Interdependence & Coordination Lecture 18 Interdependence & Coordination International Interdependence Theory: Interdependence results from capital mobility, even with floating rates. Empirical estimates of cross-country effects. International Coordination The institutions of international cooperation Theory: Prisoners’ dilemma

Interdependence under floating exchange rates Revisited Two of the results derived previously were too strong to be literally true: When we first looked at the question, floating rates insulated countries from each other’s economies. (Lect.6). But that was when KA=0 (+ORT=0 => CA =0). Since then, capital mobility has changed things. CA ≠ 0. => Floating doesn’t completely insulate. US, euroland, Japan, UK, etc., are still visibly correlated. Under κ=, we found G leaked abroad 100%, through offsetting TD. No effect remained at home. (L17) This overly strong result was a consequence of the assumption i = 𝑖∗ .

Why don’t floating rates insulate? Capital flows. The restriction i = 𝑖∗ is in reality too strong, even for modern conditions of low international capital flow barriers. Why? Reasons: (1) i  i*, when investors are aware of the likelihood of future exchange rate changes (=> Lecture 24); and (2) i* is not exogenous, if domestic country is large in world financial markets (as are US & EU). => Two-country model. Implication: Effects of AD expansion are partly felt in domestic country, partly transmitted abroad through TD.

Two-country model with perfect capital mobility For now, retain i=i* ; but drop i* = 𝑖∗ <= domestic country is big enough to affect i*. Fiscal expansion, shifting ISUS out, thereby appreciating $ and worsening TB, now also depreciates € and raises TB*. Y rises (crowding out < 100% ), despite κ=∞, Y* rises (international transmission), despite floating, as i and i* rise in tandem. BGP-620 Prof.J.Frankel

• • G↑ US expansion drives up interest rates worldwide, because US is large in world financial markets. G↑ $↑ €↓ • • => Expansion is transmitted from US to Europe. BGP-620 Prof.J.Frankel

Transmission in practice in 12 large econometric models, on average: US fiscal expansion -> Multiplier  1.5 in US 1/ and  ½ in EU & Japan. US 4% monetary expansion -> Effect on GDP  1% in US and  0 in EU & Japan. 1/ Most relevant in recession with liquidity trap (US 2009-15). Multiplier is lower in normal times, esp. under full employment (or under default risk, or in small open economies).

is transmitted positively to the rest of the world. The econometric models agree that US fiscal expansion, via TBUS <0 and TB* >0, is transmitted positively to the rest of the world. G↑ BGP-620 Prof.J.Frankel

More disagreement regarding international effects of monetary policy. A US monetary expansion, domestically, raises output & inflation. But the models divide regarding the effects on TB, TBRoW and YRoW. Reason: two effects go opposite directions. Y ↑ => TB ↓, but $↓ => TB ↑ M↑ BGP-620 Prof.J.Frankel

International macroeconomic policy coordination, continued Institutions of coordination: G7 Leaders Summit & Finance Ministers 1975 Rambouillet: ratified floating 1978 Bonn: locomotive theory 1985 Plaza: concerted intervention to depreciate $ 2013 “No currency war”: Members agree won’t intervene. BIS, Basel Committee on Banking Supervision & Financial Stability Board 1988 Basel Accord: set capital adequacy rules for intl. banks 2007 Basel II: Gov.t bonds should not necessarily get 0 risk weight. 2011 Basel III: Higher capital requirements. G20 includes big emerging markets; 2009 London: G20 overtook G8, responded to global recession with simultaneous stimulus. OECD for industrialized countries . IMF for everyone (“Surveillance”).

International policy coordination is an application of game theory. In one game, the players choose their level of spending. Dilemma: Each is afraid to expand alone. Cooperation here means joint expansion. In another game, the players choose the monetary/fiscal mix. BGP-620 Prof.J.Frankel

THE GAME OF “COMPETITIVE DEPRECIATION” A third game is what Brazilian Minister Guido Mantega had in mind in 2010 when he warned of “Currency Wars.” THE GAME OF “COMPETITIVE DEPRECIATION” U.S. lowers i Japan lowers i* Global i too low => Excessive flows (to EMs) ¥ depreciates, Japan’s TB rises $ depreciates, US TB rises BGP-620 Prof.J.Frankel

Applications of the theory of coordination Name of the game: Nash equilibrium: Non-cooperative Cooperative Exporting unemployment Everyone contracts Everyone expands (locomotive) Competitive appreciation Everyone raises i Everyone refrains from changing the exchange rate. Competitive depreciation Everyone lowers i } BGP-620 Prof.J.Frankel

End of Lecture 19: International Interdependence and International Coordination

Appendix: Transmission in practice, continued: When the stimulus originates outside the US Fiscal expansion: again, 12 large econometric models show that the transmission (to the US) is positive. Monetary expansion: again, the econometric models disagree whether transmission is positive or negative. because the income effect and exchange rate effect on the TB go opposite directions. BGP-620 Prof.J.Frankel

G↑ A fiscal expansion in the rest of the OECD countries via TBRoW <0 and TBUS >0, is transmitted positively to the US. G↑ BGP-620 Prof.J.Frankel

M↑ Disagreement regarding international effects of monetary policy. A foreign monetary expansion raises output & inflation there. But the models divide regarding cross-border transmission. Reason: 2 effects go opposite directions. YRoW↑ => TBRoW↓, but €↓ => TBRoW↑ M↑ BGP-620 Prof.J.Frankel