Advanced Lecture Notes for Hall and Taylor, Chapter 2
Maintained by:
Leigh Tesfatsion
Email:
tesfatsi@iastate.edu
Last Updated: 31 August 1996
PLEASE NOTE: For the figures accompanying these notes, see
the class lectures.
Basic References: Macro Principles Review;
HT Chapter 2; Study Guide, Chapter 2
1. THE ECONOMY AS A CIRCULAR FLOW
Modern industrialized economies are extremely complex---how to get a
handle on this complexity?
Standard approach in current mainstream economics: First try
for a "slice in time" picture of the economy. Consider who are
the key types of economic agents in the economy at a point in
time, together with the key types of economic transactions they
are engaged in.
Key types of agents in a modern industrialized economy: Firms,
consumers, financial intermediaries (e.g. banks), and government
policy-makers.
Key types of economic transactions: Exchanges of goods and
services (physical flows) in return for payments (money flows)
Figure 1: The Economy During a Given Period of Time,
Conditional on a Given "State of the Economy"
Figure 2: Figure 1 Extended to Include Financial Intermediaries
Fig 3: Fig 2 Extended to Include Government and a Foreign Sector
2. AGGREGATE DEMAND AND AGGREGATE SUPPLY
The circular flow figures give us a view of a modern
industrialized economy in terms of its principal types of
economic agents and the transactions which interconnect them.
Assuming the industrialized economy is organized in a
decentralized fashion, so that buy and sell decisions are made
by individual households and firms without central direction
from government, a useful alternative way to view the economy is
through its market structure.
A. #Review of Supply and Demand Curves for an Individual Market#
In a market consisting of a number of buyers and sellers
for some particular item (good or service) B, for example bread,
supply-demand analysis determines an "equilibrium" (market
clearing) price p and quantity q for B. Note that the prices p
denote #per unit# prices, e.g., if bread is measured in pounds,
p represents the price for one pound of bread.
The #supply curve for B# is a schedule of price and quantity
pairs (q,p) such that, for each price p, the corresponding
quantity q gives the #maximum# number of units of B which
producers would be willing to produce and sell at that price.
The supply curve (typically) slopes upward because higher prices
are needed in order to compensate a producer for the higher cost
of obtaining additional resources needed to produce an
additional amount of the item.
Figure Depicting Supply Curve
The #demand curve for B# is a schedule of price and quantity
pairs (q,p) such that, for each price p, the corresponding
quantity q is the #maximum# number of units of B which
households and/or firms are willing to buy at that price. The
demand curve (typically) slopes downward because buyers as a
group respond to lower prices by purchasing more units of the
item.
Figure Depicting Demand Curve
Putting demand and supply together constitutes the "market" for
B.
#Market Equilibrium#: A point (q0,p0) is said to represent a
#market equilibrium for B# if it lies on both the supply curve
for B and the demand curve for B, that is, if it is a point
where the supply and demand curves for B intersect one another.
In a freely operating market (e.g. no price controls or quantity
rationing), the market price and quantity are determined
#simultaneously# by the intersection of the supply and demand
curves. At any such intersection point (q0,p0), for the given
price p0, buyers are just willing to buy the quantity q0 which
producers are just willing to supply, and the market is said to
#clear#.
At any point on the graph other than the "equilibrium"
(intersection) point E, either buyers or sellers would be
dissatisfied. Suppose, for example, that the current price for
B is too low for market clearing---e.g. the price is at the
level p2, depicted below. At the price level p2, households
would demand qd units of B, which is more than the amount qs
which producers wish to supply. In other words, there would be
#excess demand# for B at price p2. When households demand more
of an item than is available, they will tend to bid up the
price. As prices rise, suppliers will have an incentive to
produce more of the item. At the same time, demand for the item
will fall. This process will continue until excess demand is
eliminated and the market comes to rest at the equilibrium point
E = (q0,p0).
Figure Depicting Market Equilibrium
Key Point: The useful concepts of supply and demand as applied
to the buying and selling of individual goods and services also
be usefully applied at the #macro# level to characterize
"equilibrium" outcomes for #aggregate# supply and demand in an
economy as a whole.
