Download Fixed Exchange Rates and the Trilemma

Topics on International
Macroeconomics (Lecture 1)
Marko Korhonen
Department of Economics
In this course
1) Selected topics on International
Macroeconomics (lectures 1 to 4)
2) Economics of Monetary Union + some other
topics (student presentations)
Why study international
macroeconomics?
• What economies are closed?
– Maybe reasonable for North Korea, Cuba, Iran
– Closed economies analysis is outdated
• Open economies have different features than closed
economies
– True general eguilibrium model
– Deal with agents that are not homogenous (at least two
different countries)
– Interaction between financial markets, goods markets and
factor markets
– Research is driven by empirical anomalies
• PPP, UIP, Feldstein-Horioka puzzle, Carry Trade,…
Introduction
• International macroeconomics is devoted to the study of largescale economic problems in interdependent economies.
• It is macroeconomic because it focuses on key economy-wide
variables such as exchange rates, prices, interest rates, income,
wealth, and the current account.
• It is international because a deeper understanding of the
global economy emerges only when the interconnections
among nations are fully considered.
Introduction
• Unique features of international macroeconomics can be
reduced to three key elements: the world has many
monies (not one), countries are financially integrated (not
isolated), and in this context economic policy choices are
made (but not always very well).
Contents (preliminary)
Lecture 1
- Complete theory for exchange rates: asset and
monetary approach. (Dornbusch overshooting
model)
- Fixed exchange rate and trilemma. (Danish krona)
- Measuring international macroeconomics data
- Global imbalances (U.S. versus EDC countries)
- External wealth (U.S)
Contents (preliminary)
Lecture 2
- The gains from financial globalization.
- Gains from efficient investment
- Feldstein-Horioka puzzle
- Lucas paradox
- Gains from diversification of risk
- Home bias
Contents (preliminary)
Lecture 3
- Stabilization policy (Latvia and Poland)
- IS-LM-FX-model (Britain and Europe).
- The benefits of fixed exchange rate
Contents (preliminary)
Lecture 4
- Exchange rates in the long-run
- Nontraded goods and the BalassaSamuelson model
- Exchange rates in the short-run
- The carry trade, peso problems
- The efficient market hypothesis
Student presentations
• Every student, individually or as a part of a team (max
2 persons), will take a charge of a lecture.
• It will be graded on the basis of how well the student
defines the topic posed, analyzed and quided.
• 45-60 minutes presentation.
• Every student have to write a lecture diary on the
presentations (except your own one) where you
summarize the essential elements of lectures.
• You should hand your lecture diary before the first
exam.
• The student presentation topics will be give on January 19th,
time 12-14 (TA 101).
Student presentations topics
• Debt and default
• The global macroeconomy and the 2007-2013
crisis
• The economics of the Euro
• The history and politics of the Euro
• Eurozone tensions in tranquil times 1999-2007
• The eurozone in crisis 2008-2013.
Student presentations topics
• Paul De Grauwe: Economics of Monetary Union
Table of Contents:
Costs and Benefits of Monetary Union
1: The Costs of Common Currency
2: The Theory of Optimum Currency Areas: A Critique
3: The Benefits of a Common Currency
4: Costs and Benefits Compared
Monetary Union
5: The Fragility of Incomplete Monetary Union
6: How to Complete a Monetary Union?
7: The Transition to a Monetary Union
8: The European Central Bank
9: Monetary Policy in the Eurozone
10: Fiscal Policies in Monetary Unions
11: The Euro and Financial Markets
Grading
• Student presentation + lecture diary (max 50 points) + final exam (50
points), so the total maximum is 100 points
• Presentation gives you at maximum 30 points and participation on the
other students presentations and lecture diary gives you at maximum 20
points.
– No presentation means that you are not able to get participation and lecture
diary points.
• Final exam
– 50 points
– If you have not make a presentation (max 100 points)
• Grading:
–
–
–
–
–
For the grade 5 you need 90-100 points
For the grade 4 you need 80-90 points
For the grade 3 you need 70-80 points
For the grade 2 you need 60-70 points
For the grade 1 you need 50-60 points
Schedule
• The final schedule can be found in the Noppa-portal
• https://noppa.oulu.fi/noppa/kurssi/721317s/luennot
Final Schedule
10.01.17
ti 14.15-17.00 SÄ105 (Lecture 1)
11.01.17
ke 14.15-17.00 L9 (Lecture 2)
17.01.17
ti 14.15-17.00 SÄ105 (Lecture 3)
18.01.17
ke 14.15-17.00 L9 (Lecture 4)
19.01.17
to 12.15-14.00 TA101 (Student presentation topics given)
31.01.17
ti 14.15-17.00 SÄ105 (Student presentations)
01.02.17
ke 14.15-17.00 L9 (Student presentations)
02.02.17
to 12.15-14.00 TA101 (Student presentations)
07.02.17
ti 14.15-17.00 SÄ105 (Student presentations)
08.02.17
ke 14.15-17.00 L9 (Student presentations)
09.02.17
to 12.15-14.00 TA101 (Student presentations)
Foreign Exchange: Currencies
• A complete understanding of how a country’s
economy works requires that we study the
exchange rate, the price of foreign currency.
• Because products and investments move across
borders, fluctuations in exchange rates have
significant effects on the relative prices of home
and foreign goods (such as autos and clothing),
services (such as insurance and tourism), and
assets (such as equities and bonds).
Foreign Exchange: Currencies
How Exchange Rates Behave
Major Exchange Rates The chart shows two key exchange rates from 2003 to 2010.
The China-U.S. exchange rate varies little and would be considered a fixed exchange rate, despite
a period when it followed a gradual trend.
The U.S.-Eurozone exchange rate varies a lot and would be considered a floating exchange rate.
A Complete Theory for Exchange Rates: Unifying the Monetary
and Asset Approaches
For a complete theory of exchange rates:
• We need the asset approach—short-run money market
equilibrium and uncovered interest parity:


