International Linkages

Rational Expectations

International Linkages

• Economies are linked internationally through:

  • Trade in goods.

  • Financial markets.

• Exchange Rate:

  • The price of a foreign currency in terms of the dollar.

  • A high exchange rate (weak dollar) reduces imports and increases exports, stimulating aggregate demand.

• Fixed Exchange Rates:

  • Central banks buy and sell foreign currency to peg the exchange rate.

• Floating Exchange Rates:

  • The market determines the value of one currency in terms of another.

• Maintaining a Fixed Exchange Rate:

  • If a country has a balance of payments deficit, the central bank buys back domestic currency using foreign currency and gold reserves or borrowing from abroad.

  • If the deficit persists and the country runs out of reserves, it must allow the value of its currency to fall.

• Long Run Exchange Rate Adjustment:

  • Exchange rates adjust to equalize the real cost of goods across countries.

• Capital Mobility:

  • Perfect capital mobility and fixed exchange rates: Fiscal policy is powerful.

  • Perfect capital mobility and floating exchange rates: Monetary policy is powerful.

International Linkages

• Globalization:

  • National economies are becoming more closely interrelated, moving toward a single global economy.

  • Economic influences from abroad have powerful effects on the U.S. economy.

  • U.S. economic policies have substantial effects on foreign economies.

• Economic Interdependence:

  • U.S. economic growth or recession significantly impacts countries like Mexico and Japan.

  • Fiscal stimulus or stringency in other industrial countries affects the U.S. economy.

  • Tightening of U.S. monetary policy affects interest rates worldwide and changes the value of the dollar, impacting U.S. competitiveness and global trade/GDP.

• Linkages Among Open Economies:

  • Trade (in goods and services).

  • Finance.

• Trade Linkage:

  • A country's production is exported.

  • Goods consumed or invested at home are produced abroad and imported.

  • In 2002, U.S. exports: 11.2% of GDP, imports: 16.4% of GDP.

  • The U.S. engages in relatively little international trade (closed economy) compared to countries like the Netherlands (very open economy).

• Impact of Trade Linkages:

  • Spending on imports escapes the circular flow of income.

  • Exports increase the demand for domestically produced goods.

  • The IS-LM model needs amendment to include international effects.

  • Prices of U.S. goods relative to competitors impact demand, output, and employment.

• Currency Value Impact:

  • A decline in dollar prices of competitors shifts demand away from U.S. goods.

  • Imports rise and exports fall (e.g., 1980-1985 when the dollar increased in value).

  • Conversely, a decline in the dollar's value makes U.S.-produced goods cheaper, exports rise, and imports decline.

• International Finance Links:

  • Daily turnover in the foreign exchange market: $1.5 trillion (15$.

  • U.S. residents can hold U.S. assets or assets in foreign countries.

  • Portfolio managers seek the most attractive yields worldwide.

• International Investment:

  • International investors shifting assets link asset markets, affecting income, exchange rates, and monetary policy's ability to affect interest rates.

The Balance of Payments and Exchange Rates

• Balance of Payments:

  • Record of transactions between a country's residents and the rest of the world.

  • Two main accounts: current account and capital account.

• Balance-of-Payments Accounting Rule:

  • Any transaction causing payment by a country's residents is a deficit item.

  • Examples: Imports, gifts to foreigners, purchase of land abroad, deposits in foreign banks.

  • Surplus items: Sales of airplanes abroad, payments by foreigners for U.S. licenses, pensions from abroad, foreign purchases of U.S. assets.

• Current Account:

  • Records trade in goods and services and transfer payments.

  • Services: Freight, royalty payments, and interest payments.

  • Also includes net investment income: interest and profits on assets abroad less income foreigners earn on U.S. assets.

  • Transfer payments: Remittances, gifts, and grants.

  • Trade balance: Records trade in goods.

  • Current account balance: Trade balance + trade in services + net transfers.

• Capital Account:

  • Records purchases and sales of assets, such as stocks, bonds, and land.

  • U.S. capital account surplus (net capital inflow): Receipts from the sale of assets exceed payments for purchases of foreign assets.

