trade and finance in the cambridge- alphametrics model cambridge endowment for research in finance...

Trade and Finance Trade and Finance in the Cambridge-in the Cambridge-

Alphametrics Alphametrics ModelModel

Cambridge Endowment for Research in Finance (CERF) Alphametrics Ltd.

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CERF internal seminar, Cambridge, December 2006

CERF and Alphametrics

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Trade and finance: what drives what?Trade and finance: what drives what? Accounting for income, expenditure, trade, Accounting for income, expenditure, trade,

and net acquisition of financial assets and net acquisition of financial assets Expenditure behaviour and disequilibriumExpenditure behaviour and disequilibrium Policy regimes, imbalances and Policy regimes, imbalances and

adjustmentadjustment A show…A show… Financial model, structural flows, wealth Financial model, structural flows, wealth

and feedbacks in the context of and feedbacks in the context of international policy co-ordinationinternational policy co-ordination


Trade & finance: adjustment Trade & finance: adjustment process in normal timesprocess in normal times

IfIf the LHS is determined by the LHS is determined by endogenousendogenous demand demand responding to income and wealth targetsresponding to income and wealth targets

Such can only be consistent with what countries Such can only be consistent with what countries find themselves saving or borrowingfind themselves saving or borrowing

Financial flows would respond with high Financial flows would respond with high exchange rate elasticity to accommodate the exchange rate elasticity to accommodate the current accountcurrent account

Feedbacks to income and wealth may be Feedbacks to income and wealth may be expectedexpected


Accounting: net savingsAccounting: net savings

National income National income Y Y is identical to expenditure, is identical to expenditure, for the world economy, for a country as a for the world economy, for a country as a whole and for any chosen domestic whole and for any chosen domestic disaggregation:disaggregation:

Net savings of institutions are intrinsically Net savings of institutions are intrinsically related related


Accounting: financial Accounting: financial investmentinvestment

Net acquisition of financial assets Net acquisition of financial assets NA NA is the is the difference between income difference between income Y Y and and totaltotal expenditure on goods and services expenditure on goods and services HH : :

The net financial balance The net financial balance A A is given by the is given by the position at the end of the prior period plus position at the end of the prior period plus net acquisition and holding gains net acquisition and holding gains GAGA: :


Accounting: wealthAccounting: wealth

Wealth Wealth WW comprises the financial position comprises the financial position AA as well as tangible assets as well as tangible assets K K (subject to (subject to depreciation and holding gains):depreciation and holding gains):

The distribution of holding gains and losses The distribution of holding gains and losses is not the same for financial assets (which is not the same for financial assets (which are liabilities to some one else) as for are liabilities to some one else) as for tangible assetstangible assets


Expenditure behaviourExpenditure behaviour

HH, spending on goods (including gross , spending on goods (including gross investment) and services in each country is investment) and services in each country is determined on the basis of assumptions about determined on the basis of assumptions about income income Y*Y* and a financial objective and a financial objective NA*NA*

TThe conventional expression:he conventional expression:

is a special case where: is a special case where:

But the financial objective may derive from But the financial objective may derive from targets for wealth targets for wealth W* W* or the country's expected or the country's expected financial position financial position A*A*, with allowance for , with allowance for GK* GK* or or GA*GA*


……endogenously driving W endogenously driving W incomeincome

For the world as a whole, income For the world as a whole, income YW YW is equal to is equal to spendingspending

world income tends to exceed or fall short of world income tends to exceed or fall short of assumptions depending on whether expected assumptions depending on whether expected income and financial objectives summed over all income and financial objectives summed over all countries yield a negative (deficit) or a positive countries yield a negative (deficit) or a positive (surplus) figure(surplus) figure

The aggregate of country-level objectives imparts The aggregate of country-level objectives imparts an an upward or downward biasupward or downward bias to movements of to movements of aggregate demand in the world as a whole aggregate demand in the world as a whole


… … and there is no equilibriumand there is no equilibrium

Income assumptionsIncome assumptions Y Y ** are influenced by many are influenced by many factors including the strength of a country's trade factors including the strength of a country's trade balance, productive potential and financial balance, productive potential and financial conditionsconditions

The The expectedexpected NA*NA* is nothing more or less than the is nothing more or less than the sum of processes by which households, firms and sum of processes by which households, firms and governments attempt to reach their wealth targetsgovernments attempt to reach their wealth targets

Wealth targetsWealth targets may be affected by market valuation may be affected by market valuation The complex aggregation of The complex aggregation of NA*NA* would determine would determine

the strength of the the strength of the global multiplierglobal multiplier and thus and thus YWYW Unless universal perfect competition and constant returns Unless universal perfect competition and constant returns

to scale are assumed, full employment of the world to scale are assumed, full employment of the world economy requires a deliberate policy of demand economy requires a deliberate policy of demand managementmanagement (Kaldor) (Kaldor)


