Springer Texts in Business and Economics

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Giancarlo Gandolfo

International Financeand Open-EconomyMacroeconomics

Second Edition

With Contributions by Daniela Federici

123

Giancarlo GandolfoClasse di Scienze MoraliAccademia Nazionale dei LinceiRome, Italy

ISSN 2192-4333 ISSN 2192-4341 (electronic)Springer Texts in Business and EconomicsISBN 978-3-662-49860-6 ISBN 978-3-662-49862-0 (eBook)DOI 10.1007/978-3-662-49862-0

Library of Congress Control Number: 2016945040

© Springer-Verlag Berlin Heidelberg 2002, 2016This work is subject to copyright. All rights are reserved by the Publisher, whether the whole or part ofthe material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation,broadcasting, reproduction on microfilms or in any other physical way, and transmission or informationstorage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodologynow known or hereafter developed.The use of general descriptive names, registered names, trademarks, service marks, etc. in this publicationdoes not imply, even in the absence of a specific statement, that such names are exempt from the relevantprotective laws and regulations and therefore free for general use.The publisher, the authors and the editors are safe to assume that the advice and information in this bookare believed to be true and accurate at the date of publication. Neither the publisher nor the authors orthe editors give a warranty, express or implied, with respect to the material contained herein or for anyerrors or omissions that may have been made.

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To the memory of my fatherEdgardo Gandolfo

Preface

Following standard practice in international economics, I have always treated thetheory of international trade separately from international finance, thus writing myInternational Economics textbook as a two-volume course (Vol. 1 on the theory ofinternational trade and Vol. 2 on international monetary theory). This text had twoeditions, several reprints, and translations in other languages. However, the differentpace of the revisions of the two volumes suggested to make them self-contained andindependent from each other. The volume covering trade was published in 1998(second edition 2014) under the title International Trade Theory and Policy. Thisis the second edition of the volume covering international finance (the first editionwas published in 2001). This new edition contains a wealth of additional materialthat has been introduced thanks to the suggestions of colleagues and students and tothe comments contained in book reviews. All has been thoroughly classroom testedin both undergraduate and graduate courses in various universities in Italy and othercountries.

In the Preface to the first edition (1986) of International Economics, I wrote:

There is no lack of good international economics textbooks ranging from the elementaryto the advanced, so that an additional drop in this ocean calls for an explanation. In thepresent writer’s opinion, there seems still to be room for a textbook which can be usedin both undergraduate and graduate courses, and which contains a wide range of topics,including those usually omitted from other textbooks. These are the intentions behind thepresent book, which is an outcrop from undergraduate and graduate courses in internationaleconomics that the author has been holding at the University of Rome ‘La Sapienza’ since1974, and from his ongoing research work in this field.

Accordingly, the work is organised as two-books-in-one by distributing the materialbetween text and appendices.

The treatment in the text is directed to undergraduate students and is mainly confinedto graphic analysis and to some elementary algebra, but it is assumed that the reader willhave a basic knowledge of economics. Each chapter has a mathematical appendix, where(i) the topics treated in the text are examined at a level suitable for advanced undergraduateor first-year graduate students, and (ii) generalizations and/or topics not treated in the text(including some at the frontiers of research) are formally examined.

The text is self-contained, and the appendices can be read independently of the textand can, therefore, also be used by students who already know ‘graphic’ internationaleconomics and want to learn something about its mathematical counterpart. Of course theconnections between text and appendices are carefully indicated, so that the latter can beused as mathematical appendices by the student who has mastered the text, and the text

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can be used as graphic and literary exposition of the results derived mathematically in theappendices by the student who has mastered these. [. . . ]

The present book maintains the same approach, in particular the unique two-tierfeature and the ample coverage of topics, including many at the frontiers of research,whose often obscure mathematical aspects are fully clarified in the second tier.This new edition has been thoroughly revised and enriched thanks to the numerouscontributions by Professor Daniela Federici that bring the book up-to-date.

