1. International Finance Econ 356 Karine Gente kgente@interchange-ubc.ca

2. Web page: http://www.econ.ubc.ca/directory/sess/sfac kg.htm http://www.econ.ubc.ca/directory/sess/sfac kg.htm Office room: Buch tower 1099 D Teaching Assistant: Kang Shi Email: kangshi@interchange.ubc.ca Office room: Buch tower 1099C Office hrs: Friday 2:00-3:00

3. Introduction Macroeconomic Equilibrium and Open Economy

4. Open economies The development of international trade (volume) Trade barriers and restrictions on capital flows tend to disappear (GATT + WTO rounds) A disequilibrium between imports and exports

5. Exports and Imports as a % of GDP (1960-2000) France Japan Canada United States

6. International trade

7. Percentage of GDP 40 35 30 25 20 15 10 5 0 CanadaFranceGermanyItalyJapanU.K.U.S. ImportsExports Imports and Exports as a percentage of output: 2000

8. International trade (1999) Exports relative to imports

9. International trade becomes more intensive. The openess degree measured by (EX+IM)/GDP is about 73% for Canada against 23% for Japan. Exports need not be equal to imports -> Capital flows -> The higher IM-EX, the more the country dependent on the rest of the world.

10. Domestic Country Rest of the World Money (I) Imports Domestic Country Rest of the World Exports Money (II)

11. Imports>ExportsI>II Domestic Country goes into debt vis-à-vis the Rest of the World Imports<ExportsI<II Domestic Country goes into excedent vis-à-vis the Rest of the World

12. Canada

13. Measures of Financial Integration Source: WEO, Lane and Milesi-Ferreti (2003)

14. Measures of Financial Integration Source: WEO, Lane and Milesi-Ferreti (2003) 0.00 0.10 0.20 0.30 0.40 0.50 Developing Countries 0.0 0.2 0.4 0.6 0.8 1.0 19701974197819821986199019941998 Restriction Measure (left scale) Openness Measure (right scale)

15. We can distinct capital flows as –Bank lending (Indirect Finance) –Portfolio flows (Direct Finance) –Foreign Direct Investment: Investment of a foreign firm in a country. FDI is driven by the desire of entreprises to exploit their intangible property in markets outside their home country. Portfolio flows vary sharply instead of FDI are quite insensitive to short-run swings in macroeconomic conditions

16. Direct vs. Indirect Finance

17. Net Private Capital Flows (Billions of USD) Source: WEO 100 120 140 160 180 All Developing Economies -20 0 20 40 60 80 197019751980198519901995 Year Bank Lending Portfolio Flows FDI

18. Net Private Capital Flows (Billions of USD) Source: WEO More Financially Integrated Economies -20 0 20 40 60 80 100 120 140 160 180 197019751980198519901995 Year Bank Lending Portfolio Flows FDI Less Financially Integrated Economies -2 0 1 2 3 4 5 6 7 8 9 197019751980198519901995 Year Bank Lending Portfolio Flows FDI

19. All this evidence suggests that international economic integration has hugely increased. What are the consequences? –Growth and development –Efficiency of government policies –Contagion and crisis

20. International Economic Integration (IEI) IEI refers to the extent and strength of real- sector and financial-sector linkages among national economies. Real-sector linkages occur through the international transactions in goods and services while the financial-sector linkages occur through international transactions in financial assets.

21. Channels Through Which IEI Can Raise Economic Growth Higher Economic Growth International Economic Integration Direct Channels  Augmentation of available savings  Transfer of technology (FDI)  Development of financial sector Indirect Channels  Promotion of specialization  Inducement for better policies  Enhancement of capital inflows by signaling better policies

22. International economic integration could help growth and development

23. International Economic Integration and Contagion International economic integration Real sector linkages through exchange of goods Financial-sector linkages through international transactions in financial assets. Contagion (crisis, fiscal policy…)

24. Example Imagine two countries: A and B Expansionary Fiscal Policy in Country A ↑ Demand (country A) - Domestic goods - Imports Country B’s Exports ↑ Country B’s Income ↑

25. Example Imagine A and B are developing countries with common features (GDP per capita, inflation, …). You have in your bonds portfolio some bonds of Country A government’s debt and some of Country B government’s debt. Country A’s government says that the government debt cannot be reimbursed, what do you do?

