1. BGP-620 -- International Macroeconomics
Staff -- Professor: Jeffrey Frankel , Littauer 217
Office hours: Mon.& Tues., 3:00-4:00. Faculty Asst.: Minoo Ghoreishi, Belfer 505 (617)
Teaching Fellow: Tilahun Emiru      Course Assistant: Madi Sarsenbayev
Times – Lectures: Tues. & Thurs., 1:15-2:30 p.m., L 280
Review session: Fridays, 1:15-2:30, L382
Final exam: Wed., May 3, 2017, 3:00-6:00 p.m.
Requirements -- Textbook: World Trade & Payments + Readings.
7 Problem Sets (20%) + Midterm (30%) + Final exam (50%).

2. Big topics covered in the course
I) ELASTICITIES & THE TRADE BALANCE
II) THE KEYNESIAN MODEL OF INCOME
MONEY AND THE BALANCE OF PAYMENTS
IV) GLOBALIZATION OF FINANCIAL MARKETS
V) FISCAL & MONETARY POLICY UNDER INTERNATIONAL CAPITAL MOBILITY
VI) INTERDEPENDENCE AND COORDINATION
VII) SUPPLY, INFLATION & MONETARY UNION
VIII) EXPECTATIONS & DETERMINATION OF THE EXCHANGE RATE
Professor Jeffrey Frankel, Kennedy School, Harvard University

3. TOPIC I: ELASTICITIES & THE TRADE BALANCE
Lecture 1: Balance of Payments Accounting
Lecture 2: Supply & demand for foreign exchange; export and import elasticities
Lecture 3: Empirical effects of devaluation on the trade balance

4. Lecture 1: Balance of payments accounting
Definition: The balance of payments is the year’s record of economic transactions between domestic and foreign residents.
The rules:
If you have to pay a foreign resident, normally in exchange for something that you bring into the country, then the something counts as a debit.
If a foreign resident has to pay you for something, then the something counts as a credit.
Professor Jeffrey Frankel, Kennedy School, Harvard University

5. “Primary income,” mainly investment income
≡ “secondary income”
NOW CALLED “FINANCIAL ACCOUNT”

6. Examples of a debit on the current account:
You, an American, buy DVDs from India => import appears as debit on US merchandise account.
You import services (electronically) of an Indian software firm => debit appears on US services account (“overseas outsourcing”).
You buy the services, instead, from a subsidiary that the Indian software firm set up last year in the US. This is not an international transaction, and so does not appear in the accounts.
But assume the subsidiary then sends profits back to India => US reports payments of investment income. It is as if the US is paying for the services of Indian capital.
Employees of the subsidiary in the US (or any other US resident entities) send money to relatives back in India => US reports paying unilateral transfers .
API Prof.J.Frankel, Harvard University

7. API-120 - Prof.J.Frankel, Harvard University
Examples of debits on the financial account (previously “capital account”), long-term
Instead of buying DVDs from India, you buy the company in India that makes them. => acquisition of assets (debit) under Foreign Direct Investment (FDI).
Instead of buying the entire company in India, you buy some stock in it => acquisition of portfolio investments (equities).
Instead of buying stock in the company, you lend it money for 2 years => acquisition of portfolio investments (bonds or bank loans).
API Prof.J.Frankel, Harvard University

8. Examples of debits on the financial account, short term:
You lend to the Indian company in the form of 30-day commercial paper or trade credit => acquisition of short term assets (Debit: You have “imported” a claim against India.)
You lend to the Indian company in the form of cash dollars, which it doesn’t have to pay back for 30 days => acquisition of short term assets .
You are the Central Bank, and you buy securities of the Indian company (an improbable example for the Fed – but some central banks now diversify international investments) => increase in US official reserve assets.
API Prof.J.Frankel, Harvard University

9. API-120 - Prof.J.Frankel, Harvard University
The rules, continued
Each transaction is recorded twice:
an import of a good or security has to be paid for.
E.g., when an importer pays cash dollars, the import on the merchandise account is offset under short-term capital: the exporter in the other country has, at least for the moment, increased holdings of US assets, which counts just like any other portfolio investment in US assets.
At the end of each quarter, credits & debits are added up within each line-item;
and line-items are cumulated from the top to compute measures of external balance.
API Prof.J.Frankel, Harvard University

10. Professor Jeffrey Frankel, Kennedy School, Harvard University
Measures of US external balance,
PER QUARTER
PER QUARTER
US surplus in investment income is
roughly offset by outward transfers.
Current
Account
Goods & Services
Balance
US trade deficit in goods is partially offset by a surplus in services.
Professor Jeffrey Frankel, Kennedy School, Harvard University