PUS  M US /[ LUS (i$ )YUS ]


PEUR  M EUR /[ LEUR (i )YEUR ] The asset approach

E$e/ €  E$e/ €

i$  i€ 

E$ / €

© 2014 Worth Publishers
International Economics, 3e | Feenstra/Taylor
(4-4)
18
A Complete Theory for Exchange Rates: Unifying the Monetary
and Asset Approaches
• To forecast the future expected exchange rate, we also need
the long-run monetary approach—a long run monetary model
and purchasing power parity:


e
e
e
 M EUR /[ LEUR (i )YEUR ] The monetary approach

e
e
 PUS
/ PEUR

e
e
e
PUS
 M US
/[ LUS (i$e )YUS
]
e
PEUR
E$e/ €
(4-5)
• Combining the asset and monetary approach, we can see how
the two key mechanisms of expectations and arbitrage
determine exchange rates in both the short run and the long
run.
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International Economics, 3e | Feenstra/Taylor
19
A Complete Theory for Exchange Rates: Unifying the Monetary
and Asset Approaches
A Complete Theory of
Floating Exchange
Rates: All the Building
Blocks Together Inputs
to the model are
known exogenous
variables (in green
boxes). Outputs of the
model are unknown
endogenous variables
(in red boxes). The
levels of money
supply and real
income determine
exchange rates.
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International Economics, 3e | Feenstra/Taylor
20
A Complete Theory for Exchange Rates: Unifying the Monetary
and Asset Approaches
FIGURE (1 of 4)
Permanent Expansion of the Home Money Supply, Short-Run Impact
In panel (a), the home price level is fixed, but the supply of dollar balances increases
and real money supply shifts out. To restore equilibrium at point 2, the interest rate falls
from i1$ to i2$. In panel (b), in the FX market, the home interest rate falls, so the
domestic return decreases and DR shifts down. In addition, the permanent change in
the home money supply implies a permanent, long-run depreciation of the dollar.
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International Economics, 3e | Feenstra/Taylor
21
A Complete Theory for Exchange Rates: Unifying the Monetary
and Asset Approaches
FIGURE (2 of 4)
Permanent Expansion of the Home Money Supply, Short-Run Impact (continued)
Hence, there is also a permanent rise in Ee$/€, which causes a permanent increase in the
foreign return i€ + (Ee$/€ − E$/€)/E$/€, all else equal; FR shifts up from FR1 to FR2. The
simultaneous fall in DR and rise in FR cause the home currency to depreciate steeply,
leading to a new equilibrium at point 2′ (and not at 3′, which would be the equilibrium
if the policy were temporary).
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22
A Complete Theory for Exchange Rates: Unifying the Monetary
and Asset Approaches
FIGURE (3 of 4)
Permanent Expansion of the Home Money Supply, Short-Run Impact (continued)
Long-Run Adjustment: In panel (c), in the long run, prices are flexible, so the home price
level and the exchange rate both rise in proportion with the money supply. Prices rise to
P2US, and real money supply returns to its original level M1US/P1US.
The money market gradually shifts back to equilibrium at point 4 (the same as point 1).
© 2014 Worth Publishers
International Economics, 3e | Feenstra/Taylor
23
A Complete Theory for Exchange Rates: Unifying the Monetary
and Asset Approaches
FIGURE (4 of 4)
Permanent Expansion of the Home Money Supply, Short-Run Impact (continued)
Long-Run Adjustment (continued): In panel (d), in the FX market, the domestic return DR,
which equals the home interest rate, gradually shifts back to its original level. The foreign
return curve FR does not move at all: there are no further changes in the Foreign interest
rate or in the future expected exchange rate. The FX market equilibrium shifts gradually to
point 4′. The exchange rate falls (and the dollar appreciates) from E2$/€ to E4$/€. Arrows in
both graphs show the path of gradual adjustment.
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24
A Complete Theory for Exchange Rates: Unifying the Monetary
and Asset Approaches
Overshooting
FIGURE (1 of 2)
Responses to a Permanent Expansion of the Home Money Supply
In panel (a), there is a one-time permanent increase in home (U.S.) nominal money
supply at time T.
In panel (b), prices are sticky in the short run, so there is a short-run increase in the
real money supply and a fall in the home interest rate.
© 2014 Worth Publishers
International Economics, 3e |
Feenstra/Taylor
25
A Complete Theory for Exchange Rates: Unifying the Monetary
and Asset Approaches
Overshooting
FIGURE (2 of 2)
Responses to a Permanent Expansion of the Home Money Supply (continued)
In panel (c), in the long run, prices rise in the same proportion as the money supply.
In panel (d), in the short run, the exchange rate overshoots its long-run value (the
dollar depreciates by a large amount), but in the long run, the exchange rate will
have risen only in proportion to changes in money and prices.
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26
Fixed Exchange Rates and the Trilemma
What Is a Fixed Exchange Rate Regime?
• Here we focus on the case of a fixed rate regime without
controls so that capital is mobile (no capital controls) and
arbitrage is free to operate in the foreign exchange market.
• Central banks buying and selling foreign currency at a fixed
price, thus holding the market exchange rate at a fixed level
—
denoted E.
• We examine the implications of Denmark’s decision to peg its
—
currency, the krone, to the euro at a fixed rate: EDKr/€
• The Foreign country remains the Eurozone, and the Home
country is now Denmark.
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Fixed Exchange Rates and the Trilemma
What Is a Fixed Exchange Rate Regime?
• What we now show is that a country with a fixed exchange
rate faces monetary policy constraints not just in the long run
but also in the short run.
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29
Fixed Exchange Rates and the Trilemma
Pegging Sacrifices Monetary Policy Autonomy
in the Short Run: Example
The Danish central bank must set its interest rate equal to i€, the
rate set by the European Central Bank (ECB):
iDKr  i€ 
E
e
DKr / €
 EDKr / €
EDKr / €