B. #Macro Extension of Demand and Supply Curve Analysis: Rough
Definitions#
The #aggregate supply curve# is a schedule relating the
#total# supply of #all# final goods and services in an economy
to some index for the general price level in that economy.
The #aggregate demand curve# is a schedule relating the
#total# demand for #all# final goods and services in an economy
to some index for the general price level in that economy.
Making use of the previously discussed circular flow
figures, the various constituents of aggregate demand and supply
can be schematically depicted as follows:
Schematic Depiction of the Separate Constituents of Aggregate
Demand and Supply
---
Planned House. Cons | Planned
| Demands for
Planned Priv Inv |--> Final Goods -------> Aggregate --
| and Services Demand |
Planned Govt Spending | Curve |
| |
Planned Net Exports | |
--- |
| -- Price
| | Level P
|->|
| -- Output
| Level Q
-- Planned |
Planned Private Prod | Supplies of |
|--> Final Goods ------> Aggregate -----
Planned Govt Prod | and Services Supply
--- Curve
In order to develop and use the concepts of aggregate
demand and supply with some care, we need to start with a brief
review of the national income accounting measures conventionally
used in the U.S. and elsewhere to measure #realized# output,
income, the general price level, inflation, and unemployment.
BRIEF REVIEW OF NATIONAL INCOME ACCOUNTING MEASURES
A.1 Gross National Product
The #gross national product# (GNP) for a particular country
[the "home country" HC] during a specified time period T is the
market value of all final goods and services produced during
period T using HC-owned factors of production [capital, labor,
and natural resource services].
Points to Note:
a. The time-period T for measuring GNP is conventionally
taken to be either one year (annual GNP) or three months
(quarterly GNP).
b. #Intermediate goods and services# in period T are goods
amd services #used up# in the production of other goods and
services during period T. #Final# goods and services in period T
are goods and services which are not intermediate. [Thus, the
flour sold in supermarkets constitutes part of GNP, but not the
wheat that was sold to mills in order to make the flour.]
c. GNP consists of goods and services produced using HC-owned
assets regardless of #where# the production actually takes
place.
A.2 Gross Domestic Product
As an alternative to GNP, many countries (including the
U.S.) now emphasize a measure of national production called
"gross domestic product." The #gross domestic product# (GDP)
for a HC during a specified time period T is defined to be the
market value of all final goods and services produced #within
the borders of the HC during period T#, without regard to whether
the production is done by factors of production owned by the HC or
by the rest of the world (ROW).
It follows from the definitions of GNP and GDP that the
only difference between them concerns the treatment of output
produced by HC-owned assets #outside# the borders of the HC and
the treatment of output produced by ROW-owned assets #within#
the borders of the HC.
Define "net factor payments from abroad in period T"
---abbreviated by NFP(T)---to be the payments received by
HC-owned factors of production employed in ROW production during
period T minus the payments received by ROW-owned factors of
production employed in HC production during period T. Then
GDP(T) = GNP(T) - NFP(T) .
Following HT, we shall henceforth we shall work in terms of GDP.
A.3 Constituent Parts of GDP
Economists and statisticians at the Bureau of Economic
Analysis (BEA) of the U.S. Commerce Department in Washington, D.C.
are responsible for collecting data on the GDP and its
constituent parts and publishing the National Income and Product
Accounts (NIPA).
There are three equivalent ways to measure GDP:
by spending;
by value added;
by earned income.
By accounting definition, the total amount of spending is
necessarily equal to the value of total net production (value
added), which in turn is necessarily equal to the total amount
of earned income.
