RELACION Y CARACTERISTICAS DE LOS SONDEOS UTILIZADOS
HOJAS 1:50.000 Hoja 129
The IS-LM-FE model provides a good opportunity to illustrate and re-emphasize the distinction between endogenous and exogenous variables, and to show how institutional arrangements change the nature of a variable.
A model always comprises
■ exogenous variables – their values are deter-mined outside the model, and
■ endogenous variables – to describe their behav-iour is the very purpose of the model.
A model may have an arbitrary number of exoge-nous variables. But it can only explain as many en-dogenous variables as it has (independent) equations.
The IS-LM-FE model has been reduced to three equations – which take the form of market equilibrium conditions – to explain three endogenous
BOX 4.5
‰
Box 4.5 continued
(a) Flexible exchange rates iWorld
(b) Fixed exchange rates iWorld
Figure 4.11 Fixed exchange rates Figure 4.10 Flexible exchange rates
variables. Figure 4.10 sketches how the exogenous variables have an impact on the three endogenous variables, and how the latter interact.
We must remember here, however, that our ini-tial larger model, with equations explaining other endogenous variables such as consumption, invest-ment, exports, imports and more, has been reduced to three equations by repeatedly substituting equa-tions into each other and thus eliminating these variables. Thus, for example, consumption does not appear any more. But it can be considered a hidden endogenous variable whose equilibrium value is re-trieved by substituting equilibrium income into the consumption function.
Institutions and the endogeneity of variables
The above interpretation implicitly assumes that the exchange rate is flexible, determined by market forces. This makes the money supply M exogenous, and puts it under the control of the policy-maker.
The roles of the exchange rate and of the money supply are reversed if we move to a system of fixed exchange rates. Then the exchange rate becomes exogenous, is set by policy-makers, and the money supply adjusts endogenously. This modifies the model’s structure to that shown in Figure 4.11.
In terms of the representations of market equi-libria in the i-Y plane, the two institutional scenarios work as shown in panels (a) and (b) of Figure 4.12.
Under flexible exchange rates the positions of FE and LM are set exogenously. The exchange rate determines the position of IS, and endogenously adjusts so as to let IS pass through the given point of intersection between FE and LM (panel (a)).
Under fixed exchange rates the positions of FE and IS are set exogenously. The money supply, which determines the position of LM, endogenously adjusts so as to let LM pass through the given point of intersection between FE and IS (panel (b)).
Exercises 119
CHAPTER SUMMARY
■ Globalization has led to large increases in most countries’ exports (relative to income) and in the volumes traded in the world’s foreign exchange market.
■ The balance of payments is a meticulous record of a country’s inhabitants’
cross-border transactions. It is useful for macroeconomic purposes as a mirror image of the foreign exchange market. Viewed this way, it helps identify the main motives behind the demand for foreign currency.
■ The goods market is in equilibrium if income, the interest rate and the exchange rate assume values that make aggregate demand equal to output produced.
■ Aggregate demand rises with income (through consumption), falls as the in-terest rate rises (through investment), and rises with the exchange rate (through net exports).
■ The foreign exchange market is dominated by financial investors. The de-mand exercised by importers and exporters is negligible in relative volume.
■ Equilibrium in the foreign exchange market obtains if domestic assets and foreign assets yield identical returns. If individuals have stationary ex-change rate expectations this means that the domestic interest rate must equal the world interest rate.
■ Using interest rate parity as the equilibrium condition for the foreign ex-change market does not imply that the capital account is balanced. It means that investors are indifferent between holding domestic or foreign assets.
Hence, they are ready to finance any current account disequilibrium that might occur.
■ Only one macroeconomic equilibrium (defined as simultaneous equilibrium in all three markets) exists. Income, the interest rate and the exchange rate assume one specific value each.
balance of payments surplus 105 capital account 109
closed economy 100 current account 108 FE curve 113
flexible exchange rates 106
foreign exchange market 106 globalization 99
IS-LM model 99
official reserves account 103 open economy 100
risk neutral 110
Key terms and concepts
E X E R C I S E S
4.1 How open is your country’s economy at present (a) as measured by the export ratio?
(b) as measured by the import ratio?
Use data from Eurostat, the IMF, the OECD or national sources to address this question.
4.2 Suppose an artificial country called Spain recorded the cross-border transactions listed below:
4.5 Consider an economy that is characterized by constant prices, flexible exchange rates and perfect capital mobility, and where the IS and LM curves can be written as follows:
Initially, the exogenous variables take the follow-ing values:
(a) Draw the equilibrium curves for the money market, the foreign exchange market and the goods market into an diagram.
(b) Compute the equilibrium levels of the interest rate, income and the foreign exchange rate.
