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International Linkages

International Linkages. Chapter #13. Introduction. National economies are becoming more closely interrelated => movement toward globalization or single global market Economic influences from abroad have affects on the U.S. economy

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International Linkages

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  1. International Linkages Chapter #13

  2. Introduction • National economies are becoming more closely interrelated => movement toward globalization or single global market • Economic influences from abroad have affects on the U.S. economy • Economic occurrences and policies in the U.S. affect economies abroad • When the U.S. moves into a recession, it tends to pull down other economies • When the U.S. is in an expansion, it tends to stimulate other economies • Key linkages among open economies & some first pieces of analysis • Economies are linked through two broad channels • Trade in goods and services • Some of a country’s GDP exported  increase demand for domestically produced goods • Some goods consumed or invested at home are produced abroad and imported  a leakage from the circular flow of income • Finance • Portfolio managers shop the world for the most attractive yields • Investors shift assets around the world, linking home & foreign assets markets affect income, exchange rates & the ability of monetary policy to affect interest rates • U.S. residents can hold U.S. assets OR assets in foreign countries

  3. The Balance of Payments • Record of residents’ transactions with the rest of the world • Two main accounts: • Current account: records trade in goods & services, as well as transfer payments • Capital account: records purchases and sales of financial assets & land • Central point of international payments: must pay for foreign purchases • If spending exceeds income, deficit financed by selling assets or by borrowing • Current account deficit must be financed by an offsetting capital inflow • Current account + Capital account = 0 • Official reserves > 0 when domestic private residents don’t sell or borrow abroad enough, government covers ≠ from reserves causing them to ↓

  4. Exchange Rate Systems • Direct ForEx quote (US stand point): Price of foreign currency in terms of $ • If you could buy 1 Irish punt for $1.38, nominal exchange rate e = $1.38/1 punt = 1.38 • Dollar cost of sandwich sold for 2.39 punts = 2.39 punts * 1.38 = $3.30 • Demand for punt in exchange for $ = supply of $ in exchange for punt • Fixed exchange rate system (regime): central banks hold $ reserves to be able to intervene in ForEx market (trading home currency for $) in order to maintain fixed $ price of the home currency • Balance of payments determines the level of central bank’s intervention • If US has a current account deficit w/ Japan (demand for ¥ > supply of ¥ in exchange for $) the Bank of Japan buys excess $ w/ ¥ to maintain fixed $/ ¥ exchange rate • Country that persistently runs balance of payment deficits has to devalue its currency (otherwise central bank runs out of foreign currency reserves & cannot maintain fixed e) • Flexible (floating) exchange rate system: central banks allow the exchange rate to adjust to equate the supply and demand for foreign currency • If US has a current account deficit w/ Japan the Bank of Japan stands aside allowing for $ to depreciate (¥ to appreciate), e.g. from e0 = ₵0.86/¥1 = 0.86 to e1 = 0.90, making Japanese goods more expensive for Americans & lowering US demand for Japanese products • Appreciation is %Δ of denominator currency = (end e – beg e)/beg e = end e/beg e - 1

  5. The Exchange Rate in the Long Run • Determined by relative purchasing power of each country’s currency (like gold standard, often tested with price of Big Mac in different countries) • Two currencies are at purchasing power parity (PPP) when a unit of domestic currency can buy the same basket of goods at home or abroad • Relative purchasing power measured by real exchange rate R = ePf/P, ratio of foreign prices Pf to home price P both measured in $) • e$/punt = 1.38, sandwich costs 2.39 punt & $3.09 in US, R = 1.38*2.39/3.09 = 1.07 • If R =1, currencies are at PPP • If R >/< 1, goods abroad are more/less expensive, ↑/↓ demand for home goods causing ↑/↓ of P or ↓/↑ e (home currency app/depreciates) => R slowly → 1 due to ≠ baskets of goods, barriers (natural – transaction costs & artificial – tariffs) & non-movable assets (land) • Cost of barley in UK relative to thatin Holland over a long time period • R for barley tends to equalize • But, long time periods of deviation • Best estimate for modern times is deviations from PPP is reduced by half in about 4 years • PPP holds in the LR, but it is only one of exchange rate determinants

  6. Goods Trade, Equilibrium & Balance of Trade • To bring foreign trade into IS-LM model assume fixed price & flat AS curve • With NX, domestic spending no longer solely determines domestic output • Spending by domestic residents: DS = DS(Y, i) = C + I + G • Spending on domestic goods: DS + NX = C + I + G + NX • Net exports: NX = NX(Y, Yf, R) = X(Yf, R) – Q(Y, R) • ↑ in home income Y ↑ import Q & worsens the trade balance => ↓ AD • ↑ in foreign income Yf ↑ exports X & improves the trade balance => ↑ AD • Real depreciation of home country R improves the trade balance => ↑ AD • Marginal propensity to import = fraction of income spent on imports • IS curve steeper in an open than in a closed economy (for given ↓ in interest %, smaller ↑ in output & income restores goods equilibrium) • IS curve now includes NX as AD component IS: Y = DS(Y, i) + NX(Y, Yf, R) • ↑ in competitiveness (real depreciation) ↑ demand for home goods => shifts IS curve to the right • ↑ in Yf↑ foreign spending on home goods=> shifts IS curve to the right