GDP = TOTAL SPENDING = TOTAL VALUE ADDED = TOTAL EARNED INCOME
where
TOTAL VALUE ADDED = FIRM REVENUES FROM - FIRM PAYMENTS TO OTHER
THE SALE OF PRODUCED FIRMS FOR GOODS AND SERVICES
GOODS AND SERVICES USED UP IN INTERMEDIATE STAGES
OF PRODUCTION
and
TOTAL EARNED INCOME = PRE-TAX WAGES + PRE-TAX PROFITS
+ PRE-TAX INTEREST + PRE-TAX RENT
= AFTER-TAX WAGES, PROFITS, INTEREST, AND RENT
+ GOVERNMENT INCOME (TAX REVENUES).
Note that value added for period T includes expenditures for
capital to be used in #future# production periods, i.e., capital
goods not fully used up in the intermediate stages of production
during period T.
We will concentrate in class on the spending definition of GDP.
#GDP measured through spending: The National Income Accounting Identity#:
GDP = C + I + G + [EX - IM]
Realized Realized gross Realized HC Realized net exports
consumption investment spending government (exports - imports)
spending by by HC firms spending i.e. net spending
HC households (including (including on HC produced
(including import spending) import spending) goods and service
import spend.) during period T during period T by ROW during
during period T) period T.
or
GDP = [ C + I + G - IM] + [ EX ]
Value of all final Spending by HC private Spending by ROW
goods and services and public sectors on on final goods and
produced within the final goods and services services produced
borders of the HC produced within the borders within the borders
during period T of the HC during period T of the HC during
period T
IMPORTANT REMARK:
Comparing this equation to our previous depiction for
aggregate demand, one might wonder whether GDP simply coincides
with the concept of aggregate demand.
The crucial difference between aggregate demand and GDP is
that aggregate demand is #planned# expenditure on goods and
services #corresponding to some possibly hypothetical price
level# whereas GDP is #realized# expenditure on goods and
services for the #actual# price level.
Note that #planned# expenditures on goods and services may
fail for various reasons to be actually realized--there may be
excess demand or supply. One might say, then, that aggregate
demand for any given price level is the #anticipated# level of
GDP corresponding to that price level, assuming agents can buy
and sell all they want to at that price level.
REMARKS ON AGGREGATE CONSUMPTION C:
C comprises #net# household-sector spending on final goods
and services for current use.
Goods may be either durable or nondurable.
Net spending on newly built homes is the only type of net
household expenditure for goods which is #not# included in C;
for national income accounting purposes, it is counted as fixed
investment [part of I].
REMARKS ON AGGREGATE INVESTMENT I:
Investment I consists of both #inventory# and #fixed# investment.
#Inventory investment# is simply the change in the total stock
of inventories (raw materials, parts, and unsold finished goods)
held by business firms over the stated period of time.
#Fixed investment# consists of expenditures made on physical
capital goods (e.g., equipment and structures) in order to
increase capabilities for production in the future.
[Example: The purchase of a newly built house or building by
the private sector is viewed as the purchase of a physical
capital good which will produce a stream of outputs (housing
services) to the owner over the coming years. Note that the
#transfer# of ownership of an existing house or building from
one household or firm to another does not get counted as
investment in period T, since it does not represent spending on
a newly produced good or service.]
Investment does #not# include purchases of financial assets
such as stock shares, bonds, or any other paper asset. These
transactions are transfers of claims to income streams from
existing assets; they do not constitute expenditures for newly
produced goods and services.
Similarly, the purchases of physical capital goods produced
in periods previous to period T are excluded from the measure
for period T investment. Such purchases of existing previously
produced goods are simply transfers of ownership claims which
net out to zero in the aggregate.
The investment I counted in GDP is #gross#, i.e., it
includes that part of investment made to replace worn out
capital [capital stock depreciation]. An alternative measure to
GDP is #net national product# (NNP), which is defined the same
as GDP except that only #net# investment is counted, where
Net Investment = Gross Investment - Depreciation Expenditures.
Another concept occasionally used is #Final Sales#, defined
to be GDP minus inventory investment. Since inventory
investment exhibits large fluctuations, final sales tend to
fluctuate less than GDP.
REMARKS ON GOVERNMENT EXPENDITURE G:
Government expenditure G includes government purchases of
final goods and services at all three levels of
government---federal, state, and local.
