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Lecture 8
International Finance
ECON 243 – Summer I, 2005
Prof. Steve Cunningham
Capital Mobility



Perfect Capital Mobility means that a practically
unlimited amount of international capital flows in
response to the slightest change in one country’s
interest rates.
Absent political and macroeconomic risks, a
successful fixed exchange rate regime should make
perfect capital mobility more likely. (Exchange
rate risk is zero.)
For a small country, perfect capital mobility
implies that the country’s interest rate must be
equal to the world interest rate.
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Capital Mobility and Monetary Policy

Under fixed exchange rates and perfect capital
mobility, international capital flows dictate the
country’s money supply.


International conditions dominate domestic policy.
If a country tries to reduce its money supply to raise its
interest rates for domestic policy reasons,
1.
A slightly higher interest rate attracts a nearly unlimited capital
inflow.
2. The exchange rate must be defended by selling domestic
currency, thereby expanding the money supply.
3. It is impossible to sterilize in the face of such large capital flows.
4. The expanding money supply lowers the domestic interest rate.
3
Capital Mobility and Fiscal Policy

Under fixed exchange rates, perfect capital
mobility enhances domestic fiscal policy.



Because interest rates cannot rise, there is no
possibility for “crowding out”.
If the government increases spending without
raising taxes, it incurs deficits.
The deficits can easily be financed by in the
enormous capital inflows.
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Trade-off?
Improved fiscal policy effectiveness is not a
good substitute for monetary policy.
Fiscal policy is cumbersome—slow to enact, not
so responsive as monetary policy.
Fiscal policy is very much influenced by shortrun political interests.
Not helpful for handling long-run inflationary
issues.
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Monetary Policy Without FE
i
LM1
LM0
i1
i
LM1
LM0
i1
i0
IS
Y1 Y0
Y
Under normal conditions, ignoring
international complications, a reduction
in the money supply raises interest rates,
making investment more expensive,
slowing output.
i0
IS
Y0
Y
?
Again ignoring international complications,
if investment is not sensitive to interest rate
changes, a reduction in the money supply
raises interest rates a lot, but this has little
effect on output.
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Monetary Policy
Under fixed exchange rates and perfect capital mobility
i
FE
i0
LM
IS
Y0
Y
In this case, any change in the domestic
money supply causes a change in the
interest rate, leading to the movement
of enormous international capital
flows. These capital flows happen
almost instantly, and continue until the
interest rates are restored to their
original level—the same level as the
world interest rate.
Thus, effectively, the interest rate is
fixed at the world rate, and domestic
monetary policy cannot change the
interest rate, and therefore cannot
affect the domestic economy.
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Fiscal Policy without FE
LM
i
i
IS0
i1
IS1
LM0
i0
IS1
i0
IS0
Y0,1
Y
Under normal conditions, ignoring
international complications, if money
demand is very unresponsive to interest
rates, then fiscal policy simply raises
interest rates, and rendered weak as a
result of “crowding out”.
Y0
Y1
Y
Again ignoring international complications,
if money demand is sensitive to interest rate
changes, fiscal stimulus is powerful. Small
changes in interest rates have a large
impact on the money supply-demand
equilibrium. There is no crowding out.
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Fiscal Policy
Under fixed exchange rates and perfect capital mobility
i
FE
i0
LM
IS
Y0
Y1
A stimulative fiscal policy shifts IS to
the right. Any tiny increase in the
interest rate generates enormous
changes in the domestic money
supply-demand equilibrium as a
result of the enormous capital
inflow. FE and LM are both
anchored at the world interest rate.
Thus there is no possibility of
crowding out, and fiscal policy is
powerful.
Y
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Policy Effectiveness

Under perfect capital mobility and fixed
exchange rates,


Monetary policy is limited to defending the
fixed exchange rate, and
Fiscal policy can be powerful.
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Internal Shocks

A domestic monetary shock alters the equilibrium
relationship between money supply and demand
because:



The money supply changes, or
People alter their personal systems of determining how
much money to hold (demand) perhaps as a result of
innovations or changes in the payments system.
A domestic spending shock alters domestic real
expenditure by a change in one of its components
(C,I,G). An example is a fiscal policy change.
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External Shocks

An international capital-flow shock is an
unexpected shift of international funds in
response to political upheaval or fears of a
international policy change. Examples are:



Fear of war
Rumors of the imposition of capital controls
Growing evidence of a likely currency
devaluation

A form of capital flight
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Adverse Int’l Capital-Flow Shock
1.
FE shifts to higher
interest rates.
2.
Official settlements
balance is in deficit at
point E. Central bank
must defend the fixed
rate.
3.
If the central bank
does not sterilize its
intervention, LM shifts
upward to left, and
external balance is
restored.
4.
Internal imbalance is
created by falling
output and rising
unemployment. 13
LM1
FE
i
1
LM
T
0
FE
0
E
IS
Y1
Y0
Y
International Trade Shocks


An international trade shock is a shift in a
country’s exports or imports arising from
causes other than changes in the real
income of the country.
These are structural changes.



