External economy considerations – Part 2

I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text by the end of this year. Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.

[This continues the discussion from rough draft of last week - External economy considerations – Part 1. At some point the pedagogy will be assessed and edited into a final draft]

15.3.4 International Competitiveness

In the previous section we learned that an appreciation (depreciation) of a nation’s exchange rate leads to foreign goods becoming cheaper (dearer) in terms of the local currency, which should lead to a rise (fall) in the quantity of imports demanded, other things equal.

Further, an appreciation (depreciation) of a nation’s exchange rate means that foreigners have to pay higher (lower) prices in their currency for locally-produced goods, which should lead to a rise (fall) in the quantity of exports demanded, other things equal.

These conclusions, however, only focus on one element of the competitiveness of a nation’s goods and services in international trade – the nominal exchange rate.

But to really answer the question – are local goods goods and services becoming more or less competitive with respect to goods and services produced overseas we have to relax the “other things equal” assumption and consider the domestic and foreign inflation rates.

This leads us to define a new concept – the real exchange rate which depends on to factors:

  • Movements in the nominal exchange rate, ee; and
  • Relative inflation rates (domestic and foreign).

There are also non-price dimensions to competitiveness, including quality and reliability of supply, which are assumed to be constant at this stage.

We define the ratio of domestic prices (P) to the rest of the world (Pw) as Pw/P, which we call a relative price because it expresses the foreign price level relative to the domestic price level. We assumed that Pw/P was constant when we analysed movements in the nominal exchange rate in th previous section.

If the nominal exchange rate (e) is fixed, then we can conclude:

  • If Pw is rising faster than P, then local goods are becoming relatively cheaper than foreign goods; and
  • If Pw is rising slower than P, then local goods are becoming relatively more expensive than foreign goods.

The inverse of the relative price ratio, namely (P/Pw) measures the ratio of export prices to import prices and is known as the terms of trade.

15.3.5 The real exchange rate

Movements in the nominal exchange rate and/or the relative price level (Pw/P) provide information about movements in the relative trading competitiveness between nations. The real exchange rate measures the combined impact of these variables and is used to measure our competitiveness in international trade.

The real exchange rate (R) is defined as:

(15.1)      R = (e.Pw/P)

where P is the domestic price level specified in local currency (say, $A), and Pw is the foreign price level specified in foreign currency units (say $US).

The real exchange rate is the ratio of prices of goods abroad measured in $A (ePw) to the $A prices of goods at home (P). So the real exchange rate, R adjusts the nominal exchange rate, e for the relative price levels.

To understand this better consider the following example. Assume that P = $A8 and Pw = $US10, and e = 0.8. Remember a quotation of e = 0.8 means that it takes 80 cents Australian to purchase one unit of US currency (that is, $US1).

So e x Pw takes the foreign price expressed in foreign currency units and converts it into an equivalent Australian dollar price at the current exchange rate. The numerator and denominator are then in like units – in this case Australian dollars – and so the movements are unambiguous.

In this case R = (0.8 x $US10)/8 = 1.25 The $US10 translates into $A12.50 and the US produced goods are more expensive than those in Australia by a ratio of 1.25, that is 25%.

A rise in the real exchange rate can occur if:

  • The nominal e depreciates; and/or
  • Pw rises more than P, other things equal.

We consider a rise in the real exchange rate to signal a nation has increased its international trade competitiveness and this should lead to an
increase local exports and reduce local imports.

A fall in the real exchange rate can occur if:

  • The nominal e appreciates; and/or
  • Pw rises less than P, other things equal.

We consider a fall in the real exchange rate to signal a nation’s international trade competitiveness has fallen and this should lead to a fall in local exports and a rise in local imports.

In Chapters 9 and 10, we considered the factors that might impact on the price level of a nation. In particular, if prices are set on unit labour costs, then the way to decrease the price level relative to the rest of the world is to reduce unit labour costs faster than everywhere else or compress profit margins.

With constant profit margins, if the rate of growth in wages is faster than labour productivity growth then unit labour costs rise and vice-versa. As we saw in Chapter 10, the real wage is a composite of the nominal wage determined in the labour market as a result of bargains between workers and employers and the price level, which is determined by firms in the goods and services market.

The problem is that if a nation attempts to improve its international competitiveness by cutting nominal wages in order to reduce real wages and, in turn, unit labour costs it not only undermines aggregate demand but also may damage its productivity performance.

If, for example, workforce morale falls as a result of cuts to nominal wages, it is likely that industrial sabotage and absenteeism will rise, undermining labour productivity.

