Daniels, Joseph P. & David D. Van Hoose. International Monetary and Financial

Economics. New York: Pearson Prentice Hall, 2014.

1. Keeping Up with a Changing World Trade Flows, Capital Flows, and the Balance of Payments.

International Economic Integration: the Importance of Global Trade and Financial Markets

Globalization includes increasing market integration, the expansion of world governance and global society, and increased mobility of people and information.

International economic integration refers to the strengthening of existing international linkages of commerce and the addition of new international

linkages.

Measuring international economic integration is a daunting task due to increased trade in services and advances in electronic commerce and communications.

o The Real and Financial Sectors of an Economy International economic integration refers to the extent and strength of real-sector

and financial-sector linkages among national economies.

o World Trade in Goods and Services Over the last thirty-five years, the volume of world trade in goods and services

has grown by almost 6 percent annually. The cumulative effect of this growth is

more than a fivefold increase in world trade.

o International Transactions in Financial Assets World exports have grown at an impressive rate since 1979. The turnover of

foreign exchange, however, has increased from twelve times the volume of world

exports of goods to more than sixty times.

o The Most Globalized Firms The five hundred largest multinational enterprises (MNEs) account for about half

of the worlds trade in goods and services and more than 90 percent of the worlds foreign direct investment.

The Balance of Payments The balance-of-payments system is a complete tabulation of the total market

value of goods, services, and financial assets that domestic residents, firms, and

governments exchange with residents of other nations during a given periods.

o Balance of Payments as a Double-Entry Bookkeeping System A debit entry records a transaction that results in a domestic resident making a

payment abroad. A debit entry has a negative value in the balance-of-payments

account.

A credit entry records a transaction that results in a domestic resident receiving a payment from abroad. A credit entry has a positive value in the balance-of-

payments system.

o Balance-of-Payments Accounts The current account measures the flow of goods, services and income across

national borders. The four basic categories within the current account are goods,

services, income and unilateral transfers.

Goods: An export of any of these items is a credit in the goods category, because this would result in a payment from abroad. An import of any of these items is a

debit in the goods category, as this would result in a payment made abroad.

Services: The services category also includes the import and export of military equipment, services, and aid.

Income: The income category tabulates interest and dividend payments to foreign residents and governments who hold domestic financial assets. It also

includes payments received by domestic residents and governments who hold

financial assets abroad. The interest payment is an export, or credit, in the income

category of the current account. Economists do not record the purchase of a

financial asset in the income category. Only the income earned on the financial

asset is included in the current account, because income earned on assets can be

used for current consumption.

Unilateral transfers: This category records the offsetting entries of exports or imports for which nothing except good-will is expected in return.

Since 1997, developed nations have experienced higher combined current account deficits, which have been closely mirrored by combined current account

surpluses of emerging nations.

The capital account tabulates cross-border transactions of financial assets among private residents, foreign residents, and domestic and foreign governments. The

private capital account tabulates two types of asset flows: investment flows and

changes in banks and brokers cash deposits that arise from foreign transactions. To help distinguish between portfolio and direct foreign investment, economists

consider the foreign acquisition of less than 10 percent of the entitys outstanding stock as portfolio investment, and the acquisition of 10 percent or more of the

entitys outstanding stock as foreign direct investment. A debit entry in the capital account, for example, records the purchase of a

foreign financial asset by a domestic private resident.

The official settlements balance measures the transactions of financial assets and deposits by official government agencies.

o Deficits and Surpluses in the Balance of Payments The overall balance of payments is the sum of the credits and debits in the current

account, capital account, official settlements, and the statistical discrepancy. The

overall balance of payments necessarily is equal to zero.

A BoP deficit corresponds to a positive official settlements balance, and a BoP surplus corresponds to a negative official settlements balance.

o The capital account and the international flow of assets A net debtor nation is one whose stock of foreign financial assets held by

domestic residents is less than the stock of domestic financial assets held by

foreign residents. A net creditor nation is one whose stock of foreign financial

assets held by domestic residents is greater than the stock of domestic financial

assets held by foreign residents.

2. The Market for Foreign Exchange

Exchange rate and the market for foreign exchange An exchange rate expresses the value of one currency relative to another.

o The Role of the Foreign Exchange Market A spot market is a market for immediate purchase and delivery of an asset,

usually within two or three days.

o Exchange Rates as Relative Prices

An exchange rate is a relative price that indicates the price of one currency in terms of another currency.

When a currency appreciates, it gains value relative to another currency. When a currency depreciates, it loses value relative to another currency.

