14.4.6 An arbitrage condition .............................................................................26 14.4.7 The supply functions................................................................................27 14.4.8 Measuring Domestic Production..............................................................28 14.4.9 Productivity, wages and non-tradable good prices ..................................28
14.5 Internal and external balance ...........................................................29
14.5.1 The household’ problem ..........................................................................29 14.5.2 The Swan diagram ...................................................................................31
14.6 Why some countries are more expensive than other?......................35
14.6.1 Real exchange rate and productivity........................................................35 14.6.2 The Balassa Samuelson proposition ........................................................36 14.6.3 Implications for Purchasing Power Parity ...............................................39 14.6.1 Nominal avenues......................................................................................39 14.6.2 Demand driven appreciation ....................................................................40 14.6.3 Comparing the two cases .........................................................................43 14.6.4 Does it matter? .........................................................................................44
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
14.7 Borrowing and repayment cycle ......................................................45
14.7.1 The two-period model..............................................................................45 14.7.2 Baseline case............................................................................................47 14.7.3 An optimal spending path with external imbalances ...............................47 14.7.4 The borrowing phase................................................................................48 Box 5: The move towards non-traded goods in Portugal, 1995-2005 .................49 14.7.5 The repayment phase ...............................................................................50 14.7.6 The illusion of the boom..........................................................................52
14.8.1 Financial instability..................................................................................53 14.8.2 The adjustment to a Sudden stop .............................................................54 Box 6 - The 2009 sudden stop in Portugal...........................................................55 14.8.3 The required structural adjustment ..........................................................56 14.8.4 Nominal Rigidities ...................................................................................57 14.8.5 Unresponsive supply................................................................................58 Box 7: Overheating and Sudden stop in Greece ..................................................61 14.8.6 Redistributive effects ...............................................................................63 14.8.7 Internal devaluation .................................................................................64 Box 8: The Portuguese bailout and the VAT tax on restaurants..........................64 14.8.8 Immiserizing growth................................................................................65 14.8.9 The Transfer Problem ..............................................................................66 14.8.10 Dutch disease ...........................................................................................67
14.9 Mitigating capital flows ...................................................................68
14.9.1 Restrictions on capital flows....................................................................69 14.9.2 Sterilization ..............................................................................................69 14.9.3 Exchange rates .........................................................................................70
Appendix 1: The two period consumer problem .........................................72
Review Questions and Exercises .................................................................73
A key relative price in open economies is the real exchange rate. The real exchange
rate is the price of foreign goods in terms of domestic goods. When the real exchange rate
changes, this comes along with changes in the pattern of consumption and of production, and
eventually with external imbalances. In this note we discuss the determinants of the real
exchange rate, and its role in macroeconomic adjustment, from the perspective of a small
open economy.
To analyse these questions, we introduce a tool that became known as the dependent
economy model or simply the TNT model1. The main assumption of the TNT model is that
the economy is composed by two sectors: one open to international trade, and the other
closed to international trade. That is, rather than assuming that an economy is entirely open or
entirely closed, the TNT steps into the real-world fact that not all sectors within an economy
are equally exposed to international competition. Accounting for such reality, the model
implies that economic shocks and policy changes may have a differential impact across
sectors, giving rise to policy dilemmas that cannot be captured in a single good framework.
The main proposition of the model is that the level of aggregate demand influences the real
exchange rate and the pattern of production. We will also see that the equilibrium real
exchange rate depends on real factors, such as productivity and preferences.
1 The model born out of the pioneer ideas of Meade (1956), Salter (1959) and Swan (1960), but it has been much improved since then. Key references include: Meade, J. 1956. The price mechanism and the Australian balance of payments. Economic Record 32, 239-56. Salter, W. 1959. “Internal and External Balance: The Role of Price and Expenditure Effects”. Economic Record 35: 226-38. Swan, T. 1960. “Economic Control in a Dependent Economy.” Economic Record 36: 51-66. Corden, 1960. The Geometric representation of policies to attain internal and external balance. Review of economic studies 28, 1-22. Dornbusch, 1980. Home goods and traded goods: The dependent Economy model. Chapter 6 in Open Economy Macroeconomics, Basic Books, New York. Obstfeld and Rogoff, 1996 M. Obstfeld and K. Rogoff, Foundations of International Macroeconomics, MIT Press, Cambridge, MA (1996).
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
As any other relative price, the real exchange rate reacts to economic shocks and may
depart, in the short run, from the level that is determined by its economic fundamentals.
These departures are called real exchange rate gaps. To define a real exchange rate gap,
however, one needs to have a reference for what the “equilibrium” should be.
In what follows it will be useful to distinguish three concepts of real exchange rate:
- The actual real exchange rate, : the one that holds each moment in time;
- The equilibrium real exchange rate, : the one that would be consistent with
flexible prices and full employment (or “internal balance”);
- The fundamental equilibrium real exchange rate, ~ : the one that would be
consistent with flexible prices (internal balance) and external balance2.
Exchange rate gaps may, therefore, refer to the difference between the actual
exchange rate and the equilibrium exchange rate, or to differences between the actual
exchange rate and the fundamental equilibrium exchange rate.
Gaps of the first type , are mostly related to price stickiness, and are expected to
vanish as prices fully adjust to clear the corresponding output markets. Gaps of the second
type ~ are what in general economists have in mind, when looking at real exchange rates:
Deviations between the actual real exchange rate and the fundamental equilibrium real
exchange rate measure the extent to which the currency is overvalued or undervalued relative
to the level that would be consistent with a sustainable debt service. Real exchange rate gaps
may persist for long periods of time, as long as external imbalances are financed by capital
flows. These ideas will be further clarified along this note.
2 This term was coined by Williamson (1983). Williamson, J., 1983. The Exchange rate system Policy analysis in international economics 5. Washington: Peterson institute for international economics.
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
A more general theory should explain, first why some countries are more expensive
than others, and second why differences in costs of living may change over time. This is our
aim for the following section.