Further, overall business investment is likely to fall in response in reaction to the extended period of recession and wage cuts, which erodes future productivity growth. Thus there is no guarantee that this sort of strategy will lead to a significant fall in unit labour costs.

There is robust research evidence to support the notion that by paying high wages and offering workers secure employment, firms reap the benefits of higher productivity and the nation sees improvements in its international competitive as a result.

15.4 Aggregate demand and the external sector – revisited

In Chapter 8 we developed the income-expenditure framework to explain the way the factors that influence the production of real GDP (or real national income). The Chapter used the National Accounting concept of GDP at constant rather than current prices as our measure of economic activity. This built on the development of the concept of effective demand in Chapter 7 which had focused on expenditure and output in nominal (current price) terms.

Our income-expenditure framework in Chapter 8 we expressed the flow of total expenditure in any period as the sum of the following sources of spending:

  • Consumption by households or persons (C)
  • Investment spending by firms (I)
  • Government spending (G)
  • Export spending by foreigners (X) minus import spending by domestic residents (M), which we denote as net exports (NX) = (X – M).

From Chapter 8, we know that the equilibrium level of real national income (Y) is determined by aggregate demand (as long as prices remain unchanged), such that:

(15.2)      Y = E = C + I + G + (X – M) = Y

In this Section, we will develop a more detailed account of net exports – (X – M) – to take into account the influence of the real exchange rate and international competitiveness, which we discussed in Section 15.3.4.

In Chapter 8, our treatment of the determinants of net exports was deliberately very simple. We assumed that exports (X) were given in any particular period and determined by national income in the rest of the world, which are beyond the influence of the local economy in question.

We also assumed that a nation imports a fixed proportion of every dollar of national income. We called that proportion the marginal propensity to import (m) defined it as the extra import spending that occurs as a result of a dollar increase in national income.

In the previous section (Section 15.3.4) we learned movements in the real exchange rate, which is a summary measure of international competitiveness, influence net exports.

We learned that the higher is the value of the real exchange rate, the cheaper are locally-produced goods and services to foreign buyers, which means they will purchase more of them. In other words, exports rise when the real exchange rate rises.

Further, the higher is the value of the real exchange rate, the more expensive do foreign-produced goods and services become to local buyers, which means they will purchase less of them. In other words, imports fall when the real exchange rate rises.

There are many other factors in the real world that determine the demand for a nation’s exports and the demand by residents for imports, which we abstract from here in order to focus on the most significant determinants.

We are also abstracting from adjustment responses which are common in international trade. So a rise in the real exchange rate might only influence future exports once existing export contracts, which tend to be multi-year, expire. In the following analysis we are simplifying by assuming that the response between movements in the real exchange rate and changes in the flows of export and import spending are within the current period.

Take exports again. We now assume that the level of exports in any period is determined by the real exchange rate (R) and world income (Yw) and we write this in the following way:

(15.3)      X = λYw + θXR

which might appear at first inspection to be daunting but if you apply the techniques and understandings we developed in Chapter 4 Methods, Tools and Techniques you will grasp the meaning of this equation fairly easily.

In Equation (15.3) the Greek letters next to world income (Yw) and the real exchange rate (R) measure how responsive export spending is to changes in these variables. The coefficient, λ measures how much a nation’s export income rises as a result of a rise in world income. If you think about it, λ is, from the perspective of the rest of the world, its marginal propensity to import.

Similarly, the coefficient θX measures the responsiveness of exports to changes in the real exchange rate. Remember we are simplifying by assuming this response is immediate and exhausted in the current period. Later in the Chapter we will introduce lagged responses and consider the J-curve phenomenon, which has been identified by economists as better described the temporal response of exports to changing real exchange rates.

From our theoretical exegesis, we conjecture that both λ and θX will be positive. So when world income and the real exchange rate rises we expect exports to increase.

From the imports side, we assume that the level of imports that a nation purchases depends on both real national income (Y) and the real exchange rate (R). Thus:

(15.4)      M = mY + θMR

The coefficient m is the marginal propensity to import and we know its value lies between 0 and 1. The coefficient θM measures the responsiveness of imports to changes in the real exchange rate. We conjecture that this coefficient will be negative, which means that when the real exchange rate rises and the nation becomes more competitiveness and foreign goods become more expensive in local currency terms, import spending falls.