I am grateful to the students from all over the world who have written me over theyears to indicate unclear points and misprints and to Guido Ascari, Marianna Belloc,Andrea Bubula, Nicola Cetorelli, Giuseppe De Arcangelis, Vivek H. Dehejia,Kieran P. Donaghy, Michele Gambera, the late Carlo Giannini, Bernardo Maggi,Giovanna Paladino, Luca Ricci, Francesca Sanna Randaccio, the late Jerome L.Stein, for their advice and comments.

None of the persons mentioned has any responsibility for possible deficienciesthat might remain.

Rome, Italy Giancarlo GandolfoJanuary 2016

Contents

Part I Introduction

1 International Finance and International Macroeconomics:An Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31.1 Globalization .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51.2 Old and New Approaches to International Finance . . . . . . . . . . . . . . . 61.3 Structure of the Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71.4 Small and Large Open Economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Part II The Basics

2 The Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132.2 The Spot Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152.3 The Real Exchange Rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182.4 The Effective Exchange Rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212.5 The Forward Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

2.5.1 Introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222.5.2 Various Covering Alternatives: Forward

Premium and Discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232.6 The Transactors in the Foreign Exchange Market . . . . . . . . . . . . . . . . . 27

2.6.1 Speculators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272.6.2 Non-Speculators .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282.6.3 Monetary Authorities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

2.7 Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292.7.1 Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292.7.2 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302.7.3 Swap Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312.7.4 Credit Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

2.8 Eurodollars and Xeno-Currencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342.9 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

2.9.1 N-Point Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

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3 Exchange-Rate Regimes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393.1 The Two Extremes, and Intermediate Regimes. . . . . . . . . . . . . . . . . . . . 393.2 The Bretton Woods System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

3.2.1 The Monetary Authorities’ Intervention . . . . . . . . . . . . . . . . . 443.3 The Current Nonsystem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463.4 International Organisations .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

3.4.1 The IMF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473.4.2 The World Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

4 International Interest-Rate Parity Conditions . . . . . . . . . . . . . . . . . . . . . . . . . . 534.1 Covered Interest Arbitrage, and Covered Interest

Parity (CIP). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 534.2 Uncovered Interest Parity (UIP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 564.3 Uncovered Interest Parity with Risk Premium . . . . . . . . . . . . . . . . . . . . 574.4 Real Interest Parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 584.5 Efficiency of the Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . 594.6 Perfect Capital Mobility, Perfect Asset

Substitutability, and Interest Parity Conditions .. . . . . . . . . . . . . . . . . . . 604.7 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

4.7.1 Rational Expectations and Efficiencyof the Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . 62

4.7.2 The Peso Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 634.7.3 The Siegel Paradox .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

5 The Balance of Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 675.1 Balance-of-Payments Accounting and Presentation . . . . . . . . . . . . . . 67

5.1.1 Introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 675.1.2 Accounting Principles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 705.1.3 Standard Components . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 735.1.4 Capital Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 765.1.5 Financial Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

5.2 The Meaning of Surplus, Deficit, and Equilibriumin the Balance of Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

6 Real and Financial Flows in an Open Economy . . . . . . . . . . . . . . . . . . . . . . . . 856.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 856.2 The Row Identities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 876.3 The Column Identities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 896.4 Derived Identities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 916.5 Identities Are Only Identities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

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Part III Flow Approaches

7 The Elasticity Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 977.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 977.2 Critical Elasticities and the So-Called

Marshall-Lerner Condition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 987.2.1 The Balance of Payments in Domestic Currency .. . . . . . . 997.2.2 The Balance of Payments in Foreign Currency .. . . . . . . . . 1017.2.3 Elasticity Optimism vs Pessimism . . . . . . . . . . . . . . . . . . . . . . . 102

7.3 Foreign Exchange Market Equilibrium and Stability . . . . . . . . . . . . . 1027.3.1 Derivation of the Demand and Supply

Schedules: Multiple Equilibria and Stability . . . . . . . . . . . . 1037.4 Interrelations Between the Spot and Forward

Exchange Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1067.4.1 The Various Excess Demand Schedules . . . . . . . . . . . . . . . . . 1077.4.2 Forward Market Equilibrium and the Spot Rate . . . . . . . . . 1107.4.3 The Monetary Authorities’ Intervention . . . . . . . . . . . . . . . . . 111

