InternationalLinkages

.IntroductionNationaleconomiesarebecomingmorecloselyinterrelatedEconomicinfluencesfromabroadhaveaffectsontheU.S.economyEconomicoccurrencesandpoliciesintheU.S.affecteconomiesabroadWhentheU.S.movesintoarecession,ittendstopulldownothereconomiesWhentheU.S.isinanexpansion,ittendstostimulateothereconomiesInthischapterwepresentthekeylinkagesamongopeneconomiesandintroducesomefirstpiecesofanalysis13-2IntroductionEconomiesarelinkedthroughtwobroadchannelsTradeingoodsandservicesSomeofacountry’sproductionisexportedtoforeigncountriesincreasedemandfordomesticallyproducedgoodsSomegoodsthatareconsumedorinvestedathomeareproducedabroadandimportedaleakagefromthecircularflowofincomeFinancePortfoliomanagersshoptheworldforthemostattractiveyieldsAsinternationalinvestorsshifttheirassetsaroundtheworld,theylinkassetsmarketshereandabroad

affectincome,exchangerates,andtheabilityofmonetarypolicytoaffectinterestratesU.S.residentscanholdU.S.assetsORassetsinforeigncountries13-3TheBalanceofPaymentsandExchangeRatesBalanceofpayments:therecordofthetransactionsoftheresidentsofacountrywiththerestoftheworldTwomainaccounts:Currentaccount:recordstradeingoodsandservices,aswellastransferpaymentsCapitalaccount:recordspurchasesandsalesofassets,suchasstocks,bonds,andland13-4ExternalAccountsMustBalanceThecentralpointofinternationalpaymentsisverysimple:IndividualsandfirmshavetopayforwhattheybuyabroadIfapersonspendsmorethanherincome,herdeficitneedstobefinancedbysellingassetsorbyborrowingSimilarly,ifacountryrunsadeficitinitscurrentaccountthedeficitneedstobefinancedbysellingassetsorbyborrowingabroadSelling/borrowingimpliesthecountryisrunningacapitalaccountsurplusanycurrentaccountdeficitisofnecessityfinancedbyanoffsettingcapitalinflow