If we assume that domestic and foreign price levels are both constant, then movements in the real exchange rate, R, are mirrored in the nominal exchange rate, e. In other words, we could simply substitute the nominal exchange rate (e) for the real exchange rate (R) in Equations (15.3) and (15.4) without loss of understanding.

Thus Net Exports (NX) depends on real GDP, real World GDP and the real exchange rate, where the latter impact is the net result of the impact of the real exchange rate on exports and imports, respectively.

15.5 Trade in goods and services, product market equilibrium and the trade balance

In this Section, we continue to assume that Pw/P is constant, which means that domestic and foreign firms respond to increases in real aggregate demand by increasing real output rather than prices.

Spending on domestic goods determines real output and income. Total spending on domestically produced goods and services is equal to total spending by domestic residents minus their spending on imports plus foreign demand for exports.

Referring back to Chapter 8 and Chapter 12 we have the following behavioural equations, which comprise our theory of aggregate demand:

(15.5) Consumption function      C = C0 + cYd = C0 + c(1 – t)Y

(15.6) Investment function      I = I0 – bi

(15.7) Government spending      G

(15.8) Net exports      NX = λYw – mY + θe

Note that we have &theta is the net impact of changes in the real exchange rate, here expressed as the nominal exchange rate because we assume that Pw/P is constant.

We can substitute the individual behavioural equations into the equilibrium income Equation (15.2) such that:

(15.9)      Y = E = C0 + c(1 – t)Y + I0 – bi + G + λYw – mY + θe

Which, if we refer back to the way we simplified the equations to finally get Equation (8.16), we can write:

(15.10)      Y = 1/[1 - c(1 - t) + m] times [C0 + I0 - bi + G + λYw + θe]

This expression for equilibrium national income tells us that real GDP (Y) will be the sum of all the expenditure terms that do not directly depend on national income (those in the right-hand bracketed expression) times the multiplier (the first left-hand side term).

We can use this expression to study what happens to national income when one of the terms on the right-hand side of Equation (15.10) changes.

Conclusion

I will continue this Chapter next week.

Saturday Quiz

The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty (-:

That is enough for today!

(c) Copyright 2012 Bill Mitchell. All Rights Reserved.

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4 Responses to External economy considerations – Part 2

  1. Neil Wilson says:

    “There are also non-price dimensions to competitiveness, including quality and reliability of supply, which are assumed to be constant at this stage.”

    Previous habit is a big one. Cost of supplier change is higher than you imagine. The larger the company or organisation the harder it is to use a new supplier for anything.

    And that always makes me wonder whether the aggregate equations actually correspond to the real world, or whether they are merely simplification tools that allow you to get your head around things *and must be discarded for something more robust later*.

  2. Javier Sanchez says:

    Dear Bill,

    On the non-price factors affecting competitiveness you might want to have a look at the World Economic Forum annual reports. They define competitiveness as “the set of institutions, policies, and factors that determine the level of productivity of a country”.

    The WEF published their latest annual Global Competitiveness Report (2012-2013) in September (see: http://www3.weforum.org/docs/WEF_GlobalCompetitivenessReport_2012-13.pdf) which provides an assessment of competitiveness from a number of angles and ranks and scores 144 countries on 12 metrics divided into three main pillars: Basic requirements (macro+social), Efficiency enhancers (educ+finance+labor) and Innovation and sophistication factors.

    You might not like to read the following: “The government cannot provide services efficiently if it has to make high-interest payments on its past debts. Running fiscal deficits limits the government’s future ability to react to business cycles and to invest in competitiveness-enhancing measures.” In fact the treatment of the variables may be too mechanistic and the methodology is a little bit unclear to me, the explanation in the report is not very comprehensive.

    I’d like to read your opinion about these competitiveness measuring exercises, even if you disregard the macro one.

    Regards,

    Javier

  3. Ikonoclast says:

    “There is robust research evidence to support the notion that by paying high wages and offering workers secure employment, firms reap the benefits of higher productivity and the nation sees improvements in its international competitive as a result.”

    Typo, it should be “international competitiveness”.

    Also, should not this statement be modified by two considerations? A developing nation, like China, can pay low wages (relative to developed nations) whilst it remains a developping nation with a relatively low cost of living and standard of living.

    Also, is there not an upper bound to the efficacy of higher wages? There will come a point where higher wages induce no more productivity rises. In practice this bound is unlikely to be tested but should not the point be mentioned?

  4. Alex says:

    “This leads us to define a new concept – the real exchange rate which depends on to factors:”

    Typo – should read two factors.

    Cheers!

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