Up until 1996, no distinction was made between government
consumption and government investment--a fact that many economists
strongly criticized. All government expenditure was treated as if
it were consumption expenditure. Starting in 1996, government
expenditures have been separated into investment and consumption portions.
Government expenditure G #excludes# transfer payments such
as welfare payments, social security benefit payments,
unemployment insurance payments, and interest payments on the
public debt. These payments are transfers of #existing# income
among taxpayers, not income payments for the purchase of newly
produced goods and services.
REMARKS ON NET EXPORTS NE:
HT use "X" for net exports, but many economists use "X" for
exports and "M" for imports, hence X-M for net exports. To
avoid confusion, we will use NE for net exports, EX for exports,
and IM for imports. Thus NE p EX - IM.
#Exports# are deliveries to ROW of goods and services
produced within the borders of the HC during period T.
#Imports# are deliveries to the HC of goods and services
produced within the borders of ROW during period T.
Imported goods and services [goods and services produced
within the borders of ROW during period T] should clearly not be
included in the measure of the HC's GDP, hence they are
#subtracted# from the total of all HC spending to arrive at a
measure of total spending for goods and services produced within
the borders of the HC in period T.
Exports and imports do not include loans between countries,
of any other exchanges of financial assets.
A NOTE ON GDP VERSUS INCOME:
A complication in the measurement of income is the
appropriate operational treatment of taxes and transfers.
Typically GDP is #not# used as a measure of income in the U.S.
because the prices used to compute GDP are those paid by
purchasers, which include sales and excise taxes. Also, GDP
includes depreciation expenditures.
An important measure of income in the U.S. is #National
Income# (NI). National income differs from GDP in that it
excludes depreciation expenditures [e.g. purchase of replacement
capital], sales and excise taxes, and business transfers, and
includes net subsidies to government businesses. Two other
important measures are #personal income# (income received by the
household sector before taxes) and #disposable income# (income
received by the household sector after taxes).
Personal Income = National Income
- [Contributions for Social Security]
- [Corporate Retained Earnings]
+ [Nonbusiness Interest]
+ [Transfer Payments From Government and
Business]
Disposable Income = Personal Income - Income Taxes.
B. Nominal vs. Real Gross Domestic Product
Roughly speaking, period-T #nominal# GDP is the value of
final goods and services produced in period T as measured in
period T prices:
Period-T Nominal GDP = Value of final goods and services
produced in period T measured in
period T prices
Ideally, period-T "real" gross national product should then be a
measure of year-T production in physical terms rather than in
money units. However, apples cannot simply be added to
oranges. Something is needed to transform the various
heterogeneous types of goods and services into a common unit, so
that addition can take place.
To undertake the computation of #annual# real GDP, it has
been traditional to designate some conventionally chosen year
(e.g., 1987) to be the #base year#. #Real GDP for year T# is
then defined to be the value of final goods and services
produced in year T as measured in base year prices:
Year-T Real GDP = Value of final goods and services
(Traditional measure) produced in year T measured in
base year prices
This type of measure for real output (using fixed base year
prices to evaluate the output) is referred to as a "fixed
weight" measure.
#IMPORTANT NOTE#: In early 1996 the Commerce Department adopted
a new system for measuring real GDP---called the "chain-weighted
method"---under which GDP is deflated by an inflation rate yardstick
that is updated every year. The difference between GDP measured by
the traditional fixed-weight measure and GDP measured by the
traditional measure can be rather substantial.
Although advocates claim that the chain-weighted measure for
real GDP corrects for inflation effects in a more timely
up-to-date fashion, the measure has a number of expositional
drawbacks that are still under debate and it has not yet been
incorporated routinely into economic texts. We will follow HT
in using the more traditional measure of real GDP for the
duration of this course.
Given the (traditional) measure of real GNP, the #Year-T
GDP Implicit Price Deflator P(T)# is defined to be
Year-T Nominal GDP
P(T) = --------------------- .