A cross rate is a third exchange rate that we calculate from two bilateral exchange rates.

The bid-ask spread is the difference between the bid price, or price offered for the purchase of a currency, and the ask price, or price at which the currency is

offered for sale. The bid-ask margin is the bid-ask spread expressed as a percent

of the ask price.

o Real Exchange Rates A real exchange rate is a bilateral exchange rate that has been adjusted for price

changes that occurred in the two nations.

o The Effect of Price Changes

= (

)

Measuring the overall strength or weakness of a currency: effective exchange rates An effective exchange rate is a measure of the weighted-average value of a

currency relative to two or more other currencies.

To construct an Effective Exchange Rate economists compose a currency basket. Next they select a base year and weights.

In contrast to calculating effective nominal exchange rates, however, we use real exchange rates in computing the real effective exchange rate.

Foreign Exchange Arbitrage o Arbitrage is an activity through which individuals seek immediate profits based on

price differentials.

o Spatial arbitrage refers to arbitrage transactions conducted across space, such as across two different geographical markets.

o For a triangular arbitrage opportunity to exist, one of three exchange rates must not be equal spatially.

The demand for and supply of currencies We shall assume that there are no obstructions or controls on foreign exchange

transactions. In addition, addition, we shall assume that governments do not buy

or sell currencies in order to manipulate their values. Under these assumptions,

market forces of supply and demand determine the value of a currency.

o The Demand for a Currency The primary function of a currency is to facilitate transactions. Thus, the demand

for a currency is a derived demand. That is, we derive the demand for a currency

from the demand for the goods, services, and assets that people use the currency

to purchase.

Because the demand for a currency is a derived demand, the various factors that cause a change in the demand for a currency are all of the factors that cause a

change in the foreign demand for that countrys goods, services, and assets. o The Supply of a Currency

The various factors that cause a change in the supply of a currency are the factors that cause a change in a countrys demand for a foreign countrys goods, services, and assets.

o The Equilibrium Exchange Rate The equilibrium exchange rate is the rate at which the quantity of a currency

demanded is equal to the quantity supplied. At the equilibrium exchange rate, the

market clears, meaning that the quantity demanded is exactly equal to the

quantity supplied.

Purchasing Power Parity Purchasing Power Parity (PPP) states that, ignoring transportation costs, tax

differentials, and trade restrictions, traded homogeneous goods and services

should have the same price in two countries after converting their prices into a

common currency.

Price differences could be considered a factor of currency demand because relatively lower prices in a nation cause the demand for that nations currency to increase.

Purchasing power parity is a theory of the relationship between the prices of traded goods and services and the exchange rate.

Both absolute PPP and relative PPP do not consider financial flows and money stocks.

o Absolute Purchasing Power Parity

Absolute PPP: = . The domestic price level expressed in the domestic currency should equal the foreign price level expressed in the domestic currency.

When absolute PPP holds, then the bilateral spot exchange rate should equal the

ratio of the price levels of the two nations.

Some problems arise when applying absolute PPP to all goods and services of two nations. One reason is that people in two nations may consume different sets

of goods and services. Thus, the price levels for the two nations would be based

on the prices of different goods, meaning that the arbitrage argument that lies

behind the absolute PPP condition could not apply.

If absolute PPP holds, then the real exchange rate is equal to 1. o Relative Purchasing Power Parity

Relative PPP is a weaker version of PPP, as it addresses price changes as opposed to absolute price levels. Relative PPP, as an exchange rate theory, relates

exchange rate changes to the differences in price changes across countries.

Relative PPP performs well during periods of very high inflation, because during these periods price changes are the dominant influence on the value of a currency.

% = % %

3. Exchange-Rate Systems, Past to Present

Exchange-Rate Systems A monetary order is a set of laws and regulations that establishes the framework

within which individuals conduct and settle transactions. It also sets forth the

rules that form the nations exchange rate system, and, either formally or informally, the nations participation in an exchange rate system.

An exchange-rate system is the set of rules governing the value of an individual nations currency relative to other foreign currencies.

The Gold Standard Convertibility is the ability to freely exchange a currency for a commodity or

another currency at a given rate of exchange.

To maintain the mint parity, or the exchange value between gold and the national currency, a nation must condition its money stock on the level of its gold reserves.

o The Gold Standard as an Exchange-Rate System The exchange value between gold and the dollar determined the international

value of the dollar. This indirectly established an exchange value between the

domestic currency and the currencies of all other countries on a gold standard.

o Performance of the Gold Standard If the supply of gold is rather constant, this particular aspect of a gold standard,

therefore, promotes long-run stability of the nations money stock and long-run stability of real output, prices, and the exchange rate. Another important aspect

of a commodity-backed monetary order is that it does not require a central bank.

