International Leakages (part 3)By Misha Lee Soriano

Highlights of the Report

• Economies are linked internationally through trade in goods and through financial markets. The exchange rate is the price of a foreign currency in terms of the dollar. A high exchange rate (a weak dollar) reduces imports and increases exports, stimulating aggregate demand.

• Under fixed exchange rates, central banks buy and sell foreign currency to peg the exchange rate. Under floating exchange rates, the market determines the value of one currency in terms of another.

Highlights of the Report

• If a country wishes to maintain a fixed exchange rate in the presence of a balance of payments deficit, the central bank must buy back domestic currency, using its reserves of foreign currency and gold or borrowing reserves from abroad. If the balance of payments deficit persists long enough for the country to run out of reserves, it must allow the value of its currency to fall.

• In the very long run, exchange rates adjust so as to equalize the real cost of goods across countries.

Highlights of the Report

• With perfect capital mobility and fixed exchange rates, fiscal policy is powerful. With perfect capital mobility and floating exchange rates, monetary policy is powerful.

NAMES DEFINITION

Balance of Payments

The record of transactions of the residents of a country with the rest of the world

Current Account

Records trade in goods and services, as well as transfer payments

Capital Account

Records purchases and sales of assets, such as stocks, bonds, and land

Balance-of-Payments

Deficit

Occurs when more money is leaving the country than entering it

Balance-of-Payments Surplus

Occurs when more money is entering the country than leaving it

Exchange Rate Terminologies

NAMES DEFINITION

Fixed Exchange Rate

System

A system in which exchange rates are determined by governments and central banks rather than the free market, and maintained through foreign exchange market intervention

InterventionSales or purchases of foreign exchange by the central bank in order to stabilize exchange rates

Flexible/Floating

Exchange Rate System

A system in which exchange rates are allowed to fluctuate with the forces of supply and demand

Clean FloatingFlexible exchange rate system in which the central bank does not intervene in foreign exchange markets

Dirty Floating

Flexible exchange rate system in which the central bank intervenes foreign exchange market in order to affect the short-run value of its currency

Exchange Rate Terminologies

NAMES DEFINITION

Devaluation

Decrease in the value of the domestic currency relative to the currencies of other countries; used when exchange rates are fixed

Revaluation

Increase in the value of the domestic currency relative to the currencies of other countries; used when exchange rates are fixed

Depreciation

Decrease in the value of the domestic currency relative to the currencies of other countries; used when exchange rates are flexible

Appreciation

Increase in the value of the domestic currency relative to the currencies of other countries; used when exchange rates are flexible

Exchange Rate Terminologies

Capital Mobility

• One of the striking facts about international economy is the high degree of integration or linkage among financial/capital markets – the markets in which bonds and stocks are traded.

• If foreign exchange rates are permanently fixed, taxes are the same everywhere, and international asset holders never face political risks (nationalization, restrictions on transfer of assets, default risk by foreign governments). There would be strict equality in the world capital markets.

Capital Mobility

• In reality, there are tax differences among countries. Exchange rates can change, perhaps significantly, and thus affect the payoff of a foreign investment.

• Interest rate dissimilarities among major industrialized countries that are adjusted to eliminate the risk of exchange rate changes are partially practiced.

• Henceforth, capital is very highly mobile across borders.

Capital Mobility

Perfect Capital Mobility• Capital is perfectly mobile internationally when

investors in search of the highest return, can purchase assets in any country they can choose, quickly, with low transaction costs, and in unlimited accounts.

The high degree of capital market integration implies that any one country’s interest rates cannot get too far out of line without bringing about capital flows that tend to restore yields to the world level.

When capital mobility is

perfect, interest rates in the

home country cannot diverge

from those abroad. This has

major implications for the effects of monetary and fiscal policy

under fixed and floating

exchange rates.

POLICYFIXED

EXCHANGE RATES

FLEXIBLE EXCHANGE

RATES

Monetary Expansion

No output change;

reserve losses equal to money

increase

Output expansion;

trade balance improves; exchange

depreciation

Fiscal Expansion

Output expansion;

trade balance worsens

No output change;

reduced net exports;

exchange appreciation

Capital Mobility

Capital Mobility

The introduction of trade in goods means that some of the demand for our output comes from abroad and that some spending by our residents is on foreign goods. The demand for our goods depends on the real exchange rata as well as on the levels of income at home and abroad.

A real depreciation or increase in foreign income increases net exports and shifts the IS curve out to the right. There is equilibrium in the goods market when the demand for domestically produced goods is equal to the output of those goods.

• The model first proposed by Robert Mundell and Marcus Fleming that explores economy with flexible exchange rates and perfect capital mobility.

