International Finance ECON 243 – Summer I, 2005 Prof. Steve Cunningham Lecture 8 International Finance ECON 243 – Summer I, 2005 Prof. Steve Cunningham

Capital Mobility Perfect Capital Mobility means that a practically unlimited amount of international capital flows in response to the slightest change in one country’s interest rates. Absent political and macroeconomic risks, a successful fixed exchange rate regime should make perfect capital mobility more likely. (Exchange rate risk is zero.) For a small country, perfect capital mobility implies that the country’s interest rate must be equal to the world interest rate.

Capital Mobility and Monetary Policy Under fixed exchange rates and perfect capital mobility, international capital flows dictate the country’s money supply. International conditions dominate domestic policy. If a country tries to reduce its money supply to raise its interest rates for domestic policy reasons, A slightly higher interest rate attracts a nearly unlimited capital inflow. The exchange rate must be defended by selling domestic currency, thereby expanding the money supply. It is impossible to sterilize in the face of such large capital flows. The expanding money supply lowers the domestic interest rate.

Capital Mobility and Fiscal Policy Under fixed exchange rates, perfect capital mobility enhances domestic fiscal policy. Because interest rates cannot rise, there is no possibility for “crowding out”. If the government increases spending without raising taxes, it incurs deficits. The deficits can easily be financed by in the enormous capital inflows.

Trade-off? Improved fiscal policy effectiveness is not a good substitute for monetary policy. Fiscal policy is cumbersome—slow to enact, not so responsive as monetary policy. Fiscal policy is very much influenced by short-run political interests. Not helpful for handling long-run inflationary issues.

Monetary Policy Without FE LM1 LM1 LM0 LM0 i1 i1 i0 i0 IS IS Y Y Y1 Y0 Y0 ? Under normal conditions, ignoring international complications, a reduction in the money supply raises interest rates, making investment more expensive, slowing output. Again ignoring international complications, if investment is not sensitive to interest rate changes, a reduction in the money supply raises interest rates a lot, but this has little effect on output.

Monetary Policy Under fixed exchange rates and perfect capital mobility In this case, any change in the domestic money supply causes a change in the interest rate, leading to the movement of enormous international capital flows. These capital flows happen almost instantly, and continue until the interest rates are restored to their original level—the same level as the world interest rate. Thus, effectively, the interest rate is fixed at the world rate, and domestic monetary policy cannot change the interest rate, and therefore cannot affect the domestic economy. i FE i0 LM IS Y0 Y

Fiscal Policy without FE LM i i IS1 IS0 i1 LM0 i0 i0 IS1 IS0 Y Y0 Y Y0,1 Y1 Under normal conditions, ignoring international complications, if money demand is very unresponsive to interest rates, then fiscal policy simply raises interest rates, and rendered weak as a result of “crowding out”. Again ignoring international complications, if money demand is sensitive to interest rate changes, fiscal stimulus is powerful. Small changes in interest rates have a large impact on the money supply-demand equilibrium. There is no crowding out.

Fiscal Policy Under fixed exchange rates and perfect capital mobility A stimulative fiscal policy shifts IS to the right. Any tiny increase in the interest rate generates enormous changes in the domestic money supply-demand equilibrium as a result of the enormous capital inflow. FE and LM are both anchored at the world interest rate. Thus there is no possibility of crowding out, and fiscal policy is powerful. i FE i0 LM IS Y0 Y Y1

Policy Effectiveness Under perfect capital mobility and fixed exchange rates, Monetary policy is limited to defending the fixed exchange rate, and Fiscal policy can be powerful.

Internal Shocks A domestic monetary shock alters the equilibrium relationship between money supply and demand because: The money supply changes, or People alter their personal systems of determining how much money to hold (demand) perhaps as a result of innovations or changes in the payments system. A domestic spending shock alters domestic real expenditure by a change in one of its components (C,I,G). An example is a fiscal policy change.

External Shocks An international capital-flow shock is an unexpected shift of international funds in response to political upheaval or fears of a international policy change. Examples are: Fear of war Rumors of the imposition of capital controls Growing evidence of a likely currency devaluation A form of capital flight

Adverse Int’l Capital-Flow Shock FE shifts to higher interest rates. Official settlements balance is in deficit at point E. Central bank must defend the fixed rate. If the central bank does not sterilize its intervention, LM shifts upward to left, and external balance is restored. Internal imbalance is created by falling output and rising unemployment. LM1 FE1 i LM0 T FE0 E IS Y1 Y0 Y

International Trade Shocks An international trade shock is a shift in a country’s exports or imports arising from causes other than changes in the real income of the country. These are structural changes. British beef. A country that is found to use DDT in its agriculture. It alters the current account.