• External Accounts Balancing:

  • If a person spends more than their income, the deficit is financed by selling assets or borrowing.

  • A country with a current account deficit must finance it by selling assets or borrowing abroad, resulting in a capital account surplus.

  • $Current Account + Capital Account = 0$

  • If no assets to sell, no foreign currency reserves, and no borrowing is possible, the country must balance its current account.

• Splitting the Capital Account:

  • Transactions of the private sector.

  • Official reserve transactions (central bank activities).

  • A current account deficit can be financed by private residents selling assets/borrowing abroad or by the government running down foreign exchange reserves.

  • Conversely, a surplus allows the private sector to pay off debt/buy assets abroad or the central bank to add currency to reserves.

• Balance-of-Payments Surplus:

  • Increase in official exchange reserves.

  • $Balance-of-Payments Surplus = Increase in Official Exchange Reserves = Current Account Surplus + Net Private Capital Inflow$

• Balance of Payments Deficit:

  • If both current and private capital accounts are in deficit, the overall balance of payments is in deficit.

  • If one account is in surplus and the other is in deficit to the same extent, the overall balance of payments is zero.

• Exchange Rate Definition:

  • The price of one currency in terms of another.

• Fixed Exchange Rate System:

  • Foreign central banks buy and sell their currencies at a fixed price in terms of dollars.

• How Fixed Exchange Rates Work:

  • Central banks are prepared to buy or sell any amount of dollars at fixed rates.

  • Nobody would pay more than the fixed rate since they can purchase at that price from the central bank.

• Intervention:

  • Buying or selling of foreign exchange by the central bank.

  • The balance of payments measures the amount of foreign exchange intervention needed from the central banks.

  • If demand for yen exceeds supply, the Bank of Japan buys excess dollars, paying with yen.

• Operating Like a Price Support Scheme:

  • The price fixer makes up the excess demand or takes up the excess supply.

  • Necessary to hold an inventory of foreign currencies.

• Persistent Deficits:

  • If a country runs persistent balance of payments deficits, the central bank runs out of foreign exchange reserves and is unable to continue its intervention.

  • The central bank may devalue the currency, making it cheaper for foreigners to buy.

• Flexible (Floating) Exchange Rate System:

  • Central banks allow the exchange rate to adjust to equate the supply and demand for foreign currency.

• Clean vs. Managed (Dirty) Floating:

  • Clean Floating: Central banks stand aside completely.

  • Managed Floating: Central banks intervene to influence exchange rates.

The Euro

• European Integration:

  • Western Europe has undergone increasing economic integration (free trade, labor mobility, etc.).

• European Union (EU):

  • The integration process has led to the EU.

• European Monetary Union (EMU) and the Euro:

  • Creation of a monetary union with a common currency (the euro).

  • Started in January 1999 (exchange rates fixed) and completed in January 2002 (coins and notes introduced).

• Controversy:

  • Germany had a history of low inflation, while other European economies did not.

  • Germans worried about the new money.

• Convergence Process:

  • Countries had to reach specific targets.

  • These targets are called the "Maastricht criteria."

• Maastricht Criteria Qualifiers:

  • Specific targets like $2\%$ or less inflation.

  • No restrictions on capital flows.

  • No devaluation in the preceding $2$ years.

  • A budget deficit of less than $3\%$ of GDP.

  • A debt ratio below $60\%$ of GDP.

• The European Central Bank (ECB):

  • There are questions about giving up national currencies and exchange rates.

• Wage and Price Adjustments: Can the various European economies adjust to shocks by movements in wages and prices?

• Political Integration:

  • There has been a process of economic and political integration.

• Expansion of the Euro Area:

  • There are questions if Great Britain will join and more.

  • The euro will be used in a much larger part of the world map.

• Creating a Money That Is on a Par with the Dollar:

  • Europe has taken a huge step toward creating a money that is on a par with the dollar.

Floating, Clean and Dirty

• Clean Floating:

  • Central banks stand aside completely and allow exchange rates to be freely determined in the foreign exchange markets.

  • Since the central banks do not intervene in the foreign exchange markets in such a system, official reserve transactions are, accordingly, zero.