For the moment, just keep on hold with a main idea: in general, the relative PPP
provides a reasonable benchmark for a country’ equilibrium real exchange rate when
disturbances are nominal in nature: since the real exchange rate is a real variable, in the long
run it should not be affected by monetary shocks. Yet when shocks affecting the economy are
real - such as changes in tariffs, transport costs, productivity or in preferences - the long run
real exchange rate is expected to be affected. In that case, the PPP theory fails, even in its
relative formulation.
Box 3: The relative PPP hypothesis in the real world
To illustrate the PPP hypothesis with real world data, we refer to Figure 3. The figure
displays the evolution of the pound-USD nominal exchange rate, the ratio of consumer price
indexes in the UK and in the US, and the ratio between the two (the bilateral real exchange
rate). The nominal exchange rate between the pound and the dollar (red line) was fixed along
1960-1971 (with devaluations in 1967 and 1968), and then became flexible, exhibiting high
volatility. The relative price level (blue line), in turn, evolved slowly over time, reflecting
short-run price stickiness. Thus, while the two series have evolved basically together over
time, supporting the relative PPP hypothesis, short-run price stickiness prevented the two
series to match exactly each moment in time. Hence, the real exchange rate was not exactly
constant each moment in time4.
4 Frankel and Rose found that temporary deviations from PPP, such as those implied by volatile nominal exchange rates, die away slowly over time, with half of the departure from PPP still remaining four years after the shock [Frankel, J., Rose, A., 1996. A panel project on Purchasing Power Parity: mean reversion within and between countries”. Journal of International Economics 40, 209-224].
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
to TA2 ), a surplus in the balance of goods and services will emerge (in the figure, this is
illustrated by the distance 0202 TT AQTB ).6
In sum, in the case of traded goods, shifts in the domestic demand or in the domestic
supply cannot affect the price level: imbalances are matched by the balance of goods and
services, TB.
14.3.4 Non-traded good prices and the level of aggregate demand
We now put the pieces together to examine the implications of an increase in
domestic absorption in a small open economy. If – as it is reasonable to assume – both traded
and non-traded goods are normal goods, then an increase in national expenditure causes the
demand for both goods to increase, as depicted in figures 2 and 3. In the case of tradable-
goods, the price remains constant, but the demand expansion gives rise to a deficit in the TB.
In the case of non-tradable-goods, the demand expansion causes price to increase.
All in all, we conclude that, in a small open economy, an aggregate demand
expansion leads to an increase in the relative price of non-traded goods and to a deficit in the
balance of goods and services.
14.3.5 The real exchange rate and non-traded goods
The Consumer Price Index is a weighted average of traded and non-traded good
prices. Denoting by α the share of traded goods in domestic expenditure, the Consumer Price
Index (P) shall be computed as:
6 Note that the analysis in Figures 2 and 3 is incomplete, because it takes each market separately, without accounting for substitution effects. Thus, for instance, when the relative price of non-tradable-goods increase, one expects consumers to switch expenditure away from the non-tradable-goods towards the tradable-good, and firms to reallocate resources away from the tradable-good sector towards the non-tradable-good sector. These substitution effects are better addressed in a general equilibrium framework, as done in the following sections.
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
The GDP deflator, which is an average of traded and of non-traded goods, exhibits a
different dynamics. As shown in the figure, the GDP price deflator increased faster than
traded good prices along 1995-2009. This is the other side of the coin of the real exchange
rate appreciation observed in Figure 1.
Figure 7 - Prices of imports, exports and of GDP in Portugal 1995-2013
0.9
1
1.1
1.2
1.3
1.4
1.5
1.6
I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I
14.6 Why some countries are more expensive than other?
14.6.1 Real exchange rate and productivity
When one compares the cost of living in different countries, we observe a tendency
for goods to be more expensive in rich countries than in poor countries. One explanation for
this was formulated by Bela Balassa and Paul Samuelson7. In short, the authors contended
that price levels tend to be higher in rich countries than in poor countries because
productivity in traded goods is higher in rich countries than in poor countries.
To see this in terms of our model, let’s consider again equation (23), but using the law
of one price, (11). The price of non-traded goods in the home country is equal to:
a
zFePP L
TN* (39)
A similar expression holds in the foreign country:
*
****
a
FzPP L
TN (40)
Combining these two expressions with (15a), and abstracting from price stickiness,
the equilibrium real exchange rate is determined as follows:
1
*
1**1*
a
a
Fz
Fz
P
eP
L
L
N
N (41)
Equation (41) states that, the equilibrium real exchange rate shall reflect cross-country
differences in the marginal products of labour in tradable and in non-tradable sectors. For
instance, if the home country has a lower cost of living than the foreign country, this can be
7 Balassa, B. (1964), "The Purchasing Power Parity Doctrine: A Reappraisal", Journal of Political Economy 72 (6): 584–596. Samuelson, P. A. (1964), "Theoretical Notes on Trade Problems", Review of Economics and Statistics 46 (2): 145–154.
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
the fact that the relative price of tradable-goods decreased from 20 to 16 induces a
substitution effect whereby the demand for non-tradable-good declines. In the figure, the two
effects exactly cancel out, so that the demand for non-tradable-good remains invariant8.
On the supply side, note that producing 5.12TQ when z=1.25 requires 100TL
workers. In the non-tradable-good sector, there will still be 200NL workers producing
exactly 200NQ . Hence, the productivity shift does not cause employment to be
reallocated across sectors.
Figure 14 – The Balassa Samuelson effect
This exercise clearly shows a real exchange rate appreciation does not need to come
along with an external imbalance: as long as the real exchange rate appreciation is backed by
a productivity increase, it is possible for wages and expenditure to increase without
challenging the external solvency of the country. The real exchange rate appreciation
8 This is a consequence of assuming unit elasticity of substitution between the two goods. Whenever the elasticity of substitution between traded and non-traded goods in consumption is different from one, changes in z, will induce permanent reallocations of labour across sectors that are not accounted for in our model illustration.
