Lecture 7 International Finance ECON 243 – Summer I, 2005 Prof. Steve Cunningham

Extended IS-LM Model Goods market equilibrium requires: Y s = Y d Y s = C + I d + G + (X – M) Y s – C – G = I d + (X – M) S = I d + I f Goods market equilibrium requires: Y s = Y d Y s = C + I d + G + (X – M) Y s – C – G = I d + (X – M) S = I d + I f But S = S 0 + sY, so that S = S(Y). But S = S 0 + sY, so that S = S(Y). I d + I f = I, and I = I o – α i, or I = I(i) I d + I f = I, and I = I o – α i, or I = I(i) So this condition is essentially S(Y) = I(i). So this condition is essentially S(Y) = I(i).

Extended IS-LM (Continued) But, S(Y) = I(i) is essentially a statement that saving = investment in the loanable funds market. But, S(Y) = I(i) is essentially a statement that saving = investment in the loanable funds market. Compare this to the neoclassical model, wherein S(i) = I(i), and we could draw: S,I i I S i* S*,I* In this model, there is no one variable on which to adjust, and S(Y) = I(i): Y i IS (I=S) Y*Y* i*

Extended IS-LM (Continued) Clearly S(Y) = I(i) implies an infinite number of possibilities, of combinations of Y and i that bring the capital market (and therefore goods market) into equilibrium. Clearly S(Y) = I(i) implies an infinite number of possibilities, of combinations of Y and i that bring the capital market (and therefore goods market) into equilibrium. But which combination (Y,i) is the one that will actually happen? But which combination (Y,i) is the one that will actually happen? To answer this, we need to look at the money market. To answer this, we need to look at the money market.

Extended IS-LM (Continued) The demand for money (on the short run) is related: The demand for money (on the short run) is related: Positively to nominal GDP (PY), since this is a measure of the volume of the transactions that people want to make with money, and Positively to nominal GDP (PY), since this is a measure of the volume of the transactions that people want to make with money, and Negatively to interest rates (i) because holding money involves foregoing interest, hence there is an opportunity cost. Negatively to interest rates (i) because holding money involves foregoing interest, hence there is an opportunity cost. Thus the demand for money L = L(PY,i). (“L” is used for “liquidity”, M d = L.) Thus the demand for money L = L(PY,i). (“L” is used for “liquidity”, M d = L.)

Extended IS-LM (Continued) The supply of money is controlled (more or less) by the central bank—in the U.S., that is the Fed. The supply of money is controlled (more or less) by the central bank—in the U.S., that is the Fed. So M s is essentially “exogenous”. So M s is essentially “exogenous”. So equilibrium in the money market requires M d = M s, or L = M s. Thus, M s = L(PY,i). So equilibrium in the money market requires M d = M s, or L = M s. Thus, M s = L(PY,i). The demand for money rises with transactions volume and PY. The demand for money rises with transactions volume and PY. The demand for money falls with the opportunity cost of holding money, i. The demand for money falls with the opportunity cost of holding money, i. If we hold prices constant, then M s = L(Y,i). If we hold prices constant, then M s = L(Y,i).

Extended IS-LM (Continued) Compare to the neoclassical model wherein M s = L(Y) since M = kPY. M M* i* i In this model, again there are two variables (Y,i) that can adjust: LM (L=M) i Y Y*Y* i*i*

Extended IS-LM (Continued) In this model, the nominal interest rate is set in the money market. In this model, the nominal interest rate is set in the money market. This is compared to the returns on capital in the capital market. This is compared to the returns on capital in the capital market. Decision makers decide on how much to invest (I) based on the comparison of the cost of investment and its expected return. Decision makers decide on how much to invest (I) based on the comparison of the cost of investment and its expected return. The real interest rate follows from the capital market (S=I). The real interest rate follows from the capital market (S=I). So it takes both money market and goods/capital-market to resolve the economy. So it takes both money market and goods/capital-market to resolve the economy.