Contractionary Policy Policy Responses State of the Domestic Economy High Unemployment Rapid Inflation Surplus Expansionary Policy ?? Deficit Contractionary Policy State of Balance of Payments In the situations marked by “??”, aggregate demand policy cannot deal effectively with both the internal and external situations simultaneously.

Policy Responses When confronted with one of the situations marked with ??, the government is in a trap. Internal imbalance solutions worsen the external balance, and vice-versa. It has three choices: It can abandon the goal of external balance, which will require eventual abandonment of the fixed exchange rate. It can abandon the goal of internal balance, at least on the short run. It can search for other solutions, like…?

Alternative for the Short Run Robert Mundell and J. Marcus Fleming realized there might be a possibility of using an appropriate “policy mix”. Stimulative monetary policy lowers interest rates; stimulative fiscal policy raises interest rates.  Maybe a combination, each offsetting the worst of the other? It is the changes in interest rates that affect the payments balance. So with a combined policy, one could have fiscal policy stimulus and lower interest rates! More generally, monetary and fiscal policies can be mixed so as to achieve any combination of internal and external goals in the short run.

Assignment Rule According to Mundell’s assignment rule: Assign fiscal policy the task of stabilizing the domestic economy (only), Assign to monetary policy the task for stabilizing the balance of payments (only) Each arm of policy concentrates on a single task, making coordination of policy trivial. Also each arm of policy is addressing the issues it cares most about. Timing, though, remains critical. Lags from either side could result in unstable oscillations.

Monetary-Fiscal Recipes State of the Domestic Economy High unemployment Rapid Inflation Surplus Easier monetary policy, easier fiscal policy Easier monetary policy, tighter fiscal policy Deficit Tighter monetary policy, easier fiscal policy Tighter monetary policy, tighter fiscal policy State of Balance of Payments

Exchange Rates and the Trade Balance What is the effect of a change in the nominal exchange rate on the volumes of exports and imports? As long as the change in the exchange rate alters the int’l price competitiveness, it should change the volume of trade. What is the effect on the value of trade? This is more difficult. (Remember both prices and volumes are changing.)

Devaluation (Surrender) The devaluation should improve international price competitiveness as long as any changes in the domestic price level or foreign price level do not offset the exchange rate change. Exports increase as goods become cheaper to foreign buyers. Imports decrease as foreign goods become more expensive to domestic buyers. OVERALL, the current account tends to improve. The result on the capital account is less clear.

Consider a devaluation Consider a devaluation of the dollar, where the CA balance is measure in pounds per year: CA balance = P£X • X - P£m • M £ price of Exports Quantity of Exports £ price of Imports Quantity of Imports  No change or down  No change or up  No change or down  No change or down Effect = • • -

Problem? In the case of perfectly inelastic demand for exports and imports, devaluing the dollar could result in a worsened trade balance. The foreign price of exports fall, but quantities demanded are NOT responsive to price, so the volume stays the same. Thus P£X is lower, but X is unchanged, and P£X • X is lower. The value of exports declines.

More Likely Result On the short run, prices will be able to adjust more quickly than quantities. (Export demand is more inelastic in the short run.) So immediately following a devaluation or depreciation, the value of exports will fall, worsening the trade balance. Over the longer term, prices can adjust. (Export demand is more elastic in the long run.) So longer term, the trade balance would improve. In fact, the longer the elapsed time since the devaluation or depreciation, the more likely the trade balance is to be improved.

J Curve It is more likely that the drop in the value of the home currency will improve the trade balance, especially in the long run. Net change in trade balance + Months since devaluation - 18 months

Flexible Exchange Rates Under a clean float, external balance is maintained by the changing exchange rates. Policy focuses on internal balance. Remaining questions: What are the effects of shocks? How does the exchange rate change resolve external imbalances? How do fluctuations in the exchange rate affect the macroeconomy?

Expansionary Monetary Policy Capital flows out Current account balance improves Money supply increases Interest rate drops Our currency depreciates GDP rises more Current account balance worsens Spending and output increase Price level rises

Expansionary Monetary Policy (2) Under floating exchange rates, monetary policy is powerful in its effects on internal balance. The induced change in the exchange rate reinforces the domestic effects of monetary policy. Monetary policy is a more powerful tool for managing the domestic economy under flexible exchange rates.

Expansionary Monetary Policy LM0 FE0 Following expansionary monetary policy, the currency depreciates to correct the deficit payments balance—FE moves to the right. IS moves to the right as the current account improves. i LM1 E0 FE1 E1 T1 IS1 IS0 Y0 Y1 Y

Expansionary Fiscal Policy Interest rate rises Capital flows in Our currency may appreciate at first, but probably depreciates eventually GDP falls, then rises more Gov’t spending increases Current account balance worsens Spending and output increase Price level rises