i
Equals zero
for a credible
fixed exchange rate
Denmark has lost control of its monetary policy: it cannot
independently change its interest rate under a peg.
M DEN  PDEN LDEN (iDKr )YDEN  PDEN LDEN (i€ )YDEN
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Fixed Exchange Rates and the Trilemma
Pegging Sacrifices Monetary Policy Autonomy
in the Short Run: Example
Our short-run theory still applies, but with a different chain of
causality.
• Under a float:
o The home monetary authorities pick the money supply M.
o In the short run, the choice of M determines the interest
rate i in the money market; in turn, via UIP, the level of i
determines the exchange rate E.
o The money supply is an input in the model (an exogenous
variable), and the exchange rate is an output of the model
(an endogenous variable).
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31
Fixed Exchange Rates and the Trilemma
Pegging Sacrifices Monetary Policy Autonomy
in the Short Run: Example
Our short-run theory still applies, but with a different chain of
causality.
• Under a fix, this logic is reversed:
o Home monetary authorities pick the fixed level of the exchange
rate E.
o In the short run, a fixed E pins down the home interest rate i via
UIP (forcing i =i*); in turn, the level of i determines the level of
the money supply M necessary to meet money demand.
o The exchange rate is an input in the model (an exogenous
variable), and the money supply is an output of the model (an
endogenous variable).
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Fixed Exchange Rates and the Trilemma
FIGURE
A Complete Theory of
Fixed Exchange Rates:
Same Building Blocks,
Different Known and
Unknown Variables
Unlike in in previous
Figure, the home
country is now assumed
to fix its exchange rate
with the foreign country.
The levels of real
income and the fixed
exchange rate
determine the home
money supply levels,
given outcomes in the
foreign country.
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33
Fixed Exchange Rates and the Trilemma
Pegging Sacrifices Monetary Policy Autonomy
in the Long Run: Example
• The price level in Denmark is determined in the long run by
PPP. But if the exchange rate is pegged, we can write long-run
PPP for Denmark as:
PDEN  EDKr / € PEUR
• With the long-run nominal interest and price level outside of
Danish control, monetary policy autonomy is impossible. We
just substitute iDKr  i€ and PDEN  EDKr / € PEURinto Denmark’s
long-run money market equilibrium to obtain:
M DEN  PDEN LDEN (iDKr )YDEN  EDKr / € PEUR LDEN (i )YDEN
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34
Fixed Exchange Rates and the Trilemma
The Trilemma
Consider the following three equations and parallel statements
about desirable policy goals.
1.
e
A fixed exchange rate
EDKr
/ €  E DKr / €
0
• May be desired as a means to promote
EDKr / €
stability in trade and investment
• Represented here by zero expected
depreciation
International capital mobility
2.
iDKr
e
E DKr
• May be desired as a means to promote
/ €  E DKr / €
 i€ 
integration, efficiency, and risk sharing
E /€
DKr

exp ected
depreciation
• Represented here by uncovered interest
parity, which results from arbitrage
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Fixed Exchange Rates and the Trilemma
The Trilemma
Consider the following three equations and parallel statements
about desirable policy goals.
3. iDKr / €  i€
Monetary policy autonomy
• May be desired as a means to manage the
Home economy’s business cycle
• Represented here by the ability to set the
Home interest rate independently of the
foreign interest rate
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Fixed Exchange Rates and the Trilemma
The Trilemma
• Formulae 1, 2, and 3 show that it is a mathematical
impossibility as shown by the following statements:
o 1 and 2 imply not 3 (1 and 2 imply interest equality,
contradicting 3).
o 2 and 3 imply not 1 (2 and 3 imply an expected change
in E, contradicting 1).
o 3 and 1 imply not 2 (3 and 1 imply a difference between
domestic and foreign returns, contradicting 2).
• This result, known as the trilemma, is one of the most
important ideas in international macroeconomics.
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Fixed Exchange Rates and the Trilemma
The Trilemma
The Trilemma Each corner of the triangle represents a viable policy choice.
The labels on the two adjacent edges of the triangle are the goals that can
be attained; the label on the opposite edge is the goal that has to be
sacrificed.
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APPLICATION
The Trilemma in Europe
The Trilemma in Europe
The figure shows selected central banks’ base interest rates for the period 1994 to 2010 with
reference to the German mark and euro base rates.
In this period, the British made a policy choice to float against the German mark and (after 1999)
against the euro. This permitted monetary independence because interest rates set by the Bank of
England could diverge from those set in Frankfurt.
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APPLICATION
The Trilemma in Europe
The Trilemma in Europe (continued)
No such independence in policy making was afforded by the Danish decision to peg the krone
first to the mark and then to the euro. Since 1999 the Danish interest rate has moved in line
with the ECB rate. Similar forces operated pre-1999 for other countries pegging to the mark,
such as the Netherlands and Austria. Until they joined the Eurozone in 1999, their interest
rates, like that of Denmark, closely tracked the German rate.
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Measuring Macroeconomic Activity: An Overview
FIGURE 5-1
The Closed Economy
Measurements of
national expenditure,
product, and income
are recorded in the
national income and
product accounts,
with the major
categories shown.
The purple line
shows the circular
flow of all
transactions in a
closed economy.
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41
International transactions: Balance-ofPayments
• Balance-of-Payments Accounting
– A country’s international transactions are recorded in
the balance-of-payments accounts.
– A country’s balance of payments has two main
components: the current account and the financial
account.
– The current account records exports and imports of
goods and services and international receipts or
payments of income.
– The financial account keeps record of sales of assets
to foreigners and purchases of assets located abroad.
Measuring Macroeconomic Activity: An Overview
FIGURE 5-2
The Open Economy Measurements
of national expenditure, product,
and income are recorded in the
national income and product
accounts, with the major
categories shown on the left.
Measurements of international
transactions are recorded in the
balance of payments accounts,
with the major categories shown
on the right.
The purple line shows the flow of
transactions within the home
economy.
The green lines show all crossborder transactions.
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43
Income, Product, and Expenditure
From GNE to GDP: Accounting for Trade in Goods and Services
GDP