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
same time with price stability and nominal exchange rate stability: in face of a productivity
shock, the adjustment in the real exchange rate has to take place in one manner of the other9.
In terms of our numerical example (with 21 ), when z increases from 1z to
25.1z , given the employment level 100TL , the wage rate in units of foreign currency,
eW must increase from 201 to 2025.1 . Whether this is achieved with an increase in
nominal wage from 5W to 25.6W or through a nominal exchange rate appreciation
from 100e to 80e is just a matter of choice between price stability or exchange rate
stability.
More complicated is when technological progress is slower in a country than abroad.
In that case, the real exchange rate needs to depreciate, which requires a decline in nominal
wages or, in alternative, a nominal exchange rate depreciation. The difficulty in adjusting
downwards nominal wages is one of the reasons why many fixed exchange rate regimes
collapse.
14.6.2 Demand driven appreciation
By now, we have examined only equilibria in which the trade balance is zero. The
reason is that we want to abstract from inter-temporal considerations, namely those
underlying borrowing and repayment cycles. In this section, we stick with the case without
borrowing, but we allow the country to run a deficit in the Trade Balance. The trick is to
assume that deficit in the trade balance is financed with another component in the Current
Account, so that the country net borrowing is still equal to zero. This could be, for instance, a
unilateral transfer from abroad (external aid). With such an assumption, one can explore the
9 An interesting example of a tension between nominal avenues occurred in some Eastern European countries in the 1990s, during the run up to the EMU: these countries were experimenting fast technological change, but at the same time they were committed with nominal exchange rate stability and with low inflation, so as to be entitled with EMU membership. Of course, it would be impossible to meet these two criteria at the same time (Szarpáry, G. Transition Countries' Choice of Exchange Rate Regime in the Run-Up to EMU Membership , Finance and Development, June 2001).
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
point 1: in point 1 there is still internal balance (that is, TT QC ), but the economy does not
lie on the TT curve, because there is a deficit in the TB10.
The question that arises is why the real exchange rate appreciated. The reason is that
the higher demand for both goods brought about with the foreign aid generated an excess
demand for the non-tradable-good. Since the non-tradable good cannot be imported, its
relative price had to increase, to 16 . This increase in the relative price of the non-traded
good induced substitution effects, both in production and in consumption (Figure 15).
On the supply side, the increase in the relative price of non-traded goods induced a
reallocation of resources away from the tradable-good sector towards the non-tradable good
sector: the supply of T contracted to 82 TQ , and the supply of N expanded to
2362300 2 NQ . The change in together with the reallocation of production
towards non-traded goods implied an increase in GDP in terms of the traded good to
75.221 NT QQQ . On the demand side, the increase in the relative price of the non-
traded good helped moderate the consumption of this good, shifting the demand towards
imported goods. Given the level of absorption, A=22.75+6.75=29.511 and 16 , the new
consumption levels are 75.142 ACT , 236 TN CC .
Note that the real exchange rate appreciation from 0 to 1 came along with an increase
in the marginal product of labour in the tradable good sector. Such increase was achieved by
the reallocation of labour away towards the non-tradable good sector. Productivity increased
because of diminishing returns.
10 A different question is whether this trade deficit actualy constitutes an external imbalance: note that since there is no borrowing, there is no issue on sustainability here.
11 Note that because the market for non-traded good must balance, NN QC , equations (25) and (27)
imply that any difference between production and expenditure must be accounted by the traded-good sector, only.
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
Sudden stops are a recurrent cause of balance of payment crises in emerging
economies. The increased mobility of international capital that followed the worldwide
liberalization of capital movements along the late 1980s and early 1990s exposed emerging
economies (but not only) to this new phenomenon of capital flow reversals. Examples of
crises triggered by capital flow reversals include those in Chile in 1982, Mexico in 1994,
Southeast Asia in 1997 and the Peripheral Europe in 2010-12.
A sudden capital outflow implies that a country has to move from an external deficit
to an external surplus in a short period of time. This poses a policy change to policymakers
for two reasons: First, the required real exchange rate depreciation may not be easy to achieve
when wages and prices are sticky. Second, structural rigidities may prevent the supply side
from adjusting as desired in the short term. In plus, during a sudden stop, the increased
uncertainty may translate into lower availability of credit to the private sector, delaying the
reallocation process. In general, sudden stops force economies to painful adjustments,
characterized by falling in asset prices, banking crises, currency crashes, and sovereign debt
crises14.
14.8.2 The adjustment to a Sudden stop
In general, financial markets give more time for an economy to adjust during the
boom phases than during the repayment phase. Periods of demand expansion fuelled by
foreign borrowing (“capital flow bonanzas”) tend to be prolonged and smooth, as financial
markets build confidence in the country. However, borrowing phases often finish abruptly,
tilted by confidence crises that alter the agents’ perception regarding the solvability of the
country. When a confidence crisis materializes, lenders will refuse to extend new loans to the
country, forcing the later to external balance – or close to it- in a short period of time.
14 A systematic view in Reinhart, C. M. and K. S. Rogoff (2909), This Time is Different: Eight Centuries of Financial Folly, Princeton University Press.
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
Of course, for a move from 1 to 0 to be possible, one would need wages to be flexible
and labour to be mobile across sectors. While these two assumptions may look reasonable in
the long run, they may well fail in a very short period of time during which countries are
forced to adjust to sudden stops.
14.8.4 Nominal Rigidities
Departing from point 1 in Figure 17, suppose again that the economy is forced to
move towards external balance. Further assume that in this economy, 100 ePT , and
wages were sticky at W=6.25. A question arises on how will the external balance be met in
that case15.
Of course, if the country could change the nominal exchange rate, nominal wage
stickiness would not be a problem: remember that the adjustment requires the ratio W/e to
decline to 0.05, so if the nominal wage remained stuck at W=6.25, a nominal exchange rate
depreciation to e=125 would do the job, allowing the economy to move to point 0, and spend
A=20.