  • The exchange rate adjusts to make the current and capital accounts sum to zero.

• Managed, or Dirty, Floating:

  • Central banks intervene to buy and sell foreign currencies in attempts to influence exchange rates.

Terminology

• Exchange Rate

  • The price of one currency in terms of another.

• Depreciation:

  • A currency depreciates when, under floating rates, it becomes less expensive in terms of foreign currencies.

• Appreciation:

  • A currency appreciates when it becomes more expensive in terms of foreign money.

• Devaluation:

  • A devaluation takes place when the price of foreign currencies under a fixed rate regime is increased by official action.

• Revaluation:

  • The opposite of a devaluation of a currency.

Recap

• Balance-of-payments Accounts:

  • Record of the transactions of the economy with other economies.

  • The capital account describes transactions in assets, while the current account covers transactions in goods and services, as well as transfers.

• Balance-of-Payments Deficit (or Surplus):

  • The sum of the deficits (or surpluses) on current and capital accounts.

• Fixed Exchange Rates:

  • Central banks stand ready to meet all demands for foreign currencies at a fixed price in terms of the domestic currency.

  • They finance the excess demands for, or supplies of, foreign currency (i.e., the balance-of-payments deficits or surpluses, respectively) at the pegged (fixed) exchange rate by running down, or adding to, their reserves of foreign currency.

• Flexible Exchange Rates:

  • The demands for and supplies of foreign currency are equated through movements in exchange rates.

  • Under clean floating, there is no central bank intervention and the balance of payments is zero.

  • Sometimes central banks intervene in a floating rate system, engaging in so-called dirty floating.

The Exchange Rate in the Long Run

• Exchange Rate Determination:

  • In the long run, the exchange rate between a pair of countries is determined by the relative purchasing power of currency within each country.

• Purchasing Power Parity (PPP):

  • Two currencies are at purchasing power parity when a unit of domestic currency can buy the same basket of goods at home or abroad.

• Real Exchange Rate:

  • The ratio of foreign to domestic prices, measured in the same currency.

  • It measures a country's competitiveness in international trade.

  • The real exchange rate, $R$, is defined as: $R = \frac{eP_f}{P}$, where:

    • $P$ is the domestic price level.

    • $P_f$ is the foreign price level.

    • $e$ is the dollar price of foreign exchange.

• Interpretation of R:

  • If $R = 1$, currencies are at PPP.

  • If the U.S. real exchange rate rises (above 1), goods abroad are more expensive than in the United States.

  • As long as R > 1, we expect the relative demand for domestically produced goods to rise.

• Limitations of PPP:

  • Market forces prevent the exchange rate from moving too far from PPP or from remaining away from PPP indefinitely.

  • There are several reasons for slow movement toward PPP:

    • Market baskets differ across countries.

    • There are many barriers to the movement of goods between countries.

    • Many goods are "nontraded" and cannot move.

• Relative PPP:

  • PPP implies that in the long run, the real exchange rate will return to its average level.

Trade in Goods, Market Equilibrium, and the Balance of Trade

• Effects of Trade in Goods:

  • We can now study the effects of trade in goods on the level of income and the effects of various disturbances on both income and the trade balance.

• IS-LM Framework:

  • In this section, we fit foreign trade into the IS-LM framework.

• Price Level:

  • We assume that the price level is given and that the output demanded will be supplied.

• Domestic Spending and Spending on Domestic Goods

  • In an open economy, part of domestic output is sold to foreigners (exports) and part of spending by domestic residents purchases foreign goods (imports).

• Domestic Spending:

  • Spending by domestic residents $= A = C + I + G$.

• Spending on Domestic Goods:

  • $= A + NX = (C + I + G) + (X - Q) = (C + I + G) + NX$, where:

    • $X$ is the level of exports.

    • $Q$ is imports.

    • $NX = X - Q$ is the trade surplus.

• Income Determination:

  • We will assume that domestic spending depends on the interest rate and income, so $A = A(Y, i)$.

• Net Exports:

  • Depend on our income, which affects import spending; on foreign income, $Y_f$, which affects foreign demand for our exports; and on the real exchange rate, $R$.

