Lecture 8Lecture 8

International FinanceInternational Finance

ECON 243 – Summer I, 2005ECON 243 – Summer I, 2005

Prof. Steve CunninghamProf. Steve Cunningham

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Capital MobilityCapital Mobility Perfect Capital MobilityPerfect Capital Mobility means that a means that a

practically unlimited amount of international practically unlimited amount of international capital flows in response to the slightest capital flows in response to the slightest change in one country’s interest rates.change in one country’s interest rates.

Absent political and macroeconomic risks, a Absent political and macroeconomic risks, a successful fixed exchange rate regime successful fixed exchange rate regime should make perfect capital mobility more should make perfect capital mobility more likely. (Exchange rate risk is zero.)likely. (Exchange rate risk is zero.)

For a small country, perfect capital mobility For a small country, perfect capital mobility implies that the country’s interest rate must implies that the country’s interest rate must be equal to the world interest rate. be equal to the world interest rate.

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Capital Mobility and Monetary PolicyCapital Mobility and Monetary Policy

Under fixed exchange rates and perfect Under fixed exchange rates and perfect capital mobility, international capital flows capital mobility, international capital flows dictate the country’s money supply.dictate the country’s money supply.

International conditions dominate domestic policy.International conditions dominate domestic policy. If a country tries to reduce its money supply to If a country tries to reduce its money supply to

raise its interest rates for domestic policy reasons, raise its interest rates for domestic policy reasons, 1.1. A slightly higher interest rate attracts a nearly unlimited A slightly higher interest rate attracts a nearly unlimited

capital inflow.capital inflow.

2.2. The exchange rate must be defended by selling domestic The exchange rate must be defended by selling domestic currency, thereby expanding the money supply.currency, thereby expanding the money supply.

3.3. It is impossible to sterilize in the face of such large capital It is impossible to sterilize in the face of such large capital flows.flows.

4.4. The expanding money supply lowers the domestic interest The expanding money supply lowers the domestic interest rate.rate.

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Capital Mobility and Fiscal PolicyCapital Mobility and Fiscal Policy

Under fixed exchange rates, perfect Under fixed exchange rates, perfect capital mobility enhances domestic capital mobility enhances domestic fiscal policy.fiscal policy.

Because interest rates cannot rise, Because interest rates cannot rise, there is no possibility for “crowding there is no possibility for “crowding out”.out”.

If the government increases spending If the government increases spending without raising taxes, it incurs deficits.without raising taxes, it incurs deficits.

The deficits can easily be financed by The deficits can easily be financed by in the enormous capital inflows.in the enormous capital inflows.

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Trade-off?Trade-off?

Improved fiscal policy effectiveness Improved fiscal policy effectiveness is not a good substitute for is not a good substitute for monetary policy.monetary policy.

Fiscal policy is cumbersome—slow to Fiscal policy is cumbersome—slow to enact, not so responsive as monetary enact, not so responsive as monetary policy.policy.

Fiscal policy is very much influenced Fiscal policy is very much influenced by short-run political interests.by short-run political interests.

Not helpful for handling long-run Not helpful for handling long-run inflationary issues.inflationary issues.

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Monetary Policy Without FEMonetary Policy Without FE

IS

LM0

Y

i

i1

Y0

IS

LM0

Y

i

i0

Y0

LM1

i1

Y1

LM1

i0

?

Under normal conditions, ignoring international complications, a reduction in the money supply raises interest rates, making investment more expensive, slowing output.

Again ignoring international complications, if investment is not sensitive to interest rate changes, a reduction in the money supply raises interest rates a lot, but this has little effect on output.

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Monetary PolicyMonetary Policy

IS

LM

Y

i

i0

Y0

FE

In this case, any change in the domestic money supply causes a change in the interest rate, leading to the movement of enormous international capital flows. These capital flows happen almost instantly, and continue until the interest rates are restored to their original level—the same level as the world interest rate.

Thus, effectively, the interest rate is fixed at the world rate, and domestic monetary policy cannot change the interest rate, and therefore cannot affect the domestic economy.

