Macroeconomics in the World Economy: Theory and ......England encounters a recession, reducing its imports, while U.S. real output and real income surge, increasing U.S. imports (British

Macroeconomics in the World Economy:Theory and Applications

Topic 8: The International Economy

Dennis Plott

University of Illinois at ChicagoDepartment of Economics

http://blackboard.uic.edu

Spring 2014

Plott (ECON 221) Spring 2014 1 / 64

http://blackboard.uic.edu

Outline

1 Topic 8: The International EconomyThe Open Economy

Exchange Rates & PPP

The Open Goods Market

Trilemma


Goals & Readings

Goals (a sample)

Explain how exchange rates are determined under a floating system.Explain the link between the exchange rate and net exports.Explain how different shocks affect the exchange rate and NX .Demonstrate monetary coordination in the global economy.Discuss potential problems of a currency union.

Readings

Chapter 5Chapter 13


Outline




Trilemma

Plott (ECON 221) The Open Economy Spring 2014 4 / 64

Trade Surpluses and Deficits

Autarky (closed economy): a situation in which a country does not

trade with other countries.

In an open economy:

spending need not equal output.saving need not equal investment.

Exports (EX) = foreign spending on domestic goods

Imports (IM) = spending on foreign goods

Net exports (NX) a.k.a. the "trade balance":

NX = EX − IM = Y − (C + I +G)

trade surplus: output > spending and exports > imports

Size of the trade surplus = NX

trade deficit: spending > output and imports > exports

Size of the trade deficit = −NX


Balance of Payments (BP)

Balance of payments (BP): a summary of all the transactions that took

place between the individuals, firms, and government units of one

nation and those of all other nations during a year.

BP = CA+KA+FA = 0

Current account (CA): the section in a nation’s balance of payments

that records its exports and imports of goods and services, its net

investment income, and its net transfers.

capital account (KA) and financial account (FA): the section of a

nation’s balance of payments that records (1) debt forgiveness by and

to foreigners and (2) foreign purchases of assets in the United States

and U.S. purchases of assets abroad.

Note: in practice, measurement problems, recorded as a statistical

discrepancy, prevent BP = 0 from holding exactly; for simplicity, ignore

this empirical observation.


Current Account (CA)

CA = NX +NFP+NUT

Current account identity: CA = change in the net financial position of acountry towards the rest of the world.

Net factor payments (NFP): net income from abroadNet unilateral transfers (NUT): payments made from one country toanother

Usually net factor payments and net unilateral transfers are relatively

small so, for simplicity, use CA = NX

Trade in assets compensates for trade in goods: if we buy more foreign

goods then we must sell more domestic assets to foreigners to get the

foreign currency needed.

Always two sides of a CA deficit: a portfolio side and a trade side.


Outline




Trilemma

Plott (ECON 221) Exchange Rates & PPP Spring 2014 8 / 64

The Foreign Exchange Market and Exchange Rates

Exchange rate: the price at which one currency exchanges for another

in the foreign exchange market.

Nominal exchange rate: the value of one country’s currency in terms of

another country’s currency.

Real exchange rate: the price of domestic goods in terms of foreign

goods.

Floating (Flexible) exchange rate: an exchange rate that is determined

by demand and supply in the foreign exchange market with no direct

intervention by the central bank.

Appreciation: an increase in the market value of one currency relative

to another currency.

Depreciation: a decrease in the market value of one currency relative

to another currency.

Speculators: currency traders who buy and sell foreign exchange in an

attempt to profit from changes in exchange rates.


Determinants (Shifters) of Exchange Rates withExamples

Change in tastes

Japanese electronic equipment declines in popularity in the UnitedStates (Japanese yen depreciates; U.S. dollar appreciates). Europeantourists reduce visits to the United States (U.S. dollar depreciates;European euro appreciates).

Change in relative incomes

England encounters a recession, reducing its imports, while U.S. realoutput and real income surge, increasing U.S. imports (British poundappreciates; U.S. dollar depreciates).

