International Finance Final

National income identity (open economy)

Y = C + I + G + CA, where CA = EX − IM is the current account.

National income identity (closed economy)

Y = C + I + G.

Output = Income = Expenditure

The three things that are equal for the economy as a whole (all called Y).

Savings definition

S = Y − C − G (national savings).

Savings-investment identity (closed)

S = I.

Savings-investment identity (open)

S = I + CA, equivalently S − I = CA.

Current Account (other names)

Net Exports (NX); Net Foreign Investment (NFI).

Effect of higher savings on CA

Increases CA (since S − I = CA).

Effect of higher investment on CA

Decreases CA.

Three things that raise the current account

Higher savings, lower investment, lower government budget deficit.

Government savings relation

S = Private Savings − Government Budget Deficit.

Developed-country pattern

S > I, CA > 0, financial outflow.

Developing-country pattern

S < I, CA < 0, financial inflow.

BOP account identity

CA + Cap.A + NEO = FA (positive FA = financial outflow in this course).

Four parts of the BOP

Current Account, Financial Account, Capital Account, Net Errors and Omissions.

Double-entry bookkeeping (BOP)

Every international transaction is recorded twice with opposite stance.

CA surplus and the financial account

Positive FA and a financial (capital) outflow.

CA deficit and the financial account

Negative FA and a financial (capital) inflow.

Current Account components

Goods trade, Services trade, Primary Income, Secondary Income.

Primary Income

Interest, dividends, and wages workers earn abroad.

Secondary Income

Transfers: pensions, reparations, foreign aid.

Services trade examples

Legal services, tourist spending, shipping fees.

Financial Account components

Direct Investment, Portfolio Investment, Other Investment, Official Settlement Balance.

Direct Investment

Acquiring foreign assets to participate in management (M&A, subsidiaries).

Portfolio Investment

Acquiring foreign stocks/bonds for income or capital gains.

Other Investment

Mainly bank loans.

Official Settlement Balance (OSB)

Changes in official international reserves; reflects government decisions.

NRPFA

Non-reserve portion of the financial account; reflects private decisions.

BOP surplus/deficit equation

CA + Cap.A + NEO − NRPFA = OSB; OSB>0 surplus, OSB<0 deficit.

BOP deficit meaning

Running down official international reserves; may signal a crisis.

Causes of a BOP crisis

A current-account deficit and/or financial outflows (positive NRPFA).

US empirical pattern

High consumption; current account negative almost the whole period (I > S).

Japan empirical pattern

Investment once high but declining; rising G; CA positive almost throughout (S > I).

Singapore empirical pattern

Switched in the mid-1980s from CA deficit (developing) to CA surplus (developed).

Exchange rate definition

The price of one currency in terms of another; an asset price.

Direct terms

Price of the foreign currency in terms of the domestic currency (this course's default).

Indirect terms

Price of the domestic currency in terms of the foreign currency.

Depreciation

A decrease in a currency's value (in direct terms, E rises).

Appreciation

An increase in a currency's value (in direct terms, E falls).

Home depreciation effect on trade

Exports rise, imports fall (home goods cheaper, foreign goods dearer).

Home appreciation effect on trade

Exports fall, imports rise.

FX market main actors

Commercial banks (interbank market, volume) and central banks (policy expectations).

FX financial centers

London, New York, Tokyo, Frankfurt, Singapore; integrated by arbitrage, 24-hour single market.

Arbitrage

Profiting from price differences across markets; integrates markets.

Hedge

Reducing or managing risk.

Speculation

Profiting from active trading on one's own guess; provides liquidity.

Vehicle currency

A currency widely used for third-party contracts; the USD is the most common.

Spot exchange rate

Rate for immediate (spot) delivery.

Forward exchange rate

Rate for future delivery, fixed at the contract date.

Swap (synthesis)

Equivalent to a spot trade plus a forward trade.

Futures

Standardized contracts traded on an organized exchange.

Options

The right (not obligation) to buy or sell.

Determinants of an asset price

Expected real rate of return, risk, liquidity.

Real rate of return

Nominal rate of return minus the inflation rate.

ERoR on a foreign asset

R* + (Eᵉ − E)/E = foreign interest rate + expected home-currency depreciation.

ERoR on a home asset

The domestic interest rate R.

Interest Parity Condition (IPC)

R = R* + (Eᵉ − E)/E; equilibrium of the currency market.

IPC model endogenous variable

The exchange rate E (R, R*, Eᵉ are exogenous).

Effect of higher R on E (short-run)

E falls (home appreciation); negative impact.

Effect of higher R* on E

E rises (home depreciation); positive impact.

Effect of higher Eᵉ on E

E rises (home depreciation); positive impact.

Short-run interest-rate conclusion

A high-interest-rate country's currency appreciates (R up, E down).

Short-run vs long-run R-E relation

Short-run: R up, E down. Long-run: relative R up, E up (the reversal).

Functions of money

Medium of exchange, unit of account, store of value.

M1

Bank notes plus demand (checking) deposits.

Why money is demanded despite zero return

Its liquidity; it is the medium of exchange.

Effect of higher R on money demand

Less money demand (R is the opportunity cost).

Effect of higher Y on money demand

More money demand (more transactions).

Real money demand function

M^d/P = L(R,Y); decreasing in R, increasing in Y.

Money-market equilibrium

M/P = L(R,Y).

Money-market model endogenous variable

The interest rate R (M^s, P, Y exogenous).

Effect of higher money supply on R

R falls.

Effect of higher price level on R

R rises (real money supply falls).

Effect of higher real income on R

R rises (money demand rises).

Asset prices and rates of return

Rising asset prices imply lower rates of return, and vice versa.

Combined model inputs

Five exogenous variables: M^s, P, Y, R*, Eᵉ.

Combined model: M^s up

E rises (depreciation).

Combined model: P up

E falls (appreciation).

Combined model: Y up

E falls (appreciation).

Combined model: R* up

E rises (depreciation).

Combined model: Eᵉ up

E rises (depreciation).

Causes of home depreciation (E up)

Higher M^s, higher R*, higher Eᵉ, lower P, lower Y.

Short-run vs long-run models

Short-run: sticky prices, P exogenous. Long-run: flexible prices, P endogenous.

Purchasing Power Parity (PPP)

E = P/P*; exchange rates equalize relative price levels.

Higher price level effect (PPP)

Lower currency value (higher E).

Money market solved for P (long run)

P = M / L(R,Y).

Monetary approach solution

E = (M/M) ÷ [L(R,Y)/L(R,Y*)].

Monetary approach: relative money supply

Positive impact on E.

Monetary approach: relative interest rate

Positive impact on E (long-run).

Monetary approach: relative real income

Negative impact on E.

Interest-rate puzzle

Short-run R lowers E, long-run relative R raises E (opposite conclusions).

Real interest rate equation

r = R − π.

Fisher equation

R = r + π.

Fisher effect

One-to-one relationship between inflation and the nominal interest rate.

Money growth and inflation (long run)

Money-supply growth determines inflation, which raises R one-for-one (Fisher).

Refined long-run driver

Relative money-supply growth (C2′), not the interest rate itself.

Reasons PPP fits poorly

Trade barriers/non-tradables, imperfect competition, measurement differences, Balassa-Samuelson.

Balassa-Samuelson effect

High-productivity (developed) countries have higher non-tradable prices and overall price levels.

Real exchange rate q

q = E·P*/P; relative price of home vs foreign goods.

Real depreciation

q rises (home goods become relatively cheap).