Gross
domestic
product

C

I 
G


Gross
national
expenditure
GNE





EX

IM




All imports,
 All exports,

final & intermediate final & intermediate 




(5-1)
Trade balance
TB
This formula says gross domestic product is equal to gross
national expenditure (GNE) plus the trade balance (TB).
The trade balance (TB), also referred to as net exports, may be
positive or negative.
• If TB > 0, exports are greater than imports and we say a country
has a trade surplus.
• If TB < 0, imports are greater than exports and we say a country
has a trade deficit.
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44
Income, Product, and Expenditure
From GDP to GNI: Accounting for Trade in Factor Services
• Gross national income equals gross domestic product (GDP)
plus net factor income from abroad (NFIA).
GNI 
C  I G

 ( EX  IM )  ( EX FS  IM FS )



 

Gross nationalexpenditure
GNE
Trade balance
TB

(5-2)
Net factor income from abroad
NFIA
GDP
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45
APPLICATION
Celtic Tiger or Tortoise?
FIGURE 5-3
A Paper Tiger? The chart
shows trends in GDP, GNI,
and NFIA in Ireland from
1980 to 2011. Irish GNI
per capita grew more
slowly than GDP per
capita during the boom
years of the 1980s and
1990s because an everlarger share of GDP was
sent abroad as net factor
income to foreign
investors. Close to zero in
1980, this share had risen
to around 15% of GDP by
the year 2000 and has
remained there.
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46
Income, Product, and Expenditure
From GNI to GNDI: Accounting for Transfers of Income
If a country receives transfers worth UTIN and gives transfers
worth UTOUT, then its net unilateral transfers (NUT), are
NUT = UTIN − UTOUT .
Adding net unilateral transfers to gross national income, gives a
full measure of national income in an open economy, known as
gross national disposable income (GNDI), henceforth Y:
Y  C  I  G   ( EX  IM )  ( EX FS  IM FS )  (UT  UT ) (5-3)
 
 
 
 
GNDI
GNE
Trade
balance
(TB )
Net factor income
from abroad
( NFIA)



Net unilateral
transfers
(NUT )
GNI
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47
Income, Product, and Expenditure
From GNI to GNDI: Accounting for Transfers of Income
FIGURE 5-4
Major Transfer Recipients The chart
shows average figures for 2000 to
2010 for all countries in which net
unilateral transfers exceeded 15%
of GNI. Many of the countries
shown were heavily reliant on
foreign aid, including some of the
poorest countries in the world,
such as Liberia, Eritrea, Malawi,
and Nepal. Some countries with
higher incomes also have large
transfers because of substantial
migrant remittances
from a large number of emigrant
workers overseas (e.g., Tonga, El
Salvador, Honduras, and Cape
Verde).
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48
Income, Product, and Expenditure
What the National Economic Aggregates Tell Us
Y  C

I 
G  {( EX  IM )  ( EX FS  IM FS )  (UT  UT )} (5-4)


 

 
 
GNDI
GNE
Trade
balance
(TB )
Net factor income
from abroad
( NFIA)
Net unilateral
transfers
(NUT )

Current account
( CA )
• On the left is our full income measure, GNDI.
• The first term on the right is GNE, which measures payments
by home entities.
• The remaining terms measure net payments to the home
country from all international transactions in goods, services,
and income. We group the three cross-border terms into an
umbrella term that is called the current account (CA).
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49
Income, Product, and Expenditure
Understanding the Data for the National Economic Aggregates
TABLE 5-1
U.S. Economic Aggregates in 2012 The table shows the computation of GDP, GNI, and GNDI in
2012 in billions of dollars using the components of gross national expenditure, the trade
balance, international income payments, and unilateral transfers.
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50
Income, Product, and Expenditure
Some Recent Trends
FIGURE 5-5
U.S. Gross National Expenditure and Its Components, 1990-2012 The figure shows
consumption (C), investment (I), and government purchases (G) in billions of dollars.
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51
2 Income, Product, and Expenditure
Some Recent Trends
FIGURE 5-6
U.S. Current Accounts and Its Components, 1990-2012 The figure shows the trade
balance (TB), net factor income from abroad (NFIA), and net unilateral transfers (NUT) in
billions of dollars.
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52
The U.S. Trade Balance and Current Account As
Percentages Of GDP: 1960-2012
What the Current Account Tells Us?
Y  C  I  G  CA
(5-5)
• This equation is the open-economy national income identity.
It tells us that the current account represents the difference
between national income Y (or GNDI) and gross national
expenditure
GNE (or C + I + G). Hence:

• GNDI is greater than GNE if and only if CA is positive, or in
surplus.
• GNDI is less than GNE if and only if CA is negative, or in
deficit.
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What the Current Account Tells Us?
• The current account is also the difference between national
saving (S = Y − C − G) and investment:
S
  I  CA
(5-6)
Y C G
• This equation is called the current account identity even
though it is just a rearrangement of the national income
identity. Thus,
• S is greater than I if and only if CA is positive, or in surplus.
• S is less than I if and only if CA is negative, or in deficit.
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APPLICATION
Global Imbalances
FIGURE 5-7 (1 of 2)
Saving, Investment, and Current Account Trends: Industrial Countries
The charts show saving, investment, and the current account as a percent of each
subregion’s GDP for four groups of advanced countries. The United States has seen both
saving and investment fall since 1980, but saving has fallen further than investment,
opening up a large current account deficit approaching 6% of GDP in recent years.
Japan’s experience is the opposite: investment fell further than saving, opening up a large
current account surplus of about 3% to 5% of GDP.
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APPLICATION
Global Imbalances
FIGURE 5-7 (2 of 2)
Saving, Investment, and Current Account Trends: Industrial Countries (continued)
The Euro area has also seen saving and investment fall but has been closer to balance
overall.
Other advanced countries (e.g., non-Euro area EU countries, Canada, Australia, etc.)
have tended to run large current account deficits.
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APPLICATION
Global Imbalances
• We define private saving (Sp) as that part of after-tax private
sector disposable income Y that is not devoted to private
consumption C.
Sp  Y  T  C
(5-7)
• We define government saving (Sg) as the difference between
tax revenue T received by the government and government
purchases G.

Sg  T  G
(5-8)
• Private saving plus government saving equals total national
saving, S
S  Y  C  G  (Y  T  C )  (T  G )



Privatesaving
 S p  Sg
(5-9)
Government saving
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APPLICATION
Global Imbalances
FIGURE 5-8 (1 of 2)
Private and Public Saving Trends: Industrial Countries
This chart shows
private saving and the
chart on the next slide
public saving, both as a
percent of GDP. Private
saving has been
declining in the
industrial countries,
especially in Japan
(since the 1970s) and in
the United States (since
the 1980s). Private
saving has been more
stable in the Euro area
and other countries.
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APPLICATION
Global Imbalances
FIGURE 5-8 (2 of 2)
Private and Public Saving Trends: Industrial Countries (continued)
Public saving is clearly
more volatile than
private saving. Japan
has been mostly in
surplus and massively
so in the late 1980s and
early 1990s. The United
States briefly ran a
government surplus in
the late 1990s but has
now returned to a
deficit position.
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APPLICATION
Global Imbalances
Do government deficits cause current account deficits?
• Sometimes they go together, but these “twin deficits” are not
inextricably linked, as is sometimes believed.
• We can use the equation just given and the current account
identity to write
CA  S p  Sg  I
(5-10)
• The theory of Ricardian equivalence asserts that a fall in
public saving is fully offset by a contemporaneous rise in
private saving.

• However, empirical studies do not support this theory: private
saving does not fully offset government saving in practice.
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APPLICATION
Global Imbalances
FIGURE 5-9 (1 of 3)
Global Imbalances
The charts show
saving (blue),
investment (red), and
the current account
(beige) as a percent
of GDP.
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APPLICATION
Global Imbalances
FIGURE 5-9 (2 of 3)
Global Imbalances (continued)
In the 1990s,
emerging markets
moved into current
account surplus and
thus financed the
overall trend toward
current account
deficit of the
industrial countries.
Note: Oil producers
include Norway.
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APPLICATION
Global Imbalances
FIGURE 5-9 (3 of 3)
Global Imbalances (continued)
For the world as a
whole since the
1970s, global
investment and
saving rates have
declined as a percent
of GDP, falling from a
high of near 26% to
low near 20%.
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Observations from the figures
• The large observed U.S. current account deficits must
be matched by current account surpluses of other
countries with the United States.
• Over the past decade, an increasing fraction of the U.S.
current account deficit is accounted for by current
account deficits with China.
• Figure 1.8 displays the U.S. current account with China
as a fraction of the total U.S. current account balance.
• This ratio was about 20 percent in 1999 and has been
increasing steadily, reaching a peak of 70 percent in
2009.
Observations from the figures
• The expanding commercial relation between the United States and
China has reached a magnitude such that the respective total
current accounts are beginning to mirror each other.
• This phenomenon is evident from figure 1.9,which displays the
current account balances of the United States and China as
fractions of their respective GDPs.
• Since the mid 1990s, the U.S. widening current account deficits
have coincided with a growing path of Chinese current account
surpluses.
• Notice that the great recession of 2008-2009 was associated with a
significant improvement in the U.S. current account and an equally
important contraction in the Chinese current account surplus.
Measuring Macroeconomic Activity: An Overview
FIGURE 5-2
The Open Economy Measurements
of national expenditure, product,
and income are recorded in the
national income and product
accounts, with the major
categories shown on the left.
Measurements of international
transactions are recorded in the
balance of payments accounts,
with the major categories shown
on the right.
The purple line shows the flow of
transactions within the home
economy.
The green lines show all crossborder transactions.
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The Balance of Payments
Accounting for Asset Transactions: The Financial Account
• The financial account (FA) records transactions between
residents and nonresidents that involve financial assets. This
definition covers all types of assets:
• real assets such as land or structures,
• and financial assets such as debt (bonds, loans) or equity,
issued by any entity.
• Subtracting asset imports from asset exports yields the home
country’s net overall balance on asset transactions, which is
known as the financial account, where FA = EXA − IMA.
• The financial account therefore measures how the country
accumulates or decumulates assets through international
transactions.
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The Balance of Payments
Accounting for Asset Transactions: The Capital Account
• The capital account (KA) covers two remaining areas of asset
movement of minor quantitative significance.
1. the acquisition and disposal of nonfinancial, nonproduced
assets (e.g., patents, copyrights, trademarks, etc.)
2. capital transfers (i.e., gifts of assets), an example of which
is the forgiveness of debts
• We denote capital transfers received by the home country as
KAIN and capital transfers given by the home country as KAOUT.
The capital account, KA = KAIN − KAOUT, denotes net capital
transfers received.
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The Balance of Payments
Accounting for Home and Foreign Assets
• From the home perspective, a foreign asset is a claim on a
foreign country.
• When a home entity holds such an asset, it is called an
external asset of the home country.
• When a foreign entity holds such an asset, it is called an
external liability of the home country because it represents
an obligation owed by the home country to the rest of the
world.
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The Balance of Payments
Accounting for Home and Foreign Assets
• If we use superscripts “H” and “F” to denote home and
foreign assets, we can break down the financial account as
the sum of the net exports of each type of asset:
FA  ( EX AH  IM AH )  ( EX AF  IM AF )  ( EX AH  IM AH )  ( IM AF  EX AF )