The interesting case arises when the exchange rate is fixed16. In that case, wage
stickiness implies that the real exchange rate remains constant at 161 . Thus, the only way
for the economy to meet the external balance (forced by the market) is through a sharper
contraction of aggregate demand, to 16UA (point U in Figure 17). Since point U lies on the
left of the NN locus, there will be unemployment.
To see how this move looks like in the product space, we turn to Figure 21. In the
figure, note that the optimal production pattern remains the same as in point 1, because the
15 In the following, we assume the sudden stop requires the country to move exactly to external balance, not to repay earlier debt.
16 In alternative, you may think in countries where wages are formally or informally indexed to a foreign currency, such as the US dolar. This type of indexation often occurs as a natural response to high inflation rates. In these “dollarized” economies, the exchange rate depreciation fails to induce changes in the real exchange rate, because the ratio W/e is locked.
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
(licensing) or simply because it takes time for a project to be designed, evaluated, and
implemented17.
Because of these structural rigidities, a move along the PPF may take time to
materialize, even if prices are fully flexible. In the following, we consider the extreme case in
which resources are not reallocated at all. This case can be interpreted as the very short term
in our model.
17 The existence of barriers to the reallocation of labour across sectors motivates the so-called “structural reforms”. During the 2011-2014 bailout, Portugal was required to implement a significant number of labour market reforms, in order to speed up the reallocation of labour form non-traded good sectors to traded good sectors. Unfortunately, political constraints paid a toll in the implementation of these reforms, so part of them was abandoned. In part, the lack of ownership of the programme was implied by a recession that was deeper than expected, in a context of weak growth in Europe and tightening credit conditions.
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
food service activities (restaurants), to raise fiscal revenues. This measure acted as internal
revaluation, thereby moving the relative prices in the wrong direction. With the VAT hike in
restaurants, the relative price of non-tradable-goods increased to consumers, causing the
income expansion path to rotate further down, and the external balance to be met below point
U with an even higher unemployment level.
14.8.8 Immiserizing growth
An issue that has regained importance in international economics is the existence of
positive externalities in manufactures production, in particular learning by doing effects18.
These externalities imply that productivity at the firm level in a given industry may be a
positive function of the size of that industry in the economy and of the country cumulative
experience in that industry.
In the framework above, a learning-by-doing externality in the traded good sector can
be modelled postulating a positive relationship between the productivity parameter in period
2 and the level of production in the tradable good sector in period 1. That is:
TQzz 122 , with 0'z
This equation states that the more a country gets specialized in traded goods in the
first period, the more the production possibility frontier will shift upwards in the second
period (biased towards the traded good sector), allowing the country to enjoy a Balassa-
Samuleson effect, and thereby a higher utility level. In contrast, a country that starts out as a
net borrower, because it exhibit a pattern of production biased towards non traded goods, is
18 A recent discussion in Ostry, J., Ghosh, A., Korinek, A., 2012. Multilateral aspects of managing the capital account, IMF Staff Discussion note, September 7.
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
more likely to loose opportunities in terms of learning by doing, engaging in a kind of
immiserizing growth19.
14.8.9 The Transfer Problem
By now, we have discussed the case of an aggregate demand expansion that is
financed by external borrowing: the deficit in the balance of goods and services leads to a
positive capital account, meaning that the country accumulates liabilities against non-
residents in the first period. In the second period, the foreign debt has to be repaid, so the
country has to run an external surplus, which in turn requires a real exchange rate
depreciation. A difference story occurs when the aggregate demand expansion is caused by a
unilateral transfer from abroad. With positive unilateral transfers, the country can run a
deficit in the trade balance without accumulating liabilities against non-residents.
To see this in terms of our numerical example, just assume that 0*1 r , so that
the household prefers consumption to be smoothed. Also assume that the supply side remains
invariant, with z=1. In that case, we saw that a country without transfers would remain in
internal and external balance, just like in Figure 11. If the economy received a permanent
transfer 75.621 NUTNUT , however, it could sustain an equilibrium like the one
described in Figure 15 in the two periods. In each period the current account would be
075.675.6 NUTTBCA and there would no repayment phase.
With no question, with the unilateral transfer, the expenditure level achieved by the
economy is higher than without the transfer, so households will be better off. The other side
of the coin is that employment moved to the non-tradable-good sector, in result of the real
exchange rate appreciation. This shrinking of the traded good sector in consequence of
transfers from abroad is often a matter of concern for policymakers, especially when transfers
19 This analysis suggests that it pays for a country to pursue a policy of undervalued exchange rate, sustained by capital controls, in order to achieve a pattern of production biased towards tradable-goods, and by then faster technological progress. Some authors have claimed that this reasoning has inspired the “neo-mercantilist” policies implemented in some emerging economies, notably China.
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are related to foreign aid aiming to help countries facing difficulties in servicing their external
debt. By inducing a real exchange rate appreciation and a deficit in the trade balance,
international transfers may delay the adjustment process that the country is suppose to make
to become externally solvent20. Moreover, if unilateral transfers stop flowing in, the country
may face an adjustment problem similar to that of a sudden stop.
14.8.10 Dutch disease
The reallocation of employment towards the non-traded good sector that comes along
with a real exchange rate appreciation was coined as “Dutch Disease” by the Economist
magazine, in 1977. The phenomenon was subsequently modelled in the works of Corden and
Neary21.
The label “Dutch Disease” was inspired in the case of Netherlands in the 1960s. At
that time, Netherlands discovered natural gas in the North Sea. Such a discovery gave rise to
sizeable export revenues, meaning that the country external budget constraint was
substantially relaxed. The phenomenon was labelled “disease” because the real exchange rate
appreciation that came along with the resource discovery impacted negatively in traditional
manufactures, leading to de-industrialization. Episodes of “Dutch Disease” have been
identified in many commodity exporters, especially oil exporting countries.