Extended IS-LM (Continued) For an economy without trade: IS LM Y i i* Y*

Extended IS-LM (Continued) Mathematically, simultaneously solve the two equations: I(i) = S(Y) M = L(Y,i) Mathematically, simultaneously solve the two equations: I(i) = S(Y) M = L(Y,i) With Y* compute C* = C(Y*) With Y* compute C* = C(Y*) Back out employment, wages, etc. Back out employment, wages, etc. From C, you get labor supply From C, you get labor supply From Y, you get labor demand From Y, you get labor demand Labor supply = labor demand tells you the wages. Labor supply = labor demand tells you the wages. Y*, i*, S*, M*, I*

Extended IS-LM (Continued) To extend this to an open economy, we add the foreign exchange (FE) or balance of payments(BP) market. To extend this to an open economy, we add the foreign exchange (FE) or balance of payments(BP) market. To do this, we examine how the official settlements balance (B) is affected by income (Y) and interest rates (i). To do this, we examine how the official settlements balance (B) is affected by income (Y) and interest rates (i). It turns out that : B = CA(Y) + KA(i) with Y negatively related to B, and i positively related to B. It turns out that : B = CA(Y) + KA(i) with Y negatively related to B, and i positively related to B.

Extended IS-LM (Continued) Raising Y lowers the current account because: Raising Y lowers the current account because: It creates more demand for imports, It creates more demand for imports, Leads to trade deficits (or lower trade surpluses). Leads to trade deficits (or lower trade surpluses). Raising the interest rate (i) raises the capital account because it: Raising the interest rate (i) raises the capital account because it: Attracts capital from abroad Attracts capital from abroad Creating a capital account surplus (or lowering the capital account deficit). Creating a capital account surplus (or lowering the capital account deficit).

Extended IS-LM (Continued) We construct the FE curve which is the combinations of Y and i that bring the official settlements balance to zero. We construct the FE curve which is the combinations of Y and i that bring the official settlements balance to zero. In other words, FE is all the combinations of Y and i that create a balance of payments equilibrium (without any official reserve transactions). In other words, FE is all the combinations of Y and i that create a balance of payments equilibrium (without any official reserve transactions). B = CA(Y) + KA(i) - +

Extended IS-LM (Continued) B = CA(Y) + KA(i) - +  Note that for B to stay the same, increases in Y must be met with offsetting increases in i.  This means that both must increase and decrease together.

Extended IS-LM (Continued) FE Y i ii YY At this point, i is too high for Y. This raises the capital account and B=CA+KA>0. At this point,Y is too high for this level of i. Thus imports are driven too high, lowering the current account. This leads to B=CA+KA<0

Extended IS-LM (Continued) What determines the slope of the FE line? What determines the slope of the FE line? Answer: the sensitivity of capital flows to interest rate changes. Answer: the sensitivity of capital flows to interest rate changes. If capital flows are very sensitive to interest rates, then FE is relatively flat. If capital flows are very sensitive to interest rates, then FE is relatively flat. If capital flows are extremely sensitive to interest rates, then there must be little in the way of obstacles to these flows. When the FE line is nearly flat, we have “perfect capital mobility. If capital flows are extremely sensitive to interest rates, then there must be little in the way of obstacles to these flows. When the FE line is nearly flat, we have “perfect capital mobility. If capital flows are insensitive to interest rates, then FE is relative vertical. If capital flows are insensitive to interest rates, then FE is relative vertical.

Extended IS-LM (Continued) IS LM Y i i* Y* IS LM Y i i* Y* IS LM Y i i* Y* FE The official settlements balance is 0. The official settlements balance is in deficit. The official settlements balance is in surplus.

Using the Extended Model If the country is on a fixed exchange rate regime, official settlements imbalances indicate that the fixed exchange rate must be defended. Intervention is required. (The settlements balance is not zero.) If the country is on a fixed exchange rate regime, official settlements imbalances indicate that the fixed exchange rate must be defended. Intervention is required. (The settlements balance is not zero.) If the country is on a clean float, then some shifting of curves will occur to bring the three curves together at the same point. If the country is on a clean float, then some shifting of curves will occur to bring the three curves together at the same point.