Net export of home assets
Net export of foreign assets
Net export of home assets
=
Net additionsto
external liabilities
Net import of foreign assets
=
Net additionsto
external assets
(5-11)
• FA equals:
o the additions to external liabilities (the home-owned
assets moving into foreign ownership, net)
o minus the additions to external assets (the foreign-owned
assets moving into home ownership, net).
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The Balance of Payments
How the Balance of Payments Accounts Work:
A Macroeconomic View
• Recall that gross national disposable income is
Y  GNDI  GNE  TB  NFIA  NUT 
GNE
CA


Resources available
to home country from income
• In addition, the home economy can free up resources by
engaging in net sales (or purchases) of assets. We calculate
these extra resources using our previous definitions:
[ EX
KAOUT ]  [ IM
KAIN ]
A  
A  

Value of
all assets
exported
Value of
all assets
exported
as gifts
Value of
all assets
imported
 EX A  IM A  KAIN  KAOUT 
Value of
all assets
imported
as gifts



Value of
all assets exported via sales
Value of
all assets imported via purchases
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FA

KA



Extra resources available
to the home country
due to asset trades
81
The Balance of Payments
How the Balance of Payments Accounts Work:
A Macroeconomic View
• Adding the last two expressions, we have the value of the total
resources available to the home country for expenditures. This
total value is equal the total value of home expenditure on
final goods and services, GNE:
GNE
CA



Resources available
to home country due to income
FA

KA




GNE
Extra resources available
to the home country
due to asset trades
• Cancelling GNE from both sides we obtain the result known as
the balance of payments identity or BOP identity:
CA

Current account
+
KA

Capital account
+
FA

=
0
(5-12)
Financial account
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The Balance of Payments
How the Balance of Payments Accounts Work:
A Microeconomic View
• The components of the BOP identity allow us to see the
details behind why the accounts must balance.
CA  (EX  IM )  (EX FS  IM FS )  (UT UT )
KA  (KA  KA )
FA  (EX AH  IM AH )  (EX AF  IM AF )
(5-13)
• If an item has a plus sign, it is called a balance of payments
credit or BOP credit.
 • If an item has a minus sign, it is called a balance of payments
debit or BOP debit.
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The Balance of Payments
How the Balance of Payments Accounts Work:
A Microeconomic View
• We have to understand one simple principle: every market
transaction (whether for goods, services, factor services, or
assets) has two parts.
• If party A engages in a transaction with a counterparty B,
then A receives from B an item of a given value, and in
return B receives from A an item of equal value.
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The Balance of Payments
Understanding the Data for the Balance of Payments Account
TABLE 5-2 (1 of 3)
The U.S. Balance of Payments in 2012
The table shows U.S. international transactions in 2012 in billions of dollars.
Major categories are in bold type.
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The Balance of Payments
Understanding the Data for the Balance of Payments Account
TABLE 5-2 (2 of 3)
The U.S. Balance of Payments in 2012 (continued)
The table shows U.S. international transactions in 2012 in billions of dollars.
Major categories are in bold type.
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The Balance of Payments
Understanding the Data for the Balance of Payments Account
TABLE 5-2 (3 of 3)
The U.S. Balance of Payments in 2012 (continued)
The table shows U.S. international transactions in 2012 in billions of dollars.
Major categories are in bold type.
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The Balance of Payments
Understanding the Data for the Balance of Payments Account
• A country that has a current account surplus is called a (net)
lender. By the BOP identity, it must have a deficit in its asset
accounts.
• Any lender, on net, buys assets (acquiring IOUs from
borrowers). For example, China is a large net lender.
• A country that has a current account deficit is called a (net)
borrower. By the BOP identity, it must have a surplus in its
asset accounts.
• Any borrower, on net, sells assets (issuing IOUs to lenders).
As we can see, the United States is a large net borrower.
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The Balance of Payments
Some Recent Trends in the U.S. Balance of Payments
FIGURE 5-10
U.S. Balance of
Payments and Its
Components, 19902012 The figure shows
the current account
balance (CA), the
capital account balance
(KA, barely visible), the
financial account
balance (FA), and the
statistical discrepancy
(SD), in billions of
dollars.
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The Balance of Payments
What the Balance of Payments Account Tells Us
• The balance of payments accounts consist of:
o the current account, which measures external imbalances
in goods, services, factor services, and unilateral
transfers.
o the financial and capital accounts, which measure asset
trades.
• Surpluses on the current account side must be offset by
deficits on the asset side. Deficits on the current account
must be offset by surpluses on the asset side.
• The balance of payments makes the connection between a
country’s income and spending decisions and the evolution
of that country’s wealth.
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External Wealth
• Just as a household is better off with higher wealth, all else
equal, so is a country.
• “Net worth” or external wealth with respect to the rest of
the world (ROW) can be calculated by adding up all of the
home assets owned by ROW and then subtracting all of the
ROW assets owned by the home country.
• In 2012, the United States had an external wealth of about
–$4,474 billion. This made the United States the world’s
biggest debtor in history at the time of this writing.
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External Wealth
The Level of External Wealth
• The level of a country’s external wealth (W) equals
 ROW assets   Home assets 
External
wealth
 = owned by home   owned by ROW  (5-14)