A Dutch disease arising because of a booming natural resource sector can also be
analysed with reference to Figure 15. Assume that the natural resource sector is a “third
sector”, say oil, different from what we have labelled as traded (manufactures, T) and non-
20 Evidence on the relationship between unilateral transfers and real exchange rate appreciation and de-industrialization include: Rajan, R, Subramanian, A., 2009. Aid, Dutch disease and manufacturing growth, Journal of Development Economics 94(1), 106-118. Lartey, E., Mandelam, F., Acosta, P., 2008. Remittances, Exchange rate regimes and the Dutch Disease: a panel data analysis. Federal Reserve Bank of Atlanta, Working Paper Series 12-2008.
21 Corden WM (1981). “The exchange rate, monetary policy and North Sea oil. Oxford Economic papers 23-46. Corden WM (1984). "Boom Sector and Dutch Disease Economics: Survey and Consolidation". Oxford Economic Papers 36: 362. Corden WM, Neary JP (1982). "Booming Sector and De-industrialisation in a Small Open Economy". The Economic Journal 92 (December): 825–848.
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
traded (N) - that is, the PPF and preferences apply to T and N, only, not to oil. Under this
interpretation, one can model the oil export revenue as playing the role of the transfer in the
model above: the domestic absorption will expand, causing the real exchange rate to
appreciate, and the final equilibrium is as described by point 1 in Figure 15. The only
difference in respect to the transfer case is that excess demand for non-oil traded goods (T),
amounting to -6.75, is now matched by oil exports22.
The Dutch disease is seen as a problem because it leads to the contraction of the
manufactures sector, and consequently to the loss of important skills, and learning by doing.
On the other hand, large swings in the oil prices give rise to periods of macroeconomic
overheating followed by phases of financial stress, when oil prices fall down. Because of the
harmful effects of the Dutch Disease, many governments in commodity exporting countries
have created wealth funds, in order to save in good times and to spend the accumulated
savings when the terms of trade deteriorate. These funds allow governments to smooth their
spending, mitigating the impact of dramatic changes in the terms of trade.
14.9 Mitigating capital flows
The reallocation of resources towards non-traded goods and the implied loss of
learning by doing effects, as well as the threat of a financial crises caused by excessive
borrowing can be interpreted as market failures.
As long as individual domestic borrowers do not take into account the costs they
impose on others domestic agents, there is scope for government intervention to avoid
excessive borrowing.
22 In the real world, the expansion in aggregate demand often comes ahead of oil production, because there is a phase of investment. In this case, a deficit in the current account arises, to be financed with future oil revenues.
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
One avenue to overcome the implications of excessive borrowing is to impose
restrictions on capital inflows23. Restrictions on capital flows have been followed in countries
like Chile, Brazil, and China. A problem with capital controls is that they loose effectiveness
as time goes by. The reason is that people learn how to import capital in a hidden manner: for
instance, by over-invoicing exports, under-invoicing imports or simulating emigrants’
remittances. Because financial innovations will always find ways of circumventing the
regulations, capital controls tend to lose effectiveness along time. Still, capital controls can
play a role in mitigating the impact of capital inflows, especially in the short term.
Central banks can also use regulation to alter the compositions of the liabilities
thereby generated. For instance, central banks may force banks to hold a given amount of
assets denominated in foreign currency, so as to avoid currency mismatches at the time of the
outflow.
As for maturities, central banks can also banish short term lending, so as to reduce
liquidity risks, when banks borrow abroad in short maturities to extend long run credit.
14.9.2 Sterilization
Another tool to moderate the inflow of capital into an economy is monetary
sterilization. Under fixed exchange rates, a central bank is obliged to buy the incoming
foreign currency, expanding domestic liquidity. But then the central bank may try to buy back
part of the liquidity generated, selling domestic assets to banks in the open market. As long as
domestic assets and foreign assets are not perfect substitutes, monetary sterilization may help
mitigate the monetary expansion caused by capital inflow. A complementary measure to
23 In theory, this policy will be the first best whenever the distortion is originated abroad. That is, when capital inflows are motivated by “push” factors (increased savings in partner countries). A similar instrument would be to tax international capital flows (the Tobin Tax).
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
monetary effects of capital flows. As everything else in economics, the optimal answer to the
policy question is: “it depends” 24.
24 Recent discussion regarding the role of capital flows and of exchange rate regimes during the Great Recession include Krugman (2013) and Gosh et al. (2013). Ghosh, A., Ostry, J., Qureshi, M. , 2013. Exchange Rate Management and Crisis Susceptibility: A Reassessment . Paper presented at the 14th Jacques Polak Annual Reserach Conference, IMF. Krugman, P., 2013, Currency regimes, capital flows and crises. Paper presented at the 14th Jacques Polak Annual Reserach Conference, IMF.
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
1. Suppose the assumptions needed for LOOP hold. As an example, assume that there are only two goods, say bread and milk, and that their prices are USD 1.0 and USD 2.0 and €1.00 and €2.00, respectively in the US and in the Eurozone, with the euro-dollar exchange rate equal to 1. Is this possible in this case for absolute PPP not to hold?
2. Consider a world with a single homogeneous good, which can either be produced domestically or abroad under conditions of perfect competition. Initially, the world price of this good is 100 USD and the price of the USD in terms of domestic currency (pesos) is 2.
a) Suppose the price of the good in the domestic economy was initially 190 pesos. In the absence of trade costs, what do you think it would happen?
b) In the real life, do you believe the adjustment described in a) would be instantaneous? Why?
c) Suppose now that transport and other trade costs amounted to 20% of the price of the good. In this case, how would the non-arbitrage condition hold for exports and for imports? Find out the implied band for the real exchange rate.
3. Along the last decades, a number of countries (notably China) have pursued a policy of undervalued real exchange rates, keeping the domestic demand repressed and accumulating current account surpluses. Can you provide a rational for this policy?
