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International Finance Econ 356 Karine Gente [email protected] • Web page: http://www.econ.ubc.ca/directory/sess/sfac kg.htm Office room: Buch tower 1099 D • Teaching Assistant: Kang Shi Email: [email protected] Office room: Buch tower 1099C Office 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) Japan France 30 25 20 15 10 1960 1965 1970 1975 1980 1985 1990 1995 2000 Canada 19 60 19 63 19 66 19 69 19 72 19 75 19 78 19 81 19 84 19 87 19 90 19 93 19 96 19 99 15 13 11 9 7 5 United States 45 35 30 25 20 15 1965 1970 1975 1980 1985 1990 1995 19 60 19 63 19 66 19 69 19 72 19 75 19 78 19 81 19 84 19 87 19 90 19 93 19 96 19 99 14 12 10 8 6 4 40 International trade Table 1.5 Top 15 international trade ($bn.), 1999 country exports % of world country USA imports % of world 1,116 15.9 1 USA 956 13.7 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 Imports and Exports as a percentage of output: 2000 Percentage40 of GDP 35 30 25 20 15 10 5 0 Canada France Germany Imports Exports Italy Japan U.K. U.S. International trade (1999) Exports 1200 USA relative to 1000 imports import value 800 600 Germany 400 Japan 200 Netherlands 0 0 200 400 600 export value 800 1000 1200 • 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. Money (I) Domestic Country Rest of the World Imports Exports Domestic Country Rest of the World 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 19 70 19 72 19 74 19 76 19 78 19 80 19 82 19 84 19 86 19 88 19 90 19 92 19 94 19 96 19 98 20 00 Canada Current account balance (% of GDP) 3 2 1 0 -1 -2 -3 -4 -5 -6 Measures of Financial Integration Industrial Countries 1.0 Restriction Measure (left scale) 1.5 Openness Measure (right scale) 0.8 1.2 0.6 0.9 0.4 0.6 0.2 0.3 0.0 0.0 1970 1974 Source: WEO, Lane and Milesi-Ferreti (2003) 1978 1982 1986 1990 1994 1998 Measures of Financial Integration Developing Countries 1.0 0.50 Openness Measure (right scale) Restriction Measure (left scale) 0.8 0.40 0.6 0.30 0.4 0.20 0.2 0.10 0.0 0.00 1970 1974 Source: WEO, Lane and Milesi-Ferreti (2003) 1978 1982 1986 1990 1994 1998 • 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) All Developing Economies 180 Bank Lending 160 Portfolio Flows FDI 140 120 100 80 60 40 20 0 1970 1975 1980 1985 -20 Year Source: WEO 1990 1995 Net Private Capital Flows (Billions of USD) More Financially Integrated Economies Less Financially Integrated Economies 180 9 8 Bank Lending 160 Portfolio Flows Portfolio Flows 7 FDI 140 Bank Lending FDI 6 120 5 100 4 80 3 60 2 40 1 20 0 1970 0 1970 1975 1980 1985 -20 1980 1985 1990 1995 -2 Year Source: WEO 1975 -1 Year 1990 1995 • 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 realsector 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 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 Higher Economic Growth International economic integration could help growth and development International Economic Integration and Contagion International 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 Country B’s Income ↑ ↑ Demand (country A) - Domestic goods - Imports Country B’s Exports ↑ 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 C C d C f I Id If G G d G f superscripts: d = spending on domestic goods f = spending on foreign goods EX = exports = foreign spending on domestic goods IM = imports = C f + I f + G 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 Y C d I d G d EX (C C f ) (I I f ) (G G f ) EX C I G EX (C f I f G f ) C I G EX IM C I G NX The national income identity in an open economy Y = C + I + G + NX or, NX = Y – (C + I + G ) domestic spending net exports 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 NX = Y – (C + I + G ) implies NX = (Y – C – G ) – I = S – I trade balance = net capital outflows Long-run Equilibrium • An open economy model : – Two countries Country A SA,IA Country B SB,IB IA+IB=SA+SB – Small open economy Domestic Country Rest of the World r* Saving and Investment in a Small Open Economy production function: consumption function: investment function: Y Y F (K , L ) C C (Y T ) I I (r ) exogenous policy variables: G G , T T National Saving: The Supply of Loanable Funds r S Y C (Y T ) G To simplify, national saving does not depend on the interest rate S S, I Assumptions re: capital flows a. 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* a & b imply r = r* c implies r* is exogenous Investment: The Demand for Loanable Funds r Investment is still a downward-sloping function of the interest rate, but the exogenous world interest rate… r* …determines the country’s level of investment. I (r ) I (r* ) S, I If the economy were closed… r …the interest rate would adjust to equate investment and saving: S rc I (r ) I (rc ) S S, I But in a small open economy… the exogenous world interest rate determines investment… r r* …and the difference between saving rc and investment determines net capital outflows and net exports S NX I (r ) I1 S, I Three experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 1. Fiscal policy at home r An increase in G or decrease in T reduces saving. r * 1 S2 S1 NX2 NX1 Results: I 0 I (r ) NX S 0 I1 S, I 2. Fiscal policy abroad Expansionary fiscal policy abroad raises the world interest rate. r NX2 r2* S1 NX1 r * 1 Results: I 0 I (r ) NX I 0 I (r ) * 2 I (r1* ) S, I 3. An increase in investment demand r S r* EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. NX1 I (r )1 I1 S, I 3. An increase in investment demand r ANSWERS: I > 0, S = 0, S NX2 r* net capital outflows and net exports fall by the amount I NX1 I (r )2 I (r )1 I1 I2 S, I 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