Marshall-Lerner Condition - Assignment Example

Mid Term a) Define and explain the so-called "Marshall-Lerner" condition and assuming this condition holds, explain the relationship between the foreign exchange ("forex") market and the balance-of-payments (BoP) under both flexible and pegged-rate policy regimes. The Marshall-Lerner condition is a condition that can be fulfilled when devaluation of a country’s currency improves the balance of payments of that country and revaluation of the currency worsens the country’s balance of payment if the country’s sum of price elasticity of demand for imports and exports is greater than 1(Cherunilam 385). This means that devaluation of currency should be given consideration only when the Marshall-Lerner can be satisfied. Therefore, provided the elasticity of demand for exports and imports is greater than one, even if the elasticity of demand for exports is zero but the elasticity of demand for imports is greater than 1, then devaluation can improve the balance of payments. Also, provided the elasticity of demand for exports and imports is greater than one, even if the elasticity of demand for imports is zero but the elasticity of demand for exports is greater than 1, then devaluation can improve the balance of payments. In a flexible exchange rate system, automatic adjustments caused by the market mechanism determine the value of currency. Therefore, in a flexible exchange system, the foreign exchange market will only be stable if there is an automatic adjustment of the disturbance that upsets the balance of payments, through adjustment of the exchange rate, and the foreign exchange market is always stable whenever the Marshall-Lerner condition is fulfilled (Reinert, Rajan and Glass 756). In a pegged-rate policy regime, there are no automatic adjustments and therefore, there is room for appreciation or depreciation of currency. There is no direct relationship between the foreign exchange market and the balance of payments because this foreign exchange does not allow for automatic adjustments, but the monetary authority has to intervene on the foreign exchange market to maintain the uniformity by financing the balance of payments (Macdonald 316). (b) Explain the general - i.e. upward-sloping-form of the FE curve and explain how it shifts, under a flexible-rate regime, when there is a BoP deficit. The main components of the current account are exports and imports and these are more closely related to national income than interest rates. On the other hand, the capital account consists of financial items, and is more closely associated with interest rates. The upward slope of FE curve is the point above the intersection of the foreign exchange schedule and the balance of payments schedule which indicates a higher interest that attracts more capital inflows, which results into a balance of payments surplus (Meyer 22). However, external surplus increases the national income and encourages domestic spending, including imports and the balance of payments moves to the deficit, leading to an upward slope of the schedule above the intersection. Under a flexible rate regime, and when there is a balance of payments deficit, the surplus of a country’s national income will encourage domestic spending. This includes spending on imports and the FE slope shifts upwards. Also, a lower domestic interest rate compared to abroad leads to a reduced capital inflow, and possibly encourages capital outflow (Meyer 22). This results into a deficit in the balance of payments. Given that national income has been reduced by the external deficit, and domestic spending has been reduced, especially on imports, the FE curve shifts upwards to clear the deficit in the balance of payments. 2. Under "PCM"( Perfect Capital Mobility), discuss the following contractionary policy effects on a "small" countrys income, money supply, interest rate policy, and exchange rate when the small country pursues: a) Flexible-rate policy; i) An increase in the taxes in the small country Under perfect capital mobility, an increase in taxes in a small country will lead to a decrease in a consumption and increase in saving. This will lower the small country’s income because consumers will purchase less in the small country, while they will invest more in another country where taxes are relatively low. Money supply reduces drastically because the level of spending will be low while the interest rates will increase and the exchange rate will decrease. ii) A reduction in the quantity of money in the small country When the quantity of money is reduced in the small country, money supply also decreases. This decreases the idle cash balance with the public. Citizens of the small a country will shift their investment to other countries and this will reduce the small country’s income. Interest rates will be high while the small country’s exchange rate will decrease. iii) An increase in a "large" trading countrys taxes If a large country increases trading taxes, its citizens will consume less within the country and consume more from other countries. This will lead to a reduction in the country’s income. Money supply with the large country will also decrease while interests will increase and the exchange rates will decrease. This is because investments will be shifted from the large country to another country where taxes may be lower. Therefore, the small country’s income, exchange rate and money supply will increase while interest rates will decrease. iv) A decrease in the "large" countrys money supply When the large country decreases its money supply, interest rates within the country will increase while the country’s currency will appreciate in the foreign exchange market. However, there will be a decrease in the country’s income level and money supply while interest rates will decrease. Therefore, the small country’s income, money supply will increase while interest rates will increase. The small country’s currency will appreciate in the foreign exchange market. b) Pegged-rate policy; i) An increase in the taxes in the small country; In a fixed exchange, an increase in taxes has no effect on exchange rate. However, it increases output level because there is no currency appreciation. Therefore, the small country’s income and interest rates will increase while money supply and exchange rate will remain unchanged. ii) A reduction in the quantity of money in the small country Reducing the quantity of money in a pegged rate policy will reduce the country’s income level because investments will be discouraged. Secondly, money supply will decrease while interest rates will decrease and the country’s exchange rate will appreciate. iii) An increase in a "large" trading countrys taxes An increase in a large trading country’s taxes will have no direct effect on the exchange rate and interest policy of the small country. However, it will contribute to an increase in the small country’s income level. There will be no direct effect on the small country’s money supply. iv) A decrease in the "large" countrys money supply A decrease in the large country’s money supply will have an effect on the small country’s income level because spending will be reduced. However, there will be no direct effect on the money supply and exchange rate. Similarly, there will be no direct effect on the interest rate policy of the small country. 