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International Finance
Real World Economic
Activity
Data Collection
Economic
Analysis
Economic Theory
Models
International Finance
The Quantity Theory
Equation 1
MV = PQ
Equation 2
M
1
= k Q, where k =
P
V
Equation 3
V
P= M
Q
V
P =  M, with  =
Q
International Finance
Quantity Theory of Price Adjustment
M
2 M0
M0
t*
P
time
2P0
P0
time
Q
Q0
Q0
time
International Finance
Extreme Macro Instability
Bolivian Inflation and Monetary Growth
25000
20000
Percentage 15000
Rate of
Change 10000
Inflation
Monetary Growth
5000
Year
92
90
88
86
84
82
0
International Finance
The Purchasing Power Parity
Equation 4
Equation 5
P
d
= E P
f

E = Pf = f M f =  M f
 M
P
M
d
d
d
d
International Finance
Purchasing Power Parity and
Overshooting
M
2M0
M0
E
P,E
time
2P0, 2E0
P0,E0
P
time
International Finance
Unpleasant Monetarist Arithmetic
Equation 6
G iB T M B
+  =
+
P P P
P
P
International Finance
Unpleasant Monetarist Arithmetic:
Sargent and Wallace: P* vs P**
Deficit
time
Bonds
Money,
Bonds
Money
t*
Price
Level
time
P*
P**
time
International Finance
The Absorption Model of the
Balance of Trade
Equation 7
Y = C + I + G  T + EX  IM
Equation 8
EX  IM = Y  (C + I) + (T  G) = (Y  A) + (T  G), where A = C + I
International Finance
United States Current Account and
Fiscal Balance, 1968-1992
Year
90
80
Trade Balance
Fiscal Balance
70
68
50
0
-50
-100
-150
-200
-250
-300
-350
-400
International Finance
Further Implications
Equation 9
BOT = EX - e . p* IM
Equation 10
Current Act = BOT + e . i* Kf,d - i Kd,f
Equation 11
CapAccount  K d , f  eK f ,d
Equation 12
NFA = e. Kf,d-Kd,f
International Finance
Balance of Payments
BOP = Current Account + Capital Account
Under fixed exchange rates only:
Change in Foreign Exchange Reserves = BOP
International Finance
Fiscal and External Balances, USA
200
Fiscal Balance
100
0
Balance of
Payments
Trade Balance
Billions of US
-100
Dollars
-200
Net Foreign Asset
Pos
-300
Year
89
19
85
19
81
19
77
19
73
19
69
19
65
19
19
61
-400
International Finance
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.
International Finance
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)
International Finance
Demand and Supply of
Foreign Exchange
R($,DM)
German Supply of DM
R*
US Demand for DM
DM
International Finance
Responses to Overvaluation:
Devaluation and Fiscal
Contraction
R($,DM)
German Supply of DM
R*
R**
New US Demand
Trade Deficit
US Demand for DM
D
M
International Finance
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.
International Finance
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 savingsinvestment imbalance, and the trade balance
falls.
International Finance
Multiple Equilibria in ForEx
Market
R
B
Demand
A
Supply
C
DM
International Finance
J-Curve Dynamics
Trade Balance
Devaluation
0
time
International Finance
Triangular Arbitrage
Equation 13
R(£,$) = 1/R($,£)
Equation 14
R(£,DM) = R(£,$) R($,DM)
Equation 15
R(£,DM) = R($,DM) = .5 & R($,£) = 2 .25.
International Finance
Covered Interest Parity
K dollars
US investment
K(1+r)
(K/R)(1+r*) FR
sell
forward
buy
spot
UK investment
K/R sterling
(K/R)(1+r*)
International Finance
Covered Interest Rate Parity
Equation 16
K(1+r) = (K/R)(1+r*) FR
Equation 17
R (1+r)/(1+r*) = FR
Equation 18
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
Equation 21
(r-r*) = [E(Rt+1)-R]/R
International Finance
Measuring Capital Mobility
Equation 22
(r-r*) = [Rt+1-R]/R
Equation 23
r -  = r* - *
Equation 24
r - r* =  - *
Equation 25
(S - I) + (T - G) = (X - M)
International Finance
Real Exchange Rate
Non-tradeables
Real Exchange Rate
NT*
Tradeables
T*
International Finance
The Real Exchange Rate
Equation 26
Equation 27
R P*
P
tradeables
REXR =

