International Finance

1
Lecture 8

• International Finance
• ECON 243 Summer I, 2005
• Prof. Steve Cunningham

2
Capital Mobility

• Perfect Capital Mobility means that a practically
  unlimited amount of international capital flows
  in response to the slightest change in one
  countrys interest rates.
• Absent political and macroeconomic risks, a
  successful fixed exchange rate regime should make
  perfect capital mobility more likely. (Exchange
  rate risk is zero.)
• For a small country, perfect capital mobility
  implies that the countrys interest rate must be
  equal to the world interest rate.

3
Capital Mobility and Monetary Policy

• Under fixed exchange rates and perfect capital
  mobility, international capital flows dictate the
  countrys money supply.
• International conditions dominate domestic
  policy.
• If a country tries to reduce its money supply to
  raise its interest rates for domestic policy
  reasons,
• A slightly higher interest rate attracts a nearly
  unlimited capital inflow.
• The exchange rate must be defended by selling
  domestic currency, thereby expanding the money
  supply.
• It is impossible to sterilize in the face of such
  large capital flows.
• The expanding money supply lowers the domestic
  interest rate.

4
Capital Mobility and Fiscal Policy

• Under fixed exchange rates, perfect capital
  mobility enhances domestic fiscal policy.
• Because interest rates cannot rise, there is no
  possibility for crowding out.
• If the government increases spending without
  raising taxes, it incurs deficits.
• The deficits can easily be financed by in the
  enormous capital inflows.

5
Trade-off?

• Improved fiscal policy effectiveness is not a
  good substitute for monetary policy.
• Fiscal policy is cumbersomeslow to enact, not so
  responsive as monetary policy.
• Fiscal policy is very much influenced by
  short-run political interests.
• Not helpful for handling long-run inflationary
  issues.

6
Monetary Policy Without FE
i
i
LM1
LM1
LM0
LM0
i1
i1
i0
i0
IS
IS
Y
Y
Y0
Y0
Y1
?
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.
Under normal conditions, ignoring international
complications, a reduction in the money supply
raises interest rates, making investment more
expensive, slowing output.
7
Monetary Policy
Under fixed exchange rates and perfect capital
mobility
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 levelthe 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.
i
FE
i0
LM
IS
Y
Y0
8
Fiscal Policy without FE
LM
i
i
IS1
IS0
i1
LM0
i0
IS1
i0
IS0
Y
Y
Y0
Y0,1
Y1
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.
9
Fiscal Policy
Under fixed exchange rates and perfect capital
mobility
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.
i
FE
i0
LM
IS
Y
Y0
Y1
10
Policy Effectiveness

• Under perfect capital mobility and fixed exchange
  rates,
• Monetary policy is limited to defending the fixed
  exchange rate, and
• Fiscal policy can be powerful.

11
Internal Shocks

• A domestic monetary shock alters the equilibrium
  relationship between money supply and demand
  because
• The money supply changes, or
• People alter their personal systems of
  determining how much money to hold (demand)
  perhaps as a result of innovations or changes in
  the payments system.
• A domestic spending shock alters domestic real
  expenditure by a change in one of its components
  (C,I,G). An example is a fiscal policy change.

12
External Shocks

• An international capital-flow shock is an
  unexpected shift of international funds in
  response to political upheaval or fears of a
  international policy change. Examples are
• Fear of war
• Rumors of the imposition of capital controls
• Growing evidence of a likely currency devaluation
• A form of capital flight

13
Adverse Intl Capital-Flow Shock

• FE shifts to higher interest rates.
• Official settlements balance is in deficit at
  point E. Central bank must defend the fixed rate.
• If the central bank does not sterilize its
  intervention, LM shifts upward to left, and
  external balance is restored.
• Internal imbalance is created by falling output
  and rising unemployment.

LM1
FE1
i
LM0
T
FE0
E
IS
Y0
Y1
Y
14
International Trade Shocks

• An international trade shock is a shift in a
  countrys exports or imports arising from causes
  other than changes in the real income of the
  country.
• These are structural changes.
• British beef.
• A country that is found to use DDT in its
  agriculture.
• It alters the current account.

15
Policy Responses
State of the Domestic Economy
State of Balance of Payments
In the situations marked by ??, aggregate
demand policy cannot deal effectively with both
the internal and external situations
simultaneously.
16
Policy Responses

• When confronted with one of the situations marked
  with ??, the government is in a trap. Internal
  imbalance solutions worsen the external balance,
  and vice-versa.
• It has three choices
• It can abandon the goal of external balance,
  which will require eventual abandonment of the
  fixed exchange rate.
• It can abandon the goal of internal balance, at
  least on the short run.
• It can search for other solutions, like?