British beef.
A country that is found to use DDT in its
agriculture.
It alters the current account.
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Policy Responses
State of the Domestic Economy
High
Unemployment
State of
Balance of
Payments
Rapid Inflation
Surplus
Expansionary
Policy
??
Deficit
??
Contractionary
Policy
In the situations marked by “??”, aggregate demand policy cannot deal
effectively with both the internal and external situations simultaneously.
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Policy Responses
When confronted with one of the situations
marked with ??, the government is in a trap.
Internal imbalance solutions worsen the external
balance, and vice-versa.
It has three choices:


1.
2.
3.
It can abandon the goal of external balance, which
will require eventual abandonment of the fixed
exchange rate.
It can abandon the goal of internal balance, at least
on the short run.
It can search for other solutions, like…?
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Alternative for the Short Run

Robert Mundell and J. Marcus Fleming realized
there might be a possibility of using an
appropriate “policy mix”.




Stimulative monetary policy lowers interest rates;
stimulative fiscal policy raises interest rates.  Maybe a
combination, each offsetting the worst of the other?
It is the changes in interest rates that affect the
payments balance.
So with a combined policy, one could have fiscal policy
stimulus and lower interest rates!
More generally, monetary and fiscal policies can be
mixed so as to achieve any combination of internal and
external goals in the short run.
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Assignment Rule

According to Mundell’s assignment rule:



Assign fiscal policy the task of stabilizing the domestic
economy (only),
Assign to monetary policy the task for stabilizing the
balance of payments (only)
Each arm of policy concentrates on a single task,
making coordination of policy trivial.


Also each arm of policy is addressing the issues it cares
most about.
Timing, though, remains critical. Lags from either side
could result in unstable oscillations.
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Monetary-Fiscal Recipes
State of the Domestic Economy
State of
Balance of
Payments
High unemployment
Rapid Inflation
Surplus
Easier monetary policy,
easier fiscal policy
Easier monetary policy,
tighter fiscal policy
Deficit
Tighter monetary policy,
easier fiscal policy
Tighter monetary policy,
tighter fiscal policy
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Exchange Rates
and the Trade Balance

What is the effect of a change in the
nominal exchange rate on the volumes of
exports and imports?


As long as the change in the exchange rate
alters the int’l price competitiveness, it should
change the volume of trade.
What is the effect on the value of trade?

This is more difficult. (Remember both prices
and volumes are changing.)
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Devaluation (Surrender)

The devaluation should improve international
price competitiveness as long as any changes in
the domestic price level or foreign price level do
not offset the exchange rate change.



Exports increase as goods become cheaper to foreign
buyers.
Imports decrease as foreign goods become more
expensive to domestic buyers.
OVERALL, the current account tends to improve. The
result on the capital account is less clear.
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Consider a devaluation
Consider a devaluation of the dollar, where the CA
balance is measure in pounds per year:
CA balance =
P £X
•
Effect =
-
Quantity
of Exports
£ price of
Exports

No
change
or down
X
•

No
change or up
P£m
•
M
£ price of
Imports
Quantity
of Imports

No
change
or down

No
change
or down
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•
Problem?

In the case of perfectly inelastic demand for
exports and imports, devaluing the dollar
could result in a worsened trade balance.


The foreign price of exports fall, but quantities
demanded are NOT responsive to price, so the
volume stays the same.
Thus P£X is lower, but X is unchanged, and
P£X • X is lower. The value of exports declines.
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More Likely Result




On the short run, prices will be able to adjust more
quickly than quantities. (Export demand is more inelastic
in the short run.)
So immediately following a devaluation or depreciation,
the value of exports will fall, worsening the trade
balance.
Over the longer term, prices can adjust. (Export demand
is more elastic in the long run.) So longer term, the trade
balance would improve.
In fact, the longer the elapsed time since the devaluation
or depreciation, the more likely the trade balance is to
be improved.
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J Curve

It is more likely that the drop in the value of
the home currency will improve the trade
balance, especially in the long run.
+
Net change in
trade balance
0
Months since
devaluation
-
18 months
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Flexible Exchange Rates



Under a clean float, external balance is
maintained by the changing exchange rates.
Policy focuses on internal balance.
Remaining questions:



What are the effects of shocks?
How does the exchange rate change resolve
external imbalances?
How do fluctuations in the exchange rate affect
the macroeconomy?
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Expansionary Monetary Policy
Capital flows out
Money
supply
increases
Interest
rate
drops
Our currency
depreciates
Spending
and
output
increase
Current
account
balance
improves
GDP
rises
more
Current
account
balance
worsens
Price level
rises
27
Expansionary Monetary Policy (2)



Under floating exchange rates, monetary
policy is powerful in its effects on internal
balance.
The induced change in the exchange rate
reinforces the domestic effects of monetary
policy.
Monetary policy is a more powerful tool for
managing the domestic economy under
flexible exchange rates.
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Expansionary Monetary Policy
LM0
i
FE0
LM1
E0
FE1
T1
E1
IS0
Y0
Y1
IS1
Following
expansionary
monetary policy, the
currency depreciates
to correct the deficit
payments balance—
FE moves to the right.
IS moves to the right
as the current account
improves.
Y
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Expansionary Fiscal Policy
Interest
rate rises
Capital
flows in
Our currency
may appreciate
at first, but
probably
depreciates
eventually
Gov’t
spending
increases
Spending
and
output
increase
GDP falls,
then rises
more
Current
account
balance
worsens
Price level
rises
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