Pnontradeables
Pcpi
REXR 
R
Pcpi
Equation 28
REXR 
P wpi
Pcpi
International Finance
U.S. Real Exchange Rate Swings, 79-81
Indices Based on Unit Labor Costs and CPI
1.8
1.6
1.4
1.2
1
Index
0.8
0.6
0.4
0.2
0
Real Ex. Index-1
Real Ex. Index - 2
79 80 81 82 83 84 85 86 87 88 89 90 91
Year
International Finance
Classification of Policy Regimes
Exchange Rate Regime
Instrument
Fixed
Flexible
Monetary
Policy
WEAK
STRONG
Fiscal
Policy
STRONG
WEAK
International Finance
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
International Finance
Mundell - Fleming Model
General Equilibrium
r
IS
LM
E
FF
Y
International Finance
Endogeneity of the Money Supply
Equation 30
 M = Res = BOP(Y,r), BOPY < 0, BOPr > 0
International Finance
Mundell - Fleming Model
Effects of Monetary Expansion
r
LM
LM’
E
FF
E’
IS
Y
International Finance
Mundell - Fleming Model
Effects of Fiscal Expansion
r
LM
LM’
E
FF
E’
IS’
IS
Y
International Finance
Mundell - Fleming Model
Effects of Devaluation
r
LM
LM’
E
FF
FF’
IS
Y
International Finance
Swan Diagram: Internal/External
Balance
r
II
B:external surplus,
internal inflation
EE
A:external deficit,
internal inflation.
G-T
International Finance
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*
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Dornbusch Model: Basic Setup
e
DD
A
AA
p
International Finance
Dornbusch Model: Monetary
Expansion with Overshooting
e
DD
B
C
AA’
A
AA
p
International Finance
Wicksell's Problem
Sweden
timber
Norway
fish
Denmark
wheat
ultimate flows
intermediate flows
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Bilateral Exchange
Arrangements-Unbalanced
Flows
A
C
B
D
International Finance
D’s Money as Medium of Exchange, Barter between
A and B
A
C
B
D
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A’s and B’s Money as Media of Exchange
A
C
B
D
International Finance
Borrowing and Lending
Strategies
Lending
Borrowing
Period 1
r1
i1
r
r2
i
i2
Positive maturity transformation
Period 2
International Finance
The Phillips Fixed-Coefficient
Model of the Banking System
Equation 32
R= r D
C=k D
MB = R + C
Equation 33
MB = r D + k D
D
1
=
MB r + k
International Finance
Internal Structure of Eurodollar
Market
Borrowers
Lenders
USA
London
Europe
International Finance
Eurodollar Market and OPEC
Recycling
Borrowers
Lenders
USA
OPEC
Deposits
London
Europe
LDC
Borrowers
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Manufacturing, Resources, and Service Sector Economy
D-r
D-m
D-s
w
Services
O
w
Manufacturing
employment
Resource
employment
R
M
O'
International Finance
Manufacturing, Resources, and Service Sector EconomyDirect Deindustrialization Due to Boom in Resource Sector:
M-M': Direct De-industrialization Effect
D-m
D-r
D-s
W’
w
O
R
M
M'
O'
International Finance
Manufacturing, Resources, and Service Sector EconomyIndirect Deindustrialization Due to Boom in Ensuring Service-Sector Boom:
M'-M'': Indirect De-industrialization Effect
D-r
D-m
D-s
w''
w'
w
O
R
M
M' M''
O'
International Finance
Key Macroeconomic Variables of the World
Economy
Before and During Debt Crisis
20
15
10
5
0
-5
-10
-15
LIBOR Rate
Inflation- Ind. Goods
Inflation- Commodity
OECD Growth
70-79
80-82
Years
83-84
International Finance
Latin American Per-Capita Output Growth
Inflation
4
3
2
1
0
-1
-2
-3
200
150
100
50
0
62-80
80-84
84
62-80
Gross Investment -GDP Ratio
25
20
15
10
5
0
62-80
80-84
84
80-84
84
International Finance
Structure of Latin American Debt in 1983
100
80
Total Debt
Bank Debt
US Bank Debt
Billions of US 60
Dollars
40
20
ue
l
a
o
Ve
ne
z
ic
ex
M
hi
le
C
l
zi
ra
B
Ar
ge
nt
in
a
0
International Finance
Secondary Market Value
B
A
Nominal Value of Debt
C
International Finance
Seignorage and Dollarization:
Multiple Equilibria
Equation 34
M M M
=
P
M P
M
M
g t =
with  =
P
M
g t =
Equation 35
M
= A e
P
m  p = a   ,
m  log (M)
p  log (P)
a  log (A)
International Finance
Inflation Laffer Curve

Deficit
A
B
 (M/P)
International Finance
Inflationary Dynamis in a Dollarized Indexed Economy
Oil
Shock
Manufacturing
50%
Import
Component
50%
wages
Devaluation
Price of
Output
COLA
Indexed Gov't
Debt
Dollarization
Fiscal Deficit
Monetary
Growth
International Finance
Figure 1:Instruments of Markets
Banks
Structure of Financial Markets
CD's
Bonds
T'Bills
Time and Saving Deposits Acceptances
Mortgages
Mortgage-backed securities
Parallel loans and currency swaps
Repurchase Agreements
Long-term bonds
Commercial Paper
Stripped and zero coupon bonds
Prime and score securities
Swaps:debt for equity
Equity Optioned and non-optioned equity
Heaven and hell bonds
Dual currency bonds
warrants and convertible bonds
Poisoned pills
Preferred stock
Foreign Exchange
spot
forward
future
call/put option
International Finance
Figure 2
Trading Structure in Financial Markets
Exchange-traded
Futures
Over-thecounter
Swaps
Structured/
embedded
Convertibles
Warrants
Options
International Finance
Figure 3
Nikkei-linked bond with puts
put
Investor
Issuer
coupon,premium
premium
Arranging bank
premium
put
Investor
put
International Finance
Figure 4
Equity derivative swap, two-sided
appreciation
Bank A
Bank B
depreciation
premium (upfront or LIBOR flow)
International Finance
Figure 5
Customized derivative swap
premium for call at 22,000
appreciation
Bank A
Investor
5%
T-notes at 5%
appreciation in Nikkei
over 22,000
Figure 6
International Finance
Equity Derivative Swap with
Embedded Options
LIBOR Prem
Bank Y
Index apprec.
Knock-out on Nikkei
Yen/$ Quanto
Bank X
Figure 7
International Finance
Swap Credit Exposure:
Regulatory Approach
OEM
Credit
conversion
Swap credit
risk
CEM
Mark to
market
Swap credit
risk
International Finance
Figure 8
Creation of a Differential Swap
Company
Y
i-US
i-US
Bank A
Bank B
US fixed
i-DM less SPR
DM fixed
i-DM
Bank C
i-DM and i-US: DM and US LIBOR