17
Alternative for the Short Run

• Robert Mundell and J. Marcus Fleming realized
  there might be a possibility of using an
  appropriate policy mix.
• Stimulative monetary policy lowers interest
  rates stimulative fiscal policy raises interest
  rates. ? Maybe a combination, each offsetting the
  worst of the other?
• It is the changes in interest rates that affect
  the payments balance.
• So with a combined policy, one could have fiscal
  policy stimulus and lower interest rates!
• More generally, monetary and fiscal policies can
  be mixed so as to achieve any combination of
  internal and external goals in the short run.

18
Assignment Rule

• According to Mundells assignment rule
• Assign fiscal policy the task of stabilizing the
  domestic economy (only),
• Assign to monetary policy the task for
  stabilizing the balance of payments (only)
• Each arm of policy concentrates on a single task,
  making coordination of policy trivial.
• Also each arm of policy is addressing the issues
  it cares most about.
• Timing, though, remains critical. Lags from
  either side could result in unstable oscillations.

19
Monetary-Fiscal Recipes
State of the Domestic Economy
State of Balance of Payments
20
Exchange Rates and the Trade Balance

• What is the effect of a change in the nominal
  exchange rate on the volumes of exports and
  imports?
• As long as the change in the exchange rate alters
  the intl price competitiveness, it should change
  the volume of trade.
• What is the effect on the value of trade?
• This is more difficult. (Remember both prices and
  volumes are changing.)

21
Devaluation (Surrender)

• The devaluation should improve international
  price competitiveness as long as any changes in
  the domestic price level or foreign price level
  do not offset the exchange rate change.
• Exports increase as goods become cheaper to
  foreign buyers.
• Imports decrease as foreign goods become more
  expensive to domestic buyers.
• OVERALL, the current account tends to improve.
  The result on the capital account is less clear.

22
Consider a devaluation
Consider a devaluation of the dollar, where the
CA balance is measure in pounds per year CA
balance PX X -
Pm M
Quantity of Imports
Quantity of Exports
price of Exports
price of Imports
? No change or down
? No change or down
? No change or up
? No change or down
Effect


-
23
Problem?

• In the case of perfectly inelastic demand for
  exports and imports, devaluing the dollar could
  result in a worsened trade balance.
• The foreign price of exports fall, but quantities
  demanded are NOT responsive to price, so the
  volume stays the same.
• Thus PX is lower, but X is unchanged, and PX
  X is lower. The value of exports declines.

24
More Likely Result

• On the short run, prices will be able to adjust
  more quickly than quantities. (Export demand is
  more inelastic in the short run.)
• So immediately following a devaluation or
  depreciation, the value of exports will fall,
  worsening the trade balance.
• Over the longer term, prices can adjust. (Export
  demand is more elastic in the long run.) So
  longer term, the trade balance would improve.
• In fact, the longer the elapsed time since the
  devaluation or depreciation, the more likely the
  trade balance is to be improved.

25
J Curve

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

Net change in trade balance

0
Months since devaluation
-
18 months
26
Flexible Exchange Rates

• Under a clean float, external balance is
  maintained by the changing exchange rates.
• Policy focuses on internal balance.
• Remaining questions
• What are the effects of shocks?
• How does the exchange rate change resolve
  external imbalances?
• How do fluctuations in the exchange rate affect
  the macroeconomy?

27
Expansionary Monetary Policy
Capital flows out
Current account balance improves
Money supply increases
Interest rate drops
Our currency depreciates
GDP rises more
Current account balance worsens
Spending and output increase
Price level rises
28
Expansionary Monetary Policy (2)

• Under floating exchange rates, monetary policy is
  powerful in its effects on internal balance.
• The induced change in the exchange rate
  reinforces the domestic effects of monetary
  policy.
• Monetary policy is a more powerful tool for
  managing the domestic economy under flexible
  exchange rates.

29
Expansionary Monetary Policy
LM0
FE0
Following expansionary monetary policy, the
currency depreciates to correct the deficit
payments balanceFE moves to the right. IS moves
to the right as the current account improves.
i
LM1
E0
FE1
E1
T1
IS1
IS0
Y
Y0
Y1
30
Expansionary Fiscal Policy
Interest rate rises
Capital flows in
Our currency may appreciate at first, but
probably depreciates eventually
GDP falls, then rises more
Govt spending increases
Current account balance worsens
Spending and output increase
Price level rises