4.6 Consider an economy with fixed exchange rates and perfect capital mobility. It is characterized as follows:
Use the following initial values of the exogenous variables:
(a) Suppose the exchange rate is fixed at 1.
What is the resulting equilibrium level of income and the resulting money supply?
(b) To what level does the world interest rate have to move in order to obtain an income level of 1600? What is the corresponding money supply?
4.7 Usually, we assume the simplified FE curve repre-sented by equation i = iWorld. We now introduce taxes on interest earnings.
Analyze Switzerland (a small country with bank secrecy law) and the rest of the world using the graphical apparatus of the Mundell–Fleming
iWorld =5
500 Seat Toledos sold to Ireland €7,500,000 10,000 Duffy CDs sold in Spain €150,000 Sergio Garcia flies Air France to New York
10 times, using the A380 from Paris
€70,000 Franz Beckenbauer spends several golf holidays
in Marbella
€40,000 Ruud van Nistelrooy sends cheques home to mum
in Holland
€200,000 Julio Iglesias earns dividend on Microsoft stocks €1,900,000 Spain’s government contributes to EU budget €1,000,000 Ford acquires office building in Barcelona €10,000,000 Real Madrid invests in Eurosport TV stocks €5,000,000 Government pays interest on Spanish
government bonds held abroad
€2,800,000
Assemble Spain’s balance of payments. Assume there are no statistical discrepancies. What is the current account balance? What are net exports?
What is the capital account balance? Is the balance of payments in surplus or deficit?
4.3 Consider a small open economy that faces the macroeconomic situation as shown in Figure 4.13.
Describe the mechanisms that bring about a macroeconomic equilibrium in which all three market equilibrium lines intersect
(a) under flexible exchange rates (b) under fixed exchange rates.
4.4 Suppose investment is independent of the interest rate and the FE curve is horizontal.
Sketch the macroeconomic equilibrium under fixed and flexible exchange rates and describe the mechanisms that help achieve it.
Figure 4.13
Applied problems 121
model. Suppose that foreigners pay taxes on their interest earnings at home at the rate zWorld, and the Swiss pay taxes at the rate zCH6 zWorld. Distinguish between scenarios (a) and (b):
(a) The governments of both countries are perfectly informed about interest earnings of their inhabitants. Investors have to pay taxes in their country of residence independent of where their returns are generated. What is the equilibrium condition on the international capital market (FE curve)?
(b) Suppose that foreigners do not report their returns realized in Switzerland to their
revenue authorities. This is possible because of the bank secrecy law in Switzerland. They prefer to pay the withholding tax which is set to zCHfor simplicity. What is the equilibrium condition on the capital market?
Suppose the FE curve is characterized by the situa-tion described in (b).
(c) What happens to the Swiss economy if the bank secrecy law is abolished? Does your answer depend on whether the exchange rate is flexible or fixed?
Good complementary reading to this chapter might be your country’s recent balance of payments report, published by either the central bank or the govern-ment. Examples available online are:
■ European Central Bank – for the euro-area balance of payments:
www.ecb.int/pub/pdf/mobu/mb200810en.pdf
■ National Statistics Online – home of official UK statistics:
www.statistics.gov.uk/pdfdir/bop0908.pdf
■ Statistics Sweden on behalf of the Riksbank:
www.scb.se/statistik/FM/FM0001/2008K02/
20080829%20Kvartalspublikation%20Engelska.
■ Schweizerische Nationalbank:
www.snb.ch/ext/stats/bop/pdf/en/bop.book.pdf
■ Deutsche Bundesbank – reports the bilateral balance of payments with many countries:
http://www.bundesbank.de/download/statistik/
stat_sonder/statso11_en.pdf
Recommended reading
A P P L I E D P R O B L E M S
RECENT RESEARCH
Testing uncovered interest parity
Uncovered interest parity introduced in equation (4.4) states that the difference between the domestic interest rate i and the foreign interest rate i* equals the expected depreciation of the home currency ee:
. If depreciation expectations are rational (for more on this see Chapter 8), they should be correct on average: where n denotes expectations errors which on average are zero.
Substituting the first into the second equation gives . M. Chinn and G. Meredith (‘Testing e = i - i* + n
e = ee +n ee = i - i*
uncovered interest parity at short and long horizons’, University of California Santa Cruz, Working Paper 2000–01) test this equation by regressing deprecia-tion rates on interest differentials, that is they esti-mate the coefficients of the equation
If open interest parity holds together with rational expectations, the estimate of a should be 0 and the estimate of b should equal 1. Selected estimation results based on quarterly data for the sample period 1983:I–2000:I are
e = a + b(i - i*)
German mark
where standard errors are shown in parentheses.
