Trade and Finance in the Cambridge-Alphametrics Model

1. Trade and Finance in the Cambridge-Alphametrics Model

2. Outline Trade and finance: what drives what? Accounting for income, expenditure, trade, and net acquisition of financial assets Expenditure behaviour and disequilibrium Policy regimes, imbalances and adjustment A show… Financial model, structural flows, wealth and feedbacks in the context of international policy co-ordination

3. Trade & finance: adjustment process in normal times  If the LHS is determined by endogenous demand responding to income and wealth targets Such can only be consistent with what countries find themselves saving or borrowing Financial flows would respond with high exchange rate elasticity to accommodate the current account Feedbacks to income and wealth may be expected

4. Accounting: net savings National income Y is identical to expenditure, for the world economy, for a country as a whole and for any chosen domestic disaggregation: Net savings of institutions are intrinsically related

5. Accounting: financial investment Net acquisition of financial assets NA is the difference between income Y and total expenditure on goods and services H : The net financial balance A is given by the position at the end of the prior period plus net acquisition and holding gains GA: 

6. Accounting: wealth Wealth W comprises the financial position A as well as tangible assets K (subject to depreciation and holding gains): The distribution of holding gains and losses is not the same for financial assets (which are liabilities to some one else) as for tangible assets

7. Expenditure behaviour H, spending on goods (including gross investment) and services in each country is determined on the basis of assumptions about income Y* and a financial objective NA* The conventional expression:is a special case where: But the financial objective may derive from targets for wealth W* or the country's expected financial position A*, with allowance for GK* or GA*

8. …endogenously driving W income For the world as a whole, income YW is equal to spending? world income tends to exceed or fall short of assumptions depending on whether expected income and financial objectives summed over all countries yield a negative (deficit) or a positive (surplus) figure The aggregate of country-level objectives imparts an upward or downward bias to movements of aggregate demand in the world as a whole

9. … and there is no equilibrium Income assumptions Y * are influenced by many factors including the strength of a country's trade balance, productive potential and financial conditions The expected NA* is nothing more or less than the sum of processes by which households, firms and governments attempt to reach their wealth targets Wealth targets may be affected by market valuation The complex aggregation of NA* would determine the strength of the global multiplier and thus YW Unless universal perfect competition and constant returns to scale are assumed, full employment of the world economy requires a deliberate policy of demand management (Kaldor)

10. Policy regimes: stability objective Open system with price stability objective Monetary policy is targeted on price stability A sound external financial position is required unless that foreigners are persuaded to invest in domestic assets Exchange rate depreciation is presumed beneficial for attaining external balance but such can run counter to the domestic price objective and real depreciation may not be achieved Policy management may lead to deflation (by either curbing domestic credit creation or by means of fiscal tightening) Outcomes vary with the degree of ‘CB independence’

11. Policy regimes: growth objective Open system with demand management objective Monetary and fiscal policies are targeted on growth Net acquisition of government and private sectors would be calibrated to match the expected outcome for the current account under full capacity utilization assumptions But the external position may turn too strong leading to internal price inflation. Monetary tightening may be successful provided that confidence of external investors is not affected The growth objective may eventually be abandoned A feasible alternative may be globally co-ordinated demand management

12. Policy regimes: intervention Managed systems When a country's external position is very weak, it becomes difficult to introduce or maintain an open system In the face of a persistent shortage of foreign exchange the government restricts use of foreign exchange to essential debt service and purchases of imports. The foreign exchange position is managed directly by the central bank and the domestic financial system is effectively isolated from international financial markets. Full employment remains a remote goal but a liberalized open regimen is likely to make matters worse. This is still the position of many low income countries 

13. Policy trade-offs in the absence of international co-ordination Countries with a strong trading position may achieve full employment with external surplus Other countries would cope at intermediate positions Countries like the US, UK, etc. may have external borrowing power. Domestic borrowing would sustain high employment in the face of continuing external deficits. Likely break points are inability to engender private and public debt on the scale necessary to maintain full employment => recession refusal of external investors to acquire domestic assets at the current exchange rate => devaluation The sum of implied financial targets exerts upward or downward momentum on global demand and may as well lead to imbalances

14. … and now for your entertainment: sketches of a ‘soft’ landing in the US

18. Back to the financial model If in normal times the adjustment process runs from the income and trade accounts to the financial account, why and when a financial model is needed? Modelling financial flows in abnormal times? … impossible Modelling exchange rates? … nearly impossible There is no clear causality running from structural flows to exchange rates

19. structural flows include the current account and direct investment is there a clear impact on the exchange rate?

20. exchange rates are highly volatile in nearly all countries there is no apparent causality from financial flows to exchange rates

21. Understanding structural flows A trade and income model should at the very least incorporate trade flows, external income flows and direct investment Such ‘structural flows’ are relevant for growth, income distribution and development It is plausible that these can be modeled in relation with policy regimes Direct investment may be sensitive to changes in the exchange rate and stock mkt. indexes

22. Disentangling financial flows Foreign currency and securities are acquired by the private sector and monetary authorities Liquidity and precautionary motives may help explaining outflows Since the exchange rate is generally determined by longer-term expectations rather than structural flows, given domestic demand for foreign currency investments and deposits the balancing item in the exchange account would be non-resident investments

23. Valuation changes may matter The scope for variation of market prices and real exchange rates is constrained by the impact on net external assets and liabilities (depending on currency denomination), thus: wealth (and wealth ‘volatility’) domestic and international distribution of income; confidence and expectations NB: and they lead to confusion too (Hausman… et al.)

24. Feedbacks from wealth to expenditure may be relevant Spending decisions are likely influenced by the perception of valuation changes in wealth and by the distributional impact of income flows on households, firms and governments Such complicates the role of monetary and fiscal policy (for example: i-rte tightening may be necessary to constrain excessive private debt against wealth appreciation but it may precipitate a recession…) How then policy co-ordination should work?