4. A synchronized surge of capital flows from industrial countries to emerging economies is better explained by push factors or by pull factors? Explain.
5. Why might large capital inflows be a matter of concern for policymakers? Which policy measures can a country implement to mitigate a capital inflow surge? What are their pros and cons?
6. Comment: “The Purchasing Power Parity is a reasonable predictor of nominal exchange rates in a context where nominal shocks dominate, but not in the presence of large real shocks”.
7. The Republic of Korbut is a small open economy with free capital movements that has been subject to a rise in the productivity of traded goods. Explain the options and the trade-offs involved concerning the choice of the exchange rate policy. Can real appreciation be avoided? If the primary objective of the monetary authorities was to control inflation which policy should be followed?
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
8. A usual practice in high inflation countries is to set-up labour contracts indexed to exchange rate, that is w=w(e). Referring to the TNT model, explain to which extent this practice may undermine the macroeconomic adjustment.
9. Consider a small open economy under a fixed exchange rate regime. This economy has initially two sectors: one of traded goods and other of non-traded goods. Starting from a situation of internal and external balance, describe the adjustment process of that economy following the discovery of an important mineral resource (third sector). Which policies shall the authorities adopt so as to minimize the impact of that discovery?
10. Consider a small open economy with two goods, one traded internationally and another non-traded. In the initial situation, aggregate expenditure and aggregate production are equal and the economy is in internal and external balance.
a) Assume that this economy is hit by a large capital inflow. Knowing that the central bank follows a fixed exchange rate regime, explain the impact of this capital inflow on domestic money supply and on the level of aggregate demand.
b) Analyse the macroeconomic impact of the aggregate demand shift, with help of a graph. In particular, discuss the impact on: (i) the relative price of non-traded goods; (ii) the production pattern; (ii) the consumption pattern; (iii) the trade balance.
c) Now assume that there is a sudden capital flow reversal. Explain why wage flexibility and labour mobility are important to minimize the adjustment costs. Would this economy be better served with a flexible exchange rate regime
Exercises
11. (Balassa-Samuelson and PP exchange rates) Consider a small open economy producing a tradable-good (T) and a non-tradable (N) good. The corresponding production functions are TT aLY and NN LY , with 1a . Define w as the nominal
wage rate, TP as the price of T, NP as the price of N and as the real exchange rate.
The weight of each good in the consumer price index is 50%. The foreign price of the tradable-good is 1* TP and the nominal exchange rate in this economy is 100e .
a) Assuming that firms maximize profits under perfect competition, find out the equilibrium wage rate in this economy in units of domestic currency, as well as the prices of the two goods and the consumer price index.
b) Now assume that the foreign economy is similar to the home economy, except in that 2* a . What would be the wage rate there, in units of foreign currency?
c) Find out the equilibrium real exchange rate between the two economies? Would absolute PPP hold in this case? Why?
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
d) On the basis of your findings, how much would be the purchasing power of workers at home relative to that of workers abroad? Explain the exchange rate measure used in this international comparison.
12. (Balassa Samuelson effect and Exchange Rate regimes): Consider a small open economy producing a traded good (T) and a non-traded (N) good. The corresponding production functions are TT aLY and NN LY . Assume that the foreign prices of
these goods are 1** NT PP and that the nominal exchange rate is 100e . Finally,
assume the weight of each good in the consumer price index is 50%. Define w as the nominal wage rate, TP as the price of T , NP as the price of N and as the real
exchange rate.
1. Assume first that 4a .
d) Find out the labor demand equations in the two sectors
e) Compute the equilibrium wage rate, the corresponding price level and the real exchange rate.
f) Now suppose that the nominal exchange rate depreciated to 400e . What would happen to the price level and to the real exchange rate? Was PPP a good theory in that case? In absolute terms or in relative terms?
2. Departing again from 100e , examine the impact of a fall in the productivity of the traded good from 4a to 1a
g) Describe the implications of such a shift on TP , NP , and the equilibrium real
exchange rate, assuming that the nominal exchange rate was fixed.
h) If non-traded good prices were sticky, how could the central bank easy the adjustment process setting the nominal exchange rate?
13. (Balassa Samuelson effect and Exchange Rate regimes): Consider a small open economy producing a tradable-good (T) and a non-tradable (N) good. The corresponding production functions are TT aLY and NN bLY . Assume that the
foreign prices of these goods are 1** NT PP and that the nominal exchange rate is
1e . Finally, assume the weight of each good in the consumer price index is 50%. Define w as the nominal wage rate, TP as the price of T , NP as the price of N and as
the real exchange rate.
1. Assume first that 1 ba
a) Find out the labor demand equations in the two sectors.
b) Compute the equilibrium for the wage rate, the price level and the real exchange rate.
2. Consider an increase in the productivity of the tradable-good from 1a to a 4 .
c) Describe the implications of such a shift on TP , NP , w and the equilibrium real exchange
rate, assuming that the nominal exchange rate was fixed.
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
d) If instead the central bank’ goal was to keep the inflation rate equal to zero, what should happen to prices and to the nominal exchange rate?
e) What should happen to the real exchange rate if the productivity shock was instead on parameter b?
14. (Balassa-Samuelson, exchange rate options) Consider a small open economy producing a traded good (T) and a non-traded (N) good. The corresponding production functions are TT aLQ and NN bLQ . Assume that the foreign prices of these goods
are 1** NT PP and that the nominal exchange rate is 1e . Finally, assume the two
goods weight the same in the consumer price index, that is NT PPP 5.05.0 .
Assume first that 1 ba
a) (Initial equilibrium): Find out the labour demand equations in the two sectors.
b) Compute the equilibrium wage rate, the CPI and the real exchange rate, PeP* .