26. Questions of International Finance Why international trade and international capital flows? What are the consequences of international economic integration on production (flows of inputs)? Consumption (flows of goods)? How international economic integration changes the way monetary and fiscal policies affect economies? How do crisis appear and spread?

27. Reminder about Macroeconomic Equilibrium in an Open Economy Readings: Macroeconomics, N. Gregory Mankiw (Harvard U.), chapter 5.

28. In an open economy, Spending need not equal output: Y≠C+I+G Saving need not equal investment S≠I

29. The financial sector channels funds from net lender-savers to net borrower-investors Because financial sector can redirect surplus funds, leakages and injections of each sector need not balance –I ≠ S –G ≠ T –Im ≠ Ex

30. Preliminaries EX = exports = foreign spending on domestic goods IM = imports = C f + I f + G f = spending on foreign goods superscripts: d =spending on domestic goods f =spending on foreign goods

31. Preliminaries, cont. NX = net exports ( the “trade balance”) = EX – IM If NX > 0, country has a trade surplus equal to NX If NX < 0, country has a trade deficit equal to – NX

32. GDP = expenditure on domestically produced g & s

33. The national income identity in an open economy Y = C + I + G + NX or, NX = Y – (C + I + G ) net exports domestic spending output

34. International capital flows Net capital outflows =S – I =net outflow of “loanable funds” =net purchases of foreign assets the country’s purchases of foreign assets minus foreign purchases of domestic assets When S > I, country is a net lender When S < I, country is a net borrower

35. Another important identity NX = Y – (C + I + G ) implies NX = (Y – C – G ) – I = S – I trade balance = net capital outflows NX = Y – (C + I + G ) implies NX = (Y – C – G ) – I = S – I trade balance = net capital outflows

36. Long-run Equilibrium An open economy model : –Two countries –Small open economy Country A S A,I A Country B S B,I B I A +I B =S A +S B Domestic Country Rest of the World r*

37. Saving and Investment in a Small Open Economy

38. National Saving: The Supply of Loanable Funds r S, I To simplify, national saving does not depend on the interest rate

39. Assumptions re: capital flows a. domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.) b. perfect capital mobility: no restrictions on international trade in assets c. economy is small: cannot affect the world interest rate, denoted r* a & b imply r = r* c implies r* is exogenous a & b imply r = r* c implies r* is exogenous

40. Investment: The Demand for Loanable Funds Investment is still a downward-sloping function of the interest rate, r *r * but the exogenous world interest rate… …determines the country’s level of investment. I (r* ) r S, I I (r )I (r )

41. If the economy were closed… r S, I I (r )I (r ) rcrc …the interest rate would adjust to equate investment and saving:

42. But in a small open economy… r S, I I (r )I (r ) rcrc r* I 1I 1 the exogenous world interest rate determines investment… …and the difference between saving and investment determines net capital outflows and net exports NX

43. Three experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand

44. 1. Fiscal policy at home r S, I I (r )I (r ) I 1I 1 An increase in G or decrease in T reduces saving. NX 1 NX 2 Results:

45. 2. Fiscal policy abroad r S, I I (r )I (r ) Expansionary fiscal policy abroad raises the world interest rate. NX 1 NX 2 Results:

46. 3. An increase in investment demand r S, I I (r )1I (r )1 EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. NX 1 I 1I 1 S

47. 3. An increase in investment demand r S, I I (r )1I (r )1 ANSWERS:  I > 0,  S = 0, net capital outflows and net exports fall by the amount  I NX 2 NX 1 I 1I 1 I 2I 2 S I (r )2I (r )2

48. References The Economics of Money, Banking and Financial Markets, 6th edition, Mishkin. International Economics: Theory and Policy, Paul Krugman and Maurice Obstfeld.

49. Course Overview I. International capital mobility a. Why international capital flows? b. The reasons of exchange: some aspects of international trade and intertemporal choice c. Recent evolutions of financial integration d. The Balance of Payments

50. Course Overview II. The Exchange rate: a key variable a. Some definitions of exchange rate b. Exchange rates in the long-run: The Purchasing Power Parity (PPP) theory c. Different exchange rate regimes

51. Course Overview III. Consequences of financial integration on short-run macroeconomic equilibrium: the Mundell-Fleming approach a. The short-run equilibrium b. Monetary and Fiscal Policies in case of flexible exchange rate c. Monetary and Fiscal Policies in case of fixed exchange rate IV. Currency crises