Change in relative prices

Switzerland experiences a 3% inflation rate compared to Canada’s 10%rate (Swiss franc appreciates; Canadian dollar depreciates).


Determinants (Shifters) of Exchange Rates withExamples (Continued)

Change in relative real interest ratesThe Federal Reserve drives up interest rates in the United States, whilethe Bank of England takes no such action (U.S. dollar appreciates;British pound depreciates).

Change in relative expected returns on stocks, real estate, orproduction facilities

Corporate tax cuts in the United States raise expected after-taxinvestment returns in the United States relative to those in Europe (U.S.dollar appreciates; the euro depreciates)

SpeculationCurrency traders believe South Korea will have much greater inflationthan Taiwan (South Korean won depreciates; Taiwan dollarappreciates). Currency traders think Norway’s interest rates willplummet relative to Denmark’s rates (Norway’s krone depreciates;Denmark’s krone appreciates).


The Foreign Exchange Market and Exchange Rates(Continued)

Fixed exchange rate: an exchange rate the value of which is

determined by a decision of the government or the central bank and is

achieved by central bank intervention in the foreign exchange market

to block the unregulated forces of demand and supply.

Devaluation: a reduction in a fixed exchange rate.

Revaluation: an increase in a fixed exchange rate.

Pegging: the decision by a country to keep the exchange rate fixed

between its currency and another currency; e.g., dollarization.

Capital controls: Limits on the flow of foreign exchange and financial

investment across countries.

Managed float exchange rate system: a system in which private buyers

and sellers in the foreign exchange market determine the value of

currencies most of the time, with occasional government intervention.


Floating & Fixed Exchange Rates

In a system of floating exchange rates, e is allowed to fluctuate in

response to changing economic conditions.

In contrast, under fixed exchange rates, the central bank trades

domestic for foreign currency at a predetermined price.


Floating vs. Fixed Exchange Rates

Argument for floating rates:

allows monetary policy to be used to pursue other goals (stable growth,low inflation).flexible exchange rates allow countries to formulate theirmacroeconomic policies independently of other nations.

Argument against floating rates:

increased element of risk which my discourage international trade.Possible solution is "hedging".exchange fluctuations may involve shifts of labor and other resourcesbetween production between the domestic market and for export.the day-to-day fluctuations may encourage speculation wherebyexchange rate movements become exaggerated.


Floating vs. Fixed Exchange Rates

Arguments for fixed rates:

avoid uncertainty and volatility, making international transactionseasier.discipline monetary policy to prevent excessive money growth andhyperinflation.

Arguments against fixed rates:

if an exchange rate is fixed incorrectly then this may lead to speculationagainst the currency.defending a fixed exchange may not be possible in the long-run sincethere is a zero lower bound to the amount of foreign reserves a centralbank has.


The Nominal Exchange Rate

DefinitionNominal exchange rate (enom): units of foreign currency that can be

purchased with 1 unit of domestic currency

The nominal exchange rate is the rate at which two currencies are

exchanged on the foreign exchange market

Example: the nominal exchange rate between the U.S. dollars and the

euro is now 0.8 euro per dollar

It means that 1 dollar can buy 0.8 euro in the foreign exchange market

(the market for international currencies)


Foreign Exchange Market

Who trades on the foreign exchange market; e.g., euro/dollar ?

European importers demand dollars to buy U.S. goods and services(U.S. exports)European investors demand dollars to buy U.S. assets (U.S. financialinflows)American importers supply dollars (and demand euro) to buy Europeangoods and services (U.S. imports)American investors supply dollars to buy European assets (U.S.financial outflows)


Dollars Demand and Supply

When the value of the dollar is higher, everything else equal, U.S.goods and assets are more expensive

European importers and investors demand less dollars to buy U.S.goods and assets

Demand for dollars is downward sloping

U.S. importers and investors supply more dollars to buy Europeangoods and assets

Supply of dollars is upward sloping


The Real Exchange Rate

If you know that enom = 0.8 euro, do you know if it is cheaper to leave in

Europe or in the U.S.?

