Lernmaterialien für OEM an der Universität Konstanz

Equivalent economic outcomes (consumption/savings choices) can be expected if we use any arbitrary combination to finance government expenditure

• It has numerous advantages like:
  1. It enhances the efficiency of resource allocation and the competitiveness of the domestic financial sector
  2. Transfer of technology and management practices through foreign direct investment
  3. Improvement of macroeconomic policy discipline and intensity of trade 
  4. Enablement of welfare-improving current account imbalances which could finance higher investment or smooth consumption 
• But also, some disadvantages like:
  1. Debt-creating capital flows which might be problematic for a country running a continuous and large CA deficit. If debt is nominated in foreign currency, valuation changes like a depreciation of the domestic currency could be very costly (FDIs always considered positively)
  2. Sudden stops, capital flow reversals, currency crisis 

• They illustrate that 
  1. The law of one price and the PPP can be violated due to transaction/transportation costs 
  2. this indicates that the real exchange rate is bounded in a corridor which takes those costs into account
  3. if this corridor is systematically surpassed, infinite profits would be possible by exchanging currencies and importing/exporting goods

• Like in the BS, we distinguish between tradanle and non-tradable goods to make inference about changes in the real exchange rate between two coutntries. The key difference to the BS model is that the marginal productivity of labor is no longer constant but decreasing 
• First, firms make their decison about the quantities of goods they want to produce, keeping in mind that marginal productivity of ecah good is decreasing and wages in both sectors are identical. This gives the pridction posssibilty curve which is strictly concave (slope=quotient of marginal productivities for a given input). The output of nontradables is increasing if the ratio of relative prices between non-tradables and tradables is increasing and the optimal output ratio is given where the quotient of marginal productivities of tradables to nontradables is equal to the ratio of relative prices between non-tradables and tradables 
• We assume homoethic preferences, meaning that if relative prices do not change, a increase in income leads to the same consumption ratio simply with higher quantities
• We know that as a market clearing condition, consumption of non-tradables has to be equal to the production of non-tradables and thus the consumption of tradables is quantity of non-tradables produced multiplied by the ratio of consumption of tradables to non-tradables
• The (negative) trade balance is then given by the consumption of tradables which we could determine minus the quqntitiy of tradables produced. Note that the trade deficit is thus only a function of the relative prices (of one single period) and the trade balance decreases strictly with the ratio of relative prices between non-tradables and tradables because the output of tradables increase and the consumption of tradables decrease when the price of tradabkes increase and this increases the trade balance
• The price level is a function of the ratio of the relative prices and the real exhange rate increases if the ratio increases, meaning that the currency appreaciates for an increase in the price of non-tradables of a country (foreigners have to pay relatively more for a haircut --> I get less dollar for a euro)

Accoring to the TNT model, an appreciation of the domestic currency leads to a deterioration of the trade balance, because more goods will be imported and less exported. Accoring to the ML condition, this is true in the long-term, however in the short-term, the trade balance might even improve as the price of the importabales vecomes cheaper if our currency appreciates. In the long-term, quantities adjust and the trade balance will effectively decrease, which is also illustrated by the J-Curve

If a large economy increases its demand for consumption, i.e., increases its CA deficit, the world financial market faces an additional demand which moves interest rates up. On the contrary, a higher interest rate will increase the CA surplus 

• The model wants to explain why nominal exchange rates can heavily fluctuate by assuming than prices of goods adjust slowly and the covered/uncovered interest parity holds
• Suppose there is a unexpected permanent increase in the money supply and prices don’t adjust instantly. This has several effects in the short-and the long-run
• In the long-run
  1. real money supply is the same as before because prices will adjust
  2. the nominal exchange rate will depreciate and then stay on a constant level
• In the short run
  1. The nominal exchange rate will depreciate even further than in the long run to come up for an expected increase in the nominal exchange rate
  2. The exchange rate is expected to appreciate because the domestic interest rate has to decrease if money supply increases. If the uncovered interest parity holds, a decrease in the domestic interest must be followed by an expected increase in the exchange rate 
• Compared to the monetary approach the exchange rate reacts more strongly to a change in the quantity of money

• According to FH, savings shoks have no impact on investments in an economy  because the country can borrow from abroad and would just deteriorate their CA balance. 
• Their suggestion is in line with our model of a small open economy with production because firms decisions to produce solely depends on the interest rate and not on a change in savings and consumption decisons from the households, thus only the CA is affected by a change in savings 
• Here lies the problem of the FH approach because only a savings shock (discount factor shock) for small economies is meaningful because an increase in savings for large economies lead to a decrease of the world interest rate which in turn leads to an increase in investments despite the country being open. It is thus a bad measure of capital mobility beacsue savings and investements can move at the same time