International Linkages Chapter #13

Introduction National economies are becoming more closely interrelated => movement toward globalization or single global market –Economic influences from abroad have affects on the U.S. economy –Economic occurrences and policies in the U.S. affect economies abroad When the U.S. moves into a recession, it tends to pull down other economies When the U.S. is in an expansion, it tends to stimulate other economies Key linkages among open economies & some first pieces of analysis Economies are linked through two broad channels 1.Trade in goods and services Some of a country’s GDP exported  increase demand for domestically produced goods Some goods consumed or invested at home are produced abroad and imported  a leakage from the circular flow of income 2.Finance Portfolio managers shop the world for the most attractive yields Investors shift assets around the world, linking home & foreign assets markets  affect income, exchange rates & the ability of monetary policy to affect interest rates U.S. residents can hold U.S. assets OR assets in foreign countries

The Balance of Payments Record of residents’ transactions with the rest of the world Two main accounts:  Current account: records trade in goods & services, as well as transfer payments  Capital account: records purchases and sales of financial assets & land Central point of international payments: must pay for foreign purchases –If spending exceeds income, deficit financed by selling assets or by borrowing –Current account deficit must be financed by an offsetting capital inflow Current account + Capital account = 0 Official reserves > 0 when domestic private residents don’t sell or borrow abroad enough, government covers ≠ from reserves causing them to ↓

Exchange Rate Systems Direct ForEx quote (US stand point): Price of foreign currency in terms of $ –If you could buy 1 Irish punt for $1.38, nominal exchange rate e = $1.38 / 1 punt = 1.38 –Dollar cost of sandwich sold for 2.39 punts = 2.39 punts * 1.38 = $3.30 –Demand for punt in exchange for $ = supply of $ in exchange for punt Fixed exchange rate system (regime): central banks hold $ reserves to be able to intervene in ForEx market (trading home currency for $) in order to maintain fixed $ price of the home currency Balance of payments determines the level of central bank’s intervention –If US has a current account deficit w/ Japan (demand for ¥ > supply of ¥ in exchange for $) the Bank of Japan buys excess $ w/ ¥ to maintain fixed $/ ¥ exchange rate –Country that persistently runs balance of payment deficits has to devalue its currency (otherwise central bank runs out of foreign currency reserves & cannot maintain fixed e) Flexible (floating) exchange rate system: central banks allow the exchange rate to adjust to equate the supply and demand for foreign currency –If US has a current account deficit w/ Japan the Bank of Japan stands aside allowing for $ to depreciate (¥ to appreciate), e.g. from e 0 = 0.86 / ¥1 = 0.86 to e 1 = 0.90, making Japanese goods more expensive for Americans & lowering US demand for Japanese products –Appreciation is %Δ of denominator currency = (end e – beg e) / beg e = end e / beg e - 1

The Exchange Rate in the Long Run Determined by relative purchasing power of each country’s currency (like gold standard, often tested with price of Big Mac in different countries) –Two currencies are at purchasing power parity (PPP) when a unit of domestic currency can buy the same basket of goods at home or abroad –Relative purchasing power measured by real exchange rate R = ePf / P, ratio of foreign prices P f to home price P both measured in $)  e $/punt = 1.38, sandwich costs 2.39 punt & $3.09 in US, R = 1.38*2.39 / 3.09 = 1.07  If R =1, currencies are at PPP  If R >/ R slowly → 1 due to ≠ baskets of goods, barriers (natural – transaction costs & artificial – tariffs) & non-movable assets (land) Cost of barley in UK relative to that in Holland over a long time period –R for barley tends to equalize –But, long time periods of deviation Best estimate for modern times is deviations from PPP is reduced by half in about 4 years –PPP holds in the LR, but it is only one of exchange rate determinants

Goods Trade, Equilibrium & Balance of Trade To bring foreign trade into IS-LM model assume fixed price & flat AS curve With NX, domestic spending no longer solely determines domestic output  Spending by domestic residents: DS = DS(Y, i) = C + I + G  Spending on domestic goods: DS + NX = C + I + G + NX  Net exports: NX = NX(Y, Y f, R) = X(Y f, R) – Q(Y, R)  ↑ in home income Y ↑ import Q & worsens the trade balance => ↓ AD  ↑ in foreign income Y f ↑ exports X & improves the trade balance => ↑ AD  Real depreciation of home country R improves the trade balance => ↑ AD Marginal propensity to import = fraction of income spent on imports –IS curve steeper in an open than in a closed economy (for given ↓ in interest %, smaller ↑ in output & income restores goods equilibrium) IS curve now includes NX as AD component IS: Y = DS(Y, i) + NX(Y, Y f, R) –↑ in competitiveness (real depreciation) ↑ demand for home goods => shifts IS curve to the right –↑ in Y f ↑ foreign spending on home goods => shifts IS curve to the right