Policy regimes: stability Policy regimes: stability objectiveobjective Open system with price stability objectiveOpen system with price stability objective

Monetary policy is targeted on price stabilityMonetary policy is targeted on price stability A sound external financial position is required A sound external financial position is required

unless that foreigners are persuaded to invest in unless that foreigners are persuaded to invest in domestic assetsdomestic assets

Exchange rate depreciation is presumed beneficial Exchange rate depreciation is presumed beneficial for attaining external balance but such can run for attaining external balance but such can run counter to the domestic price objective and real counter to the domestic price objective and real depreciation may not be achieveddepreciation may not be achieved

Policy management may lead to deflation (by either Policy management may lead to deflation (by either curbing domestic credit creation or by means of curbing domestic credit creation or by means of fiscal tightening)fiscal tightening)

Outcomes vary with the degree of ‘CB Outcomes vary with the degree of ‘CB independence’ independence’


Policy regimes: growth Policy regimes: growth objectiveobjective Open system with demand management Open system with demand management

objectiveobjective Monetary and fiscal policies are targeted on growthMonetary and fiscal policies are targeted on growth Net Net acquisition of government and private sectors acquisition of government and private sectors

would be calibrated to match the expected would be calibrated to match the expected outcome for the current account under full capacity outcome for the current account under full capacity utilization assumptionsutilization assumptions

But the external position may turn too strong But the external position may turn too strong leading to internal price inflation. Monetary leading to internal price inflation. Monetary tightening may be successful provided that tightening may be successful provided that confidence of external investors is not affectedconfidence of external investors is not affected

The growth objective may eventually be abandonedThe growth objective may eventually be abandoned A feasible alternative may be globally co-ordinated A feasible alternative may be globally co-ordinated

demand managementdemand management


Policy regimes: interventionPolicy regimes: intervention

Managed systemsManaged systems When a country's external position is very weak, it When a country's external position is very weak, it

becomes difficult to introduce or maintain an open becomes difficult to introduce or maintain an open system system

In the face of a persistent shortage of foreign exchange In the face of a persistent shortage of foreign exchange the government restricts use of foreign exchange to the government restricts use of foreign exchange to essential debt service and purchases of imports. essential debt service and purchases of imports.

The foreign exchange position is managed directly by The foreign exchange position is managed directly by the central bank and the domestic financial system is the central bank and the domestic financial system is effectively isolated from international financial markets. effectively isolated from international financial markets.

Full employment remains a remote goal but a liberalized Full employment remains a remote goal but a liberalized open regimen is likely to make matters worse. open regimen is likely to make matters worse.

This is still the position of many low income countries This is still the position of many low income countries


Policy trade-offs in the Policy trade-offs in the absence of international co-absence of international co-ordinationordination Countries with a strong trading position may achieve Countries with a strong trading position may achieve

full employment with external surplusfull employment with external surplus Other countries would cope at intermediate positions Other countries would cope at intermediate positions Countries like the US, UK, etc. may have external Countries like the US, UK, etc. may have external

borrowing power. Domestic borrowing would sustain borrowing power. Domestic borrowing would sustain high employment in the face of continuing external high employment in the face of continuing external deficits. Likely break points aredeficits. Likely break points are inability to engender private and public debt on the scale inability to engender private and public debt on the scale

necessary to maintain full employment => necessary to maintain full employment => recessionrecession refusal of external investors to acquire domestic assets at the refusal of external investors to acquire domestic assets at the

current exchange rate => current exchange rate => devaluationdevaluation The sum of implied financial targets exerts upward or The sum of implied financial targets exerts upward or

downward momentum on global demand and may as downward momentum on global demand and may as well lead to imbalanceswell lead to imbalances


… … and now for your and now for your entertainment: entertainment: sketches of a ‘soft’ landing in the sketches of a ‘soft’ landing in the USUS A slowdown in the U.S. is triggered by

domestic deflation from 2007

Such is above and beyond the assumed stock/flow adjustment

Implications of resource constraints in general, and of changes in energy prices 2005-2006 in particular are already underway.


