Lecture 19 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 ITF-220 Prof.J.Frankel

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 completely insulated countries from each other’s economies. But that was when KA=0 (=> CA =0). o Since then, capital mobility has changed things. o Indeed, US, euroland, Japan, UK, etc., are still correlated.  Under κ= , we found  G leaked abroad 100%, through offsetting TD. No effect remained at home. o This overly strong result was a consequence of the assumption i =. ITF-220 Prof.J.Frankel

The restriction i = is in reality too strong, even for modern conditions of low barriers to international capital flows. Reasons: (1) i  i*, when investors are aware of likelihood of future exchange rate changes, 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.  Why don’t floating rates insulate? Capital flows. ITF-220 Prof.J.Frankel

Two-country model with perfect capital mobility For now, retain i=i*, but drop i* = <= domestic country is big enough to affect i*. Fiscal expansion, shifting IS US out, o thereby appreciating $ and worsening TB, o now also depreciates € and raises TB*. o So Y rises (crowding out < than 100% ), despite κ=∞, o Y* rises (international transmission), despite floating, o as i and i* rise in tandem. ITF-220 Prof.J.Frankel

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

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 ). Multiplier is lower under full employment (or under default risk, or in small open economies). ITF-220 Prof.J.Frankel

The econometric models agree that US fiscal expansion, via TB US 0, is transmitted positively to the rest of the world. G↑G↑

ITF-220 Prof.J.Frankel Similarly, a fiscal expansion in the rest of the OECD countries via TB RoW 0, is transmitted positively to the US. G↑G↑

ITF-220 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, TB RoW and Y RoW. Reason: two effects go opposite directions. Y ↑ => TB ↓, but $↓ => TB ↑ M↑M↑

ITF-220 Prof.J.Frankel 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. Y RoW ↑ => TB RoW ↓, but €↓ => TB RoW ↑ M↑M↑

International macroeconomic policy coordination Institutions of coordination: G8 Leaders Summit & G7 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 1988 Basel Accord: set capital adequacy rules for intl. banks 2007 Basel II: Gov.t bonds should not necessarily get 0 risk weight Basel III: Higher capital requirements. G20 includes big emerging markets;  2009 London: G20 replaced G7/G8, responded to global recession with simultaneous stimulus. OECD for industrialized countries. IMF for everyone (“Surveillance”). ITF-220 Prof.J.Frankel

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

ITF-220 Prof.J.Frankel 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 A third game is what Brazilian Minister Guido Mantega had in mind in 2010 when he warned of “Currency Wars.”

ITF-220 Prof.J.Frankel Theories 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