Because there was short-run random changes in the demand and supply of gold, however, there were also short-run random changes in the money stock and in

the prices of goods and services. The short-run volatility of the money stock, in

part, led to periodic financial and banking instability.

o The Collapse of the Gold Standard Following World War I, the Bank for International Settlements (BIS) was

founded as part of an effort to facilitate German reparations.

What brought about the demise of the gold standard was a return to parity values that led to overvalued currencies, such as the case with the United Kingdom, or

undervalued currencies, such as the case with the French franc. In addition,

nations facing a worldwide depression decided to pursue objectives such as

higher employment levels and real growth rates, rather than to maintain the

exchange value of their currencies.

The Bretton Woods System o The Bretton Woods Agreement

The Bretton Woods system was a system of adjustable pegged exchange rates whose parity values could be changed when warranted. Each country established

and maintained a parity value of tis currency, or peg, relative to gold or the U.S.

dollar. All chose the U.S. dollar, making the system a dollar-standard system.

Nations could change their parity values, either revaluing or devaluing, with

approval of the IMF.

o Performance of the Bretton Woods System The incompatibility of the U.S. and European macroeconomic policies and the

unwillingness of the U.S. government to devalue the dollar or of European

governments to revalue their currencies brought about the end of the system.

o The Smithsonian Agreement and the Snake in the Tunnel The agreement established new par values, most representing a revaluation of

European currencies relative to the dollar, but with a wider band of 2.25 percent

on either side of the parity value.

Shortly after the Smithsonian Agreement, the six member nations of the European Economic Community (Belgium, France, Italy, Luxembourg, the

Netherlands, and West Germany), announced a plan to move toward a greater

monetary union. The most significant monetary agreement in the history of the world ended just fifteen months after it began.

The flexible-exchange-rate system o The Economic Summits and a New Order

In 1975, French President Valery Giscard dEstaing decided to host an informal gathering of the leaders of the major industrialized nations, France, Germany,

Italy, Japan, the United Kingdom and the United States. Discussions on the

exchange-rate system continued between the representatives of the United States

and France. The IMF member nations completed the negotiations, known as the

Jamaica Accords, in Jamaica in 1976. At the 1998 Birmingham summit, British

Prime Minister Tony Blair invited President Yeltsin to participate in all the

summit meetings, formally expanding the participation nations to eight.

o Performance of the Floating-Rate System By allowing its currencys exchange value to be determined by market forces, a

floating-rate country is able to focus monetary policies on domestic objectives.

o The Plaza Agreement and the Louvre Accord Under the Louvre Accord, nations would intervene on behalf of their currencies

from time to time. Consequently, the system is not a true flexible exchange-rate

system.

Other forms of exchange-rate arrangements today o Dollarization

Dollarization is the adoption of another nations currency as the sole legal tender. o Independent Currency Authorities

A currency board pegs the value of the domestic currency and buys and sells foreign reserves in order to maintain the pegged value. Changes in the stock of

foreign reserves solely determine the domestic money stock. Currency boards,

therefore, better isolate monetary policy form domestic political pressures.

4. The Forward Currency Market and International Financial Arbitrage

Foreign Exchange Risk Foreign exchange risk is the risk that the value of a future receipt or obligation

will change due to a change in foreign exchange rates.

o Types of Foreign Exchange Risk Exposure Transaction exposure is the risk that the cost of a transaction, or the proceeds

from a transaction, in terms of domestic currency, may change due to changes in

exchange rates.

Translation exposure is the foreign exchange risk that results from the conversion of the value of a firms foreign-currency-denominated assets and liabilities into a common currency value.

Economic exposure is the risk that changes in exchange values might alter a firms present value of the future income streams.

The Forward Exchange Market The Forward Exchange Market is a market for contracts that ensure the future

delivery of a foreign currency at a specified exchange rate.

o Covering a Transaction with a Forward Contract

Firms with short positions in foreign currencies can assume long positions in the forward market by purchasing forward contracts guaranteeing payments

denominated in foreign currencies.

Firms with long positions in foreign currencies can assume short positions in the forward market by selling currencies in the forward exchange market.

o Determination of Forward Exchange Rates If there are no currency restrictions or government interventions, the market

forces of supply and demand determine forward exchange rates.

o The Forward Exchange Rate as a Predictor of the Future Spot Rate

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12

100

=

This condition states that the forward premium must equal the expected appreciation of the currency, and the forward discount must equal the expected

depreciation of the currency.