Under fixed exchange rates and perfect capital mobility

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Fiscal Policy without FEFiscal Policy without FE

IS0LM0

Y

i

Y0

IS0

LM

Y

i

i0

Y0,1

i1

i0

Under normal conditions, ignoring international complications, if money demand is very unresponsive to interest rates, then fiscal policy simply raises interest rates, and rendered weak as a result of “crowding out”.

Again ignoring international complications, if money demand is sensitive to interest rate changes, fiscal stimulus is powerful. Small changes in interest rates have a large impact on the money supply-demand equilibrium. There is no crowding out.

IS1

IS1

Y1

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Fiscal PolicyFiscal Policy

IS

LM

Y

i

i0

Y0

FE

Y1

A stimulative fiscal policy shifts IS to the right. Any tiny increase in the interest rate generates enormous changes in the domestic money supply-demand equilibrium as a result of the enormous capital inflow. FE and LM are both anchored at the world interest rate. Thus there is no possibility of crowding out, and fiscal policy is powerful.

Under fixed exchange rates and perfect capital mobility

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Policy EffectivenessPolicy Effectiveness

Under perfect capital mobility and Under perfect capital mobility and fixed exchange rates, fixed exchange rates, Monetary policy is limited to defending Monetary policy is limited to defending

the fixed exchange rate, andthe fixed exchange rate, and Fiscal policy can be powerful.Fiscal policy can be powerful.

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Internal ShocksInternal Shocks

A A domestic monetary shockdomestic monetary shock alters the alters the equilibrium relationship between money equilibrium relationship between money supply and demand because:supply and demand because: The money supply changes, orThe money supply changes, or People alter their personal systems of People alter their personal systems of

determining how much money to hold determining how much money to hold (demand) perhaps as a result of innovations (demand) perhaps as a result of innovations or changes in the payments system.or changes in the payments system.

A A domestic spending shockdomestic spending shock alters alters domestic real expenditure by a change in domestic real expenditure by a change in one of its components one of its components (C,I,G). (C,I,G). An example An example is a fiscal policy change.is a fiscal policy change.

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External ShocksExternal Shocks

An An international capital-flow shockinternational capital-flow shock is is an unexpected shift of international an unexpected shift of international funds in response to political upheaval funds in response to political upheaval or fears of a international policy or fears of a international policy change. Examples are:change. Examples are: Fear of warFear of war Rumors of the imposition of capital Rumors of the imposition of capital

controlscontrols Growing evidence of a likely currency Growing evidence of a likely currency

devaluationdevaluation A form of capital flightA form of capital flight

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Adverse Int’l Capital-Flow ShockAdverse Int’l Capital-Flow Shock

Y

i

IS

FE0

LM0

LM1

FE1

E

T

1. FE shifts to higher interest rates.

2. Official settlements balance is in deficit at point E. Central bank must defend the fixed rate.

3. If the central bank does not sterilize its intervention, LM shifts upward to left, and external balance is restored.

4. Internal imbalance is created by falling output and rising unemployment.

Y0Y1

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International Trade ShocksInternational Trade Shocks

An An international trade shockinternational trade shock is a is a shift in a country’s exports or shift in a country’s exports or imports arising from causes other imports arising from causes other than changes in the real income of than changes in the real income of the country. the country.

These are These are structural changesstructural changes.. British beef. British beef. A country that is found to use DDT in its A country that is found to use DDT in its

agriculture.agriculture. It alters the current account.It alters the current account.

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Policy ResponsesPolicy Responses

High High UnemploymeUnemployme

ntnt Rapid InflationRapid Inflation

SurplusSurplus Expansionary Expansionary PolicyPolicy ????

DeficitDeficit ???? ContractionarContractionary Policyy Policy

State of the Domestic EconomyState of the Domestic Economy

State ofState ofBalance ofBalance ofPaymentsPayments

In the situations marked by “??”, aggregate demand policy cannot deal effectively with both the internal and external situations simultaneously.

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Policy ResponsesPolicy Responses

When confronted with one of the When confronted with one of the situations marked with ??, the situations marked with ??, the government is in a trap. Internal government is in a trap. Internal imbalance solutions worsen the external imbalance solutions worsen the external balance, and vice-versa.balance, and vice-versa.

