International Finance - Lecture VII

International Finance

Course Outline

The course covers the following topics, with possible changes:

• Introduction to international finance and the history of international finance, including basic features of the foreign exchange market and data sources (February 18th).
• Balance of payments structure and national income accounting for an open economy, including the international investment position (February 25th).
• Guest lecture by Prof. Talluri, Michigan State University (March 4th).
• Introduction to exchange rate determination using the asset approach, including covered and uncovered interest rate parity (March 11th).
• Prices and exchange rates, including purchasing power parity and long-run aspects of exchange rate determination (March 18th). First assignment due.
• The Fisher effect, nominal and real exchange rates, exchange rates and competitiveness, and the Balassa-Samuelson effect (March 25th).
• Nominal and real convergence in the EU and introduction to the AA-DD model (April 1st).
• The AA-DD model with additional details and application on policy analysis (April 8th).
• Fixed exchange rates, macroeconomic implications, interventions and sterilization, the policy trilemma, and policy options for reaching internal and external balance using the Swan diagram (April 15th).
• Monetary integration, covering costs and benefits (April 22nd).
• Monetary integration effects and empirical research, including equilibrium exchange rates (FEER) (April 29th).
• A brief introduction to models of balance of payments crises and debts of developing countries (May 6th).
• Holiday - Dean’s day (May 13th).
• Make-up class covering Forex forecasting, fundamental approaches versus alternatives, a brief overview of technical analysis, and the future of the International Monetary System (IMS). Second assignment due (May 20th).

Assignments and Quizzes

• Assignment results will be discussed.
• Quizzes are part of the assessment.
• Last quiz had 45 participants.
• The next quiz will be opened with a deadline.

Reading for the Next Session

• Krugman – chapter 17 and appendix
• Tasks:
  • Read especially the section on adjustment to permanent policy shocks.
  • Understand the logic of the third curve in the AA-DD model (XX curve).
• New data (released on March 27):
  • Eurostat - PPPs for GDP per capita in 2024: preliminary estimates
  • https://ec.europa.eu/eurostat/web/products-eurostat-news/w/ddn-20250327-2
  • https://ec.europa.eu/eurostat/statistics- explained/index.php?title=PurchasingpowerparitiesandGDPpercapita_ - preliminaryestimate
  • Make sure that you understand the role of PPP in international comparisons of GDP per capita
• For volunteers:
  • International Economics (S. Suranovic) on AA-DD model
  • Mao Takongmo (2019): Revisiting the AA-DD Model in Zero Lower Bound

DD-AA Model

• A model which provides analysis of three markets in a simple framework:
  • Output – markets of goods and services
  • Foreign exchange markets
  • Money market
• Short run focus
• Two curves:
  • DD: Shows combinations of output and the exchange rate at which the output market is in short-run equilibrium
  • AA: The inverse relationship between output and exchange rates needed to keep the foreign exchange markets and the money market in equilibrium

DD Curve

• Combinations of output and the exchange rate at which the output market is in short-run equilibrium.

Determinants of Aggregate Demand

• Aggregate demand can be expressed as: $D = C + I + G + CA$ where $CA ≡ X – M$
• $D = C(Y – T) + I + G + CA(EP*/P, Y – T)$
• Or more simply: $D = D(EP*/P, Y – T, I, G)$
• Where:
  • $E$ is the nominal exchange rate
  • $P*$ is the foreign price level
  • $P$ is the domestic price level
  • $Y$ is the output
  • $T$ is taxes
  • $I$ is investment
  • $G$ is government spending
  • $CA$ is current account balance

Determinants of aggregate demand include:

• Real exchange rate: an increase in the real exchange rate increases the current account, and therefore increases aggregate demand of domestic products.
• Disposable income: an increase in the disposable income increases consumption expenditure but decreases the current account. Since consumption expenditure is usually greater than expenditure on foreign products, the first effect dominates the second effect.
• As income increases for a given level of taxes, aggregate consumption expenditure and aggregate demand increase by less than income.
• For simplicity, we assume that exogenous political factors determine government purchases $G$ and the level of taxes $T$.
• For simplicity, we currently assume that investment expenditure $I$ is determined by exogenous business decisions.
• A more complicated model shows that investment depends on the cost of spending or borrowing to finance investment: the interest rate.

Short-Run Equilibrium for Aggregate Demand and Output

• Equilibrium is achieved when the value of income from production (output) $Y$ equals the value of aggregate demand $D$. $Y = D(EP*/P, Y – T, I, G)$
• Value of output and income from production.
• Aggregate demand as a function of the real exchange rate, disposable income, investment expenditure, and government purchases.

