Economics of International Financial Policy: ITF 220 Staff -- Professor: Jeffrey Frankel, Littauer...

Economics of International Financial Policy: ITF 220

Staff -- Professor: Jeffrey Frankel , Littauer 217Office hours: Mondays 4:15-5:15; Tuesdays 2:00-3:00.

Faculty Asst.: Minoo Ghoreishi, Belfer 505 (617) 384-7329

Times – Lectures: Mon. & Wed., 2:40-4:00 p.m., Littauer 382 Review sessions: Fridays, 11:40-1:00, Littauer 332 Final exam: Monday, May 11, 2014, 2:00-5:00 p.m.

Requirements -- Textbook: World Trade & Payments + Readings. 7 Problem Sets (20%) + Midterm (30%) + Final exam (50%).

Professor Jeffrey Frankel, Kennedy School, Harvard University

Big topics covered in the courseI) ELASTICITIES & THE TRADE BALANCE

II) THE KEYNESIAN MODEL OF INCOME

III) THE MONETARY APPROACH TO THE BALANCE OF PAYMENTS

IV) GLOBALIZATION OF FINANCIAL MARKETSV) FISCAL & MONETARY POLICY UNDER

INTERNATIONAL CAPITAL MOBILITYVI) INTERDEPENDENCE AND COORDINATIONVII) SUPPLY, INFLATION & MONETARY UNION

VIII) EXPECTATIONS, MONEY, & DETERMINATION OF THE EXCHANGE RATE

• Lecture 1: Balance of Payments Accounting

• Lecture 2: Supply & demand for foreign exchange; export and import elasticities

• Lecture 3: Empirical effects of devaluation on the trade balance

TOPIC I: ELASTICITIES & THE TRADE BALANCE


Lecture 1:Balance of payments accounting

• Definition: The balance of payments is the year’s record of economic transactions between domestic and foreign residents.

• The rules:– If you have to pay a foreign resident,

normally in exchange for something that you bring into the country, then the something counts as a debit.

– If a foreign resident has to pay you for something, then the something counts as a credit.

NOW CALLED “FINANCIAL ACCOUNT”

“Primary income,” mainly investment income

≡ “secondary income”

I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

-250000

-200000

-150000

-100000

-50000

0

U.S. International Transactions

Balance on current account (line 1 less line 9) /4/ Balance on goods and services (line 2 less line 10)

Seasonally Adjusted

Goods

Goods &Services

CurrentAccount

Measures of external balanceUS 2004-2013

US services surplus partially offsets the deficit in goods.

PER QUARTER


Examples on the current account:• You, an American, import software CD-roms from India

=> debits appear on US merchandise account.• You import services (electronically) of an Indian software firm

=> debit appears on US services account. (This is the famous and controversial “overseas outsourcing.”)

• You buy the services, instead, from a subsidiary that the Indian software firm set up last year in the US. This is not an international transaction, and so does not appear in the accounts. But assume the subsidiary sends some profits back to India => debit appears on US investment income account. (It is as if the US is paying for the services of Indian capital.)

• Employees of the subsidiary in the US (or any other US resident entities) send money to relatives back in India => debit appears under unilateral transfers.


Examples on the long-term capital account: Instead of buying software CD-roms from India,

you buy the company in India that makes them. => debit appears on US capital account, under FDI. (You have imported ownership of the company.)

Instead of buying the entire company in India, you buy some stock in it => debit appears on US capital account, under equities.

(You have imported claims against an Indian resident.)

Instead of buying stock in the company, you lend it money for 2 years => debit appears on US capital account, under bonds or bank loans. (Again, you have imported a claim against an Indian resident.)


Examples on the short-term capital account: You lend to the Indian company in the form

of 30-day commercial paper or trade credit => debit appears on US short-term capital account. (Again, you have acquired a claim against India.)

You lend to the Indian company in the form of cash dollars, which they don’t have to pay back for 30 days => debit appears on US short-term capital account.

You are the Central Bank, and you buy securities of the Indian company (an improbable example for the Fed – but some central banks, acting like “Sovereign Wealth Funds,” now make international investments of this sort) => debit appears as a US official reserves transaction.

The rules, continued

• Each transaction is recorded twice: once as a credit and once as a debit.– E.g., when an importer pays cash dollars,

• the debit on the merchandise account is offset by • a credit under short-term capital:

the exporter in the other country has, at least for now, increased holdings of US assets, which counts as a credit just like any other portfolio investment in US assets.

• At the end of each quarter, credits & debits are added up within each line-item;

• and line-items are cumulated from the top to compute measures of external balance.


Some balance of payments identities• CA ≡ Rate of increase in net international investment position.

– CA-surplus country (Japan) accumulates claims against foreigners;– CA-deficit country (US) borrows from foreigners.