Rates of income growth [%](historic and projected)

-.02

-.01

.00

.01

.02

.03

.04

.05

.06

.07

70 75 80 85 90 95 00 05 10 15

DY_US (S1H) DY_US (Baseline)

DY_US

-.06

-.04

-.02

.00

.02

.04

.06

.08

.10

70 75 80 85 90 95 00 05 10 15

DY_JA (S1H) DY_JA (Baseline)

DY_JA

-.01

.00

.01

.02

.03

.04

.05

.06

70 75 80 85 90 95 00 05 10 15

DY_WE (S1H) DY_WE (Baseline)

DY_WE

-.04

-.02

.00

.02

.04

.06

.08

70 75 80 85 90 95 00 05 10 15

DY_OD (S1H) DY_OD (Baseline)

DY_OD

-.04

-.02

.00

.02

.04

.06

.08

70 75 80 85 90 95 00 05 10 15

DY_AM (S1H) DY_AM (Baseline)

DY_AM

-.04

.00

.04

.08

.12

.16

70 75 80 85 90 95 00 05 10 15

DY_AF (S1H) DY_AF (Baseline)

DY_AF

-.1

.0

.1

.2

.3

.4

.5

.6

70 75 80 85 90 95 00 05 10 15

DY_ME (S1H) DY_ME (Baseline)

DY_ME

-.02

.00

.02

.04

.06

.08

.10

70 75 80 85 90 95 00 05 10 15

DY_AS (S1H) DY_AS (Baseline)

DY_AS

-.02

.00

.02

.04

.06

.08

.10

.12

.14

70 75 80 85 90 95 00 05 10 15

DY_CN (S1H) DY_CN (Baseline)

DY_CN

-.5

-.4

-.3

-.2

-.1

.0

.1

.2

70 75 80 85 90 95 00 05 10 15

DY_UR (S1H) DY_UR (Baseline)

DY_UR

-.08

-.06

-.04

-.02

.00

.02

.04

.06

.08

70 75 80 85 90 95 00 05 10 15

DY_EE (S1H) DY_EE (Baseline)

DY_EE


Trade balances over Income(historic and projected)

-10

-8

-6

-4

-2

0

2

70 75 80 85 90 95 00 05 10 15

BY_US (S1H) BY_US (Baseline)

BY_US

-2

-1

0

1

2

3

4

5

6

7

70 75 80 85 90 95 00 05 10 15

BY_JA (S1H) BY_JA (Baseline)

BY_JA

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

70 75 80 85 90 95 00 05 10 15

BY_WE (S1H) BY_WE (Baseline)

BY_WE

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

70 75 80 85 90 95 00 05 10 15

BY_OD (S1H) BY_OD (Baseline)

BY_OD

-2

-1

0

1

2

3

70 75 80 85 90 95 00 05 10 15

BY_AM (S1H) BY_AM (Baseline)

BY_AM

-2

-1

0

1

2

3

4

5

70 75 80 85 90 95 00 05 10 15

BY_AF (S1H) BY_AF (Baseline)

BY_AF

-4

0

4

8

12

16

20

24

70 75 80 85 90 95 00 05 10 15

BY_ME (S1H) BY_ME (Baseline)

BY_ME

-2

-1

0

1

2

3

70 75 80 85 90 95 00 05 10 15

BY_AS (S1H) BY_AS (Baseline)

BY_AS

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

70 75 80 85 90 95 00 05 10 15

BY_CN (S1H) BY_CN (Baseline)

BY_CN

-1

0

1

2

3

4

70 75 80 85 90 95 00 05 10 15

BY_UR (S1H) BY_UR (Baseline)

BY_UR

-6

-5

-4

-3

-2

-1

0

1

70 75 80 85 90 95 00 05 10 15

BY_EE (S1H) BY_EE (Baseline)

BY_EE


Growth of main world variables: Income, population, exports of manufactures, and use of raw materials and energy

-.02

-.01

.00

.01

.02

.03

.04

.05

.06

.07

70 75 80 85 90 95 00 05 10 15

DY (S1H) DY (Baseline)

DY

.010

.012

.014

.016

.018

.020

.022

70 75 80 85 90 95 00 05 10 15

DN (S1H) DN (Baseline)

DN

-.04

-.03

-.02

-.01

.00

.01

.02

.03

.04

.05

70 75 80 85 90 95 00 05 10 15

DYN (S1H) DYN (Baseline)

DYN

-.10

-.05

.00

.05

.10

.15

.20

.25

70 75 80 85 90 95 00 05 10 15

DX (S1H) DX (Baseline)

DX

-.03

-.02

-.01

.00

.01

.02

.03

.04

.05

.06

70 75 80 85 90 95 00 05 10 15

DEP (S1H) DEP (Baseline)

DEP

.00

.01

.02

.03

.04

.05

70 75 80 85 90 95 00 05 10 15

DAP (S1H) DAP (Baseline)

DAP


Back to the financial modelBack to the financial model

If If in normal times the adjustment in normal times the adjustment process runs from the income and trade process runs from the income and trade accounts to the financial account, why accounts to the financial account, why and when a financial model is needed?and when a financial model is needed? Modelling financial flows in Modelling financial flows in abnormalabnormal times? times?

… … impossibleimpossible Modelling exchange rates? Modelling exchange rates?