Year-T Real GDP
The GDP implicit price deflator P(T) is not unit free. For
example, for the U.S., its unit of measure is [Year-T dollars
per Base-Year Dollar]. Note, in analogy to micro, that one has
P(T) x Real GDP = Nominal GDP
"price" "quantity" expenditure
(Year T Dollars Per (Base Year Dollars) (Year T Dollars)
Base Year Dollar)
The GDP Implicit Price Deflator provides one useful way to
measure the #real# purchasing power of the dollar, i.e., the
amount of goods and services #in physical terms# which a dollar
can buy. Alternative purchasing power measures will be
discussed later on.
C. Saving and Investment
To avoid substantial confusion in the discussion of saving
and investment, it is essential to distinguish between what is
#planned# and what is #actually realized#.
Realized Saving = Planned Savings + Unintended Savings (or Dissavings)
Realized Investment = Planned Investment + Unintended Investment
(e.g., unintended inventory accumulation
or deccumulation)
#Planned saving# can and typically does differ from
#planned investment#. Indeed, the equality of planned saving
and planned investment is equivalent to the equilibrium
condition that aggregate demand equals aggregate supply. This
will be seen in later lectures.
On the other hand, #realized saving# is defined to be
realized income minus realized consumption. Given this
definition for realized saving, it follows from the National
Income Accounting Identity that realized saving #must# coincide
with realized investment.
To see the latter point, consider first the case of an
economy without a foreign sector (i.e., a closed economy) and
without a government sector. Then:
GDP (realized total income) = C (realized cons spend)
+ I (realized inv spend)
together with
S (realized saving) = GDP (realized total income)
- C (realized cons spend.);
implies
S = I .
Now consider the generalization of this result to an open
HC economy with a government sector. As in HT, the following
abbreviations will be used. The term "private sector" refers to
the household sector and business sector combined.
F = Government transfers to the HC private sector;
N = Interest paid by HC government to HC private sector holders
of public debt (debt instruments issued by the HC government);
T = Taxes;
V = Factor income and transfer payments from ROW (net);
S`p = Private saving (personal savings of the HC household sector plus
business savings of the HC business sector);
S`g = Government saving (the negative of the government deficit);
S`r = ROW saving vis-a-vis the HC (approx = net HC borrowing from ROW);
Y = GDP;
C = Consumption Spending;
I = Investment Spending;
G = Government spending;
NE = Net exports.
Then
S`p = [Y + V + F + N - T] - C
Disposable Income Consumption
S`g = [T - F - N] - G = - [Gov't Def]
Govt Income [Tax Receipts Government
Net of Transfer and "Consumption"
Interest Payments
S`r = IM - V - EX = - V + [HC trade deficit
with ROW]
Income received ROW Consumption | |
by ROW from HC of HC goods and | |
from sale of ROW and services --------------
goods/services "current account"
and from ROW
factor payments
NOTE: S`r = ROW saving vis-a-vis the HC = (net) HC borrowing from ROW
Clearly the HC must finance any excess of imports over exports
by borrowing from ROW [selling financial assets to ROW, i.e.,
claims to future income streams such as stock shares, bonds, and
deeds to commercial real estate.] However, HC net gifts and
other transfer payments to ROW must also be financed by HC
borrowing, so -V must also appear in the definition of S`r.
Summing the three sources of savings, using the notation NE
= [EX - IM], one obtains
S = S`p + S`g + S`r = ([Y+V+F+N - T] - C) + (T-F-N-G) + (IM - V - EX)
= Y - C - G - NE
= I .
In short, it has been shown that realized savings must equal
realized investment, even in an open economy:
S`p + S`g + S`r = I
HC national savings ROW savings HC investment
| |
| |
--- Total Savings------
at Disposal of HC
This relation is very informative. The sum of S`p and S`g
gives total HC savings, or HC "national savings." Given a low
level of private savings S`p (such as in the U.S. in recent
years), a decrease in government savings S`g (i.e., an increase
in the government budget deficit) must either depress HC
investment I or increase ROW savings S`r (i.e., increase HC net
borrowing from ROW) or both.
