Presentation on theme: "International Finance ECON 243 – Summer I, 2005 Prof. Steve Cunningham"— Presentation transcript:
1International Finance ECON 243 – Summer I, 2005 Prof. Steve Cunningham Lecture 8International FinanceECON 243 – Summer I, 2005Prof. Steve Cunningham
2Capital MobilityPerfect Capital Mobility means that a practically unlimited amount of international capital flows in response to the slightest change in one country’s 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 country’s interest rate must be equal to the world interest rate.
3Capital Mobility and Monetary Policy Under fixed exchange rates and perfect capital mobility, international capital flows dictate the country’s 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.
4Capital 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.
5Trade-off?Improved fiscal policy effectiveness is not a good substitute for monetary policy.Fiscal policy is cumbersome—slow 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.
6Monetary Policy Without FE LM1LM1LM0LM0i1i1i0i0ISISYYY1Y0Y0?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.
7Monetary PolicyUnder fixed exchange rates and perfect capital mobilityIn 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.iFEi0LMISY0Y
8Fiscal Policy without FE LMiiIS1IS0i1LM0i0i0IS1IS0YY0YY0,1Y1Under 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.
9Fiscal 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.iFEi0LMISY0YY1
10Policy EffectivenessUnder perfect capital mobility and fixed exchange rates,Monetary policy is limited to defending the fixed exchange rate, andFiscal policy can be powerful.
11Internal ShocksA domestic monetary shock alters the equilibrium relationship between money supply and demand because:The money supply changes, orPeople 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.
12External ShocksAn 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 warRumors of the imposition of capital controlsGrowing evidence of a likely currency devaluationA form of capital flight
13Adverse Int’l 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.LM1FE1iLM0TFE0EISY1Y0Y
14International Trade Shocks An international trade shock is a shift in a country’s 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.
15Contractionary Policy Policy ResponsesState of the Domestic EconomyHigh UnemploymentRapid InflationSurplusExpansionary Policy??DeficitContractionary PolicyState ofBalance ofPaymentsIn the situations marked by “??”, aggregate demand policy cannot deal effectively with both the internal and external situations simultaneously.
16Policy ResponsesWhen 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…?
17Alternative 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.
18Assignment Rule According to Mundell’s 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.
20Exchange 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 int’l 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.)
21Devaluation (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.
22Consider 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£ price of ExportsQuantityof Exports£ price of ImportsQuantityof ImportsNo change or downNo change or upNo change or downNo change or downEffect =••-
23Problem?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 P£X is lower, but X is unchanged, and P£X • X is lower. The value of exports declines.
24More Likely ResultOn 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.
25J CurveIt 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+Months since devaluation-18 months
26Flexible 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?
28Expansionary 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.
29Expansionary Monetary Policy LM0FE0Following 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.iLM1E0FE1E1T1IS1IS0Y0Y1Y
30Expansionary Fiscal Policy Interest rate risesCapital flows inOur currency may appreciate at first, but probably depreciates eventuallyGDP falls, then rises moreGov’t spending increasesCurrent account balance worsensSpending and output increasePrice level rises