international finance econ 356 karine gente [email protected]
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• Web page: http://www.econ.ubc.ca/directory/sess/sfackg.htm
Office room: Buch tower 1099 D
• Teaching Assistant: Kang ShiEmail: [email protected] room: Buch tower 1099COffice hrs: Friday 2:00-3:00
Introduction
Macroeconomic Equilibrium and Open Economy
Open economies
• The development of international trade (volume)
• Trade barriers and restrictions on capital flows tend to disappear (GATT + WTO rounds)
• A disequilibrium between imports and exports
Exports and Imports as a % of GDP (1960-2000)
10
15
20
25
30
1960 1965 1970 1975 1980 1985 1990 1995 2000
579
111315
France Japan
Canada
468
101214
United States
15
20
25
30
35
40
45
1965 1970 1975 1980 1985 1990 1995
International trade
Table 1.5 Top 15 international trade ($bn.), 1999
country exports % of world country imports % of world
1 USA 956 13.7 USA 1,116 15.9
2 Germany 626 8.9 Germany 593 8.5
3 Japan 465 6.6 UK 396 5.7
4 France 382 5.5 Japan 380 5.4
5 UK 374 5.3 France 338 4.8
6 Italy 292 4.2 Italy 275 3.9
7 Canada 278 4.0 Canada 259 3.7
8 Netherlands 249 3.6 Netherlands 220 3.1
9 China 219 3.1 Hong Kong 203 2.9
10 Hong Kong 212 3.0 China 190 2.7
Percentageof GDP
40
35
30
25
20
15
10
5
0Canada France Germany Italy Japan U.K. U.S.Imports Exports
Imports and Exports as a percentage of output: 2000
International trade (1999)
0
200
400
600
800
1000
1200
0 200 400 600 800 1000 1200
export value
impo
rt v
alue
Netherlands
Japan
Germany
USAExports
relative to
imports
• International trade becomes more intensive.
• The openess degree measured by (EX+IM)/GDP is about 73% for Canada against 23% for Japan.
• Exports need not be equal to imports-> Capital flows-> The higher IM-EX, the more the country
dependent on the rest of the world.
Domestic Country
Rest of the World
Money (I)
Imports
Domestic Country
Rest of the World
Exports
Money (II)
• Imports>Exports I>II Domestic Country goes into debt vis-à-vis the Rest of the World
• Imports<Exports I<II Domestic Country goes into excedent vis-à-vis the Rest of the World
Canada
Current account balance (% of GDP)
-6
-5
-4
-3
-2
-1
0
1
2
3
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
Measures of Financial Integration
Industrial Countries
0.0
0.2
0.4
0.6
0.8
1.0
1970 1974 1978 1982 1986 1990 1994 1998
0.0
0.3
0.6
0.9
1.2
1.5
Restriction Measure (left scale) Openness Measure (right scale)
Source: WEO, Lane and Milesi-Ferreti (2003)
Measures of Financial Integration
Source: WEO, Lane and Milesi-Ferreti (2003)
0.00
0.10
0.20
0.30
0.40
0.50Developing Countries
0.0
0.2
0.4
0.6
0.8
1.0
1970 1974 1978 1982 1986 1990 1994 1998
Restriction Measure (left scale) Openness Measure (right scale)
• We can distinct capital flows as– Bank lending (Indirect Finance)– Portfolio flows (Direct Finance)– Foreign Direct Investment: Investment of a foreign
firm in a country. FDI is driven by the desire of entreprises to exploit their intangible property in markets outside their home country.
• Portfolio flows vary sharply instead of FDI are quite insensitive to short-run swings in macroeconomic conditions
Direct vs. Indirect Finance
Net Private Capital Flows(Billions of USD)
Source: WEO
100
120
140
160
180
All Developing Economies
-20
0
20
40
60
80
1970 1975 1980 1985 1990 1995
Year
Bank Lending
Portfolio Flows
FDI
Net Private Capital Flows(Billions of USD)
Source: WEO
More Financially Integrated Economies
-20
0
20
40
60
80
100
120
140
160
180
1970 1975 1980 1985 1990 1995
Year
Bank Lending
Portfolio Flows
FDI
Less Financially Integrated Economies
-2
-1
0
1
2
3
4
5
6
7
8
9
1970 1975 1980 1985 1990 1995
Year
Bank Lending
Portfolio Flows
FDI
• All this evidence suggests that international economic integration has hugely increased.
• What are the consequences?– Growth and development– Efficiency of government policies– Contagion and crisis
International Economic Integration (IEI)
IEI refers to the extent and strength of real- sector and financial-sector linkages among national economies. Real-sector linkages occur through the international transactions in goods and services while the financial-sector linkages occur through international transactions in financial assets.
Channels Through Which IEI Can Raise Economic Growth
Higher Economic Growth
International Economic Integration
Direct Channels Augmentation of available savings Transfer of technology (FDI) Development of financial sector
Indirect Channels Promotion of specialization Inducement for better policies Enhancement of capital inflows by signaling better policies
International economic integration could help growth and development
International Economic Integration and ContagionInternational economic integration
Real sector linkages through exchange of goods
Financial-sector linkages through international
transactions in financial assets.
Contagion (crisis, fiscal policy…)
Example
• Imagine two countries: A and B
Expansionary Fiscal Policy in Country A
↑ Demand (country A)- Domestic goods
- Imports
Country B’s Exports ↑ Country B’s Income ↑
Example
• Imagine A and B are developing countries with common features (GDP per capita, inflation, …).
• You have in your bonds portfolio some bonds of Country A government’s debt and some of Country B government’s debt.