Price Level Changes So far we assumed that prices are fixed. (Short-run “stickiness.”) So far we assumed that prices are fixed. (Short-run “stickiness.”) Price levels do change for three reasons: Price levels do change for three reasons: Domestic inflationary pressures related to money supply growth rates. Domestic inflationary pressures related to money supply growth rates. Aggregate demand changes. Aggregate demand changes. Shocks. Shocks.

Trade and Prices Imports and exports depend upon production levels and incomes in the country under analysis and in the rest of the world. Imports and exports depend upon production levels and incomes in the country under analysis and in the rest of the world. Demand for imports is also related to the price of the imported goods relative to the price of similar domestic goods. That is, it depends upon the real exchange rate. Demand for imports is also related to the price of the imported goods relative to the price of similar domestic goods. That is, it depends upon the real exchange rate. The price ratio is (P f r )/P. The price ratio is (P f r )/P.

Trade and Prices (Continued) Thus M = M(Y) is not really complete. Thus M = M(Y) is not really complete. We add the relative price term: M = M(Y, P f r/P) We add the relative price term: M = M(Y, P f r/P) Our demand for foreign goods is less if the prices of the imports makes them relatively expensive. Our demand for foreign goods is less if the prices of the imports makes them relatively expensive. Our demand for foreign goods is higher if our incomes are higher (Y). Our demand for foreign goods is higher if our incomes are higher (Y). + -

Trade and Prices (Continued) Likewise, for exports we have: X = X(Y f, P f r/P) Likewise, for exports we have: X = X(Y f, P f r/P) Foreign demand for our goods are higher if they are enjoying higher incomes (Y f ). Foreign demand for our goods are higher if they are enjoying higher incomes (Y f ). Foreign demand for our goods is higher if our goods are relatively cheaper. Foreign demand for our goods is higher if our goods are relatively cheaper. ++

Fixed Exchange Rates Once a gov’t decides to fix its exchange rate, it must defend that rate. Once a gov’t decides to fix its exchange rate, it must defend that rate. The first line of defense is official intervention The first line of defense is official intervention Intervention: the monetary authority buys or sells foreign currency in the foreign exchange market to keep the rate within the allowable band around the central value chosen for the fixed rate. Intervention: the monetary authority buys or sells foreign currency in the foreign exchange market to keep the rate within the allowable band around the central value chosen for the fixed rate.

Problems with Intervention Buying or selling foreign currencies causes changes in official reserves. Buying or selling foreign currencies causes changes in official reserves. The country’s money supply may change as a result of exchanging the foreign currency for domestic currency. The country’s money supply may change as a result of exchanging the foreign currency for domestic currency.

Central Bank Assets International Reserve Assets (R) International Reserve Assets (R) Domestic Assets (D) Domestic Assets (D) Denominated in the domestic currency Denominated in the domestic currency Bonds and related debt of the domestic government Bonds and related debt of the domestic government Loans made by the central bank to domestic banks or financial institutions Loans made by the central bank to domestic banks or financial institutions

Central Bank Liabilities Domestic Currency (paper money and coins) Domestic Currency (paper money and coins) Deposits of domestic banks with the central bank. Deposits of domestic banks with the central bank. These are be required to facilitate check clearing processes These are be required to facilitate check clearing processes These deposits are required as reserve requirements. These are play a role in the system known as fractional reserve banking. These deposits are required as reserve requirements. These are play a role in the system known as fractional reserve banking.

Fractional Reserve Banking Banks only maintain (in reserve) a small fraction of their total deposits. Banks only maintain (in reserve) a small fraction of their total deposits. The required ratio of these reserves is to deposits is called the required reserve ratio, and is set by the Fed. The required ratio of these reserves is to deposits is called the required reserve ratio, and is set by the Fed. Because of fractional reserve banking, money is expanded through the money multiplier process. Because of fractional reserve banking, money is expanded through the money multiplier process.