International Financial Arbitrage o The International Flows of Fund and Interest Rate Determination

In a competitive market, the supply and demand for funds available for lending, or loanable funds, determine interest rates. The market supply schedule for

loanable funds is an upward-sloping curve. The market demand schedule slopes

downward.

o Interest Parity If expected returns on two similar instruments are different, savers will move

funds from one instrument to another. In equilibrium, these rates would be

equal. That is, we would have interest parity, in which interest rate equalization

across nations would ensure that no such flow of funds would occur.

= (+1

) (1 + )

o Exchange uncertainty and covered interest parity

(1 + ) = (

) (1 + )

Covered interest parity is a condition relating the interest rate differential on similar financial assets in two nations to the spot and forward exchange rates. In

equilibrium, the interest differential on the two assets is equal to the forward

premium or discount. If covered interest parity does not hold, financial

arbitrage is possible, and individuals will move savings from one nation to

another.

If the covered-interest parity condition is not satisfied, then a covered-interest-arbitrage opportunity exists.

Uncovered interest Parity o Uncovered Interest Arbitrage

+1

Buying currencies that are at a forward discount and selling currencies that are at a forward premium is actually equivalent to borrowing currencies of nations

with low interest rates and lending currencies of countries with high interest

rates.

Foreign Exchange Market Efficiency exists when the forward exchange rate is a good predictor often called an unbiased predictor of the future spot exchange rate, meaning that, on average, the forward exchange rate turns out to

equal the future spot exchange rate.

International Financial Markets International Capital Markets are the markets for cross-border exchange of

financial instruments that have a maturity of a year or more. International

capital market traders also exchange instruments with no distinct maturity. In

contrast, international money markets are the markets for cross-border

exchange of financial instruments with maturities of less than one year.

7. The International Financial Architecture and Emerging Economies

International Capital Flows o Explaining the Direction of Capital Flows

Hence, an FDI inflow is an acquisition of domestic financial assets that results in foreign residents owning 10 percent or more of a domestic entity. An FDI

outflow is an acquisition of foreign financial assets that result in domestic

residents owning 10 percent or more of a foreign entity.

Cross-border mergers and acquisitions are the combining of firms in different nations. A merger occurs when a firm absorbs the assets and liabilities of

another firm. An acquisition occurs when a firm purchases the assets and

liabilities of another firm.

o Capital Allocations and Economic Growth Foreign capital inflows can help to offset domestic business cycles, providing

greater stability to the domestic economy.

Financial development affects economic growth by promoting savings and directing funds to the most productive investment projects.

o Capital Misallocations and their Consequences Asymmetric information can bring about an inefficient distribution of capital

through resulting problems of adverse selection, herding behavior (savers who

lack full information base their decisions on the behavior of others who they

feel are better informed) , and moral hazard.

A policy-created distortion occurs when a government policy results in a market producing a level of output that is different from the economically

efficient level of output.

Financial liberalization has led to more efficient allocations of capital and deepening of the nations financial markets.

o Where do Financial Intermediaries Fit In? Reducing severe requirements and unnecessary and costly regulations may

improve the efficiency of a nations financial intermediaries. Efficient financial intermediaries reduce the sots of financing investment

projects, pool risks, and reduce the impact of financial market imperfections.

Consequently, they encourage more saving and finance more investment

projects.

Capital Market Liberalization and International Financial Crisis o Are All Capital Flows Equal?

Over time, portfolio capital inflows may improve capital allocations within a nation and help a nations financial sector develop. Portfolio capital flight form a developing country can leave its fragile financial sector short of much needed

liquidity, generating financial instability. This can trigger a financial crisis that

can threaten both the solvency of a nations financial intermediaries and the viability of its exchange-rate regime.

FDI is a relatively illiquid, ownership form of investment that can have a stabilizing effect on a nations economy. These long-term arrangements, however, are more difficult to arrange and result in some degree of foreign

ownership of domestic firms.

o The Role of Capital Flows in Recent Crisis Episodes Foreign capital outflows were a symptom, triggered by a loss of confidence in

the nations macroeconomic and microeconomic policies, its political stability, and the soundness of its financial markets and real productive and

manufacturing sectors. An important policy issue for emerging economies,

therefore, is how to attract FDI and minimize the reliance on portfolio capital

flows in financing investment projects.

Controls of capital inflows may prove to be effective in the short run and slow the pace of short-term inflows and lengthen the maturity of foreign debt.