(Balassa Samuelson): Now examine the implications of an an increase in the productivity of the traded good from 1a to 2a .
c) Describe the impact on TP , NP , w and the equilibrium real exchange rate, assuming
that the nominal exchange rate was fixed [A: 2NP ].
d) If instead the central bank’ goal was to keep the inflation rate equal to zero, what should happen to prices and to the nominal exchange rate? [A: 32e ].
e) Taking into account your results in c) and d), explain the trade-offs involved concerning the choice of the exchange rate policy. Can a real appreciation be avoided? If the primary objective of the monetary authorities was to control inflation which policy should be followed? (read the article by G. Szapáry, in F&D, on the policy dilemmas of transition countries in the run-up to the EMU).
f) What would happen to the real exchange rate if the productivity shock was instead on parameter b?
Now assume that the labor endowment in this economy was L=120, the consumer preferences were such that NT CC irrespectively of the price level, and that the money
demand function was given by NNTT CPCPM .
g) Show how the productivity shift from 1a to 2a impacts on the country production possibilities frontier.
h) Describe the optimal production and consumption baskets before and after the productivity shift, assuming that internal and external balance are preserved.
i) Prove that before the shock the money supply was equal to M=120.
j) After the shock, how much should be the money supply so as to: (j1) keep the exchange rate fixed; (j2) keep the price level constant. [A: 240, 160].
k) (Aggregate demand expansion): Finally, return to the initial case with 1 ba , and examine the implications of an expansion of the money supply from M=120 to
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
M=160, namely on the: (j1) consumption pattern; (j2) production pattern; (j3) trade balance. [A: TB=-40].
15. (Equilibrium RER in the medium run) Consider a small open economy producing a tradable-good (T) and a non-tradable (N) good. The corresponding production functions are 21
TT aLY and NN LY . In this economy, there are 100 workers, and prices are
flexible, so full employment is always met. Assume that the foreign prices of these goods are 1** NT PP and that the nominal exchange rate is 1e . Finally, assume the
weight of each good in the consumer price index is 50%. Define w as the nominal wage rate, TP as the price of T , NP as the price of N and as the real exchange rate.
a) Find out the labor demand equations in the two sectors.
b) Find out the expressions for the wage rate, the price level and the real exchange
rate, as a function of the unknown parameters a and TL .
c) Assume that the steady state in this economy is characterized by 1a and 64TL .
Find out what the long run equilibrium real exchange rate will be.
d) Now, consider a temporary departure form the steady state, implying a – also temporary- reallocation of 60 workers away from the tradable-good sector to the non-tradable-good sector. What would happen to the real exchange rate in this case?
e) Distinguish the phenomenon described in this exercise from the Balassa-Samuelson effect.
16. (Swan Diagram): Consider a small open economy endowed with 300 units of labour, which produces a traded good (T) and a non-traded good (N). The corresponding production functions are 5.0
TT LQ and NN LQ . It is further assumed that the utility
function is given by NT CCU , and that labour is perfectly mobile across the two
sectors.
a) Find out the demands for N and T as functions of A and NT PP .
b) Find out the supplies of N and T as functions of NT PP .
c) Find out the combinations of A and that are consistent with the internal balance. Represent in a graph. Characterize the points (10, 20), (20, 20) and (40, 20) in terms of internal balance.
d) Find out the combinations of A and that are consistent with the external balance. Represent in a graph. Characterize the points (10, 20), (20, 20), (40, 20), and (10, 10) in terms of internal balance
e) Find out the values of A and that are consistent with the internal and external balance.
f) Now suppose that domestic absorption increased to A=29.5. What would happen to the real exchange rate? Would the economy approach the external balance? Represent in the Swan diagram and in the PPF.
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
17. (Balassa Samuelson effect): Consider a small open economy endowed with 300 units of labour, which produces a traded good (T) and a non-traded good (N). The corresponding production functions are 5.0
TT zLQ and NN LQ . It is further assumed
that the utility function is given by NT CCU , and that labour is perfectly mobile
across the two sectors.
a) Distinguish the markets of T and N in respect to the process of price formation.
b) Compute the expression for the production possibilities frontier and the marginal rate of transformation in this economy, for different values of z. Represent it in a graph.
c) Denoting for w the wage rate, PT the price of T, PN the price of N, find out the labour demand equations in the two sectors. Using the arbitrage condition in the labour market and the expression for the PPF, find out the optimal supplies of T and N as a function of NT PP and z.
d) Let A denote for absorption in units of T, and further assume that the only component of absorption is private consumption. Find out the optimal demand for T and N as functions of A and NT PP .
e) Now assume that internal and external balance holds continuously in this economy, that is TT CQ and NN CQ . Find out the equilibrium values of NT PP for two
cases: z=1 and z=2. Which main proposition is illustrated here? (clue: z20 ).
f) For the two cases considered in (e), find out the corresponding values of TQ , TC and A. Represent in a graph.
g) Finally, assume that the world prices are 1** TPP and that the nominal exchange
rate is given by 100e . Explain what would happen to the real exchange rate, w and PN if there was a fall in productivity from z=1 to z=2. If nominal wages were sticky, which other instrument could be used to achieve the internal and external balance?
18. (Borrowing and repayment cycle). Consider a small open economy endowed with 300 units of labour, which produces a traded good (T) and a non-traded good (N). The corresponding production functions are 5.0
TT LQ and NN LQ . It is further assumed
that the utility function is given by NT CCU , that labour is perfectly mobile across the
two sectors, that the foreign price of the traded good is 1* TP and the nominal exchange rate is 100e .
a) Compute the expressions for optimal production and optimal consumption of the two goods as functions of A and .
b) Find out an expression for domestic income (Q) as a function of . Then, use this expression to compute the domestic demand (absorption) as a function of and the trade balance, A=Q+TB.
c) Using the equation above and the identity TBCQ TT , find out an expression relating the equilibrium level of as a function of TB. Represent in a graph and display the implied values when: TB=0; TB=-6.75; TB=6.75.