7.5 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1137.5.1 The Critical Elasticities Condition . . . . . . . . . . . . . . . . . . . . . . . 1137.5.2 The Stability of the Foreign Exchange Market . . . . . . . . . . 1217.5.3 A Model for the Simultaneous Determination

of the Spot and Forward Exchange Rate . . . . . . . . . . . . . . . . . 122References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125

8 The Multiplier Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1278.1 The Basic Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1288.2 Balance-of-Payments Adjustment in the Case

of an Exogenous Increase in Exports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1318.3 Balance-of-Payments Adjustment in the Case

of an Exogenous Increase in Imports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1348.4 Intermediate Goods and the Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1368.5 The Empirical Relevance of the Multiplier . . . . . . . . . . . . . . . . . . . . . . . . 1378.6 The Transfer Problem.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

8.6.1 The Classical Theory.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1398.6.2 The Multiplier Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1408.6.3 Observations and Qualifications . . . . . . . . . . . . . . . . . . . . . . . . . . 142

8.7 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1438.7.1 The Multiplier Without Foreign Repercussions . . . . . . . . . 1438.7.2 Foreign Repercussions in a n-Country Model . . . . . . . . . . . 1468.7.3 Intermediate Goods and the Multiplier . . . . . . . . . . . . . . . . . . . 1538.7.4 The Transfer Problem .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156

References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158

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9 An Integrated Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1619.1 Interaction Between Exchange Rate and Income

in the Adjustment Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1619.1.1 A Graphic Representation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1639.1.2 Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1669.1.3 Comparative Statics and the Transfer Problem . . . . . . . . . . 168

9.2 The J-Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1699.3 The S-Curve .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1719.4 The Alleged Insulating Power of Flexible Exchange

Rates, and the International Propagation of Disturbances . . . . . . . . 1729.5 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174

9.5.1 A Simplified Version of the Laursenand Metzler Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174

9.5.2 The BB and RR Schedules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1749.5.3 The J-Curve. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1789.5.4 The Original Two-Country Version

of the Laursen and Metzler Model . . . . . . . . . . . . . . . . . . . . . . . 182References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190

10 The Mundell-Fleming Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19110.1 Introductory Remarks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19110.2 Fixed Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192

10.2.1 Graphic Representation of the EquilibriumConditions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193

10.2.2 Simultaneous Real, Monetary and ExternalEquilibrium: Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197

10.2.3 Comparative Statics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20410.3 Flexible Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20810.4 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211

10.4.1 The Mundell-Fleming Model Under FixedExchange Rates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211

10.4.2 The Mundell-Fleming Model Under FlexibleExchange Rates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216

References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220

11 Policy Implications of the Mundell-Fleming Model,and the Assignment Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22111.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22111.2 Internal and External Balance, and the Assignment Problem.. . . . 223

11.2.1 The Assignment Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22411.2.2 Observations and Qualifications . . . . . . . . . . . . . . . . . . . . . . . . . . 226

11.3 Flexible Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22911.4 Perfect Capital Mobility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23111.5 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233

11.5.1 Monetary and Fiscal Policy Under FixedExchange Rates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233

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11.5.2 Monetary and Fiscal Policy Under FlexibleExchange Rates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238

11.5.3 Perfect Capital Mobility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242

Part IV Stock and Stock-Flow Approaches

12 The Monetary Approach to the Balance of Paymentsand Related Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24512.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24512.2 The Classical (Humean) Price-Specie-Flow Mechanism . . . . . . . . . 24512.3 The Monetary Approach to the Balance of Payments . . . . . . . . . . . . . 247

12.3.1 The Basic Propositions and Implications . . . . . . . . . . . . . . . . 24812.3.2 A Simple Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25112.3.3 Does a Devaluation Help? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25212.3.4 Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253

12.4 The New Cambridge School of Economic Policy . . . . . . . . . . . . . . . . . 25412.5 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257

12.5.1 The Classical Theory.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25712.5.2 The Monetary Approach to the Balance of Payments . . . 259

References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264

13 Portfolio and Macroeconomic Equilibrium in an Open Economy . . . . 26513.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26513.2 Asset Stock Adjustment in a Partial Equilibrium Framework . . . . 26613.3 Portfolio and Macroeconomic Equilibrium Under