W

 


A
L
• A country’s level of external wealth is also called its net
international investment position or net foreign assets. It is a
stock measure, not a flow measure.
If W > 0, home is a net creditor country: external assets
exceed external liabilities.
If W < 0, home is a net debtor country: external liabilities
exceed external assets.
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External Wealth
Changes in External Wealth
• There are two reasons a country’s level of external wealth
changes over time.
1. Financial flows: As a result of asset trades, the country
can increase or decrease its external assets and liabilities.
Net exports of home assets cause an equal increase in the
level of external liabilities and hence a corresponding
decrease in external wealth.
2. Valuation effects: The value of existing external assets
and liabilities may change over time because of capital
gains or losses. In the case of external wealth, this change
in value could be due to price effects or exchange rate
effects.
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External Wealth
Changes in External Wealth
• Adding up these two contributions to the change in external
wealth (ΔW), we find
 Change in 
Financial 
external wealth     account  




W
Net export of assets
=
FA
Capital gains on 
 external wealth 



(5-15)
Valuation effects
=
Capital gains minus capital losses
• Since −FA = CA + KA, substituting this identity into Equation (515), we obtain
 Change in   Current   Capital  Capital gains on 
external wealth   account   account    external wealth  (5-16)


 
 
 


W
CA
=
Unspent
income
KA
=
Net capital
transfers received
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Valuation effects
=
Capital gains
minus capital losses
94
The net international investment
position (External Wealth)
• One reason why the concept of Current Account
Balance is economically important is that it reflects a
country’s net borrowing needs.
• For example, as we saw earlier, in 2012 the United
States ran a current account deficit of 475 billion
dollars.
• To pay for this deficit, the country must have either
reduced part of its international asset position or
increased its international liability position or both.
• In this way, the current account is related to changes in
a country’s net international investment position.
The Current Account and the Net International Investment Position
• So we have that
ΔNIIP = CA + valuation changes,
• where NIIP denotes the net international
investment position, CA denotes the current
account, and Δ denotes change.
• In the absence of valuation changes, the level
of the current account must equal the change
in the net international investment position.
Valuation Changes and the Net International
Investment Position
• We saw earlier that a country’s net
international investment position can change
either because of current account surpluses or
deficits or because of changes in the value of
its international asset and liability positions.
• To understand how valuation changes can
alter a country’s NIIP, consider the following
hypothetical example.
An example
• Suppose a country’s international asset position, denoted
A, consists of 25 shares in the Italian company Fiat.
• Suppose the price of each Fiat share is 2 euros.
• Then we have that theforeign asset position measured in
euros is 25 × 2 = 50 euros.
• Suppose that the country’s international liabilities, denoted
L, consist of 80 units of bonds issued by the local
government and held by foreigners.
• Suppose further that the price of local bonds is 1 dollar per
unit, where the dollar is the local currency.
• Then we have that total foreign liabilities are L = 80 × 1 = 80
dollars.
An example
• Assume finally that the exchange rate is 2 dollars per euro.
Then, the country’s foreign asset position measured in
dollars is A = 50 × 2 = 100.
• The country’s NIIP is given by the difference between its
international asset position, A, and its international liability
position, L, or NIIP = A − L = 100 − 80 = 20.
• Suppose now that the euro suffers a significant
depreciation, losing half of its value relative to the dollar.
• The new exchange rate is therefore 1 dollar per euro. Since
the country’s international asset position is denominated in
euros, its value in dollars automatically falls.
• Specifically, its new value is A0 = 50 × 1 = 50 dollars.
An example
• The country’s international liability position measured
in dollars does notchange, because it is composed of
instruments denominated in the local currency.
• As a result, the country’s new international investment
position is NIIP0 = A0 − L = 50 − 80 = −30.
• It follows that just because of a movement in the
exchange rate, the country went from being a net
creditor of the rest of the world to being a net debtor.
• This example illustrates that an appreciation of the
domestic currency can reduce the net foreign asset
position.
An example
• Consider now the effect an increase in foreign stock prices
on the net international investment position of the
domestic country.
• Specifically, suppose that the price of the Fiat stock jumps
up from 2 to 7 euros.
• This price change increases the value of the country’s asset
position to 25 × 7 = 175 euros, or at an exchange rate of 1
dollars per euro to 175 dollars.
• The country’s international liabilities do not change in
value. The NIIP then turns positive again and equals 175 −
80 = 95 dollars. This example shows that an increase in
foreign stock prices can improve a country’s net
international investment position.
An example
• Finally, suppose that, because of a successful
fiscal reform in the domestic country, the price of
local government bonds increases from 1 to 1.5
dollars.
• In this case, the country’s gross foreign asset
position remains unchanged at 175 dollars, but
its international liability position jumps up to
80×1.5 = 120 dollars.
• As a consequence, the NIIP falls from 95 to to 55