3. Describe and discuss the conditions pertaining to long-run equilibrium in an international (2-country) context. Use this model to explain at least two of the variants commonly known as "purchasing-power-parity" approaches to exchange-rate movements. What happens if the exchange-rate is pegged and the money supply and/or income in the "home" country changes? Various conditions have to be fulfilled to obtain long-run equilibrium in an international or two country context. First, the domestic exports should be equivalent to foreign exports and vice versa. This means that the value of exports from a country to another should be equivalent to the value of the imports that the country gets from the other country. There has to be excess demand in one country for a commodity produced in the other country and vice versa. Another condition is that each of the countries involved in trade should have a comparative cost or comparative advantage in terms of relative efficiency. Therefore, when one country enjoys relative efficiency, the other country should have relative inefficiency. The terms of trade should be equal to the relative cost. Some of the equilibrium relationships, which should hold between product prices, interest rates and exchange rates are the Fisher effect, the interest rate parity theory and the expectations theory. Purchasing power parity is concerned with how inflation rate differences between two countries influences exchange rates. Truly, real sources of purchasing power parity normally have a lasting effect on the real exchange rate (Bayoumi and MacDonald 3). There are two variants purchasing power parity approaches to exchange rate movements. These are absolute purchasing power parity, which focuses on the equalization of real price levels and relative purchasing power parity, which focuses on the equalization of percentage changes in exchange rates and price changes across countries. When the exchange rate is pegged and the money supply and/or income in the “home” country changes, inflation rates will not directly affect exchange rates, but prices will change in the home country. 4. Explain the meaning of the so called “interesting-parity" condition, and use it in constructing a model of the effects of a monetary expansion (in a small country) which is a) "temporary";and b) "permanent. Go on to explain the meaning of the "AA/DD" diagrammatic framework and show these same effects using that model. Interest rate parity is a condition in which interest rates are equalized between the assets that are dominated in different currencies, sometimes through the forward exchange market. This equalization of rates guarantees a specified return in domestic currency for investors (Held 217). When interest rate parity exists, investors cannot get a higher return if the interest is covered. Therefore, short term foreign investing has to be conducted on an uncovered basis. The interest rate parity equation is written as; r = (1 + if) (1 + ef) – 1 Where; r is the effective yield of foreign deposit if is the quoted interest rate ef is the percentage change from the deposit date to the withdrawal date, in the value of the foreign deposit currency Temporal monetary expansion means that interest rates will be low. This means that the interest rates of a small country may be less than the interest rates of a large foreign country. As a result, the benefit of higher interest rates in large foreign country can be prevented by trading of the large foreign country’s currency at a discount, failure to which investors in the small country will benefit from investing in the large, foreign country in terms of interest earned. A permanent monetary expansion in a small country implies that the interest rates in that country will go down. When interest rates reduce in the small country, they are expected to be lower than the interest rates in a large foreign country. Due to the permanency of the monetary expansion, the currency of the large, foreign country will trade at a discount to offset the benefit of higher interest rates for investors of the small country in the long run. Effect of Increasing Money Supply Increasing money supply reduces the interest rates in a small country. This decreases the rate of return on the small country’s assets to a rate of return that is below the rate of return on similar assets in the large foreign country. Investors will begin to demand more of the large country’s currency so as to take advantage of the rate of return on the large country’s assets. The large country’s currency will appreciate while the small country’s currency will depreciate. The exchange rate will rise as denoted by the shift from AA1 to AA2. DD1 shows the demand for currency. Works Cited Bayoumi, Tamim and Ronald MacDonald. Deviations of Exchange Rates from Purchasing Power Parity - a Story featuring Two Monetary Unions. Washington, DC: International Monetary Fund , 1998. Print. Cherunilam, Francis. International Economics 5E. New Delhi: Tata McGraw-Hill Press, 2008. Print. Held, David. Global Transformations: Politics, Economics and Culture. Stanford: Stanford University Press, 1999. Print. Macdonald, Nadia Tempini. Macroeconomics and Business: An Interactive Approach. London: International Thomson Business, 1999. Print. Meyer, Annette. The Subject Is Interest Rates. Pennsyvania: RoseDog Books Press, 2011. Print. Reinert, Kenneth A, et al. The Princeton Encyclopedia of the World Economy. Princeton: Princeton University Press, 2009. Print. Read More