Fixed Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27013.3.1 Introductory Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27013.3.2 A Simple Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27113.3.3 Momentary and Long-Run Equilibrium.. . . . . . . . . . . . . . . . . 274

13.4 Portfolio and Macroeconomic Equilibrium underFlexible Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27713.4.1 Introductory Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27713.4.2 The Basic Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27913.4.3 Static Expectations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28313.4.4 Rational Expectations and Overshooting . . . . . . . . . . . . . . . . 286

13.5 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28913.5.1 Partial-Equilibrium Asset Adjustment . . . . . . . . . . . . . . . . . . . 28913.5.2 Portfolio and Macroeconomic Equilibrium

Under Fixed Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29113.5.3 Portfolio and Macroeconomic Equilibrium

Under Flexible Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . 298References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310

14 Growth in an Open Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31114.1 Export-Led Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312

14.1.1 The Lamfalussy Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312

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14.1.2 The Beckerman Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31314.2 Growth and the Balance of Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31514.3 Balance-of-Payments Constrained Growth (Thirlwall) . . . . . . . . . . . 317

14.3.1 Extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31914.4 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323

14.4.1 Exports, Growth, and the Balance of Payments . . . . . . . . . 32314.4.2 Dynamic Stability of Thirlwall’s Model . . . . . . . . . . . . . . . . . 325

References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327

Part V The Exchange Rate

15 Exchange-Rate Determination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33315.1 The Purchasing-Power-Parity Theory.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333

15.1.1 The Harrod-Balassa-Samuelson Model . . . . . . . . . . . . . . . . . . 33515.2 The Traditional Flow Approach .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33615.3 The Modern Approach: Money and Assets

in Exchange-Rate Determination.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33615.3.1 The Monetary Approach .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33715.3.2 Sticky Prices, Rational Expectations,

and Overshooting of the Exchange-Rate .. . . . . . . . . . . . . . . . 33915.3.3 The Portfolio Approach .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342

15.4 The Exchange Rate in Macroeconometric Models . . . . . . . . . . . . . . . . 34615.5 Exchange-Rate Determination: Empirical Studies . . . . . . . . . . . . . . . . 349

15.5.1 Introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34915.5.2 The Reactions to Meese and Rogoff,

and the Way Out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35115.5.3 An Economy-Wide Model Beats the Random Walk . . . . 35215.5.4 The Exchange Rate in Experimental Economics . . . . . . . . 353

15.6 Equilibrium Exchange Rates: BEERs, DEERs,FEERs and All That . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354

15.7 Chaos Theory and the Exchange Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35515.8 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357

15.8.1 PPP and the Harrod-Balassa-Samuelson Effect. . . . . . . . . . 35715.8.2 The Dornbusch Overshooting Model. . . . . . . . . . . . . . . . . . . . . 35815.8.3 The Modern Approach to Exchange-Rate

Determination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35915.8.4 Chaos Theory and the Exchange Rate. . . . . . . . . . . . . . . . . . . . 368

References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380

16 Capital Movements, Speculation, and Currency Crises . . . . . . . . . . . . . . . . 38516.1 Long-Term Capital Movements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38516.2 Short-Term Capital Movements and Foreign

Exchange Speculation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38816.2.1 Flexible Exchange Rates and Speculation . . . . . . . . . . . . . . . 390

16.3 Speculative Attacks, Currency Crises, and Contagion . . . . . . . . . . . . 39216.3.1 A First Generation Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393

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16.3.2 A Second Generation Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39616.3.3 Third Generation Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39916.3.4 Towards Fourth Generation Models? .. . . . . . . . . . . . . . . . . . . . 40416.3.5 The Indicators Approach: Can Crises Be Forecast? . . . . . 40516.3.6 Contagion .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408

16.4 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41416.4.1 A First-Generation Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41416.4.2 A Second-Generation Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41616.4.3 Krugman’s Third Generation Model: The

Stabilization Dilemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 418

17 Fixed Vs Flexible Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42317.1 The Traditional Arguments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42317.2 The Modern View . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 426