dollars.
An example
• The above examples show how a country’s net
international investment position can display
large swings solely because of movements in
asset prices or exchange rates.
• In reality, valuation changes have been an
important source of movements in the NIIP of
the United States, especially in the past two
decades.
Valuation Changes and the Net International
Investment Position
• Another way to visualize the importance of valuation changes is to
compare the actual NIIP with the one that would have obtained in
the absence of any valuation changes.
• To compute a time series for this hypothetical NIIP, start by setting
its initial value equal to the actual value.
• Our sample starts in 1976, so we set Hypothetical NIIP1976 =
NIIP1976.
• Now, according to identity ΔNIIP = CA + valuation change, if no
valuation changes had occurred in 1977, we would have that the
change in the NIIP between 1976 and 1977, would have been equal
to the current account in 1977, that is,
Hypothetical NIIP1977 = NIIP1976 + CA1977,
where CA1977 is the actual current account in 1977.
Valuation Changes and the Net International
Investment Position
• Combining this expression with identity, ΔNIIP = CA + valuation
change, we have that the hypothetical NIIP in 1978 is given by the
NIIP in 1976 plus the accumulated current accounts from 1977 to
1978, that is,
Hypothetical NIIP1978 = NIIP1976 + CA1977 + CA1978.
• In general, for any year t, the hypothetical NIIP is given by the
actual NIIP in 1976 plus the accumulated current accounts between
1977 and t.
• Formally,
Hypothetical NIIPt = NIIP1976 + CA1977 + CA1978 + · · ·+ CAt.
Valuation Changes and the Net International
Investment Position
• What caused these large change in the value of assets in favor of the
United States?
– Milesi-Ferretti, of the International Monetary Fund, decomposes the largest
valuation changes in the sample, which took place from 2002 to the end of
2007
• He identifies two main factors. First, the U.S. dollar depreciated relative to
other currencies by about 20 percent in real terms. This is a relevant factor
because the currency denomination of the U.S. foreign asset and liability
positions is asymmetric.
• The asset side is composed mostly of foreign-currency denominated
financial instruments, while the liability side is mostly composed of dollardenominated instruments.
• As a result, a depreciation of the U.S. dollar increases the dollar value of
U.S.-owned assets, while leaving more or less unchanged the dollar value
of foreign-owned assets, thereby strengthening the U.S. net international
investment position.
Valuation Changes and the Net International
Investment Position
• Second, the stock markets in foreign countries
significantly outperformed the U.S. stock market.
• Specifically, a dollar invested in foreign stock markets
in 2002 returned 2.90 dollars by the end of 2007.
• By contrast, a dollar invested in the U.S. market in
2002, yielded only 1.90 dollars at the end of 2007.
• These gains in foreign equity resulted in an increase in
the net equity position of the U.S. from the
insignificant level of $0.04 trillion in 2002 to $3 trillion
by 2007.
External Wealth
Understanding the Data on External Wealth
TABLE 5-3 (1 of 3)
U.S. External Wealth in 2011-2012
The table shows changes in the U.S. net international investment position
during the year 2012 in billions of dollars. The net result in row 3 equals
row 1 minus row 2.
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External Wealth
Understanding the Data on External Wealth
TABLE 5-3 (2 of 3)
U.S. External Wealth in 2011-2012 (continued)
The table shows changes in the U.S. net international investment position
during the year 2012 in billions of dollars.
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External Wealth
Understanding the Data on External Wealth
TABLE 5-3 (3 of 3)
U.S. External Wealth in 2011-2012 (continued)
The table shows changes in the U.S. net international investment position
during the year 2011 in billions of dollars. The net result in row 3 equals
row 1 minus row 2.
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External Wealth
Some Recent Trends
• For the past 30 years the United States has almost always had
a financial account surplus, reflecting a net export of assets to
the rest of the world to pay for chronic current account
deficits.
• If there were no valuation effects, then Eq. (5-15) implies that
the change in the level of external wealth should equal the
cumulative net import of assets over the intervening period.
• But valuation effects or capital gains can generate a significant
difference in external wealth.
• From 1988 to 2012 these effects reduced U.S. net external
indebtedness in 2012 by more than half compared with the
level that financial flows
alone would have predicted.
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External Wealth
What External Wealth Tells Us
• External wealth data tell us the net credit or debit position of
a country with respect to the rest of the world.
• They include data on external assets (foreign assets owned by
the home country) and external liabilities (home assets owned
by foreigners).
• A creditor country has positive external wealth, a debtor
country has negative external wealth.
• Countries with a current account surplus (deficit) must be net
buyers (sellers) of assets.
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External Wealth
What External Wealth Tells Us
• An increase in a country’s external wealth results from every
net import of assets; conversely, a decrease in external wealth
results from every net export of assets.
• In addition, countries can experience capital gains or losses on
their external assets and liabilities that cause changes in
external wealth.
• All of these changes are summarized in the statement of a
country’s net international investment position.
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