While there is a statistically significant relationship between the interest differential and the rate of depreciation, important differences remain:
■ A much larger share of variations in the rate of depreciation can be attributed to variations in the interest differential for the mark and the pound than for the yen. Respective coefficients of determination are 0.40, 0.43 and 0.10.
■ The equations estimated for Germany and Japan have significant constant terms, meaning that there is a depreciation tendency unrelated to the interest differential.
■ The null hypothesis b 1 is rejected for the yen and the pound, but not for the mark. (Example:
Testing b 1 for the pound yields the t-statistic (1 0.562) 0.106 4.13. Therefore the null hypothesis must be rejected.)
All in all the results are mixed. To the extent that coefficients are not as expected, it remains open to question whether this is due to expectations not being rational or because uncovered interest parity does not hold.
WORKED PROBLEM Amadeus by the dollar
A country’s exports depend on the real exchange rate (as a measure of relative prices) and on the level of income in the destination country. This should also hold for each category of exports. If Austria wel-comes American tourists, it exports. Tourists pay for the privilege of enjoying Vienna and the Alps, just as the British pay for Spanish exports of sherry to the United Kingdom. Now consider the data in Table 4.3 on nights spent by US visitors to Austria (NIGHTS), the real exchange rate of schilling versus dollar (SHPER$) and US real GDP (USGDP).
>
To check whether our export equation explains US tourism to Austria we regress NIGHTS on SHPER$ and USGDP. The result is
NIGHTS 842.7 104.3 SHPER$ 0.236 USGDP (1.60) (4.92) (3.02) 24 annual observations 1971–94; R2adj 0.50 Both coefficients are positive as expected, and are significantly different from 0, as the t-values of 4.92 and 3.02 indicate. If the schilling depreciates by one schilling per dollar (at 1987 prices), US tourists spend 104,300 more nights in Austria. If American GDP rises by one billion dollars (at 1987 prices), 236 more nights are being spent in Austria. The coefficient of determination is 0.50, saying that half of the variance in the number of nights spent by US tourists per year is accounted for by changes in the real exchange rate and in US income.
YOUR TURN
Are international interest rates equal?
A key ingredient of the Mundell–Fleming model (to be discussed in the next chapter) is the interest parity Table 4.3
NIGHTS
(thousands) SHPER$
USGDP in ’87 (billions) 1971 1,774.172 19.18385 2,955.9 1972 1,838.577 17.24196 3,107.1 1973 1,569.763 14.44078 3,268.6 1974 1,339.987 13.99124 3,248.1 1975 1,230.936 13.09453 3,221.7 1976 1,378.784 13.30245 3,380.8 1977 1,428.656 12.36859 3,533.3 1978 1,272.219 11.28735 3,703.5 1979 1,090.836 11.15924 3,796.8 1980 1,332.572 11.53090 3,776.3 1981 1,170.124 14.66295 3,843.1 1982 1,438.524 15.81757 3,760.3 1983 1,740.612 16.61142 3,906.6 1984 2,203.027 18.28409 4,148.5 1985 2,376.876 18.98412 4,279.8 1986 1,408.803 14.01424 4,404.5 1987 1,719.816 11.87747 4,539.9 1988 1,591.663 11.83786 4,718.6 1989 1,697.928 12.97130 4,838.0 1990 2,139.202 11.37000 4,897.3 1991 1,191.496 11.77773 4,867.6 1992 1,526.478 10.97878 4,979.3 1993 1,371.261 11.54847 5,134.5 1994 1,393.102 11.29254 5,342.3
Applied problems 123
condition, stating that interest rates may only differ between countries to the extent by which the exchange rate is expected to change. If the exchange rate is expected to remain where it is currently, the domestic interest rate should equal the world interest rate. To check whether this assumption is a well-guided first guess, consider the money market interest rates for Germany and the Netherlands (annual data) in Table 4.4. Let Holland be the home country and assume that the German interest rate approximates the world interest rate. Check whether the hypothesis iNL =iDis supported by the data.
To explore this chapter’s key messages further you are encouraged to use the interactive online module found at
www.pearsoned.co.uk/gartner
Table 4.4
Year Year
1980 9.06 10.13 1988 4.01 4.48
1981 11.26 11.01 1989 6.59 6.99
1982 8.67 8.06 1990 7.92 8.29
1983 5.36 5.28 1991 8.84 9.01
1984 5.54 5.78 1992 9.42 9.27
1985 5.19 6.30 1993 7.49 7.10
1986 4.57 5.83 1994 5.35 5.14
1987 3.72 5.16
iNL
iD
iNL
iD