17.2.1 Money Demand Shock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42717.2.2 Aggregate Demand Shock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42717.2.3 Aggregate Supply Shock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42717.2.4 Conclusion .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 429

17.3 The Experience of the Managed Float . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42917.3.1 Introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42917.3.2 New Light on an Old Debate? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431

17.4 Exchange-Rate Pass-Through . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43517.4.1 The Vicious Circle Depreciation-Inflation . . . . . . . . . . . . . . . 438

17.5 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44117.5.1 The Shock-Insulating Properties of Fixed

and Flexible Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44117.5.2 The Effects of Various Shocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44317.5.3 The Intertemporal Approach.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44917.5.4 The Simple Dynamics of the

Depreciation-Inflation Circle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 451

Part VI The Intertemporal Approach

18 The Intertemporal Approach to the Balance of Payments,and the Real Exchange Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45718.1 Introduction: The Absorption Approach .. . . . . . . . . . . . . . . . . . . . . . . . . . 45718.2 Intertemporal Decisions, the Current Account,

and Capital Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46018.2.1 The Feldstein-Horioka Puzzle . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46318.2.2 The Harberger-Laursen-Metzler Effect Again .. . . . . . . . . . 464

18.3 Intertemporal Approaches to the Real Exchange Rate . . . . . . . . . . . . 46518.3.1 Introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46518.3.2 The RAIOM Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46518.3.3 The NATREX Approach: An Overview . . . . . . . . . . . . . . . . . 468

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18.3.4 A More Technical Presentation . . . . . . . . . . . . . . . . . . . . . . . . . . . 47018.4 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 476

18.4.1 The Two-Period Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47618.4.2 The Harberger-Laursen-Metzler Effect . . . . . . . . . . . . . . . . . . 47818.4.3 An Infinite Horizon Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48018.4.4 The RAIOM Approach to the Real Exchange Rate . . . . . 48318.4.5 The NATREX Approach .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 486

References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494

19 Other Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49719.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49719.2 An Intertemporal Model with Endogenous Growth

in an Open Economy.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49719.2.1 The Net Borrower Economy .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 501

19.3 Nominal Rigidities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50219.3.1 Extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 506

19.4 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50719.4.1 The Dynamic Optimization Problem .. . . . . . . . . . . . . . . . . . . . 50719.4.2 The Net Borrower Nation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51119.4.3 Nominal Rigidities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515

References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525

Part VII International Monetary Integration

20 International Monetary Integration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52920.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52920.2 The Theory of Optimum Currency Areas. . . . . . . . . . . . . . . . . . . . . . . . . . 530

20.2.1 The Traditional (or “Criteria”) Approach . . . . . . . . . . . . . . . . 53120.2.2 The Cost-Benefit Approach .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53320.2.3 The New Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53620.2.4 Optimum for Whom? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 538

20.3 The Common Monetary Unit and the Basket Currency .. . . . . . . . . . 53820.4 The Common Monetary Policy, the Inconsistent

Triad, and Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54020.4.1 Fiscal Policy Coordination.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 542

20.5 The Single-Currency Problem.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54420.6 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 547

20.6.1 Fiscal Policy in a Monetary Union . . . . . . . . . . . . . . . . . . . . . . . 54720.6.2 Fiscal Coordination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 552

References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 553

21 The European Monetary Union . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55721.1 The European Monetary System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 557

21.1.1 The EMS and the Theory of OptimumCurrency Areas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559

21.2 The Maastricht Treaty and the Gradual Approach to EMU. . . . . . . 561

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21.2.1 Further Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56321.2.2 Fiscal Governance .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 567

21.3 The Institutional Aspects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56821.4 The Maastricht Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57021.5 The New Theory of Optimum Currency Areas and EMU . . . . . . . . 57321.6 The Euro and the Dollar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 576

21.6.1 The International Role of a Currency . . . . . . . . . . . . . . . . . . . . 578References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 579

Part VIII Problems of the International Monetary(Non)System

22 Key Events in the Postwar International Monetary System . . . . . . . . . . . 58522.1 Introductory Remarks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58522.2 Convertibility.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58722.3 Eurodollars . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58822.4 Special Drawing Rights. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58822.5 Collapse of Bretton Woods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59122.6 Petrodollars. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59422.7 Demonetization of Gold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59422.8 EMS and EMU .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59722.9 The International Debt Crisis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59722.10 The Asian Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 598References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 599