Balance of Payments & Capital Flows Financial markets (home & foreign) are highly integrated Start analysis with assumption of perfect international capital mobility –Low transaction costs of quick unlimited trading in any country –Large funds move across borders searching for highest return or lowest cost –Capital inflows/outflows bring interest rates in any country quickly back in line Capital flows into country (facing given price of imports, export demand & world interest rate i f ) when the interest rate is above world rate Balance of payments surplus is: BP = NX(Y, Y f, R) + CF(i - i f ), where CF is the capital account surplus –The trade balance NX is a function of domestic and foreign income  An increase in domestic income worsens the trade balance –The capital account CF depends on the interest differential  An increase in the interest rate above the world level pulls in capital from abroad, improving the capital account

Mundell-Fleming Model: Perfect Capital Mobility Under Fixed Exchange Rates The Mundell-Fleming model incorporates foreign exchange under perfect capital mobility into the standard IS-LM framework Under perfect capital mobility, the slightest interest differential provokes infinite capital inflows  central bank cannot conduct an independent monetary policy under fixed exchange rates Uncovered & covered interest rate parity 1 + i = (1/e 0 )(1 + i f )e 1 e & 1 + i = (1/e 0 )(1 + i f )f or i ≈ i f + (e 1 e - e 0 )/e 0 & i ≈ i f + (f - e 0 )/e 0 A country tightens money supply to increase interest rates: –Portfolio holders worldwide shift assets into country –Due to huge capital inflows, balance of payments shows a large surplus –The exchange rate appreciates and the central bank must intervene to hold the exchange rate fixed –The central bank buys foreign currency in exchange for domestic currency –Intervention causes domestic money stock to increase, and interest rates drop –Interest rates continue to drop until return to level prior to initial intervention

Monetary Expansion Fiscal Expansion Monetary policy is ineffective, but fiscal expansion is effective –A fiscal expansion shifts IS curve right  increases interest rates & output –Higher interest % attracts capital inflow causing currency appreciation –To manage the exchange rate central bank expands the money supply  shifting the LM curve to the right Pushes interest rates back to their initial level, but output increases yet again Consider a monetary expansion that shifts LM right from point E to E’ –At E’ there is a large payments deficit, and pressure for the exchange rate to depreciate –Central bank must intervene, selling foreign money in exchange for home money, supply of home money falls, pushing up interest %, returning LM to the original position

Perfect Capital Mobility and Flexible Exchange Rates Use the Mundell-Fleming model to explore how monetary and fiscal policy work in an economy with a flexible exchange rate and perfect capital mobility –Assume domestic prices are fixed –The exchange rate must adjust to clear the market so that the demand for and supply of foreign exchange balance –Without central bank intervention, the balance of payments must equal zero –The central bank can set the money supply at will since there is no obligation to intervene  no automatic link between BP and money supply Perfect capital mobility implies that balance of payments balances when i = i f –A real appreciation means home goods relatively more expensive => IS shifts left –A real depreciation makes home goods relatively cheaper => IS shifts right Arrows link interest rate & AD –When i > i f, the currency appreciates –When i < i f, the currency depreciates Interest % ↑ due to contractionary or restrictive econ policy (above) or ↑ in inflation causing currency depreciation.

Adjustment to a Real Disturbance Using equations for IS curve, BP and CF balance we can show how various changes affect the output level, interest rate & exchange rate Suppose exports increase: ─ At a given output level, interest rate & exchange rate, there is an excess demand for goods ─ IS shifts to the right ─ The new equilibrium, E’, corresponds to a higher income level and interest rate ─ Don’t reach E’ since BP in disequilibrium  exchange rate appreciation will push economy back to E Suppose there is a fiscal expansion: ─ Same result as with increase in exports  tendency for demand to increase is halted by exchange appreciation Real disturbances to demand do not affect equilibrium output under flexible exchange rates with capital mobility.

Adjustment to a Money Stock Change Suppose there is an increase in the nominal money supply: ─ The real stock of money, M/P, increases since P is fixed ─ At E there will be an excess supply of real money balances ─ To restore equilibrium, interest rates will have to fall  LM shifts to the right ─ At point E’, goods market is in equilibrium, but i is below the world level  capital inflows depreciate the exchange rate ─ Import prices increase, home goods more competitive & demand for home goods expands ─ IS shifts right to E”, where i = i f ─ Result: Monetary expansion leads to ↑ output & currency depreciation under flexible rates