It has three choices:It has three choices:1.1. It can abandon the goal of external balance, It can abandon the goal of external balance,

which will require eventual abandonment of which will require eventual abandonment of the fixed exchange rate.the fixed exchange rate.

2.2. It can abandon the goal of internal balance, It can abandon the goal of internal balance, at least on the short run. at least on the short run.

3.3. It can search for other solutions, like…?It can search for other solutions, like…?

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Alternative for the Short RunAlternative for the Short Run Robert Mundell and J. Marcus Fleming Robert Mundell and J. Marcus Fleming

realized there might be a possibility of realized there might be a possibility of using an appropriate using an appropriate “policy mix”“policy mix”.. Stimulative monetary policy lowers interest Stimulative monetary policy lowers interest

rates; stimulative fiscal policy raises interest rates; stimulative fiscal policy raises interest rates. rates. Maybe a combination, each offsetting Maybe a combination, each offsetting the worst of the other?the worst of the other?

It is the changes in interest rates that affect It is the changes in interest rates that affect the payments balance. the payments balance.

So with a combined policy, one could have So with a combined policy, one could have fiscal policy stimulus fiscal policy stimulus andand lower interest rates! lower interest rates!

More generally, monetary and fiscal policies More generally, monetary and fiscal policies can be mixed so as to achieve any combination can be mixed so as to achieve any combination of internal and external goals of internal and external goals in the short runin the short run. .

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Assignment RuleAssignment Rule

According to According to Mundell’s assignment ruleMundell’s assignment rule:: Assign fiscal policy the task of stabilizing the Assign fiscal policy the task of stabilizing the

domestic economy (only),domestic economy (only), Assign to monetary policy the task for stabilizing Assign to monetary policy the task for stabilizing

the balance of payments (only)the balance of payments (only) Each arm of policy concentrates on a single Each arm of policy concentrates on a single

task, making coordination of policy trivial.task, making coordination of policy trivial. Also each arm of policy is addressing the issues Also each arm of policy is addressing the issues

it cares most about.it cares most about. Timing, though, remains critical. Lags from Timing, though, remains critical. Lags from

either side could result in unstable oscillations.either side could result in unstable oscillations.

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Monetary-Fiscal RecipesMonetary-Fiscal Recipes

High unemploymentHigh unemployment Rapid InflationRapid Inflation

SurplusSurplusEasier monetary Easier monetary

policy, easier fiscal policy, easier fiscal policypolicy

Easier monetary Easier monetary policy, tighter fiscal policy, tighter fiscal

policypolicy

DeficitDeficitTighter monetary Tighter monetary

policy, easier fiscal policy, easier fiscal policypolicy

Tighter monetary Tighter monetary policy, tighter fiscal policy, tighter fiscal

policypolicy

State of the Domestic EconomyState of the Domestic Economy

State ofState ofBalance ofBalance ofPaymentsPayments

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Exchange Rates Exchange Rates and the Trade Balanceand the Trade Balance

What is the effect of a change in the What is the effect of a change in the nominal exchange rate on the nominal exchange rate on the volumes of exports and imports?volumes of exports and imports? As long as the change in the exchange As long as the change in the exchange

rate alters the int’l price rate alters the int’l price competitiveness, it should change the competitiveness, it should change the volume of trade.volume of trade.

What is the effect on the value of What is the effect on the value of trade?trade? This is more difficult. (Remember both This is more difficult. (Remember both

prices and volumes are changing.)prices and volumes are changing.)

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Devaluation (Surrender)Devaluation (Surrender)

The devaluation should improve The devaluation should improve international price competitiveness as international price competitiveness as long as any changes in the domestic long as any changes in the domestic price level or foreign price level do not price level or foreign price level do not offset the exchange rate change.offset the exchange rate change. Exports increaseExports increase as goods become cheaper as goods become cheaper

to foreign buyers.to foreign buyers. Imports decreaseImports decrease as foreign goods become as foreign goods become

more expensive to domestic buyers.more expensive to domestic buyers. OVERALL, the current account tends to OVERALL, the current account tends to

improve. The result on the capital account is improve. The result on the capital account is less clear.less clear.