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
d) Assume now that the economy is initially in internal and external balance. Find out the equilibrium values of QT, QN, NT PP , Q, and nominal wages. Represent in a
graph.
e) (Capital inflow) Now assume that there is a demand expansion, fuelled by a capital inflow amounting to 6.75 units of foreign currency. Quantify and describe in a graph the impact on the patterns of production, consumption, and the real exchange rate, assuming that all prices are fully flexible.
f) (Repayment) Sticking with the assumption of flexible prices, describe the equilibrium in the period after, when the economy is called to pay back 6.75 of foreign currency (it is assumed that the interest art in the foreign loan is zero).
g) (Nominal rigidities) Finally, consider the case where nominal wages and prices of non-traded goods could not be changed at all. In that case, how much should the domestic demand fall, for the country to repay its debt? How many workers will be unemployed in this case?
19. (Unresponsive Supply) Consider an economy where the supply side is such that production is fixed at 40TQ and 80NQ and where consumer preferences were such
that NT CC irrespectively of the price level. In this economy, the domestic demand is
given by NNTT CPCPM . Finally, assume that the exchange rate is fixed and that
NNT PPPe 1** .
a) Describe the equilibrium of this economy when M=160.
b) Examine the implications of a sudden fall in the money supply to M=80 [A: Unemployment=40].
20. Consider a small open economy endowed with 3 units of labour, which produces a traded good (T) and a non-traded good (N). The corresponding production functions are
NN LY and 21
TT LY . It is further assumed that: the utility function is given by 2121
NT CCU ; labour is perfectly mobile across the two sectors; the foreign price of the
traded good is 1* TP ; the nominal exchange rate is 1e .
a) Find out the expression for the production possibilities frontier.
b) Assuming that the economy is initially in internal and external balance, compute the equilibrium values of NY , TY , NT PP , NP . Compute the value of domestic
income in units of domestic currency.
c) Assume that there is a permanent contraction in aggregate demand (say, to pay interest on a old debt), so that its level in nominal terms falls down to 23 . If prices
remained unchanged (short run), what would be the implied levels of NY , TY , NA ,
TA and the trade balance? Discuss.
d) Now assume that wages and prices were fully flexible. Find out the new equilibrium in this economy. Explain.
e) In light of c) and d) (but not only) discuss the pros and cons of having a fixed but adjustable exchange rate regime.
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
21. Consider a small open economy with a fixed exchange rate, where two goods, T and N, are produced according to 5.02 TT LQ and NN LQ . Further assume that 15 ePT ,
total labour is 75L and the demand functions for the two gods are ACT 5.0 , and
ACN 5.0 .
a) Describe the Swan diagram. Find out the combinations of A and that are consistent with internal balance, external balance, and both. Characterize, in the diagram, the four zones of economic unhappiness.
b) Suppose that initially 3 and A=44. Classify this equilibrium in terms of internal and external balance.
c) Departing from (b), suppose that a sudden stop forced this economy to external balance. Assuming flexible prices and perfect labour mobility, how should the wage rate adjust? Describe the move in the Swan diagram. Find out what happens to employment in each sector along this move.
d) Departing from (b), suppose that nominal wages in this economy were indexed to the nominal exchange rate, according to 3eW . Would it be possible for this economy to meet the internal and external balance in this case? Describe the adjustment of the economy following the sudden stop in this case, and the implied level of A. Find out what happens to employment in each sector along this move.
e) Comparing with c) and d), which groups in the society would be better off and worse off?
22. Consider a small open economy under fixed exchange rates producing and consuming two goods, T and N. The corresponding production functions are TT LQ and
NN LQ . In this economy, labour is specific to each industry (immobile across sectors)
and the labour endowments are 50TL and 50NL . Finally, assume that the utility
function is TNCCU .
a) (Supply side): Represent the production possibilities frontier in a graph. b) (Demand-side): Prove that the demands for tradable and non-tradable-goods are
given by 2ACT and 2ACN , where A denotes for absorption in units of the
tradable-good, and for the relative price of the tradable-good. c) (Swan diagram) Find out the combinations of A and that are consistent with: (c1)
the internal balance; (c2) the external balance. (c3) Represent the two curves in a graph. (c4) Find out the levels of A and that are consistent with the simultaneous equilibrium.
d) (Repayment) Departing from the equilibrium described in c), assume that this economy faced a sudden capital outflow, amounting to 10 units of the tradable-good. (d1) What would happen to A and TC ? Quantify. (d2) Quantify the implied assuming that prices were fully flexible. Explain the intuition of the price adjustment.
e) In alternative to (d2), assume that the non-tradable-good price was sticky (that is, unchanged). Describe the adjustment of the economy to the capital outflow in that case, quantifying the implied values for NC and employment. Represent the new
position of the economy in a graph and compare with d2).
Politicas macroeconomicas, handout, Miguel Lebre de Freitas
23. Consider a small open economy with a fixed exchange rate, where two goods, T and N, are produced according to 50TQ and Q
N L
N 50 . Further assume that 1* TP , the
nominal exchange rate is 1e , and the utility function takes the following form:
NTCCU .
a) Describe the production possibilities frontier in a graph. Provide possible explanations for this particular shape.
b) Find out the demands for T and N, as functions of A (total absorption in units of T), and (the relative price of T).
c) Describe the Swan diagram. Find out the combinations of A and that are consistent with: (c1) internal balance; (c2) external balance. (c3) Identify in the diagram and characterize the four zones of economic unhappiness.
d) Suppose that initially 8.0 and A=100. Describe this equilibrium, quantifying: (d1) the prices of the two goods, and the wage rate; (d2) the unemployment level; (d3) the trade balance; (d4) if wages were fully flexible, how would the economy adjust? (d5) How is this type of adjustment labelled?
e) Now suppose that nominal wages were sticky. Considering the following money demand, NNTT CPCPM , explain what would happen to employment and to the
trade balance if money expanded from M=100 to M=125. In particular, distinguish the cases in which: (e1) the exchange rate remained fixed at 1e ; (e2) the exchange rate adjusted to preserve the external balance. (e3) Compare the two cases in the Swan diagram, and discuss.