Currentaccount+Capitalaccount=0

(1)13-5ExchangeRatesExchangerateisthepriceofonecurrencyintermsofanotherEx.Inaugust1999youcouldbuy1Irishpuntfor$1.38inU.S.currencynominalexchangeratewase=1.38Ifasandwichcost2.39punts,thatisequivalenttoWewilldiscusstwodifferentexchangeratesystems:FixedexchangeratesystemFloatingexchangeratesystem13-6FixedExchangeRatesInafixedexchangeratesystemforeigncentralbanksbuyandselltheircurrenciesatafixedpriceintermsofdollarsEnsuresthatmarketpricesequaltothefixedratesNoonewillbuydollarsformorethanfixedratesinceknowthattheycangetthemforthefixedrateNoonewillselldollarsforlessthanfixedratesinceknowcansellthemforthefixedrateForeigncentralbanksholdreservestosellwhentheyhavetointerveneintheforeignexchangemarketIntervention:thebuyingorsellingofforeignexchangebythecentralbank13-7FixedExchangeRatesWhatdeterminesthelevelofinterventionofacentralbankinafixedexchangeratesystem?ThebalanceofpaymentsmeasurestheamountofforeignexchangeinterventionneededfromthecentralbanksEx.IftheU.S.wererunningacurrentaccountdeficitvis-à-visJapan,thedemandforyeninexchangefordollarsexceededthesupplyofyeninexchangefordollars,theBankofJapanwouldbuytheexcessdollars,payingforthemwithyenUnderafixedexchangerate,pricefixersmustmakeuptheexcessdemandortakeuptheexcesssupplyMakesitnecessarytoholdaninventoryforforeigncurrenciesthatcanbeprovidedinexchangeforthedomesticcurrency13-8FixedExchangeRatesWhatdeterminesthelevelofinterventionofacentralbankinafixedexchangeratesystem?Withnecessaryreserves,FederalReservecancontinuetointerveneinforeignexchangemarketstokeeptheexchangerateconstantIfacountrypersistentlyrunsdeficitsinthebalanceofpayments:ThecentralbankeventuallywillrunoutofreservesonofforeignexchangeWillbeunabletocontinueitsinterventionBeforethisoccurs,thecentralbankwilllikelydevaluethecurrency13-9FlexibleExchangeRatesInaflexible(floating)exchangeratesystem,centralbanksallowtheexchangeratetoadjusttoequatethesupplyanddemandforforeigncurrencySupposethefollowing:Exchangerateofthedollaragainsttheyenis0.86centsperyenJapaneseexportstotheU.S.increaseAmericansmustpaymoreyentoJapaneseexportersBankofJapanstandsasideandallowstheexchangeratetoadjustExchangeratecouldincreaseto0.90centsperyenJapanesegoodsmoreexpensiveintermsofdollarsDemandforJapanesegoodsbyAmericansdeclines13-10TheExchangeRateintheLongRunInlongrun,exchangeratebetweenpairofcountriesisdeterminedbyrelativepurchasingpowerofcurrencywithineachcountryTwocurrenciesareatpurchasingpowerparity(PPP)whenaunitofdomesticcurrencycanbuythesamebasketofgoodsathomeorabroadTherelativepurchasingpoweroftwocurrenciesismeasuredbytherealexchangerateTherealexchangerate,R,isdefinedas(3),wherePfandParethepricelevelsabroadanddomestically,respectivelyIfR=1,currenciesareatPPPIfR>1,goodsabroadaremoreexpensivethanathomeIfR<1,goodsabroadarecheaperthanthoseathome13-11TheExchangeRateintheLongRunIfR=1,currenciesareatPPPIfR>1,goodsabroadaremoreexpensivethanathomeIfR<1,goodsabroadarecheaperthanthoseathome13-12TheExchangeRateintheLongRunFigure13-2showsthecostofbarleyinEnglandrelativetothatinHollandoveralongtimeperiodRealbarleyexchangeratetendedtowardsequalizationHowever,longtimeperiodsofdeviationfromequality13-13TheExchangeRateintheLongRunBestestimateformoderntimesisthatittakesabout4yearstoreducedeviationsfromPPPbyhalfPPPholdsintheLR,butonlyoneofthedeterminantsoftheexchangerate13-14TradeinGoods,MarketEquilibrium,andtheBalanceofTradeNeedtoincorporateforeigntradeintotheIS-LMmodelAssumethepricelevelisgiven,andoutputdemandedwillbesupplied(flatAScurve)Withforeigntrade,domesticspendingnolongersolelydeterminesdomesticoutput

spendingondomesticgoodsdeterminesdomesticoutputSpendingbydomesticresidentsis(4)Spendingondomesticgoodsis(5)AssumeDSdependsontheinterestrateandincome:(6)13-15NetExportsNetexports,(X-Q),istheexcessofexportsoverimportsNXdependson:domesticincomeforeignincome,Yf(7)RAriseinforeignincomeimprovesthehomecountry’stradebalanceandraisestheirADArealdepreciationbythehomecountryimprovesthetradebalanceandincreasesADAriseinhomeincomeraisesimportspendingandworsensthetradebalance,decreasingAD13-16GoodsMarketEquilibriumMarginalpropensitytoimport=fractionofanextradollarofincomespentonimportsIScurvewillbesteeperinanopeneconomycomparedtoaclosedeconomyForagivenreductionininterestrates,ittakesasmallerincreaseinoutputandincometorestoreequilibriuminthegoodsmarket13-17GoodsMarketEquilibriumIScurvenowincludesNXasacomponentofAD(8)levelofcompetitiveness(R)affectstheIScurveArealdepreciationincreasesthedemandfordomesticgoodsshiftsIStotherightAnincreaseinYfresultsinanincreaseinforeignspendingondomesticgoodsshiftsIStotheright13-18GoodsMarketEquilibrium