• Under fixed exchange rates and perfect mobility, a country cannot pursue an independent monetary policy. Interest rates cannot move out of line with those prevailing in the world market. Any attempt at independent monetary policy leads to capital flows and need to intervene until interest rates are back in line with those in the world market.

Perfect Capital Mobility Under Fixed Exchange RatesMundell-Fleming Model

Perfect Capital Mobility Under Fixed Exchange RatesMundell-Fleming Model

Monetary Expansion Under Fixed Rates and Perfect Capital Mobility

• Under fully flexible exchange rates the absence of intervention implies a zero balance of payments. Any current account deficit must be financed by private capital inflows.

• A current account b account surplus is balanced by capital outflows. Adjustments in the exchange rate ensure that the sum of the current and capital account is zero.

Perfect Capital Mobility and Flexible Exchange RatesMundell-Fleming Model

Perfect Capital Mobility and Flexible Exchange RatesMundell-Fleming Model

The Effect of Exchange Rates on Aggregate Demand

Perfect Capital Mobility and Flexible Exchange RatesMundell-Fleming Model

Effects on An Increase in the Demand for Exports

Perfect Capital Mobility and Flexible Exchange RatesMundell-Fleming Model

• If an economy with floating rates finds itself with unemployment, the central bank can intervene to depreciate the exchange rate and increase net exports and thus aggregate demand.

• Such policies are known as beggar-thy-neighbor policies because the increase in demand for domestic output comes at the expense of demand for foreign output.

ECONOMIC IMPLICATIONS OF INCREASING INTEGRATION

• Economic integration is the elimination of tariff and nontariff barriers to the flow of goods, services, and factors of production between a group of nations, or different parts of the same nation.

• It involves at least two countries to abolish customs tariffs on inner border between the states. This causes a number of effects while the phenomenon itself has specific properties for its successful development.

ECONOMIC IMPLICATIONS OF INCREASING INTEGRATION• It requires coherence of the policies (customs, tax, financial, social policies etc. and entity registration) applied in integrated states. Economic parameters (domestic savings rate, tax rates, etc.) are striving to one single multitude. Coherence policy finally leads to equal multi-dimensional economic space within integrated area.

• It needs permanency of economic integration stages applied to unified states (free trade area, customs union, economic union, political union). Otherwise integration process declines, finally leading to termination of economic unions.

ECONOMIC IMPLICATIONS OF INCREASING INTEGRATION• Economic integration leads to Pareto-reallocation of the factors (labor and capital) which move towards their better exploitation. Labor moves to area of higher wages, while capital – to area with higher returns.

• Domestic saving rates in the member states of economically integrated region strive to the one and same magnitude, described by the coherence policy of economic blocks. At the same time, practical observation shows that this phenomenon is taking place before formal creation of economic unions.

ECONOMIC IMPLICATIONS OF INCREASING INTEGRATION• Formulation of economic integration theory has been initiated by Jacob Viner who described trade creation and trade diversion effects caused by economic integration meaning a change in direction of interregional trade flows respectively caused by the change of tariffs within and outside economic union.

• The dynamics of trade creation and diversion effects was mathematically described by R.T. Dalimov. The finding shows that trade flow (an output moving from region to region) may be described with the goods flow caused by the price difference.

ECONOMIC IMPLICATIONS OF INCREASING INTEGRATION

• Economic integration of states leads to the creation of the terms of trade. Economic union of states obtains more privileged position in trade negotiations.

• Economic integration benefits (growth of economy, specifically the GDP; raise of productivity) depend on the level of development as well as a scale of unifying states.

• If there are two states being economically integrated, then the larger the size of economy the less it receives from integration and vice versa.

ECONOMIC IMPLICATIONS OF INCREASING INTEGRATION

• The same principle is observed regarding the level of development of integrating states, although it is not as clear as the firstly mentioned principle.

• Productivity in the unified area is increased. Remarkably, it is increased more in less developed states, and vice versa (Dalimov, 2008), i.e. according to the principle observed in practice.

ECONOMIC IMPLICATIONS OF INCREASING INTEGRATION

• Among the main benefits for the countries which decided to be unified is a free access to markets of the other member states.

• Since the stage of the common market, or since supranational bodies of the union are created, specific regional funds are created to reallocate revenues from more developed states to less developed ones.

ECONOMIC IMPLICATIONS OF INCREASING INTEGRATION

• This way, development of the member states is equalized, with less developed ones developing faster, leading to an increase of their earnings per capita and thus purchasing more from more developed partner states.

• Consequently, economic integration unites nations, leading them to prosper with each other.