David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 24 Exchange rates and the balance of payments
II)
t
0
..
0
NX
Given domestic and foreign incomes, a higher real
exchange rate reduces competitiveness and net exports.
Only at R0 is there trade balance. A resource discovery,
such as North Sea oil, shifts NX to NX' causing an
appreciation of the real exchange rate to R, to maintain
trade balance in the long run.
Figure 24.4 The long-run equilibrium real
exchange rote
Figure 24.4 shows that there is a unique real exchange
rate that makes net exports equal to zero. Given domestic
and foreign levels of potential output, a lower real
exchange rate raises export demand and reduces import
demand. The net export schedule NX slopes down. Only
at the real exchange rate R0 are net exports zero. At a
higher real exchange rate, competitiveness is too low and
net exports are negative. At a lower real exchange rate,
competitiveness is too high and net exports are positive .
Beginning from R0, suppose the country gets a favourable
and lasting supply shock that raises potential output Y*.
For example, the country discovers a natural resource,
such as oil or gold, or develops a new high-tech industry,
such as computers. Since the marginal propensity to
consume is less than unity, if output and income rise
by 100, aggregate demand rises by less than 100. The
remaining output is exported and net exports rise.
In Figure 24.4 the favourable supply shock shifts the net
export schedule to NX' and the long-run equilibrium
real exchange rate appreciates from R0 to R1. If finding
North Sea oil adds to UK net exports, only a fall in the
country's manufacturing exports will prevent a permanent
trade surplus. A real exchange rate appreciation -
a fall in UK competitiveness - is the market mechanism
that restores external balance. 3
Large supply shocks, such as a big resource discovery, are the exception not the norm. If no shocks occur,
the real exchange rate is constant in long-run equilibrium. This has two implications. First, if domestic and
foreign prices grow at different rates, the nominal exchange rate has to adjust steadily to keep the real
exchange rate constant. The nominal exchange rate then follows the purchasing power parity path discussed
in Section 24.4.
Second, if the nominal exchange rate is fixed as an act of policy, it is possible to maintain a constant real
exchange rate in the long run only if domestic and foreign prices change at the same rate. Otherwise the real
exchange rate is changing in the long run, and net exports will not remain zero, as external balance requires.
Foreign debt and foreign assets
Finally, we recognize that some countries have important flows of international income or payments as
a result of owning large foreign assets or having large foreign debts. The current account is net exports
(X - Z) plus r A the stock of net foreign assets multiplied by the interest rate r. For creditor countries A
is positive; for debtor countries A is negative.
Figure 24.5 shows how inherited foreign assets or debts affect the long-run equilibrium real exchange rate.
The current account CA is net exports NX, as in Figure 24.4, plus net interest on foreign assets. For current
account balance, a debtor country needs a low real exchange rate R0 to be competitive and have a sufficient
trade surplus to pay interest on its foreign debts. A creditor country has a high real exchange rate R1 to
reduce competitiveness and run a trade deficit, financed by interest earned on foreign assets.
3 The fact that a resource discovery hurts other sectors, such as manufacturing, is sometimes called Dutch Disease. Holland's real
exchange rate appreciated significantly after its discovery of offshore gas fields in the North Sea. Sterling also appreciated after
the UK subsequently found North Sea oil.
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