23 International Liquidity, the Demand for InternationalReserves, and Xeno-Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60123.1 Introductory Remarks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60123.2 The Descriptive Approach .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60223.3 The Optimizing Approach .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60423.4 Is International Liquidity Still a Problem?. . . . . . . . . . . . . . . . . . . . . . . . . 606

23.4.1 Some Facts and Puzzles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60623.5 The Composition of International Reserves . . . . . . . . . . . . . . . . . . . . . . . 60923.6 The Analysis of Euro-Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 611

23.6.1 The Fixed-Multiplier Approach . . . . . . . . . . . . . . . . . . . . . . . . . . 61123.6.2 The Portfolio Approach to Euro-Markets .. . . . . . . . . . . . . . . 612

23.7 An Evaluation of the Costs and Benefits of Xeno-Markets . . . . . . . 61423.8 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 616

23.8.1 The Maximization of a Welfare Function .. . . . . . . . . . . . . . . 61623.8.2 Intertemporal Maximization and the

Normative Theory of Economic Policy . . . . . . . . . . . . . . . . . . 61923.8.3 The Composition of International Reserves . . . . . . . . . . . . . 62423.8.4 A Portfolio Model of the Euro-Market .. . . . . . . . . . . . . . . . . . 626

References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 630

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24 Current Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63524.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63524.2 International Policy Coordination .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 636

24.2.1 Policy Optimization, Game Theory,and International Coordination . . . . . . . . . . . . . . . . . . . . . . . . . . . 636

24.2.2 The Problem of the Reference Modeland the Obstacles to Coordination.. . . . . . . . . . . . . . . . . . . . . . . 639

24.3 The Debt Problem.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64224.3.1 NATREX Model of External Debt and Real

Exchange Rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64324.4 The Subprime Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64524.5 Proposals for the International Management

of Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64824.5.1 Introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64824.5.2 McKinnon’s Global Monetary Objective . . . . . . . . . . . . . . . . 64924.5.3 John Williamson’s Target Zones. . . . . . . . . . . . . . . . . . . . . . . . . . 65024.5.4 The Tobin Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 651

24.6 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65324.6.1 International Policy Coordination . . . . . . . . . . . . . . . . . . . . . . . . 65324.6.2 Target Zones .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65524.6.3 The Tobin Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 657

References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 663

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 667

List of Figures

Fig. 3.1 Monetary authorities’ intervention to peg theexchange rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

Fig. 7.1 Multiple equilibria and stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105Fig. 7.2 The arbitrageurs’ excess demand for forward exchange .. . . . . . . . . 108Fig. 7.3 Commercial traders’ excess demand for forward exchange . . . . . . 109Fig. 7.4 Speculators’ excess demand for forward exchange . . . . . . . . . . . . . . . 110Fig. 7.5 Equilibrium in the forward exchange market . . . . . . . . . . . . . . . . . . . . . . 111

Fig. 8.1 Exogenous increase in exports, the multiplier, and thebalance of payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132

Fig. 8.2 Exogenous increase in imports, the multiplier, andthe balance of payments: case (i) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

Fig. 8.3 Exogenous increase in imports, the multiplier, andthe balance of payments: case (ii) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

Fig. 9.1 Flexible exchange rates and the level of income: thebalance-of-payments schedule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163

Fig. 9.2 Flexible exchange rates and the level of income: thereal-equilibrium schedule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

Fig. 9.3 Flexible exchange rates and the level of income:the dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

Fig. 9.4 The transfer problem under flexible exchange rates. . . . . . . . . . . . . . . 168

Fig. 10.1 Mundell-Fleming under fixed exchange rates: the realequilibrium schedule. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193

Fig. 10.2 Mundell-Fleming under fixed exchange rates: themonetary equilibrium schedule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194