… … nearly impossiblenearly impossibleThere is no clear causality running from There is no clear causality running from structural flows to exchange ratesstructural flows to exchange rates


-10

-5

0

5

10

1980 1985 1990 1995 2000

Germany

-10

-5

0

5

10

1980 1985 1990 1995 2000

UK

-10

-5

0

5

10

1980 1985 1990 1995 2000

Japan

-10

-5

0

5

10

1980 1985 1990 1995 2000

Mexico

-10

-5

0

5

10

1980 1985 1990 1995 2000

Brazil

-10

-5

0

5

10

1980 1985 1990 1995 2000

South Africa

-10

-5

0

5

10

1980 1985 1990 1995 2000

Indonesia

-10

-5

0

5

10

1980 1985 1990 1995 2000

China

-10

-5

0

5

10

1980 1985 1990 1995 2000

India

structural flows

financial flows

change in reserves

Balance of payments flows as % of GDPselected countries 1980 - 2004

structural structural flows include flows include the current the current account and account and direct direct investmentinvestment

is there a clear is there a clear impact on the impact on the exchange exchange rate?rate?


real and nominal exchange rate changesselected countries 1980 - 2004

-30

-20

-10

0

10

20

30

1980 1985 1990 1995 2000

Germany

-30

-20

-10

0

10

20

30

1980 1985 1990 1995 2000

UK

-30

-20

-10

0

10

20

30

1980 1985 1990 1995 2000

Japan

-30

-20

-10

0

10

20

30

1980 1985 1990 1995 2000

Mexico

-30

-20

-10

0

10

20

30

1980 1985 1990 1995 2000

Brazil

-30

-20

-10

0

10

20

30

1980 1985 1990 1995 2000

South Africa

-30

-20

-10

0

10

20

30

1980 1985 1990 1995 2000

Indonesia

-30

-20

-10

0

10

20

30

1980 1985 1990 1995 2000

China

-30

-20

-10

0

10

20

30

1980 1985 1990 1995 2000

India

nominal exchange rate

exchange exchange rates are rates are highly volatile highly volatile in nearly all in nearly all countriescountries

there is no there is no apparent apparent causality from causality from financial financial flows to flows to exchange exchange ratesrates

real exchange rate


Understanding structural Understanding structural flowsflows

A trade and income model should at the very A trade and income model should at the very least incorporate trade flows, external least incorporate trade flows, external income flows and direct investmentincome flows and direct investment

Such ‘structural flows’ are relevant for Such ‘structural flows’ are relevant for growth, income distribution and developmentgrowth, income distribution and development

It is plausible that these can be modeled in It is plausible that these can be modeled in relation with policy regimesrelation with policy regimes

Direct investment may be sensitive to Direct investment may be sensitive to changes in the exchange rate and stock mkt. changes in the exchange rate and stock mkt. indexesindexes


Disentangling financial flowsDisentangling financial flows

Foreign currency and securities are acquired Foreign currency and securities are acquired by the private sector and monetary by the private sector and monetary authoritiesauthorities

Liquidity and precautionary motives may Liquidity and precautionary motives may help explaining outflowshelp explaining outflows

Since the exchange rate is generally Since the exchange rate is generally determined by longer-term expectations determined by longer-term expectations rather than structural flows, given domestic rather than structural flows, given domestic demand for foreign currency investments demand for foreign currency investments and deposits the balancing item in the and deposits the balancing item in the exchange account would be non-resident exchange account would be non-resident investments investments


Valuation changes may Valuation changes may mattermatter

The scope for variation of market prices The scope for variation of market prices and real exchange rates is constrained by and real exchange rates is constrained by the impact on net external assets and the impact on net external assets and liabilities (depending on currency liabilities (depending on currency denomination), thus:denomination), thus: wealth (and wealth ‘volatility’)wealth (and wealth ‘volatility’) domestic and international distribution of domestic and international distribution of

income;income; confidence and expectationsconfidence and expectations

NB: and they lead to confusion too (Hausman… et al.)NB: and they lead to confusion too (Hausman… et al.)


Feedbacks from wealth to Feedbacks from wealth to expenditure may be relevantexpenditure may be relevant

Spending decisions are likely influenced by Spending decisions are likely influenced by the perception of valuation changes in the perception of valuation changes in wealth and by the distributional impact of wealth and by the distributional impact of income flows on households, firms and income flows on households, firms and governmentsgovernments

Such complicates the role of monetary and Such complicates the role of monetary and fiscal policy (for example: fiscal policy (for example: i-i-rte tightening rte tightening may be necessary to constrain excessive may be necessary to constrain excessive private debt against wealth appreciation private debt against wealth appreciation but it may precipitate a recession…)but it may precipitate a recession…)

How then policy co-ordination should work?How then policy co-ordination should work?

trade and finance in the cambridge- alphametrics model cambridge endowment for research in finance...

Documents

financial position

world income

financial objectives

net financial balance

financial conditionsthe

expected income

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income yw