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International Finance

Real World Economic Activity

Data Collection

Economic Theory Models

EconomicAnalysis


The Quantity Theory

PQ=MVEquation 1

V

1=k whereQ, k=

P

MEquation 2

Q

V= with M,=P

MQ

V=P

Equation 3


Quantity Theory of Price Adjustment

M

P

Q

t*

time

M0

2 M0

P0

2P0

Q0Q0

Q0

time

time


Extreme Macro Instability

Bolivian Inflation and Monetary Growth

0

5000

10000

15000

20000

25000

82 84 86 88 90 92

Year

Percentage Rate of Change

Inflation

Monetary Growth


The Purchasing Power Parity

Equation 4

Equation 5

P E=P fd

M

M=M

M=P

P=Ef

d

ff

dd

f

d


Purchasing Power Parity and Overshooting

M

P,E

M0

2M0

P0,E0

E

P

2P0, 2E0

time

time


Unpleasant Monetarist Arithmetic

Equation 6

P

B+

P

M=

P

T

P

iB+

P

G


Unpleasant Monetarist Arithmetic:Sargent and Wallace: P* vs P**

time

Money,Bonds

Bonds

t*

time

time

P*P**

Money

Deficit

PriceLevel


The Absorption Model of the Balance of Trade

Equation 7 IMEX+TG+I+C=Y

I+C=A whereG),(T+A)(Y=G)(T+I)+(CY=IMEX

Equation 8


United States Current Account and Fiscal Balance, 1968-1992

-400-350-300-250-200-150-100

-500

50

68 70 80 90

Year

Trade Balance

Fiscal Balance


Further Implications

Equation 9BOT = EX - e . p* IM

Current Act = BOT + e . i* Kf,d - i Kd,f

Equation 10

dffd KeKCapAccount ,, Equation 11

NFA = e. Kf,d-Kd,f

Equation 12


Balance of Payments

BOP = Current Account + Capital Account

Under fixed exchange rates only:Change in Foreign Exchange Reserves = BOP


Fiscal and External Balances, USA

-400

-300

-200

-100

0

100

200

1961

1965

1969

1973

1977

1981

1985

1989

Year

Billions of US Dollars

Fiscal Balance

Balance ofPayments

Trade Balance

Net Foreign AssetPos


Organization and Characteristics of FOREX Markets

• Spot and forward markets

• Many buyers and sellers, so no buyer or seller dominates

• Transactions are quick, buy/sell decisions have to be made very quickly

• Low transactions costs

• Open virtually 24/7.


Reasons to Use FOREX Markets

• Export and Import Transactions

• Triangular arbitrage in the Spot Market

• Hedging on foreign investment

• Forward speculation

• Interest arbitrage

• Engage in a speculative attack on a foreign currency (aka “hedge fund” management)


Demand and Supply ofForeign Exchange

R($,DM)

DM

US Demand for DM

German Supply of DM

R*


Responses to Overvaluation:Devaluation and Fiscal

ContractionR($,DM)

DM

US Demand for DM

German Supply of DM

R* New US Demand

Trade Deficit

R**


Conditions for a Devaluation to “Work” , or not!

• Marshall-Lerner conditions must hold: elasticity of foreign demand for export good and elasticity of domestic demand for import good must sum to value greater than unity.

• Example: imports are oil, exports are wheat. Devaluation may actually make BOT worse! People will still buy oil and just need so much wheat. Elasticity pessimism.


Further conditions why devalution may not work

• Issue of contractionary devaluation: imports may be inputs in production so devaluation may cause a fall in investment, employment, output

• Harberger-Laursen-Metzler effect: devaluation worsens income, so net saving falls quickly, so there is a savings-investment imbalance, and the trade balance falls.


Multiple Equilibria in ForEx Market

Supply

Demand

A

B

C

DM

R


J-Curve Dynamics

time

Trade Balance

0

Devaluation


Triangular Arbitrage

Equation 13

Equation 14

Equation 15

R(£,$) = 1/R($,£)

R(£,DM) = R(£,$) R($,DM)

R(£,DM) = R($,DM) = .5 & R($,£) = 2 .25.


