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International Finance

Chapter 1 The Global Macroeconomy

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Chapter Outline

• Foreign exchange: currencies and crises• Globalization of finance: debts and deficits• Government and institutions: Policies and

Performance

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Intro to International Macroeconomics

• large-scale economic problems in global interdependent economies.

• key economy-wide variables such as exchange rates, prices, interest rates, income, wealth, and the current account.

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Foreign Exchange: Currencies and Crises

• Countries have different currencies, therefore 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:

o goods (such as autos and clothing), o services (such as insurance and tourism), ando assets (such as equities and bonds).

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Foreign Exchange: Currencies and Crises

• How Exchange Rates Behave

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Foreign Exchange: Currencies and Crises

Questions - •How are exchange rates determined?•Why do some exchange rates fluctuate sharply in the short run, while others are almost constant? •Can exchange rates be forecast in the long run?•How do exchange rates affect the real economy?•How do changes in exchange rates affect the values of foreign assets, and hence national wealth?

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Foreign Exchange: Currencies and Crises

• In an exchange rate crisis a currency experiences a sudden and pronounced loss of value against another currency following a period in which the exchange rate had been fixed or relatively stable.

• There have been more than 27 exchange rate crises in the 12-year period from 1997 to 2011.

• In some cases, including Argentina in 2002, exchange rate crisis lead to governments declaring default (i.e., a suspension of payments).

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Foreign Exchange: Currencies and Crises

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Foreign Exchange: Currencies and Crises

• Governments in crisis may appeal for external help from international development organizations, such as the International Monetary Fund (IMF) or World Bank, or other countries.

Questions - •Why do exchange rate crises occur? Rational or not?•Why are these crises so economically and politically costly?•What steps might be taken to prevent crises, and at what cost?

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Globalization of Finance: Debts and Deficits

Current Account ---

CA = EX – IM = Y – ( C + I + G)• CA>0

– Exports > Imports– Total income > total spending– Net foreign wealth is increasing

• CA<0– Exports < Imports– Total income < total spending– Net foreign wealth is decreasing

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Globalization of Finance: Debts and Deficits

Source: U.S. Department of Commerce, Bureau of Economic Analysis

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Globalization of Finance: Debts and Deficits

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Globalization of Finance: Debts and Deficits

Questions -•How do different international economic transactions contribute to current account imbalances?

•How are these imbalances financed? How long can they persist?

•Why are some countries in surplus and others in deficit? What role do current account imbalances perform in a well-functioning economy?

•Why are these imbalances the focus of so much policy debate?

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Current Account Deficit

• A country borrows from another to finance its spending.

• CA deficit adds to a country’s debt.• A debtor is not necessarily a bad thing. It depends

on how a nation spends its borrowed money: on current consumption or on productive investment. If it is the latter, then the nation’s future production would increase and more than offset its debt. As a result, the nation will enjoy an enhanced ability to consume more goods and services in the future.

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Debtors and Creditors: External Wealth

• Total wealth or net worth = assets - liabilities

• A surplus (saving money by buying assets or paying down debt ) helps increase net worth.

• Similarly, a deficit (taking on debt or running down savings) contributes to a lower net wealth.

• From an international perspective, a country’s net worth is called its external wealth and it equals the difference between its foreign assets and its foreign liabilities.

• Positive external wealth makes a country a creditor nation; negative external wealth makes it a debtor nation.

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U.S. Gross Foreign Assets and Liabilities, 1976 - 2009

Source: U.S. Department of Commerce, Bureau of Economic Analysis, June 2010

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Globalization of Finance: Debts and Deficits

Questions -•What forms can a nation’s external wealth take and does the composition of wealth matter?

•What explains the level of a nation’s external wealth and how does it change over time?

•How important is the current account as a determinant of external wealth? How does it relate to the country’s present and future economic welfare?

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Government and Institutions: Policies and Performance

• Government actions influence economic outcomes in many ways by making decisions about exchange rates, macroeconomic policies, debt repayment, and so on.

• To gain a deeper understanding of the global macroeconomy, economists study policies, rules and norms, or regimes in which policy choices are made.

• At the broadest level, research also focuses on institutions, a term that refers to the overall legal, political, cultural, and social structures that influence economic and political actions.