11. Some balance of payments identities
CA ≡ Rate of increase in net international investment position.
CA-surplus country (e.g., Germany) accumulates claims against foreigners;
CA-deficit country (e.g., US) borrows from foreigners.
CA + KA + ORT ≡ 0 .
BoP ≡ CA + KA .
=> BoP ≡ -ORT ≡ excess supply of FX coming from private sector, (i.e., all credits from exports of goods, services, assets… minus all debits) which central bank absorbs into reserves, if it intervenes in FX market.
A BoP surplus country adds to its FX reserves
A BoP deficit country
either runs down its FX reserves
or, is lucky enough for foreign central banks to finance the deficit, if its currency is an international reserve asset (US $) .
A floating country does not intervene in the FX market
=> BP ≡ 0;
Exchange rate E adjusts to clear FX supply & demand in private market

12. Professor Jeffrey Frankel, Kennedy School, Harvard University
End of
Lecture 1:
Balance
of Payments
Accounting
Professor Jeffrey Frankel, Kennedy School, Harvard University

13. Lecture 2: The Elasticities Approach to the Trade Balance
Question: Under what circumstances does devaluation improve the trade balance (TB), and how much?
Model: Elasticities Approach
Key equation: Marshall-Lerner Condition
Professor Jeffrey Frankel, Kennedy School, Harvard University

14. Supply & demand for foreign exchange
D S
E ≡ price of foreign exchange
in $/₤
FX supply arises from exports,
capital inflows…
FX demand arises from imports,
capital outflows…
Quantity of foreign exchange, ₤
Professor Jeffrey Frankel, Kennedy School, Harvard University

15. Professor Jeffrey Frankel, Kennedy School, Harvard University
Assume demand for forex shifts out, from D to D’ e.g., to due to increase in demand to buy foreign goods or assets
Deficit (excess demand for foreign currency)
Depreciation (increase in price
of foreign currency)
Professor Jeffrey Frankel, Kennedy School, Harvard University

16. Professor Jeffrey Frankel, Kennedy School, Harvard University
The Elasticities Approach to the Trade Balance
derives the supply of foreign exchange
from export earnings, and
derives the demand for foreign exchange
from import spending.
Capital flows are not considered (until later), so no supply of, or demand for, FX comes from international borrowing or lending.
Professor Jeffrey Frankel, Kennedy School, Harvard University

17. How the Exchange Rate, E, Influences BoP
ASSUMPTIONS :
Supply of FX determined by EXPORT earnings
Demand for FX determined by IMPORT spending
No capital flows or transfers => BoP = TB
2) PCP: Price in terms of producer’s currency; Supply elasticity = ∞ .
=> Domestic firms set 𝑃 .
& Foreign firms set 𝑃 ∗ .
3) Complete exchange rate passthrough:
Price of X in foreign currency = 𝑃 / E
Price of Imports in domestic currency = E 𝑃 ∗ .
4) Demand is a decreasing function of price in consumer’s currency
=> X = XD ( 𝑃 / E ) .
=> M = MD (E 𝑃 ∗ ).
=> Net supply of FX = TB expressed in foreign currency ≡ TB*
= ( 𝑃 /E) XD( 𝑃 /E) ( 𝑃 ∗ ) MD(E 𝑃 ∗ ) .

18. How the TB is affected by the exchange rate (continued)
TRADE BALANCE EXPRESSED IN FOREIGN CURRENCY
TB* = ( 𝑃 /E) XD( 𝑃 /E) ( 𝑃 ∗ ) IMD(E 𝑃 ∗ ) .
EXPERIMENT : E↑
THREE EFFECTS (1) IMD( ) falls.
EFFECT ON TB* + -
(2) XD( ) rises.
(3) Value of X in terms of foreign currency falls.
Net effect on TB* is determined by Marshall-Lerner condition.
Add one more assumption: Before the devaluation, TB*=0,
so export earnings cancel out import spending,
Then devaluation improves the TB iff: εX + εM > 1 .

19. Example (i) to illustrate Marshall-Lerner condition
for TB* = ( 𝑃 /E) XD( 𝑃 /E) - ( 𝑃 ∗ ) IMD(E 𝑃 ∗ )
If εx =1, then E ↑ leaves export revenue unchanged.
Because effects (2) and (3) cancel out.
In that case, so long as εM > 0,
Marshall-Lerner condition is satisfied:
Import spending falls -- effect (1) --
=> TB* improves.
Professor Jeffrey Frankel, Kennedy School, Harvard University

20. Example (ii) to illustrate Marshall-Lerner condition
for TB* = ( 𝑃 /E) XD( 𝑃 /E) - ( 𝑃 ∗ ) IMD(E 𝑃 ∗ ) .
If εx = 0, then E ↑ cuts export revenue in proportion
because of valuation effect (3).
In that case, εM > 1 is necessary to improve TB*
because of Marshall-Lerner condition.
Intuitively fall in import spending outweighs fall in export revenue: effect (1) > effect (3) --
provided initial X revenue > import spending.
But if initial TB*<0, elasticities need not be as high.

