International Finance

1. International Finance Econ 356 Karine Gente kgente@interchange-ubc.ca

2. Web page: http://www.econ.ubc.ca/directory/sess/sfackg.htm Office room: Buch tower 1099 D • Teaching Assistant: Kang ShiEmail: kangshi@interchange.ubc.caOffice room: Buch tower 1099COffice hrs: Friday 2:00-3:00

3. Introduction Macroeconomic Equilibrium and Open Economy

4. Open economies • The development of international trade (volume) • Trade barriers and restrictions on capital flows tend to disappear (GATT + WTO rounds) • A disequilibrium between imports and exports

5. Exports and Imports as a % of GDP (1960-2000) Japan France Canada United States

6. International trade

7. Imports and Exports as a percentage of output: 2000 Percentage 40 of GDP 35 30 25 20 15 10 5 0 Canada France Germany Italy Japan U.K. U.S. Imports Exports

8. International trade (1999) Exports relative to imports

9. International trade becomes more intensive. • The openess degree measured by (EX+IM)/GDP is about 73% for Canada against 23% for Japan. • Exports need not be equal to imports -> Capital flows -> The higher IM-EX, the more the country dependent on the rest of the world.

10. Money (I) Domestic Country Rest of the World Imports Rest of the World Domestic Country Exports Money (II)

11. Imports>Exports I>II Domestic Country goes into debt vis-à-vis the Rest of the World • Imports<Exports I<II Domestic Country goes into excedent vis-à-vis the Rest of the World

12. Canada

13. Industrial Countries 1.0 1.5 Restriction Measure (left scale) Openness Measure (right scale) 0.8 1.2 0.6 0.9 0.4 0.6 0.2 0.3 0.0 0.0 1970 1974 1978 1982 1986 1990 1994 1998 Measures of Financial Integration Source: WEO, Lane and Milesi-Ferreti (2003)

14. Developing Countries 1.0 0.50 Openness Measure (right scale) Restriction Measure (left scale) 0.8 0.40 0.6 0.30 0.4 0.20 0.2 0.10 0.0 0.00 1970 1974 1978 1982 1986 1990 1994 1998 Measures of Financial Integration Source: WEO, Lane and Milesi-Ferreti (2003)

15. We can distinct capital flows as • Bank lending (Indirect Finance) • Portfolio flows (Direct Finance) • Foreign Direct Investment: Investment of a foreign firm in a country. FDI is driven by the desire of entreprises to exploit their intangible property in markets outside their home country. • Portfolio flows vary sharply instead of FDI are quite insensitive to short-run swings in macroeconomic conditions

16. Direct vs. Indirect Finance

17. All Developing Economies 180 Bank Lending 160 Portfolio Flows FDI 140 120 100 80 60 40 20 0 1970 1975 1980 1985 1990 1995 -20 Year Net Private Capital Flows(Billions of USD) Source: WEO

18. More Financially Integrated Economies Less Financially Integrated Economies 180 9 Bank Lending 8 Bank Lending 160 Portfolio Flows Portfolio Flows 7 FDI FDI 140 6 120 5 100 4 80 3 60 2 40 1 20 0 1970 1975 1980 1985 1990 1995 0 -1 1970 1975 1980 1985 1990 1995 -20 -2 Year Year Source: WEO Net Private Capital Flows(Billions of USD)

19. All this evidence suggests that international economic integration has hugely increased. • What are the consequences? • Growth and development • Efficiency of government policies • Contagion and crisis

20. International Economic Integration (IEI) IEI refers to the extent and strength of real- sector and financial-sector linkages among national economies. Real-sector linkages occur through the international transactions in goods and services while the financial-sector linkages occur through international transactions in financial assets.

21. International Economic Integration Direct Channels  Augmentation of available savings Transfer of technology (FDI)  Development of financial sector Indirect Channels  Promotion of specialization  Inducement for better policies  Enhancement of capital inflows by signaling better policies Higher Economic Growth Channels Through Which IEI Can Raise Economic Growth

22. International economic integration could help growth and development

23. International Economic Integration and Contagion International economic integration Financial-sector linkages through international transactions in financial assets. Real sector linkages through exchange of goods • Contagion (crisis, fiscal policy…)

24. Example • Imagine two countries: A and B Expansionary Fiscal Policy in Country A ↑ Demand (country A) - Domestic goods - Imports Country B’s Income ↑ Country B’s Exports ↑

25. Example • Imagine A and B are developing countries with common features (GDP per capita, inflation, …). • You have in your bonds portfolio some bonds of Country A government’s debt and some of Country B government’s debt. • Country A’s government says that the government debt cannot be reimbursed, what do you do?