Short-Run Equilibrium and the Exchange Rate: DD Schedule

• With fixed domestic and foreign levels of average prices, a rise in the nominal exchange rate makes foreign goods and services more expensive relative to domestic goods and services.
• A rise in the nominal exchange rate (a domestic currency depreciation) therefore increases aggregate demand of domestic products.
• In equilibrium, production will increase to match the higher aggregate demand.
• DD schedule shows combinations of output and the exchange rate at which the output market is in short-run equilibrium (such that aggregate demand = aggregate output).
• Slopes upward because a rise in the exchange rate causes aggregate demand and aggregate output to rise.

Shifting the DD Curve

Changes in the exchange rate cause movements along a DD curve. Other changes cause it to shift:

1. Changes in $G$: more government purchases cause higher aggregate demand and output in equilibrium. Output increases for every exchange rate: the DD curve shifts right.
2. Changes in $T$: lower taxes generally increase consumption expenditure, increasing aggregate demand and output in equilibrium for every exchange rate: the DD curve shifts right.
3. Changes in $I$: higher investment expenditure is represented by shifting the DD curve right.
4. Changes in $P$ relative to $P*$: lower domestic prices relative to foreign prices are represented by shifting the DD curve right.
5. Changes in $C$: willingness to consume more and save less is represented by shifting the DD curve right.
6. Changes in demand of domestic goods relative to foreign goods: willingness to consume more domestic goods relative to foreign goods is represented by shifting the DD curve right.

AA Curve

• Equilibrium in asset markets

Short-Run Equilibrium in Asset Markets

We consider two sets of asset markets:

1. Foreign exchange markets

   • interest parity represents equilibrium: $R = R* + (Ee – E)/E$

2. Money market

   • Equilibrium occurs when the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded: $Ms/P = L(R, Y)$
   • A rise in income from production causes the demand of real monetary assets to increase.

The AA Schedule

AA curve - the inverse relationship between output and exchange rates needed to keep the foreign exchange markets and the money market in equilibrium.

Shifting the AA Curve

1. Changes in $Ms$: an increase in the money supply reduces interest rates in the short run, causing the domestic currency to depreciate (a rise in $E$) for every $Y$: the AA curve shifts up (right).
2. Changes in $P$: An increase in the level of average domestic prices decreases the supply of real monetary assets, increasing interest rates, causing the domestic currency to appreciate (a fall in $E$): the AA curve shifts down (left).
3. Changes in the demand of real monetary assets: if domestic residents are willing to hold a lower amount of real money assets and more non-monetary assets, interest rates on nonmonetary assets would fall, leading to a depreciation of the domestic currency (a rise in $E$): the AA curve shifts up (right).
4. Changes in $R*$: An increase in the foreign interest rates makes foreign currency deposits more attractive, leading to a depreciation of the domestic currency (a rise in $E$): the AA curve shifts up (right).
5. Changes in $Ee$: if market participants expect the domestic currency to depreciate in the future, foreign currency deposits become more attractive, causing the domestic currency to depreciate (a rise in $E$): the AA curve shifts up (right).

DD-AA: SR Equilibrium

Putting the Pieces Together: the DD and AA Curves

A short-run equilibrium means a nominal exchange rate and level of output such that

1. equilibrium in the output markets holds: aggregate demand equals aggregate output.
2. equilibrium in the foreign exchange markets holds: interest parity holds.
3. equilibrium in the money market holds: the quantity of real monetary assets supplied equals the quantity of real monetary assets demanded.

A short-run equilibrium occurs at the intersection of the DD and AA curves:

• output markets are in equilibrium on the DD curve
• asset markets are in equilibrium on the AA curve

Temporary Changes in Monetary and Fiscal Policy

• Temporary policy shifts are those that the public expects to be reversed in the near future and do not affect the long-run expected exchange rate.
• Small open economy: assume that policy shifts do not influence the foreign interest rate and the foreign price level.

Temporary Changes in Monetary Policy

• Monetary Policy
• An increase in money supply (i.e., expansionary monetary policy) raises the economy’s output.
• The increase in money supply creates an excess supply of money, which lowers the home interest rate.
• As a result, the domestic currency must depreciate (i.e., home products become cheaper relative to foreign products)
• Domestic products relative to foreign products are cheaper, so that aggregate demand and output increase until a new short-run equilibrium is achieved.

Temporary Changes in Fiscal Policy

• Fiscal Policy
• An increase in government spending, a cut in taxes, or some combination of the two (i.e, expansionary fiscal policy) raises output.
• The increase in output raises the transactions demand for real money holdings,
• Increase in the home interest rate.
• As a result, the domestic currency must appreciate ($E$ falls)

Temporary Changes in Monetary and Fiscal Policy

• Policies to Maintain Full Employment
• Temporary disturbances that lead to recession can be offset through expansionary monetary or fiscal policies.
• Vice versa: temporary disturbances that lead to overemployment can be offset through contractionary monetary or fiscal policies.