Covered Interest Parity

K dollars K(1+r)

K/R sterling (K/R)(1+r*)

(K/R)(1+r*) FR

buyspot

sellforward

US investment

UK investment


Covered Interest Rate Parity

Equation 16

Equation 17

Equation 18

K(1+r) = (K/R)(1+r*) FR

R (1+r)/(1+r*) = FR

R (1+r)/(1+r*)- [(1+r*)/(1+r*)] R = FR – R

Equation 19 (r-r*)/(1+r*) = (FR-R)/R

Equation 20 (r-r*) = (FR-R)/R

(r-r*) = [E(Rt+1)-R]/REquation 21


Measuring Capital Mobility

Equation 22

Equation 23

Equation 24

Equation 25

(r-r*) = [Rt+1-R]/R

r - = r* - *

r - r* = - *

(S - I) + (T - G) = (X - M)


Real Exchange Rate

Non-tradeables

Tradeables

Real Exchange Rate

T*

NT*


The Real Exchange Rate

Equation 26

Equation 27

Equation 28

P

*P R

P

P=REXRcpilesnontradeab

tradeables

P

R REXR

cpi

P

P REXRcpi

wpi


U.S. Real Exchange Rate Swings, 79-81

Indices Based on Unit Labor Costs and CPI

00.20.40.60.8

11.21.41.61.8

79 80 81 82 83 84 85 86 87 88 89 90 91

Year

IndexReal Ex. Index-1

Real Ex. Index - 2


Classification of Policy Regimes

MonetaryPolicy

FiscalPolicy

Exchange Rate Regime

Fixed FlexibleInstrument

WEAK

STRONG

STRONG

WEAK


The Mundell-Fleming Model of Fixed Exchange Rates

Equation 29

IS Block: I(r) = S(y), I'<0, S'>0

LM Curve: M/P = L(y,r), Ly>0, Lr<0

FF Curve: BOP = EX - IM(y) + NKI(r), IM'>0, NKI'>0


Mundell - Fleming ModelGeneral Equilibrium

r

Y

E

ISLM

FF


Endogeneity of the Money Supply

Equation 30 M = Res = BOP(Y,r), BOPY < 0, BOPr > 0


Mundell - Fleming ModelEffects of Monetary Expansion

r

Y

E

LM

LM’

FF

IS

E’


Mundell - Fleming ModelEffects of Fiscal Expansion

r

Y

E

LM

LM’

FF

IS

IS’E’


Mundell - Fleming ModelEffects of Devaluation

r

Y

E

LM

LM’

FF

IS

FF’


Swan Diagram: Internal/External Balance

EE

II

r

G-T

A:external deficit, internal inflation.

B:external surplus, internal inflation


The Dornbusch Model of Flexible Exchange Rates

Equation 31

DD (Demand) Block: y = -y *+ d(e-p), d > 0

LM (Liquidity-money) Block: m/p = l(y,r), ly>0, lr<0

AA (Asset Arbitrage) Block: e = r - r*


Dornbusch Model: Basic Setup

DD

AA

p

e

A


Dornbusch Model: Monetary Expansion with Overshooting

DD

AA

p

e

AA’

A

B

C


Wicksell's Problem

Sweden

Denmark

Norway

wheat

fish

timber

ultimate flows

intermediate flows


Bilateral Exchange Arrangements-Unbalanced Flows

A B

C D


D’s Money as Medium of Exchange, Barter between A and B

A B

C D


A’s and B’s Money as Media of Exchange

A B

C D


Borrowing and Lending Strategies

r1

r2

r i

i1

i2

Borrowing Lending

Positive maturity transformation

Period 1

Period 2


The Phillips Fixed-Coefficient Model of the Banking System

Equation 32

C + R = MB

D k = C

D r = R

k+r

1=

MB

D

D k + D r = MB

Equation 33


Internal Structure of Eurodollar Market

Europe

USA

London

Lenders Borrowers


Eurodollar Market and OPEC Recycling

OPECDeposits

LDCBorrowers

Europe

USA

London

Lenders Borrowers


Manufacturing, Resources, and Service Sector Economy

O O'MR

D-mD-rD-s

Manufacturingemployment

ResourceemploymentServices

w w


Manufacturing, Resources, and Service Sector Economy-Direct Deindustrialization Due to Boom in Resource Sector:

M-M': Direct De-industrialization Effect

O O'MR

D-mD-rD-s

M'

w

W’


Manufacturing, Resources, and Service Sector Economy-Indirect Deindustrialization Due to Boom in Ensuring Service-Sector Boom:

M'-M'': Indirect De-industrialization Effect

O O'MR

D-mD-rD-s

w

w'

M'

w''

M''


Key Macroeconomic Variables of the World Economy

Before and During Debt Crisis

-15-10

-505

101520

70-79 80-82 83-84

Years

LIBOR Rate

Inflation- Ind. Goods

Inflation- Commodity

OECD Growth


Latin American Per-Capita Output Growth

-3-2-10

1234

62-80 80-84 84

Inflation

0

50

100

150

200

62-80 80-84 84

Gross Investment -GDP Ratio

0

5

10

15

20

25

62-80 80-84 84


Structure of Latin American Debt in 1983

0

20

40

60

80

100

Billions of US Dollars

Total Debt

Bank Debt

US Bank Debt


A

B

C

Nominal Value of Debt

Secondary Market Value


Seignorage and Dollarization: Multiple Equilibria

Equation 34

Equation 35

M

M= with

P

M=tg

P

M

M

M=

P

M=tg

(A)a

(P)p

(M)m

,a=pm

eA=P

M

log

log

log


Inflation Laffer Curve

(M/P)

Deficit

B

A


Inflationary Dynamis in a Dollarized Indexed Economy

Manufacturing

50%wages

50%ImportComponent

Oil Shock

Price ofOutputCOLA

Indexed Gov'tDebt

Fiscal Deficit Monetary Growth

Dollarization

Devaluation


Structure of Financial MarketsBanks

Foreign Exchange

CD's

T'Bills

Commercial Paper

Time and Saving Deposits

Long-term bonds

spot forward future call/put option

warrants and convertible bonds

Repurchase Agreements

Swaps:debt for equityDual currency bonds

Heaven and hell bonds

Parallel loans and currency swaps

Optioned and non-optioned equity

MortgagesMortgage-backed securities

Preferred stock

Stripped and zero coupon bonds

Prime and score securities

Poisoned pills

Acceptances

Figure 1:Instruments of Markets

Bonds

Equity


Trading Structure in Financial Markets

Exchange-tradedOver-the-counter

Structured/embedded

FuturesSwaps

Options

Convertibles

Warrants

Figure 2


Nikkei-linked bond with puts

Investor Issuer

Arranging bank

Investor

put

coupon,premiumput

premium

putpremium

Figure 3


Equity derivative swap, two-sided

Bank A Bank Bdepreciation

appreciation

premium (upfront or LIBOR flow)

Figure 4


Customized derivative swap

Investor Bank A

T-notes at 5%

5%

appreciation

appreciation in Nikkeiover 22,000

premium for call at 22,000

Figure 5


Equity Derivative Swap with Embedded Options

Bank Y Bank X

LIBOR Prem

Index apprec.

Knock-out on Nikkei

Yen/$ Quanto

Figure 6


Swap Credit Exposure: Regulatory Approach

OEM

Swap creditrisk

Mark tomarket

CEM

Swap creditriskSwap creditrisk

Swap creditrisk

Credit conversion

Figure 7


Creation of a Differential Swap

CompanyY

Bank A Bank B

Bank C

i-US

i-DM less SPR

i-US

US fixed

DM fixedi-DM

i-DM and i-US: DM and US LIBOR

Figure 8

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