No! You need information about prices.

The real exchange rate is the price of domestic goods relative to foreign

goods.

An increase in the real exchange rate increases the price of domestic

goods relative to foreign goods.

DefinitionReal exchange rate (e): units of foreign consumption basket that can be

obtained in exchange for 1 unit of the domestic basket

e = enom ·P

Pf


Absolute Purchasing Power Parity (PPP)

How are nominal and real exchange rates related?

Imagine two countries produce and consume the same good

If the good is freely traded, then the real exchange rate must be 1.

PPP = the price of the domestic good must equal the price of the

foreign good, in terms of domestic currency:

P = Pf

enom−→ enom = Pf

P−→ e = 1

Absolute PPP refers to the equalization of real price levels across

countries.

Empirical evidence: does not hold at all . . . e = 1 too strong of an

assumption.


Relative Purchasing Power Parity (PPP)

Relative PPP states that the percentage change in exchange rates, over any

period, equals the difference in the percentage price changes of different

countries; it refers to the equalization of real price changes across countries.

∆e

e= ∆enom

enom+ ∆P

P− ∆Pf

Pf

∆enom

enom= ∆e

e+πf −π

In the special case where the real exchange rate doesn’t change, so that∆e

e= 0,

the resulting equation is called relative purchasing power parity, since nominal

exchange rate movements reflect only changes in inflation.

Absolute PPP implies relative PPP, but the converse is not true.

Empirical evidence: PPP tends to hold in the long-run, but not in the short-run.

Why? Non-traded goods, trade tariffs, monopoly power, etc. Works well for

high-inflation countries since movements in relative inflation rates are much

larger than movements in real exchange rates.


Why Does the Real Exchange Rate Matter?

The real exchange rate represents the rate at which domestic goods

(and services) can be traded for those produced abroad.

Why does an increase in the real exchange matter?

It increases the price of domestic goods relative to foreign goods.

Substitution effect: net exports are going to be lower.

Example: dollar appreciates

German cars become cheaper relative to U.S. carsAmericans demand more German cars, imports increase, and Germansdemand less U.S. cars, exports decreaseNX decreases

IMPORTANT: NX is a decreasing function of the exchange rate

↑ e −→↓ EX ,↑ IM −→↓ NX


Outline




Trilemma

Plott (ECON 221) The Open Goods Market Spring 2014 23 / 64

Net Exports (NX)

An increase in domestic GDP (Y ) increases imports, reduces NX

An increase in foreign GDP (Y f ) increases exports, increases NX

A new channel from the interest rate to spending:

↑ r −→ e appreciates −→↓ NX

Symmetrically for foreign interest rate (rf )

So we write

NX = NX(e,r,Y ,rf ,Y f )


Investment: The Demand for Loanable Funds

Investment is still a downward-sloping function of the interest rate,

but the exogenous world interest rate determines the country’s level of

investment.

If the economy were closed the interest rate would adjust to equate

investment and saving.

But in a small open economy the exogenous world interest rate

determines investment and the difference between saving and

investment determines net capital outflow and net exports.


How e Is Determined

The accounting identity says NX = S− I

We saw earlier how S− I is determined:

S depends on domestic factors; e.g., output, fiscal policy variables, etc.I is determined by the world interest rate rw

So, e must adjust to ensure NX = S− I

Neither S nor I depends on e, so the net capital outflow curve is vertical.e adjusts to equate NX with net capital outflow, S− I .

Interpretation: supply and demand in the foreign exchange market

Demand: foreigners need dollars to buy U.S. net exports.Supply: net capital outflow (S− I) is the supply of dollars to be investedabroad.


International Capital Flows

Net capital outflow

S− Inet outflow of "loanable funds"net purchases of foreign assets: the country’s purchases of foreign assetsminus foreign purchases of domestic assets

When S > I , country is a net lender.

When S < I , country is a net borrower.