Permanent Shifts in Monetary and Fiscal Policy

• A permanent policy shift affects not only the current value of the government’s policy instrument but also the long-run exchange rate.
• This affects expectations about future exchange rates.
• A Permanent Increase in the Money Supply
• A permanent increase in the money supply causes the expected future exchange rate to rise proportionally.
• As a result, the upward shift in the AA schedule is greater than that caused by an equal, but transitory, increase (compare point 2 with point 3).
• Why? Think about PPP.

Permanent Shifts in Monetary Policy

• Adjustment to a Permanent Increase in the Money Suply
• The permanent increase in the money supply raises output above its full-employment level.
• As a result, the price level increases to bring the economy back to full employment.
• How about the long run: next picture shows the adjustment back to full employment.

Permanent Shifts in Fiscal Policy

• A Permanent Fiscal Expansion
• A permanent fiscal expansion changes the long-run expected exchange rate.
• If the economy starts at long-run equilibrium, a permanent change in fiscal policy has no effect on output.
• It causes an immediate and permanent exchange rate jump that offsets exactly the fiscal policy’s direct effect on aggregate demand.

Adding the Current Account (XX)…

Macroeconomic Policies and the Current Account

• XX schedule
• It shows combinations of the exchange rate and output at which the CA balance would be equal to some desired level.
• This desired level can be different, XX curve does not have to go through the intercept of the DD and AA schedules.
• Some authors call it Iso-CAB curve
• It slopes upward because a rise in output encourages spending on imports and thus worsens the current account (if it is not accompanied by a currency depreciation).
• It is flatter than DD.
• DD curve represents equilibrium values of aggregate demand and domestic output and we know that moving along DD curve to the right increases the current account
• XX schedule shows the combination at which the current account does not change
• The marginal propensity to consume is less than one, not all the extra GNP will be spent on consumption goods; some will be saved. Nevertheless, aggregate demand (on the right side) must rise up to match the increase in supply on the left side. Since all the increase in demand cannot come from consumption, the remainder must come from the current account.
• Monetary expansion causes the CA balance to increase in the short run.
• Expansionary fiscal policy reduces the CA balance.
  • If it is temporary, the DD schedule shifts to the right.
  • If it is permanent, both AA and DD schedules shift.

Exchange Rate Pass-Through and Inflation

• The CA in the DD-AA model has assumed that nominal exchange rate changes cause proportional changes in the real exchange rates in the short run.
• Degree of Pass-through
  • It is the percentage by which import prices rise when the home currency depreciates by 1%.
  • In the DD-AA model, the degree of pass-through is 1.
• Exchange rate pass-through can be incomplete because of international market segmentation.
• Currency movements have less-than-proportional effects on the relative prices determining trade volumes. Gradual Trade Flow Adjustment and Current Account Dynamics

Marshall-Lerner Condition

Devaluations and Trade Balance?

• Elasticity approach to balance of payments
• Alfred Marshall, Abba Lerner, J. Robinson, F. Machlup
• Central question:
• How does devaluation affect current account? Does the devaluation of a currency improve the country’s balance of trade?
• M-L condition:
• Condition that guarantees that devaluation will improve current account
• The condition is based on elasticities
• Price elasticity shows the sensitivity of an economic variable to a change in price
• E.g. price elasticity of demand for exports: $\eta_x = \frac{\% \Delta X}{\% \Delta S}$
• $\eta_x$ = (% change in exports) / (% change in price)

ML Condition - Mathematics

Normalize $P$ and $P*$ to 1

Elasticities:

• $\eta_x = \frac{dS}{dX} \frac{X}{S}$
• $\eta_m = -\frac{dS}{dM} \frac{M}{S}$

Additional assumption: Balanced trade

• $CA = P X<em>v - S P* M</em>v$
• $CA = X − S ⋅ M$
• $dCA = dX − dS ⋅ M − S ⋅ dM$
• Using $"eta<em>x$ and $"eta</em>m$ and after some algebra, the Marshall-Lerner condition is:
• \etax + \etam > 1

ML Condition - Interpretation

Devaluation will improve trade balance only if:

\etax + \etam > 1

This means that export and import must be sufficiently elastic with respect to price!

Summary

• A temporary increase in the money supply causes a depreciation of the currency and a rise in output.
• Permanent shifts in the money supply cause sharper exchange rate movements and therefore have stronger short-run effects on output than transitory shifts.
• If exports and imports adjust gradually to real exchange rate changes, the current account may follow a J-curve pattern after a real currency depreciation, first worsening and then improving.