Exchange-Rate Regimes and Financial Crises o The Corners Hypothesis

Policy makers should choose fully flexible or hard-peg-exchange-rate regimes over intermediate regimes such as adjustable-peg, crawling-peg, or basket-peg

arrangements.

o Dollarization The most important benefit of dollarization is that it eliminates currency risk

and thereby reduces risk premiums and interest rates in emerging economies.

Country risk remains however, so, interest rates will not fully converge to those

of the developed countries.

The loss of seigniorage revenues is an important cost of dollarizing an economy. Another important cost of dollarization is the loss of the lender-of-

last-resort function.

o The Trilemma Economists Joshua Aizenman and Reuven Glick claim that it was a three-part

policy mix a combination of pegged exchange rates, discretionary monetary policy, and capital market liberalization that led to financial crises. Their

explanation of the trilemma is that a nation may simultaneously chose any two,

but not three of them.

o Evaluating the Status Quo Discretionary approach to establishing conditions under which the IMF lends

(ex post conditionality) undermines the IMFs credibility both with actual borrowers and prospective borrowers.

Although the World Banks official mission is to lend to people in developing nations with projects that cannot attract private capital, the development agency

increasingly competes with private investors. The World Bank also faces

pressure from the nations that are net donors to its lending pool to maintain a

significant revenue stream of its own, thereby reducing the donors risk of loss.

9. Monetary and Portfolio Approaches to Balance-of-Payments and Exchange-Rate

Determination

Central Bank Balance Sheets o A Nations Monetary Base

Economists call total domestic securities and loans domestic credit, so the monetary base by definition is the domestic credit plus the central banks foreign exchange reserves.

Viewed from the asset side of a central banks balance sheet, the monetary base is equal to domestic credit plus foreign exchange reserves. Viewed from the

liability side of the central banks balance sheet, the monetary base is equal to currency plus bank reserves.

= +

= = ( + )

The Monetary Approach to Balance-of-Payments and Exchange-Rate Determination The monetary approach to balance-of-payments and exchange-rate

determination postulates that changes in a nations balance of payments and the exchange value of its currency are a monetary phenomenon.

o The Cambridge Approach to Money Demand The Cambridge equation postulates that the quantity of money demanded is a

fraction of nominal income. People hold a fraction of their nominal income as

money.

=

o Money, the Balance of Payments, and the Exchange Rate The current account balance plus the capital account balance is equal to the

official settlements balance. The official settlements balance consists mainly of

changes in the central banks foreign exchange reserves. We will assume that the nations foreign exchange reserves are equivalent to its official settlements balance. In this case, an increase in the official settlements balance (the foreign

exchange reserve component of the monetary base) is equivalent to a balance-

of-payments surplus.

Economists who use the monetary approach assume that purchasing power parity holds in the long run.

=

In equilibrium the actual money stock equals the quantity of money demanded. Proponents

( + ) =

o The Monetary Approach and a Fixed-Exchange-Rate Arrangement An event that causes a difference between the quantity of money demanded and

the quantity of money supplied generates a change in the nations balance of payments or in the spot exchange value of its currency.

Under a fixed-exchange-rate arrangement, the monetary approach indicates that an increase in domestic credit generates a balance-of-payments deficit, whereas

a decrease in domestic credit results in a balance-of-payments surplus.

A rise in either the foreign price level or domestic real income results in a balance-of-payments surplus. Likewise, a decline in either the foreign price

level or domestic real income results in a balance-of-payments deficit.

o The Monetary Approach and a Flexible-Exchange-Rate Arrangement Under a flexible-exchange-rate arrangement such as this, the domestic central

bank does not intervene in the foreign exchange market. The foreign exchange

reserves component of the monetary base, therefore, remains unchanged, and

the nation has neither a balance-of-payments surplus nor a balance-of-payments

deficit.

Under a flexible-exchange-rate arrangement, the monetary approach indicates that an increase in domestic credit results in a depreciation of domestic

currency, whereas a decline in domestic credit results in an appreciation of the

domestic currency.

Under a flexible-exchange-rate arrangement, the monetary approach theorizes that an increase in the foreign price level or domestic real income results in an

appreciation of the domestic currency.

o A Two-Country Monetary Model The spot exchange rate is determined by the relative quantities of money

supplied and the relative quantities of money demanded.

= ; = ,

= ; = ,

=

=

=

=

10. An Open Economy Framework

Measuring and economys performance: gross domestic product and price indexes o Gross Domestic Product

Gross Domestic Product is the total of all final goods and services produced domestically during a given interval (such as a year) and valued at market prices.