The Link Between Trade & Capital Flows

NX = Y − (C + I +G)

NX = (Y = C −G)− I

NX = S− I

trade balance = net capital outflow

Thus, a country with a trade deficit (NX < 0) is a net borrower (S < I).


Assumptions about Capital Flows

1 domestic & foreign bonds are perfect substitutes (same risk, maturity,

etc.)

2 perfect capital mobility: no restrictions on international trade in assets3 economy is small: cannot affect the world interest rate, denoted rw

1 & 2 imply r = rw

3 implies rw is exogenous


Large: Between Small and Closed

Many countries, including the U.S., are neither closed nor small open

economies.

A large open economy is between the polar cases of closed and small

open.

Consider a monetary expansion:

As in a closed economy, ∆M > 0 −→↓ r −→↑ I (though not as much)As in a small open economy, ∆M > 0 −→↓ e −→↑ NX (though not asmuch)


Small vs. Large Open Economies

In a small open economy, the quantity of funds supplied or demanded is too

small to affect the world real interest rate, so the domestic real interest rate

equals the world real interest rate. If the quantity of loanable funds supplied

domestically exceeds the quantity of funds demanded domestically at that

interest rate, the country invests some of its loanable funds abroad. If the

quantity of loanable funds demanded domestically exceeds the quantity of

funds supplied domestically at that interest rate, the country finances some

of its domestic borrowing needs with funds from abroad.

Shifts in the demand and supply of loanable funds in some countries are

sufficiently large that they affect the world real interest rate, so these

countries are considered large open economies. The factors that cause the

demand and supply of funds to shift in a large open economy will affect not

just the interest rate in that economy but the world real interest rate as well.

For example, the decline in investment demand in the United States during

the 2007–2009 lowered the world real interest rate.


Outline




Trilemma

Plott (ECON 221) Trilemma Spring 2014 32 / 64

The Impossible Trinity or Trilemma

A nation cannot have free capital flows, independent monetary policy,

and a fixed exchange rate simultaneously.

A nation must choose one side of this triangle and give up the opposite

corner.



The Open Economy IS−LM Model:The Mundell-Fleming Model

The FE curve is not affected.

The LM curve is not affected.The IS is affected by NX . . . sorry.

Still downward sloping: as r increases, e appreciates and NX decreases, ceterisparibus

The goods market equilibrium condition is now:

Y = C(·)+ I(·)+G+NX(r,Y ,rf ,Y f )

Assumption: (small) open economy with perfect capital mobility. r = rw where

rw is the real world interest rate. Note: we will also look at a large open

economy (i.e. able to affect rw) and a small open economy with a risk premium

(i.e. r 6= rw).

The excess of savings over investment is the amount U.S. residents want to lend

abroad and NX is the amount foreigners want to borrow from U.S.:

S− I = NX +NFP = CA


Robert Mundell

Robert Mundell

Nobel Prize in Economics (1999)

Contributions: Mundell-Fleming model; Mundell-Tobin effect: expectedinflation has real economic effects; Optimum Currency Areas


http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1999/mundell-bio.html

The Mundell-Fleming Model: IS∗ Curve

Drawn in {e,Y }−space

The IS∗ curve is drawn for a given value of rw.

Intuition for the slope: ↓ e −→↑ NX −→↑ Y


What Shifts the IS Curve?

The IS curve shifts to the right because of:

Any exogenous variable that shifts the closed economy IS curve to therightAny exogenous variable that increases NX , for given Y and r:

1 An increase in foreign GDP (Y f )2 An increase in foreign interest rate (rf )3 Other factors such as a reduction in saving rate of foreigners, a shift in the

world taste for U.S. goods, a change in trade barriers, etc.


The Mundell-Fleming Model: LM∗ Curve

Drawn in {e,Y }−space

The LM∗ curve:

is drawn for a given value of rw

is vertical because given rw, there is only one value of Y that equatesmoney demand with supply, regardless of e.

M

P= L(rw +πe,Y )


Fiscal Policy under Floating Exchange Rates

At any given value of e, a fiscal expansion increases Y , shifting IS∗ to

the right.