Intervention and the Money Supply A country is running an official settlements surplus, creating upward pressure on the exchange rate (the exchange rate is too low). A country is running an official settlements surplus, creating upward pressure on the exchange rate (the exchange rate is too low). The central bank intervenes by buying foreign currency, selling domestic. The central bank intervenes by buying foreign currency, selling domestic. Buying foreign currency increases int’l reserve holdings (R). Since it was bought with domestic currency, its liabilities increase as the domestic money supply is increased. Buying foreign currency increases int’l reserve holdings (R). Since it was bought with domestic currency, its liabilities increase as the domestic money supply is increased. If the money is received by a domestic bank, then it will increase bank reserves, and be multiplied via the multiplier process. If the money is received by a domestic bank, then it will increase bank reserves, and be multiplied via the multiplier process. Thus foreign exchange intervention has the effect of changing the domestic money supply. Thus foreign exchange intervention has the effect of changing the domestic money supply.

Money Supply and BOP The linkage can run the other direction. The linkage can run the other direction. If the money supply increases, that will lower the interest rate, affecting capital flows, but also the domestic economy. If the money supply increases, that will lower the interest rate, affecting capital flows, but also the domestic economy. MsMs ii YY PP CA worse Capital flows outPayments balance worsens Y? = C  + I  + G + (X – M  )

Payments Adjustments Surplus Country with Fixed Exchange Rates Y i IS FE LM LM 0 Intervention under fixed rates changes the domestic money supply. The supply change causes adjustments that lead the country back toward external balance.

Problem? It requires changes in international reserves, which may not be desirable. It requires changes in international reserves, which may not be desirable. Solution: Solution: If the central bank is willing to let the domestic money supply change, it may be able to accelerate the process by deliberately engaging in open market operations to increase the domestic money supply and accelerate the shift of LM. If the central bank is willing to let the domestic money supply change, it may be able to accelerate the process by deliberately engaging in open market operations to increase the domestic money supply and accelerate the shift of LM. This raises the issue of inflation. This raises the issue of inflation.

Problem? The adjustment toward external balance may not be consistent with internal balance. The adjustment toward external balance may not be consistent with internal balance. The shift of LM caused by the increasing money supply may cause upward pressure on prices. Inflation in undesirable, a shift toward internal imbalance. The shift of LM caused by the increasing money supply may cause upward pressure on prices. Inflation in undesirable, a shift toward internal imbalance. Rising prices may put backward pressure on LM, and also affect exchange rates. Rising prices may put backward pressure on LM, and also affect exchange rates.

Sterilization To avoid internal imbalance occurring as the central bank fights external imbalance, they may decide to attempt to resist the domestic money supply change. To avoid internal imbalance occurring as the central bank fights external imbalance, they may decide to attempt to resist the domestic money supply change. Sterilization is the practice of taking an action to reverse the effect of official intervention on the domestic money supply. Sterilization is the practice of taking an action to reverse the effect of official intervention on the domestic money supply. Because the domestic money supply does not change, LM does not move. There is no movement toward external balance. Because the domestic money supply does not change, LM does not move. There is no movement toward external balance.

Domestic Policy Independence Because intervention generally means changing the domestic money supply, maintaining a fixed exchange rate interferes with a country’s ability to engage freely in domestic monetary policy. Because intervention generally means changing the domestic money supply, maintaining a fixed exchange rate interferes with a country’s ability to engage freely in domestic monetary policy. Domestic policy has to be limited to actions that will support the fixed exchange rate. Domestic policy has to be limited to actions that will support the fixed exchange rate.

Expansionary Monetary Policy Y i IS FE LM LM 0 Y0Y0 Y Both current account and capital accounts deteriorate

Expansionary Fiscal Policy Gov’t spending rises or taxes fall (deficit spending stimulus) ii Capital inflows increase Overall payments balance may improve at first, but worsens eventually. Y  Imports increase Current account balance worsens PP Exports fall

Expansionary Fiscal Policy Y i IS FE LM’ LM Y0Y0 Y i IS FE LM LM’ Y0Y0 IS’ Y1Y1 Y2Y2 Responsive Capital Flows Unresponsive Capital Flows Payments in surplusPayments in deficit Y1Y1 Y2Y2