The tabulation of GDP always includes inventory investment, which ensures that GDP measures all production during a given year.

GDP also includes the value of depreciation, which is the value of capital goods such as machines or tools that are repaired or replaced if businesses are to

maintain their existing amount of capital.

o Nominal GDP, Real GDP, and the GDP Price Deflator Real GDP (y) is equal to nominal GDP (Y) adjusted by dividing, or deflating,

by the factor P.

Real Income and Expenditures: The IS Schedule The real value of household income is equal to the real value of the output

produced by firms, y.

The Income Identity. Households can allocate their real income in four games: real consumption spending, c; real savings, s; real net taxes, t; real import

spending, im (assumption: only households import foreign-produced goods and

services).

+ + +

The Product Identity. Household consumption, firm realized investment, and real government spending are the three domestic components of total spending

on domestically produced output. The final component of spending on

domestically produced goods and services is expenditures by foreign residents

on the output that domestic firms export abroad, or the nations real export spending, denoted by x.

+ + +

o Private and Public Expenditures Households can use their after-tax income to buy domestically produced goods

and services, to save, or to purchase foreign-produced goods and services.

= = + +

= 1

+

+

+ +

= 0 + ( ) = 0 + ( )

= 0 + ( ) + 0 + ( )

= (0 0) + [(1 ) ]

Whether induced by a fall in the real interest rate or expectations of higher real returns on investment, an increase in desired investment causes investment to rise

at any given level of aggregate income: investment is autonomous.

We shall assume that the real government spending is equal to an autonomous amount.

An increase in foreign real income levels or a depreciation of the domestic currency causes exports to increase.

o Equilibrium Income and Expenditures In equilibrium, the aggregate desired expenditures on domestically produced

goods and services by households, firms, the government, and foreign residents

are equal to total real income.

+ + +

= (0 0) + () ; = 0

= (0 0) ( 0) + ( )

(0 0) ( 0) + 0 + 0 + 0

o The IS Schedule The IS schedule is a set of combinations of real income levels and nominal

interest rates that maintains equilibrium real income.

The Market for Real Money Balances: The LM Schedule o The Transactions and Precautionary Motives for Holding Money

Transaction Motive. The motive to hold money for use in planned exchanges. Precautionary Motive. The motive to hold money for use in unplanned

exchanges.

Portfolio Motive. The motive for people to adjust their desired mix of money and bond holdings based on their speculations about interest rate movements and

anticipated changes in bond prices.

o The LM Schedule An LM schedule is a set of all combinations of real income levels and nominal

interest rates that maintain equilibrium in the money market.

The Balance of Payments: The BP Schedule and the IS-LM-BP Model Real income and the nominal interest rate together must determine a nations

balance of payments.

o Maintaining a Balance-of-Payments Equilibrium: The BP Schedule A balance-of-payments equilibrium, however, is defined as a situation in which

the current account balance and capital account balance sum to zero, so that the

official settlements balance also equals zero.

The BP schedule is a set of real income-nominal interest rate combinations that is consistent with a balance-of-payments equilibrium in which the current

account balance and capital account balance sum to zero.

o The IS-LM-BP Model At an IS-LM equilibrium, both real income and the nominal interest rate are

consistent with an equilibrium flow of real income and equilibrium in the market

for real money balances.

If an IS-LM equilibrium occurs at a point on the BP schedule, then a balance-of-payments equilibrium results. An IS-LM equilibrium above or below the BP

schedule, however, results in a balance-of-payments surplus or deficit,

respectively.

11. Economic Policy with Fixed Exchange Rates

The Objectives of Policy There are two categories of economic goals that governments and central banks

often pursue. One consists of internal balance objectives, which are goals for

national real income, employment, and inflation. The other consists of external

balance objectives, which are goals for the trade balance and other components

of the balance of payments.

o Internal Balance Objectives Most economists agree that the best available measure of the growth in overall

living standards within any nation is the growth rate of per capita gross domestic

product, or per capita GDP. Per capita GDP, therefore, is a measure of material

well-being for the average resident of a country, and the growth rate of per capita

GDP is a measure of the improvement of an average residents livings standards over time.

This measure fails to indicate how a nations income is distributed among the residents of a nation. Improvements in goods and services that residents of a

nation produce and consume are not taken into account in the compilation of

GDP statistics. Finally, the well-being of a countrys citizens likely depends on more than just the value of the nations output of goods and services.