Results: ∆e > 0,∆Y = 0


Lessons about Fiscal Policy

In a small open economy with perfect capital mobility, fiscal policy

cannot affect real GDP.

Crowding outclosed economy:

Fiscal policy crowds out investment by causing the interest rate to rise.

small open economy:

Fiscal policy crowds out net exports by causing the exchange rate to

appreciate.


Monetary Policy under Floating Exchange Rates

An increase in M shifts LM∗ right because Y must rise to restore

equilibrium in the money market.

Results: ∆e < 0,∆Y > 0


Lessons about Monetary Policy

Monetary policy affects output by affecting the components ofaggregate demand:

closed economy: ↑ M −→↓ r −→↑ I −→↑ Ysmall open economy: ↑ M −→↓ e −→↑ NX −→↑ Y

Expansionary monetary policy does not raise world aggregate

demand, it merely shifts demand from foreign to domestic products.

So, the increases in domestic income and employment are at the

expense of losses abroad.


Trade Policy under Floating Exchange Rates

At any given value of e, a tariff or quota reduces imports, increases NX ,

and shifts IS∗ to the right.

Results: ∆e > 0,∆Y = 0


Lessons about Trade Policy

Import restrictions cannot reduce a trade deficit!

Even though NX is unchanged, there is less trade:

The trade restriction reduces imports.The exchange rate appreciation reduces exports.

Less trade means fewer "gains from trade".

Import restrictions on specific products save jobs in the domestic

industries that produce those products but destroy jobs in

export-producing sectors.

Hence, import restrictions fail to increase total employment.

Also, import restrictions create sectoral shifts, which cause frictional

unemployment.


Fixed Exchange Rates

Under fixed exchange rates, the central bank stands ready to buy or sell

the domestic currency for foreign currency at a predetermined rate.

In the Mundell-Fleming model, the central bank shifts the LM∗ curve

as required to keep e at its pre-announced rate.

This system fixes the nominal exchange rate. In the long-run, when

prices are flexible, the real exchange rate can move even if the nominal

rate is fixed.


Fiscal Policy under Fixed Exchange Rates

Under floating exchange rates, fiscal policy is ineffective at changing

output.

Under fixed exchange rates, fiscal policy is very effective at changing

output.

Results: ∆e = 0,∆Y > 0


Monetary Policy under Fixed Exchange Rates

Under floating exchange rates, monetary policy is very effective at

changing output.

Under floating exchange rates, monetary policy cannot be used to

affect output.

Results: ∆e = 0,∆Y = 0


Trade Policy under Fixed Exchange Rates

Under floating exchange rates, import restrictions do not affect Y or

NX .

Under fixed exchange rates, import restrictions increase Y and NX .

However, these gains come at the expense of other countries: the

policy merely shifts demand from foreign to domestic goods.


Summary of Policy Effects in the Mundell-FlemingModel

Floating Fixed

Policy Y e NX Y e NX

Fiscal Expansion 0 + − + 0 0

Monetary Expansion + − + 0 0 0

Import Restriction 0 + 0 + 0 +


Interest-Rate Differentials

Two reasons why r may differ from rw

1 country risk:

The risk that the country’s borrowers will default on their loan repayments

because of political or economic turmoil.

Lenders require a higher interest rate to compensate them for this risk.

2 expected exchange rate changes:

If a country’s exchange rate is expected to fall, then its borrowers must pay

a higher interest rate to compensate lenders for the expected currency

depreciation.


Differentials in the Mundell-Fleming Model

r = rw +θ

θ (Greek letter "theta") is a risk premium, assumed exogenous.

Substitute the expression for r into the IS∗ and LM∗ equations:

Y = C(·)+ I(rw +θ, ·)+G+NX(·)M

P= L(rw +θ+πe,Y )


The Effects of an Increase in θ

IS∗ shifts left, because ↑ θ −→↑ r −→↓ I

LM∗ shifts right, because ↑ θ −→↑ r −→↓(

M

P

)d

, so Y must rise to

restore money market equilibrium.