The difficulty with financing a budget deficit through ROW
savings rather than through HC national savings is that the HC
government ends up selling more and more financial assets to
ROW, including ownership claims to HC productive physical assets
such as corporations and commercial real estate. The danger is
that the HC comes to depend on borrowing from abroad to finance
its expenditures; but that borrowing is not guaranteed---it is
at the discretion of ROW, not the HC.
The U.S. has recently been in just this situation. For
example, national savings for the U.S. in 1989 was approximately
13% of GDP, whereas for Japan it was 32%, for Germany it was
20%, for France it was 21%, and for the U.K. it was 17%. The
savings-investment relations for the U.S. versus Japan in 1989
are schematically depicted below, where the percentages
represent percentages of GDP for each respective country.
(From: Economic Report of the President, 1991, Tables B-1 and
B-79)
#U.S. Savings-Investment Relation in 1989#:
15% 15%
| |
| |
| 2% |
| | |
S`p + S`g + S`r = I
|
-2%
In contrast, the private savings rate of the Japanese in 1989
was high enough to finance: (a) a government deficit; (b) a
trade surplus (i.e., lending to other countries); and (c) a high
level of domestic investment.
#Japanese Savings-Investment Relation for 1989#:
|
|
|
| |
| |
| |
| |
S`p + S`g + S`r = I
| |
|
S`p + S`g = 32%
Why do the Japanese save so much? Five basic reasons have been
offered.
First, accounting differences---the Japanese count government
investment as savings, unlike the case for the U.S.
Second, the population age structure of Japan is a contributing
factor. The Japanese have among the world's highest life
expectancies, implying long retirements which must be saved for.
Third, up until their recent recession, Japan has been experiencing
a high growth rate for real income so that more funds for saving are
available.
Fourth, housing and land costs in Japan are astronomically high.
The total market value of all land in Japan (a country about the
size of California) far exceeds the market value of all of the land
in the U.S. Young people must therefore save considerable sums of
money in order to have any hope of owning their own home.
Fifth, the Japanese customarily leave large bequests for their
heirs.
D. The Balance of Payments and the Exchange Rate
Many countries, including the U.S., keep track of
international exchanges of goods, services, and assets in the
form of "balance of payments accounts." These accounts record
the flow of ROW currency reserves into or out of the HC over a
given specified period of time. These currency flows can be
divided into two main categories: (1) the "current account"; and
(2) the "capital account." In simple diagrammatic form:
--> (1) Current Account (Trade between HC
| and ROW in #newly# produced goods and
| services, plus transfers)
|
Balance of Payments --|
Accounts |
|
|
|
--> (2) Capital Account (Trade between HC
and ROW in #existing# assets, real
or financial)
#Current Account# (CA)
CA = HC Net Trades of #Newly# Produced Goods and Services
+ HC Net Transfer #Receipts#
= [HC Exports-HC Imports]
+ [ROW payments to HC factors - HC payments to ROW factors]
+ [ROW Transfers to HC - HC Transfers to ROW]
= NE + V .
#Capital Account# (KA)
The capital account (2) can in turn be broken down into two
subcategories: (2a) ROW net lending to HC resulting from asset
transactions by agents other than the HC central bank; and (2b)
the net change in HC "official reserve assets" resulting from HC
central bank transactions.
#Official reserve assets# are assets held by central banks,
other than domestic money or securities, that can be used in
making international payments. For simplicity, it will be
assumed that the only official reserve asset available to the HC
central bank is ROW currency, and the only official reserve
asset available to ROW is HC currency. Moreover, it will be
assumed that all reserves of ROW currency and HC currency for
international payments are held by the HC central bank; the ROW
central bank does not hold currency reserves. [Note: In
actuality, the U.S. holds its international currency reserves in
two main forms: gold; and reserve positions at the International
Monetary Fund.]
Finally, note that all elements of the capital account must
be consistently valued #either# in ROW currency units #or# in HC
currency units in order to be able to add and subtract them
meaningfully.