Even if policymakers were to agree that they might not have much influence on a nations natural GDP, they still might feel obligated to try to conduct policies that might reduce the frequency and extent of business-cycle fluctuations.

The sum of the ratios of those who are frictionally and structurally unemployed as a ratio of the labor force is the natural rate of unemployment. Remaining

variations in the overall unemployment rate along an economys growth path would arise from changes in the cyclical unemployment.

o External Balance Objectives Mercantilism. A view that a primary determinant of a nations wealth is its

inflows of payments resulting from international trade and commerce, so that a

nation can gain by enacting policies that spur exports while limiting imports.

The Role of Capital Mobility Capital mobility refers to the degree to which funds and financial assets are free

to flow across a nations borders. o Perfect Capital Mobility

Imperfect capital mobility is a common explanation for the failure of the uncovered interest-parity condition to be met in a number of nations.

With perfect capital mobility, variations in the nominal interest rate are the only factor that can induce balance-of-payments deficits or surpluses.

Fixed Exchange Rates and Imperfect Capital Mobility o Monetary Policy under Fixed Exchange Rates and Imperfect Capital Mobility

The channel through which monetary policy actions are transmitted to the economy is through a liquidity effect that alters desired investment and thereby

changes the real income level.

A monetary expansion generates a balance-of-payments deficit. The primary explanation for the existence of a balance-of-payments deficit is the trade deficit

stemming from increased import expenditures at a higher income level. If capital

mobility is high, the decline in the interest rate causes a significant outflow of

capital.

According to the monetary approach to the balance of payments, efforts to affect real income and the balance of payments via nonsterilized monetary expansions

or contractions ultimately are ineffective policy actions if exchange rates are

fixed.

If a central bank attempts to sterilize indefinitely, so as to maintain higher real income, then a persistent balance-of-payments deficit places continual downward

pressure on the value of the nations currency. o Fiscal Policy under Fixed Exchange Rates

A fiscal-policy-induced increase in equilibrium real income typically is smaller, because of the decline in investment stemming from a rise in the interest rate.

This fall in investment following a rise in government spending is called the

crowding-out effect.

An increase in government spending causes the IS schedule to shift to the right. This yields a higher nominal interest rate and a higher real income level. The rise

in equilibrium real income induces a rise in imports that causes the nation to

experience a trade deficit. The rise in the equilibrium interest rate generates an

inflow of some financial resources from other nations, but with low capital

mobility this inflow is not very significant.

With very high capital mobility, there is a sizable capital account surplus (a significant inflow of financial resources from abroad) that more than offsets the

trade deficit.

Under a fixed exchange rate, fiscal policy actions force a central bank to respond to international payments imbalances by reducing or accumulating foreign

exchange reserves.

Two factors complicate the ultimate effects that tax variations have on a nations equilibrium interest rate and real income level. One is the potential for Ricardian

equivalence to reduce the effect of a tax change on aggregate desired

expenditures. The second complication is that governments typically collect the

bulk of their revenues via taxation of income. Tax changes may also affect

household work effort, firm production, and, ultimately, aggregate expenditures.

Fixed Exchange Rates and Perfect Capital Mobility Actions that are undertaken in one economy might spill over to affect another

nation when capital is fully mobile.

o Economic Policies with Perfect Capital Mobility and Fixed Exchange Rate: The Small Open Economy

An expansionary monetary policy declines the interest rate below its equilibrium level. This induces significant flows of capital out of the country, which results

in a BoP deficit. To prevent a decline in the value of the nations currency, the central bank sells foreign exchange reserves. An expansionary monetary policy

action ultimately has no effect on real income when the central bank maintains a

fixed exchange rate.

An increase in government spending rises the interest rate above the foreign interest rate, so the nation experiences a balance of payments surplus as the

higher domestic interest rate induces significant inflows of capital from abroad.

The central bank begins to accumulate foreign exchange reserves in its efforts to

keep the exchange rate from changing. Consequently, fiscal policy has its

greatest possible effect on equilibrium real income when capital is perfectly

mobile.

12. Economic Policy with Floating Exchange Rates

Floating Exchange Rates and Imperfect Capital Mobility o The Effects of Exchange-Rate Variations in the IS-LM-BP Model

A fall in the value of a nations currency makes imports more expensive. Consequently, expenditures on the nations exports increase. Hence, the IS schedule shifts to the right.