Results: ∆e < 0,∆Y > 0

The fall in e is intuitive:

An increase in country risk or an expected depreciation makes holdingthe country’s currency less attractive.Note: an expected depreciation is a self-fulfilling prophecy.

The increase in Y occurs because the boost in NX (from the

depreciation) is greater than the fall in I (from the rise in r).


Why Income May Not Rise

The central bank may try to prevent the depreciation by reducing the

money supply.

The depreciation might boost the price of imports enough to increase

the price level (which would reduce the real money supply).

Consumers might respond to the increased risk by holding more

money.

Note: each of the above would shift LM∗ leftward.


Case Study: The Mexican Peso Crisis


The Peso Crisis Did Not Just Hurt Mexico

U.S. goods became expensive to Mexicans, so:

U.S. firms lost revenueHundreds of bankruptcies along U.S.-Mexican border

Mexican assets lost value (measured in dollars)

Reduced wealth of millions of U.S. citizens


Understanding the Crisis

In the early 1990s, Mexico was an attractive place for foreign

investment.During 1994, political developments caused an increase in Mexico’srisk premium (θ):

peasant uprising in Chiapasassassination of leading presidential candidate

Another factor: the Federal Reserve raised U.S. interest rates several

times during 1994 to prevent U.S. inflation; i.e. ∆rw > 0

These events put downward pressure on the peso.

Mexico’s central bank had repeatedly promised foreign investors that it

would not allow the peso’s value to fall, so it bought pesos and sold

dollars to prop up the peso exchange rate.

Doing this requires that Mexico’s central bank have adequate reserves

of dollars.

Did it?Plott (ECON 221) Trilemma Spring 2014 57 / 64

Dollar Reserves of Mexico’s Central Bank

Date Reserves

December 1993 $28 billion

17 August 1994 $17 billion

1 December 1994 $9 billion

15 December 1994 $7 billion

During 1994, Mexico’s central bank hid the fact that its reserves were

being depleted.


The Disaster

20 December 1994: Mexico devalues the peso by 13% (fixes e at 25

cents instead of 29 cents)

Investors are SHOCKED – they had no idea Mexico was running out of

reserves.

∆θ > 0 =⇒ investors dump their Mexican assets and pull their capital

out of Mexico.

22 December 2014: central bank’s reserves nearly gone. It abandons

the fixed rate and lets e float.

In a week, e falls another 30%.


The Rescue Package

1995: U.S. & IMF set up $50 billion line of credit to provide loan

guarantees to Mexico’s government.

This helped restore confidence in Mexico, reduced the risk premium.

After a hard recession in 1995, Mexico began a strong recovery from

the crisis.


International Transmission of the Business Cycle

The impact of foreign economic conditions on NX and the real

exchange rate is the principal reason why cycles are transmitted

internationally.

Imagine Europe is the major importer from U.S.

If Europe is in recession, U.S. net exports decrease and this can

generate recessionary pressure in the U.S. as well.

Let’s see now the effect of fiscal and monetary policies ripple through

the global economy.


When Should We Have a Currency Union?

What is an "Optimal Currency Area" (OCA)?

There are many benefits from having a common currency . . . but there

are macroeconomic costs.

Mundell’s criteria focus on minimizing these costs:

Synchronized business cyclesLabor mobility and flexible wagesA risk-sharing mechanism to use fiscal policy to stabilize local cycles


Is the Euro-Zone an Optimal Currency Area?

Probably not

Advantages for Southern Europe: stabilize inflation (a very extreme

nominal anchor).

Advantages for Germany and France: more power in world economy,

more developed and deep capital markets (first to finance eastern

German states after unification, later to support export-led growth).

When did problems begin? Growth model based on borrowing in the

South and export-led growth in Germany (a bit like global imbalances

in the small, but with no room for depreciation).


Documents

Macroeconomics in the World Economy: Theory and ......England encounters a recession, reducing its imports, while U.S. real output and real income surge, increasing U.S. imports (British