• Three Important Results:

  • A rise in foreign income, other things being equal, improves the home country's trade balance and therefore raises the home country's aggregate demand.

  • A real depreciation by the home country improves the trade balance and therefore increases aggregate demand.

  • A rise in home income raises import spending and hence worsens the trade balance.

• Goods Market Equilibrium:

  • The increase in import demand caused by a $1$ dollar increase in income is called the marginal propensity to import.

• Open Economy IS Curve:

  • The open economy IS curve includes net exports as a component of aggregate demand.

  • Therefore, the level of competitiveness, as measured by the real exchange rate $R$, affects the IS curve.

  • IS Curve: $Y = A(Y, i) + NX(Y, Y_f, R)$

Home Spending, Foreign Income and Real Depreciation Disturbance Effects

• Foreign Income $Y_f$

  • $exports \uparrow$

  • $NX \uparrow$

  • $IS \rightarrow Shifts Right$

  • $interest rate \uparrow$

  • $output \uparrow$

• Table 12-2 summarizes the effects of different disturbances on the equilibrium levels of income and net exports.

Repercussion Effects

• Interdependent World:

  • Our policy changes affect other countries as well as ourselves and then feed back on our economy.

• Locomotive Effect:

  • When the United States expands, it tends to pull the rest of the world into an expansion.

• Repercussion Effects and Exchange Rate Changes:

  • In Table 12-3 we show empirical estimates of the impact of changes in real exchange rates on U.S. real GDP.

  • The table reports the effect of a 10 percent dollar depreciation against all other currencies.

  • A depreciation of our exchange rate increases our income while reducing foreign incomes.

Capital Mobility

• High Degree of Integration:

  • One of the striking facts about the international economy is the high degree of integration, or linkage, among financial, or capital, markets.

• Absence of Restrictions:

  • In most industrial countries today there are no restrictions on holding assets abroad.

• Searching for the Highest Return:

  • U.S. residents, or residents in Germany or the United Kingdom, can hold their wealth either at home or abroad.

• The Simplest World:

  • Exchange rates are fixed forever, taxes are the same everywhere, and foreign asset holders never face political risks.

• Perfect Factor Mobility:

  • Capital is perfectly mobile internationally when investors can purchase assets in any country they choose, quickly, with low transaction costs, and in unlimited amounts.

• Capital Flows that Tend to Restore Yields to the World Level:

  • The high degree of capital market integration implies that any one country's interest rates cannot get too far out of line without bringing about capital flows that tend to restore yields to the world level.

• Balance of Payments:

  • implies that a relative decline in interest rates\textemdash a decline in our rates relative to those abroad\textemdash will tend to worsen the balance of payments because of the capital outflow.

The Balance of Payments and Capital Flows

• Introducing the Role of Capital Flows

  • We introduce the role of capital flows within a framework in which we assume that the home country faces a given price of imports and a given export demand.

  • We assume that the world rate of interest, i, (i.e., the rate of interest in foreign capital markets), is given.

• Balance-of-Payments Surplus

  • $BP = NX(Y, Y<em>f, R) + CF(i - i</em>f)$, where:

    • $NX$ is the trade surplus.

    • $CF$ is the capital flow.

• Capital Flows Effect: An increase in income worsens the trade balance, and an increase in the interest rate above the world level pulls in capital from abroad and thus improves the capital account..\

Policy Dilemmas: Internal and External Balance

• Internal and External Balance

  • Countries frequently face policy dilemmas, in which a policy designed to deal with one problem worsens another problem.

• External Balance

  • External balance exists when the balance of payments is close to balance.

• Internal Balance

  • Internal balance exists when output is at the full employment level.

• Perfect Capital Mobility Assumption Force

  • Our key assumption\textemdash perfect capital mobility\textemdash forces the $BP = 0$ line to be horizontal. Only at a level of interest rates equal to that of rates abroad can we have external balance.

The Mundell-Fleming Model: Perfect Capital Mobility Under Fixed Exchange Rates

• Perfect Capital Mobility Model:

  • The analysis extending the standard IS-LM model to the open economy under perfect capital mobility has a special name, the Mundell-Fleming model.