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Consider a devaluationConsider a devaluation

Consider a devaluation of the dollar, where the CA balance is measure in pounds per year:

CA balance = P£X • X - P£

m • M

Effect =

£ price of Exports

Quantity of Exports

£ price of Imports

Quantity of Imports

No

change or down

No

change or up

•-

No

change or down

•

No

change or down

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Problem?Problem?

In the case of perfectly inelastic In the case of perfectly inelastic demand for exports and imports, demand for exports and imports, devaluing the dollar could result in a devaluing the dollar could result in a worsened trade balance.worsened trade balance. The foreign price of exports fall, but The foreign price of exports fall, but

quantities demanded are NOT responsive quantities demanded are NOT responsive to price, so the volume stays the same. to price, so the volume stays the same.

Thus PThus P££XX is lower, but X is unchanged, and is lower, but X is unchanged, and

PP££X X • X is lower. The value of exports • X is lower. The value of exports

declines.declines.

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More Likely ResultMore Likely Result On the short run, prices will be able to adjust On the short run, prices will be able to adjust

more quickly than quantities. (Export demand more quickly than quantities. (Export demand is more inelastic in the short run.)is more inelastic in the short run.)

So immediately following a devaluation or So immediately following a devaluation or depreciation, the value of exports will fall, depreciation, the value of exports will fall, worsening the trade balance.worsening the trade balance.

Over the longer term, prices can adjust. Over the longer term, prices can adjust. (Export demand is more elastic in the long (Export demand is more elastic in the long run.) So longer term, the trade balance would run.) So longer term, the trade balance would improve.improve.

In fact, the longer the elapsed time since the In fact, the longer the elapsed time since the devaluation or depreciation, the more likely devaluation or depreciation, the more likely the trade balance is to be improved.the trade balance is to be improved.

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J CurveJ Curve

It is more likely that the drop in the value It is more likely that the drop in the value of the home currency will improve the of the home currency will improve the trade balance, especially in the long run.trade balance, especially in the long run.

0

+

- 18 months

Months since devaluation

Net change in trade balance

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Flexible Exchange RatesFlexible Exchange Rates

Under a clean float, external balance Under a clean float, external balance is maintained by the changing is maintained by the changing exchange rates.exchange rates.

Policy focuses on internal balance.Policy focuses on internal balance. Remaining questions:Remaining questions:

What are the effects of shocks?What are the effects of shocks? How does the exchange rate change How does the exchange rate change

resolve external imbalances?resolve external imbalances? How do fluctuations in the exchange rate How do fluctuations in the exchange rate

affect the macroeconomy?affect the macroeconomy?

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Expansionary Monetary Expansionary Monetary PolicyPolicy

Money supply increases

Interest rate drops

Spending and output increase

Current account balance worsens

Price level rises

Capital flows out

Our currency depreciates

Current account balance improves

GDP rises more

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Expansionary Monetary Expansionary Monetary Policy (2)Policy (2)

Under floating exchange rates, Under floating exchange rates, monetary policy is powerful in its monetary policy is powerful in its effects on internal balance.effects on internal balance.

The induced change in the exchange The induced change in the exchange rate rate reinforcesreinforces the domestic effects of the domestic effects of monetary policy.monetary policy.

Monetary policy is a more powerful Monetary policy is a more powerful tool for managing the domestic tool for managing the domestic economy under flexible exchange economy under flexible exchange rates.rates.

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Expansionary Monetary Expansionary Monetary PolicyPolicy

Y

i

IS0

FE1

LM1

LM0FE0

E1

E0

Y0 Y1

IS1

T1

Following expansionary monetary policy, the currency depreciates to correct the deficit payments balance—FE moves to the right. IS moves to the right as the current account improves.

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Expansionary Fiscal PolicyExpansionary Fiscal Policy

Gov’t spending increases

Interest rate rises

Spending and output increase

Current account balance worsens

Price level rises

Capital flows in

Our currency may appreciate at first, but probably depreciates eventually

GDP falls, then rises more