Fig. 10.3 Shifts in the monetary equilibrium schedule . . . . . . . . . . . . . . . . . . . . . . 195Fig. 10.4 Mundell-Fleming under fixed exchange rates: the

external-equilibrium schedule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196Fig. 10.5 Mundell-Fleming under fixed exchange rates:

macroeconomic equilibrium.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198Fig. 10.6 Mundell-Fleming under fixed exchange rates:

dynamic analysis of the adjustment process . . . . . . . . . . . . . . . . . . . . . . . 200

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xx List of Figures

Fig. 10.7 The burden of interest payments and the BB schedule. . . . . . . . . . . . 203Fig. 10.8 The transfer problem under fixed exchange rates . . . . . . . . . . . . . . . . . 205Fig. 10.9 Effects of a once-and-for-all devaluation . . . . . . . . . . . . . . . . . . . . . . . . . . 207Fig. 10.10 The Mundell-Fleming model under flexible exchange rates . . . . . . 209

Fig. 11.1 Fiscal and monetary policy for internal and externalbalance under fixed exchange rates: first case . . . . . . . . . . . . . . . . . . . . . 223

Fig. 11.2 Fiscal and monetary policy for internal and externalbalance under fixed exchange rates: second case. . . . . . . . . . . . . . . . . . 224

Fig. 11.3 Flexible exchange rates and policies for internal andexternal balance: high capital mobility . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230

Fig. 11.4 Flexible exchange rates and policies for internal andexternal balance: low capital mobility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230

Fig. 11.5 Perfect capital mobility and fiscal and monetarypolicy under fixed and flexible exchange rates . . . . . . . . . . . . . . . . . . . . 232

Fig. 13.1 Determination of portfolio equilibrium in an open economy .. . . . 268Fig. 13.2 Monetary policy, portfolio equilibrium and capital flows. . . . . . . . . 270Fig. 13.3 Static expectations: short-run equilibrium and

economic policy.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284Fig. 13.4 Rational expectations: short-run equilibrium and

economic policy.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286Fig. 13.5 Rational expectations and long-run equilibrium . . . . . . . . . . . . . . . . . . 287Fig. 13.6 Rational expectations, news, and overshooting.. . . . . . . . . . . . . . . . . . . 288

Fig. 15.1 Rational expectations and exchange-rate overshooting . . . . . . . . . . . 342Fig. 15.2 Exchange-rate determination: interaction between the

current account and the capital account. . . . . . . . . . . . . . . . . . . . . . . . . . . . 345Fig. 15.3 Observed and estimated values. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376Fig. 15.4 Phase diagram.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377Fig. 15.5 Power spectrum . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377Fig. 15.6 Correlation dimension . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378

Fig. 16.1 An example of profitable destabilizing speculation . . . . . . . . . . . . . . . 390Fig. 16.2 Debt levels, crises, and multiple equilibria . . . . . . . . . . . . . . . . . . . . . . . . 398Fig. 16.3 Balance sheets and financial crises. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403

Fig. 18.1 Intertemporal trade: pure consumption . . . . . . . . . . . . . . . . . . . . . . . . . . . . 461Fig. 18.2 Intertemporal trade: production and investment .. . . . . . . . . . . . . . . . . . 463Fig. 18.3 The NATREX model: medium-run dynamics . . . . . . . . . . . . . . . . . . . . . 474Fig. 18.4 The NATREX model: long-run dynamics . . . . . . . . . . . . . . . . . . . . . . . . . 475

Fig. 23.1 The portfolio approach to the Euro-market .. . . . . . . . . . . . . . . . . . . . . . . 613Fig. 23.2 The dynamics of the optimum reserve level . . . . . . . . . . . . . . . . . . . . . . . 621

Fig. 24.1 The Hamada diagram .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 637Fig. 24.2 The international policy game: Cournot-Nash,

Stackelberg, and cooperative solution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639

List of Tables

Table 3.1 Exchange rate arrangements, 2009–2014 (percent ofIMF members) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

Table 6.1 An accounting matrix for real and financial flows . . . . . . . . . . . . . . . . 86

Table 15.1 Estimation results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375

Table 18.1 Effects of a devaluation according to the absorption approach .. . 458

Table 24.1 Payoff matrix of the international policy game . . . . . . . . . . . . . . . . . . . 636

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