26. Questions of International Finance • Why international trade and international capital flows? • What are the consequences of international economic integration on production (flows of inputs)? Consumption (flows of goods)? • How international economic integration changes the way monetary and fiscal policies affect economies? • How do crisis appear and spread?

27. Reminder about Macroeconomic Equilibrium in an Open Economy Readings: Macroeconomics, N. Gregory Mankiw (Harvard U.), chapter 5.

28. In an open economy, • Spending need not equal output: Y≠C+I+G • Saving need not equal investment S≠I

29. The financial sector channels funds from net lender-savers to net borrower-investors • Because financial sector can redirect surplus funds, leakages and injections of each sector need not balance • I ≠ S • G ≠ T • Im ≠ Ex

30. Preliminaries superscripts: d = spending on domestic goods f = spending on foreign goods EX = exports = foreign spending on domestic goods IM = imports = Cf+ If+ Gf= spending on foreign goods

31. Preliminaries, cont. NX = net exports ( the “trade balance”) = EX – IM • If NX > 0, country has a trade surplusequal to NX • If NX < 0,country has a trade deficitequal to –NX

32. GDP = expenditure on domestically produced g & s

33. net exports domestic spending output The national income identity in an open economy Y = C + I + G + NX or, NX= Y– (C+ I + G)

34. International capital flows • Net capital outflows • S – I • net outflow of “loanable funds” • net purchases of foreign assetsthe country’s purchases of foreign assets minus foreign purchases of domestic assets • When S > I, country is a net lender • When S < I, country is a net borrower

35. Another important identity NX= Y– (C+ I+ G) implies NX = (Y– C– G) – I = S – I trade balance = net capital outflows

36. An open economy model : Two countries Small open economy Country B SB,IB Long-run Equilibrium Country A SA,IA IA+IB=SA+SB Domestic Country Rest of the World r*

37. Saving and Investment in a Small Open Economy

38. r S, I National Saving: The Supply of Loanable Funds To simplify,national saving does not depend on the interest rate

39. Assumptions re: capital flows • domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.) • perfect capital mobility:no restrictions on international trade in assets • economy is small:cannot affect the world interest rate, denoted r* a & b imply r = r* c implies r*is exogenous

40. r I(r) S, I Investment: The Demand for Loanable Funds Investment is still a downward-sloping function of the interest rate, but the exogenous world interest rate… r* …determines the country’s level of investment. I(r*)

41. r rc I(r) S, I If the economy were closed… …the interest rate would adjust to equate investment and saving:

42. r r* rc I(r) S, I I1 But in a small open economy… the exogenous world interest rate determines investment… NX …and the difference between saving and investment determines net capital outflows and net exports

43. Three experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand

44. r NX2 NX1 Results: I(r) S, I I1 1. Fiscal policy at home An increase in G or decrease in T reduces saving.

45. r NX2 NX1 I(r) S, I 2. Fiscal policy abroad Expansionary fiscal policy abroad raises the world interest rate. Results:

46. r S NX1 I(r)1 S, I I1 3. An increase in investment demand EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow.

47. r S NX2 NX1 I(r)2 I(r)1 S, I I2 I1 3. An increase in investment demand ANSWERS: I > 0, S = 0, net capital outflows and net exports fall by the amount I

48. References • The Economics of Money, Banking and Financial Markets, 6th edition, Mishkin. • International Economics: Theory and Policy, Paul Krugman and Maurice Obstfeld .

49. Course Overview I. International capital mobility a. Why international capital flows? b. The reasons of exchange: some aspects of international trade and intertemporal choice c. Recent evolutions of financial integration d. The Balance of Payments

50. Course Overview II. The Exchange rate: a key variable a. Some definitions of exchange rate b. Exchange rates in the long-run: The Purchasing Power Parity (PPP) theory c. Different exchange rate regimes