13-19HigherforeignspendingonourgoodsraisesdemandandrequiresanincreaseinoutputatgiveninterestratesRightwardshiftofISFulleffectofanincreaseinforeigndemandisanincreaseininterestratesandanincreaseindomesticoutputandemploymentFigure13-3canalsobeusedtoshowtheimpactofarealdepreciationCapitalMobilityHighdegreeofintegrationamongfinancialmarketsmarketsinwhichbondsandstocksaretradedStartouranalysiswiththeassumptionofperfectcapitalmobilityCapitalisperfectlymobileinternationallywheninvestorscanpurchaseinanycountry,quickly,withlowtransactioncosts,andinunlimitedamountsAssetholderswillingandabletomovelargeamountsoffundsacrossbordersinsearchofthehighestreturnorlowestborrowingcostInterestratesinaparticularcountrycannotgettoofaroutoflinewithoutbringingcapitalinflows/outflowsthatbringitbackinline13-20TheBalanceofPaymentsandCapitalFlowsAssumeahomecountryfacesagivenpriceofimports,exportdemand,andworldinterestrate,if,andcapitalflowsintothehomecountrywhentheinterestrateisaboveworldrateBalanceofpaymentssurplusis:(9),whereCFisthecapitalaccountsurplusThetradebalanceisafunctionofdomesticandforeignincomeAnincreaseindomesticincomeworsensthetradebalanceThecapitalaccountdependsontheinterestdifferentialAnincreaseintheinterestrateabovetheworldlevelpullsincapitalfromabroad,improvingthecapitalaccount13-21Mundell-FlemingModel:PerfectCapitalMobilityUnderFixedExchangeRatesTheMundell-FlemingmodelincorporatesforeignexchangeunderperfectcapitalmobilityintothestandardIS-LMframeworkUnderperfectcapitalmobility,theslightestinterestdifferentialprovokesinfinitecapitalinflows

centralbankcannotconductanindependentmonetarypolicyunderfixedexchangerates

WHY?13-22Mundell-FlemingModel:PerfectCapitalMobilityUnderFixedExchangeRatesAcountrytightensmoneysupplytoincreaseinterestrates:PortfolioholdersworldwideshiftassetsintocountryDuetohugecapitalinflows,balanceofpaymentsshowsalargesurplusTheexchangerateappreciatesandthecentralbankmustintervenetoholdtheexchangeratefixedThecentralbankbuysforeigncurrencyinexchangefordomesticcurrencyInterventioncausesdomesticmoneystocktoincrease,andinterestratesdropInterestratescontinuetodropuntilreturntolevelpriorinitialintervention13-23MonetaryExpansion

13-24ConsideramonetaryexpansionthatstartsfrompointEshiftsLMdownandtotherighttoE’AtE’thereisalargepaymentsdeficit,andpressurefortheexchangeratetodepreciateCentralbankmustintervene,sellingforeignmoney,andreceivingdomesticmoneyinexchangeSupplyofmoneyfalls,pushingupinterestratesasLMmovesbacktooriginalpositionFiscalExpansionMonetarypolicyisinfeasible,butfiscalexpansionunderfixedexchangeratesandperfectcapitalmobilityiseffectiveAfiscalexpansionshiftstheIScurveupandtotherightincreasesinterestratesandoutputThehigherinterestratescreatesacapitalinflowwiththetendencytoappreciatetheexchangerateTomanagetheexchangeratethecentralbankmustexpandthemoneysupplyshiftingtheLMcurvetotherightPushesinterestratesbacktotheirinitiallevel,butoutputincreasesyetagain

13-25PerfectCapitalMobilityandFlexibleExchangeRatesUsetheMundell-FlemingmodeltoexplorehowmonetaryandfiscalpolicyworkinaneconomywithaflexibleexchangerateandperfectcapitalmobilityAssumedomesticpricesarefixedUnderaflexibleexchangeratesystem,thecentralbankdoesnotinterveneinthemarketforforeignexchangeTheexchangeratemustadjusttoclearthemarketsothatthedemandforandsupplyofforeignexchangebalanceWithoutcentralbankintervention,thebalanceofpaymentsmustequalzeroThecentralbankcansetthemoneysupplyatwillsincethereisnoobligationtointervenenoautomaticlinkbetweenBPandmoneysupply

13-26PerfectCapitalMobilityandFlexibleExchangeRates

13-27Perfectcapitalmobilityimpliesthatthebalanceofpaymentsbalanceswheni=if(10)Arealappreciationmeanshomegoodsarerelativelymoreexpensive,andISshiftstotheleftAdepreciationmakeshomegoodsrelativelycheaper,andISshiftstotherightPerfectCapitalMobilityandFlexibleExchangeRates

13-28ThearrowsinFigure13-6makethelinkbetweentheinterestrateandADWheni>if,thecurrencyappreciatesWheni<if,thecurrencydepreciatesAdjustmenttoaRealDisturbance

13-29Usingequations8-10wecanshowhowvariouschangesaffecttheoutputlevel,interestrate,andexchangerateSupposeexportsincrease:Atagivenoutputlevel,interestrate,andexcha