21. How the TB is affected by the exchange rate (continued)
TRADE BALANCE EXPRESSED IN DOMESTIC CURRENCY
TB = ( 𝑃 ) XD( 𝑃 /E) (E 𝑃 ∗ ) IMD(E 𝑃 ∗ ) .
EXPERIMENT : E↑
THREE EFFECTS (2) IMD( ) falls.
EFFECT ON TB + -
(1) XD( ) rises.
(3) Value of IMports in terms of domestic currency rises.
Net effect on TB is determined by the same Marshall-Lerner condition.
Again, assume that initially TB=0.
Then devaluation improves the TB iff: εX + εM > 1 .

22. Example (iii) to illustrate Marshall-Lerner condition
for TB = ( 𝑃 ) XD( 𝑃 /E) - (E 𝑃 ∗ ) IMD(E 𝑃 ∗ )
If εM =1, then E ↑ leaves import spending unchanged.
Because effects (2) and (3) cancel out.
In that case, so long as εX > 0,
Marshall-Lerner condition is satisfied:
Export revenue rises falls -- effect (1) --
=> TB improves.
Professor Jeffrey Frankel, Kennedy School, Harvard University

23. Professor Jeffrey Frankel, Kennedy School, Harvard University
End of
Lecture 2:
Elasticities Approach to the Trade Balance
Professor Jeffrey Frankel, Kennedy School, Harvard University

24. Lecture 3: Empirical effects of the exchange rate on the trade balance
Elasticity Pessimism: Countries often fear their elasticities are too low for M-L condition.
An example when it worked: Poland after 2008.
Econometric estimation of elasticities • What is OLS regression? • Typical estimates
The J-curve • With fast pass-through to import prices • With slow pass-through to import prices.
Income as another determinant of the trade balance.

25. Poland’s exchange rate rose 35% in the 2008-09 global crisis.
Depreciation boosted net exports => Poland avoided recession
Exchange rate
Zloty / €
Source: Cezary Wójcik

26. Poland’s trade balance improved sharply in 2009 while its European trading partners all went into recession.
Trade balance in billions of euros
Source: National Bank of Poland From FocusEconomics 2014
Contribution of Net X in 2009: % of GDP > Total GDP growth: 1.7%

27. Professor Jeffrey Frankel, Kennedy School, Harvard University
How can we estimate sensitivity of export demand to exchange rate? OLS regression
X ≡ Exports demanded
EP*/P ≡ Price of foreign goods relative to domestic goods
Professor Jeffrey Frankel, Kennedy School, Harvard University

28. Common econometric finding
Estimated trade elasticities with respect to relative prices often ≈ 1, after a few years have been allowed to pass.
=> Marshall-Lerner condition holds in the medium run.
Some face a higher elasticity of demand for their exports:
small countries, and
producers of agricultural & mineral commodities or other commodities that are close substitutes for competitors’ exports.

29. Common empirical observation:
After a devaluation,
trade balance gets worse before it gets better.
Explanation:
Even if devaluation is instantly passed through to higher import prices,
buyers react with a lag.
Also, in practice,
it often takes time before the devaluation is passed through to import prices.

30. Another historical example: Mexican & Korean trade balances improved after 1994 & 1997 devaluations, respectively

31. ITF220 - Prof. J. Frankel, Harvard University
But in crises like Mexico 1994 or Korea 1997, much of the “improvement” in the trade balance is due to a fall in income Y, which reduces imports.
Imports & exports depend on both income and prices:
X = XD [( 𝑃 /E 𝑃 ∗ ), Y*]
M = MD [(E 𝑃 ∗ / 𝑃 ) , Y]
or, more simply:  X = XD (E, Y*) M = MD (E, Y).
ITF220 - Prof. J. Frankel, Harvard University

32. elasticities are mostly
Econometric estimates of elasticities.
Estimated price
elasticities (LR)
satisfy the
Marshall-Lerner
Condition.
Estimated income
elasticities are mostly
between

33. Professor Jeffrey Frankel, Kennedy School, Harvard University
End of
Lecture 3:
Empirical Effects of Devaluation on the Trade Balance
Professor Jeffrey Frankel, Kennedy School, Harvard University