• Country A’s government says that the government debt cannot be reimbursed, what do you do?
Questions of International Finance
• Why international trade and international capital flows?
• What are the consequences of international economic integration on production (flows of inputs)? Consumption (flows of goods)?
• How international economic integration changes the way monetary and fiscal policies affect economies?
• How do crisis appear and spread?
Reminder about Macroeconomic Equilibrium in an Open Economy
Readings:
Macroeconomics, N. Gregory Mankiw (Harvard U.), chapter 5.
In an open economy,
• Spending need not equal output:
Y≠C+I+G
• Saving need not equal investment
S≠I
• The financial sector channels funds from net lender-savers to net borrower-investors
• Because financial sector can redirect surplus funds, leakages and injections of each sector need not balance– I ≠ S– G ≠ T– Im ≠ Ex
Preliminaries
EX = exports = foreign spending on domestic goods
IM = imports = C f + I
f + G f
= spending on foreign goods
d fC C C d fI I I d fG G G
superscripts:d =spending on
domestic goods
f = spending on foreign goods
Preliminaries, cont.
NX = net exports ( the “trade balance”) = EX – IM
• If NX > 0, country has a trade surplus equal to NX
• If NX < 0,country has a trade deficit equal to – NX
GDP = expenditure on domestically produced g & s
d d dY C I G EX
( ) ( ) ( )ff fC C I I G G EX
( )ff fC I G EX C I G
C I G EX IM
C I G NX
The national income identity in an open economy
YY = = CC + + II + + GG + + NXNX
or, NX = Y – (C + I + G )
net exports
domestic spending
output
International capital flows
• Net capital outflows= S – I
= net outflow of “loanable funds”= net purchases of foreign assets
the country’s purchases of foreign assets minus foreign purchases of domestic assets
• When S > I, country is a net lender
• When S < I, country is a net borrower
Another important identity
NXNX = = YY – – ((CC + + II + + GG ))
impliesimplies
NXNX = ( = (YY – – CC – – GG ) – ) – II
= = SS – – II
trade balancetrade balance = = net capital outflowsnet capital outflows
NXNX = = YY – – ((CC + + II + + GG ))
impliesimplies
NXNX = ( = (YY – – CC – – GG ) – ) – II
= = SS – – II
trade balancetrade balance = = net capital outflowsnet capital outflows
Long-run Equilibrium
• An open economy model :– Two countries
– Small open economy
Country ASA,IA
Country BSB,IB
IA+IB=SA+SB
Domestic Country
Rest of the Worldr*
Saving and Investment in a Small Open Economy
production function: ( , )Y Y F K L
consumption function: ( )C C Y T
investment function: ( )I I r
exogenous policy variables: ,G G T T
National Saving: The Supply of Loanable Funds
r
S, I
To simplify,national saving
does not depend on the interest
rate
( )S Y C Y T G
S
Assumptions re: capital flowsa. domestic & foreign bonds are perfect
substitutes (same risk, maturity, etc.)
b. perfect capital mobility:no restrictions on international trade in assets
c. economy is small:cannot affect the world interest rate, denoted r*
aa & & bb imply imply rr = = r*r*
cc implies implies r*r* is exogenousis exogenous
aa & & bb imply imply rr = = r*r*
cc implies implies r*r* is exogenousis exogenous
Investment: The Demand for Loanable Funds
Investment is still a downward-sloping function of the interest rate,
r *
but the exogenous world interest rate…
…determines the country’s level of investment.
I (r* )
r
S, I
I (r )
If the economy were closed…r
S, I
I (r )
S
rc
( )cI r
S
…the interest rate would adjust to equate investment and saving:
But in a small open economy…r
S, I
I (r )
S
rc
r*
I 1
the exogenous world interest rate determines investment……and the difference between saving and investment determines net capital outflows and net exports
NX
Three experiments
1. Fiscal policy at home
2. Fiscal policy abroad
3. An increase in investment demand
1. Fiscal policy at homer
S, I
I (r )
1S
I 1
An increase in G or decrease in T reduces saving. 1
*r
NX1
2S
NX2
Results:
0I
0NX S
2. Fiscal policy abroadr
S, I
I (r )
1SExpansionary fiscal policy abroad raises the world interest rate.
1*r
NX1
NX2
Results: 0I
0NX I
2*r
1( )*I r2( )*I r
3. An increase in investment demandr
S, I
I (r )1
EXERCISE:Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow.
NX1
*r
I 1
S
3. An increase in investment demandr
S, I
I (r )1
ANSWERS:I > 0,S = 0,net capital outflows and net exports fall by the amount I
NX2
NX1
*r
I 1 I 2
S
I (r )2
References
• The Economics of Money, Banking and Financial Markets, 6th edition, Mishkin.
• International Economics: Theory and Policy, Paul Krugman and Maurice Obstfeld .
Course Overview
I. International capital mobility
a. Why international capital flows?
b. The reasons of exchange: some aspects of international trade and intertemporal choice
c. Recent evolutions of financial integration
d. The Balance of Payments
Course Overview
II. The Exchange rate: a key variable
a. Some definitions of exchange rate
b. Exchange rates in the long-run: The Purchasing Power Parity (PPP) theory
c. Different exchange rate regimes
Course Overview
III. Consequences of financial integration on short-run macroeconomic equilibrium: the Mundell-Fleming approach
a. The short-run equilibrium
b. Monetary and Fiscal Policies in case of flexible exchange rate
c. Monetary and Fiscal Policies in case of fixed exchange rate
IV. Currency crises