  7. Balance of Payments & Capital Flows • Financial markets (home & foreign) are highly integrated • Start analysis with assumption of perfect international capital mobility • Low transaction costs of quick unlimited trading in any country • Large funds move across borders searching for highest return or lowest cost • Capital inflows/outflows bring interest rates in any country quickly back in line • Capital flows into country (facing given price of imports, export demand & world interest rate if) when the interest rate is above world rate • Balance of payments surplus is: BP = NX(Y, Yf, R) + CF(i - if), where CF is the capital account surplus • The trade balance NX is a function of domestic and foreign income • An increase in domestic income worsens the trade balance • The capital account CF depends on the interest differential • An increase in the interest rate above the world level pulls in capital from abroad, improving the capital account

  8. Mundell-Fleming Model: Perfect Capital Mobility Under Fixed Exchange Rates • The Mundell-Fleming model incorporates foreign exchange under perfect capital mobility into the standard IS-LM framework • Under perfect capital mobility, the slightest interest differential provokes infinite capital inflows  central bank cannot conduct an independent monetary policy under fixed exchange rates • Uncovered & covered interest rate parity1 + i = (1/e0)(1 + if)e1e & 1 + i = (1/e0)(1 + if)for i ≈ if + (e1e - e0)/e0 & i ≈ if+ (f - e0)/e0 • A country tightens money supply to increase interest rates: • Portfolio holders worldwide shift assets into country • Due to huge capital inflows, balance of payments shows a large surplus • The exchange rate appreciates and the central bank must intervene to hold the exchange rate fixed • The central bank buys foreign currency in exchange for domestic currency • Intervention causes domestic money stock to increase, and interest rates drop • Interest rates continue to drop until return to level prior to initial intervention

  9. Monetary Expansion Consider a monetary expansion that shifts LM right from point E to E’ • At E’ there is a large payments deficit, and pressure for the exchange rate to depreciate • Central bank must intervene, selling foreign money in exchange for home money, supply of home money falls, pushing up interest %, returning LM to the original position Fiscal Expansion Monetary policy is ineffective, but fiscal expansion is effective • A fiscal expansion shifts IS curve right  increases interest rates & output • Higher interest % attracts capital inflow causing currency appreciation • To manage the exchange rate central bank expands the money supply  shifting the LM curve to the right • Pushes interest rates back to their initial level, but output increases yet again

  10. Perfect Capital Mobility and Flexible Exchange Rates • Use the Mundell-Fleming model to explore how monetary and fiscal policy work in an economy with a flexible exchange rate and perfect capital mobility • Assume domestic prices are fixed • The exchange rate must adjust to clear the market so that the demand for and supply of foreign exchange balance • Without central bank intervention, the balance of payments must equal zero • The central bank can set the money supply at will since there is no obligation to intervene  no automatic link between BP and money supply • Perfect capital mobility implies that balance of payments balances when i = if • A real appreciation means home goods relatively more expensive => IS shifts left • A real depreciation makes home goods relatively cheaper => IS shifts right • Arrows link interest rate & AD • When i > if, the currency appreciates • When i < if, the currency depreciates • Interest % ↑ due to contractionary orrestrictive econ policy (above) or ↑ in inflation causing currency depreciation.

  11. Adjustment to a Real Disturbance • Using equations for IS curve, BP and CF balance we can show how various changes affect the output level, interest rate & exchange rateSuppose exports increase: • At a given output level, interest rate & exchange rate, there is an excess demand for goods • IS shifts to the right • The new equilibrium, E’, corresponds to a higher income level and interest rate • Don’t reach E’ since BP in disequilibrium  exchange rate appreciation will push economy back to E Suppose there is a fiscal expansion: • Same result as with increase in exports  tendency for demand to increase is halted by exchange appreciation Real disturbances to demand do not affect equilibrium output under flexible exchange rates with capital mobility.

  12. Adjustment to a Money Stock Change Suppose there is an increase in the nominal money supply: • The real stock of money, M/P, increases since P is fixed • At E there will be an excess supply of real money balances • To restore equilibrium, interest rates will have to fall  LM shifts to the right • At point E’, goods market is in equilibrium, but i is below the world level  capital inflows depreciate the exchange rate • Import prices increase, home goods more competitive& demand for home goods expands • IS shifts right to E”, where i = if • Result: Monetary expansion leads to ↑ output & currency depreciation under flexible rates

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