A currency depreciation causes the BP schedule to shift to the right. o Monetary Policy under Floating Exchange Rates

An increase in the money stock causes the LM schedule to shift rightward. Hence, there is a balance-of-payments deficit. This places downward pressure on the

value of the nations currency. Thus, the domestic currency depreciates. This causes export spending to rise and import spending to fall. Under a floating

exchange rate, therefore, an increase in the quantity of money unambiguously

constitutes an expansionary policy action that induces at least a near-term

increase in a nations real income level. o Fiscal Policy under Floating Exchange Rates

The effects of fiscal policy actions on a nations BoP and the value of its currency hinge on the degree of capital mobility.

With low capital mobility an increase in government spending causes the IS schedule to shift to the right. Therefore, the immediate effect of the rise in

government spending is a balance of payments deficit caused by an increase in

import spending resulting from a rise in real income. The nations currency depreciates in the face of the BoP deficit. The resulting rise in the exchange rate

induces net export expenditures to increase. Furthermore, the currency

depreciation causes the BP schedule to shift to the right.

With high capital mobility the resulting rise in the interest rate causes significant capital inflows into this nation. This induces a BoP surplus and the nations currency appreciates, which spurs import expenditures and reduces export

spending. Hence, the IS schedule shifts leftward. The currency appreciation also

causes the BP schedule to shift leftward.

Floating Exchange Rates and Perfect Capital Mobility

o Economic Policies with Perfect Capital Mobility and a Floating Exchange Rate: The Small Open Economy

An increase in the money stock causes the LM schedule to shift rightward. The induced decline in the equilibrium interest rate generates considerable capital

outflows. This causes the country to start to experience a BoP deficit, which

places downward pressure on the value of the nations currency. Thus, import spending declines and export spending rises. Monetary policy has the largest

possible immediate effect on real income with a floating exchange rate and

perfect capital mobility.

With perfect capital mobility, fiscal policy actions have complete crowding-out effects. Any increase in government spending crowds out an equal amount of net

export spending by foreign residents because of the currency appreciation that

the fiscal policy action causes. On net, therefore, equilibrium real income is

unaffected by the fiscal policy action.

Perfect Capital Mobility

Exchange Rate Setting Monetary Policy Fiscal Policy

Fixed Minimum Effect Maximum Effect

Floating Maximum Effect Minimum Effect

o Economic Policies with Perfect Capital Mobility and a Floating Exchange Rate: A Two-Country Example

Under a floating exchange rate and perfect capital mobility, a domestic monetary expansion can have a beggar-thy-neighbor effect on the foreign country. If the

exchange rate floats, domestic monetary policy can affect levels of real income

and interest rates in both nations within the same two-country world. Hence, the

foreign economy is no longer insulated from domestic monetary policy actions

under a floating exchange rate.

Under a floating exchange rate and perfect capital mobility, a domestic fiscal expansion has a locomotive effect on the foreign country. An increase in domestic

government spending results in expansions of real income levels in both nations.

In a two-country world with a floating exchange rate a foreign fiscal expansion

generates a locomotive effect.

Perfect Capital Mobility

Exchange Rate Setting Monetary Policy Fiscal Policy

Fixed Locomotive Effect Beggar-thy-neighbor

Floating Beggar-thy-neighbor Locomotive Effect

Fixed versus Floating Exchange Rates The fundamental trade-offs between fixed versus floating exchange rates cut

across two dimensions: economic efficiency and economic stability. The most

efficient exchange-rate system may or may not be the one that attains greater

stability of an economys overall real income performance. o Efficiency Arguments for Fixed versus Floating Exchange Rates

Economic efficiency. The allocation of scarce resources at a minimum cost.

There is a trade-off between the social costs incurred in hedging against foreign exchange risks in a system of floating exchange rates and the risk of experiencing

unhedged losses as a result of unexpected devaluations in a system of fixed

exchange rates.

o Stability Arguments for Fixed versus Floating Exchange Rates Variations in aggregate desired expenditures lead to real income instability under

a fixed-exchange-rate system. Permitting the exchange rate to float automatically

reduces the real income effects of volatility in desired expenditures.

Variations in the demand for real money balances contribute to real income instability under a floating-exchange-rate system. Fixing the exchange rate

automatically reduces the real income effects of volatility in money demand.

Maintaining a fixed exchange rate could, under some circumstances, be the better policy choice from the standpoint of achieving greater real income stability, but

adopting a system of floating exchange rates might lead to a higher level of

overall economic efficiency.

o Monetary Policy Autonomy and Fixed versus Floating Exchange Rates Adopting a system of floating exchange rates gives a nations central bank policy

autonomy that it does not possess under a system of fixed exchange rates.