The capital account KA can now be broken out as follows:
KA = (Change in ROW ownership of HC assets)
- (Change in HC ownership of ROW assets)
= (ROW net lending to the HC resulting from asset transactions
other than those conducted by the HC central bank)
less
Net change in HC official reserve assets (ROW currency reserves
held by HC central bank)
= "Non-Official Capital Account" less "Balance of Payments"
("Official Settlements Balance")
= NKA - BP .
#Balance of Payments: Accounting Identity Versus Equilibrium#
In terms of #realized# transactions, every purchase must be
financed either by an exchange of newly produced goods or
services, or by an exchange of existing assets. Consequently,
except for statistical discrepancies---i.e., errors due to
problems of measurement---in each period T it must hold as an
#accounting identity# that realized CA and KA satisfy
- CA = KA
= (ROW net lending to HC) + (Net change in HC currency reserves),
where the final term in parentheses is equal to the negative of
the net change in ROW currency reserves. For example, suppose V
is zero and imports exceed exports. Then HC citizens must pay for the
excess of imports over exports either by borrowing from ROW
(implying an increase in ROW lending to HC) or by turning in HC
currency to the HC central bank in exchange for ROW currency
which is then paid out to ROW (implying an increase in HC
currency reserves and a corresponding decrease in ROW currency
reserves at the HC central bank).
Rearranging terms in this accounting identity, and using
the previously discussed decomposition of KA into NKA - BP, one
obtains
0 = [CA + KA] = [CA + NKA - BP] ,
or equivalently,
BP = [CA + NKA] .
Note, then, that #BP can differ from zero#. The implications of
having a nonzero BP are easily understood once the relationship
between the BP and the the demand and supply for ROW currency is
understood.
First note that, under our simplifying assumption on
currency reserve holding, any transaction that gives rise to a
payment by ROW nationals to HC nationals implies an "inflow" of
ROW currency to the HC central bank. Conversely, any
transaction that gives rise to a payment by HC nationals to ROW
nationals implies an "outflow" of ROW currency from the HC
central bank.
In particular, HC exports (ROW nationals buying HC goods
and services), HC borrowing (ROW nationals buying existing HC
assets), and HC factor payment and transfer inflow (factor and
transfer payments by ROW to the HC) require ROW nationals to
obtain HC currency from the HC central bank in exchange for ROW
currency, which ADDS to the ROW reserves of the HC central bank.
Thus, HC exports, HC borrowing, and HC transfer inflows all ADD
to ROW reserves.
Conversely, HC imports (HC nationals buying ROW goods and
services), HC lending (HC nationals buying existing ROW assets),
or HC factor payment and transfer outflow (factor and transfer
payments by the HC to ROW) require HC nationals to obtain ROW
currency from the HC central bank's ROW reserves, which
CONTRACTS these ROW reserves.
ROW currency INFLOW implies an #addition# to
ROW currency reserves held by the HC central bank
-------- ROW CURRENCY INFLOW --------
| |
\/ |
HC ROW
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--------- ROW CURRENCY OUTFLOW --------
ROW currency OUTFLOW implies a #contraction# of
ROW currency reserves held by the HC central bank
HC payments and receipts from ROW thus imply direct
incremental changes in the ROW and HC currency deposits held on
reserve by the HC central bank.
Now consider the relation of ROW and HC currency flows to
an imbalance in the private sector balance of payments, BP. Let
the BP for the HC be written as
BP = [ROW Currency Inflow to HC] - [ROW Currency Outflow from HC] ,
where, in abbreviated form,
[ROW Currency Inflow] = [HC Exports + HC Borrowing + HC transfer inflow] ;
[ROW Currency Outflow] = [HC Imports + HC Lending + HC transfer outflow] .
One then has:
ROW CURRENCY INFLOW ROW CURRENCY OUTFLOW
Addition to ROW reserves Contraction of ROW reserves
(Increased Supply of ROW curr.) (Increased Demand for ROW curr.)