  • Independent Monetary Policy:

  • Under perfect capital mobility, the slightest interest differential provokes infinite capital flows.

  • Therefore, with perfect capital mobility, central banks cannot conduct an independent monetary policy under fixed exchange rates.

• Reversal of Monetary Contraction:

  • The process comes to an end when home interest rates have been pushed back down to the initial level.

  • A small interest differential moves enough money in or out of the country to completely swamp available central bank reserves.

• Conclusion:

  • Under fixed exchange rates and perfect capital mobility, a country cannot pursue an independent monetary policy.

  • Interest rates cannot move out of line with those prevailing in the world market.

Fixed Exchange Rates - Impossible Trinity

• Tight monetary policy:

  • Increased interest rates

  • Capital inflow, payments surplus

  • Pressure for currency appreciation

  • Intervention by selling home money and buying foreign money

  • Monetary expansion due to intervention lowers interest rate.

  • Back to initial interest rates, money stock, and payments balance.
    *

Reaching Equilibrium Under Fixed Exchange Rates and Perfect Capital Mobility

• Monetary Expansion:

  • But there is a large payments deficit and hence pressure for the exchange rate to depreciate.

  • The central bank must intervene, selling foreign money and receiving domestic money in exchange.

• Fiscal Expansion:

  • While monetary policy is essentially infeasible, fiscal expansion under fixed exchange rates with perfect capital mobility is, by contrast, extremely effective.

  • The higher interest rate sets off a capital inflow that would lead the exchange rate to appreciate.

  • To maintain the exchange rate, the central bank has to expand the money supply, shifting the LM curve to the right, thus increasing income further.

  • Endogenous Money Stock the commitment to maintain a fixed exchange rate makes the money stock endogenous because the central bank has to provide the foreign exchange or domestic money.

Perfect Capital Mobility and Flexible Exchange Rates

• Fully Flexible Exchange Rates:

  • Under fully flexible exchange rates the central bank does not intervene in the market for foreign exchange.

  • The exchange rate must adjust to clear the market so that the demand for and supply of foreign exchange balance.

• Zero Balance of Payments:

  • Under fully flexible exchange rates the absence of intervention implies a zero balance of payments.

  • Money Supply:

  • A second implication of fully flexible exchange rates is that the central bank can set the money supply at will.

  • Interest Rate:

  • Perfect capital mobility implies that there is only one interest rate at which the balance of payments will balance:

  • $i = i_f$.

  • Real Exchange Rate:

  • From equation (7) we know that the real exchange rate is a determinant of aggregate demand and, therefore, that changes in the real exchange rate shift the IS schedule

Adjustment to Real Disturbance

• Increase in Foreign Demand:

  • Starting from an initial equilibrium at point E in Figure 12-7, we see that the increase in foreign demand implies an excess demand for our goods.

• Aggregate Demand:

  • The capital inflows cause our currency to appreciate.

  • Exchange rate appreciation means that import prices fall and domestic goods become relatively more expensive.

• The economists have stated that real disturbances to demand do not affect equilibrium output under flexible rates with perfect capital mobility.

Fiscal Policy Under Mobile Capital

• Do not affect equilibrium output under flexible rates with perfect capital mobility, but they do affect demand.

• There is complete crowding out.

  • The crowding out takes place not because higher interest rates reduce investment but because the exchange appreciation reduces net exports.

Adjustment to a Change in the Money Stock

• Effect:

  • a change in the money stock and show that it leads, under flexible exchange rates, to an increase in income and a depreciation of the exchange rate.

  • Depreciation

  • The exchange depreciation caused by the capital outflows leads import prices to increase, domestic goods become more competitive and the demand for our output expands

  • The monetary expansion will improve the current account

• Controlling Money Stock: Central bank can control the money stock under flexible rates; which is a key aspect of that exchange rate system.

Beggar-Thy-Neighbor Policy and Competitive Depreciation

• Home Country - Increase Employment

  • We have shown that a monetary expansion in the home country leads to exchange depreciation, an increase in net exports, and therefore an increase in output and employment.

• Beggar-Thy-Neighbor Policy
  Recognition that exchange depreciation is mainly a way to increase domestic employment is important