BP negative -> [ROW Currency Inflow] less than [ROW Currency Outflow]
BP = 0 -> [ROW Currency Inflow] = [ROW Currency Outflow]
BP positive -> [ROW Currency Inflow] greater than [ROW Currency Outflow]
A #negative# BP corresponds to an #excess demand# for ROW
currency: The current purchase, sale, and transfer plans of HC
and ROW nationals would result in HC nationals having to pay
more ROW currency to ROW than is received from ROW as the result
of net inflow. An overall #contraction# in the HC central
bank's ROW currency reserves is needed to satisfy this excess
demand for ROW currency.
BP negative -> ROW currency reserves must #decrease# in order to
support the purchase, sale, and transfer plans of
HC and ROW nationals.
Conversely, a #positive# BP corresponds to an #excess supply# of
ROW currency: The current purchase, sale, and transfer plans of
HC and ROW nationals would result in HC nationals paying less
ROW currency to ROW than is received from ROW as the result of
net inflow. An #expansion# of the HC central bank's ROW
currency reserves is needed to sop up this excess supply of ROW
currency.
BP positive -> ROW currency reserves must #increase# in order to
support the purchase, sale, and transfer plans of
HC and ROW nationals.
Thus, BP not equal to 0 means that there is either an excess
demand or an excess supply of ROW currency which results from
the current purchase, sale, and transfer plans of HC and ROW
nationals, a #disequilibrium# situation in the market for ROW
currency. And the value of the BP gives the #net change# in ROW
currency reserves which must be sustained by the HC central bank
in order to support these purchase, sale and transfer plans. As
noted above, this net change is also referred to as the official
settlements balance.
BOTTOM LINE: The "foreign exchange market" (the market for ROW
vs. HC currency) is said to be in #equilibrium# when the
purchase, sale, and transfer #plans# of ROW and HC nationals are
such that BP = 0, i.e., the purchase, sale, and transfer plans
of ROW and HC nationals can be met #without# reliance on
official reserve transactions. In this case, the HC is said to
be in #BP equilibrium# or #external balance#.
Eventually, in the face of a persistent BP deficit, the HC
central bank would run out of ROW currency reserves and would no
longer be able to intervene. Consequently, this is not a
tenable long-run situation. Another possibility, however, is
that the "nominal exchange rate" might move to bring demand for
ROW currency in line with the supply of ROW currency, thus
avoiding the need for any official reserve transactions at all.
The Exchange Rate
The #exchange rate# E for the HC measures the #price of HC
currency in terms of ROW currency#, e.g., if HC = U.S. and ROW =
Japan, then
E = Number of yen/ per dollar.
The exchange E rate determines how expensive ROW goods are
relative to HC goods. When the exchange rate E rises, then
(ceteris paribus) the value of the HC currency increases
relative to ROW currency, and ROW goods become cheaper relative
to HC goods (one dollar buys more Japanes goods when the yen per
dollar ratio rises).
NOTE: Some texts and writers define the HC exchange rate
with another country A to be the inverse of the above, i.e., HC
currency per unit of country A currency. Although this is the
conventional way of reporting, e.g., the U.S. dollar-U.K. pound
sterling exchange rate, trade sources such as Business Week
report all other exchange rates for the U.S. as Country A
currency/per U.S. dollar. We will therefore stick with this
definitin.
In reality, there is a potentially different HC exchange
rate for every different ROW currency. A useful proxy for the
"average" exchange rate faced by an HC is the so-called
#trade-weighted exchange rate#. For example, the countries
whose exchange rates enter into this index for the U.S. are the
major trading partners of the U.S. The weight given to each
exchange rate entering into the index varies directly with the
amount of trade volume of that country with the U.S.
If the exchange rate E is flexible, then in principle E
should continuously adjust to equate the demand and supply for
ROW currency, and BP should thus continuously be in balance
without the need for central bank intervention in the form of
official reserve transactions.
From 1944-1973, under the Bretton Woods Agreement, exchange
rates were officially fixed. This agreement broke down in
stages from 1971-1973. In our present post-1973 system,
exchange rates are officially supposed to be floating; but
central banks do nevertheless frequently intervene in currency
markets by engaging in the purchase and sale of currencies.