• CA + KA + ORT ≡ 0 .• BoP ≡ CA + KA .• => BoP ≡ -ORT ≡ excess supply of FX coming from private sector,

(i.e., all credits from exports of goods, services, assets… minus all debits)which central banks absorb into reserves, if they intervene in FX market).– A BoP surplus country adds to its FX reserves – A BoP deficit country

• either runs down its FX reserves • or, is lucky enough for foreign central banks to finance the deficit,

if its currency is an international reserve asset (US $) .– A floating country does not intervene in the FX market

• => BP ≡ 0;• Exchange rate E adjusts to clear FX supply & demand in private market


End ofLecture 1:Balance

of Payments Accounting


Lecture 2: The Elasticities Approach to the Trade Balance

• Primary question: Under what circumstances does devaluation improve the trade balance (TB), and how much?

• Secondary question: If the currency floats (i.e., the central bank does not intervene in the forex market),how much must the exchange rate (E) move to clear the trade balance by itself ?

• Model: Elasticities Approach• Key equation: Marshall-Lerner Condition

Supply & demand for foreign exchange

D S


E ≡price offoreignexchangein $/₤

Quantity of foreign exchange, ₤

FX supply arises from exports,capital inflows…

FX demand arises from imports,capital outflows…


Depreciation (increase in price

of foreign currency)

Deficit (excess demand

for foreign currency)

Assume demand for forex shifts out e.g., to due to increase in demand to buy foreign goods or assets


The Elasticities Approach to the Trade Balance

• derives the supply of foreign exchange from export earnings, and

• derives the demand for foreign exchange from import spending.

• Capital flows are not considered (until later), so no supply of, or demand for, FX comes from international borrowing or lending.

How the Exchange Rate, E, Influences BoPASSUMPTIONS :

Þ Supply of FX determined by EXPORT earnings

Þ Demand for FX determined by IMPORT spending

1) No capital flowsor transfers=> BoP = TB

2) PCP: Price in terms of producer’s currency;Supply elasticity = ∞ .

=> Domestic firms set .

& Foreign firms set .

3) Complete exchange rate passthrough:

Price of X in foreign currency = / E

Price of Imports in domestic currency = E

4) Demand is a decreasing function of price in consumer’s currency

=> X = XD ( / E ) . => IM= IMD ( E ) .

=> Net supply of FX = TB expressed in foreigncurrency ≡ TB*

= (/E) XD(/E) - ( ) IMD(E ) .

How the TB is affected by the exchange rate (continued)

EXPERIMENT : E↑ Þ THREE

EFFECTS (1) IMD( ) falls.

TB* = (/E) XD( /E) - () IMD(E ) .

TRADE BALANCE EXPRESSED IN FOREIGN CURRENCY

EFFECT ON TB*

+ +

-(2) XD( ) rises.

(3) Price of X in terms of foreign currency falls.

NET EFFECT ON TB* is determined by Marshall-Lerner condition.

Add one more assumption: Before the devaluation, TB*=0, so export earnings cancel out import spending,

Then devaluation improves the TB iff: εX + εM > 1 .

Example (i) to illustrate Marshall-Lerner condition

for TB* = (/E) XD(/E) - () IMD(E )

• If εx =1, then E ↑ leaves export revenue unchanged.• Because effects (2) and (3) cancel out.• In that case, so long as εM > 0,

• Marshall-Lerner condition is satisfied:• Import spending falls -- effect (1) --• TB* improves.


Example (ii) to illustrate Marshall-Lerner condition

for TB* = (/E) XD(/E) - (*) IMD(E *) .

• If εx = 0, then E ↑ cuts export revenue in proportion• because of valuation effect (3).• In that case, is εM > 1 necessary to improve TB* ?

• Yes, because of Marshall-Lerner condition • -- fall in import spending then outweighs

fall in export revenue: effect (1) > effect (2) --• provided initial X revenue > import spending.

• But if initial TB*<0, elasticities need not be as high.

How the TB is affected by the exchange rate (continued)

EXPERIMENT : E↑ Þ THREE

EFFECTS (2) IMD( ) falls.

TB = () XD(/E) - (E *) IMD(E *) .

TRADE BALANCE EXPRESSED IN DOMESTIC CURRENCY

EFFECT ON TB

+ +

-(1) XD( ) rises.

(3) Price of IMports in terms of domestic currency rises.

NET EFFECT ON TB is determined by the same Marshall-Lerner condition.

Again, assume that initially TB=0.

Then devaluation improves the TB iff: εX + εM > 1 .


• Two examples when it worked: • Italy after 1992;

• Poland after 2008.

• To be continued in Lecture 3 …

What is the effect on TB in practiceof increases in the exchange rate?


1992 devaluation

Rise in trade balance

Effect of Italy’s 1992 devaluation (in the European ERM crisis), as measured by the lira’s Real Effective Exchange Rate value, on its Trade Balance.

Poland’s exchange rate rose 35% in the 2008-09 global crisis.

I III V VII IX XI I III V VII IX XI I III V VII IX2008 2009 2010

3.2

3.5

3.7

4.0

4.2

4.5

4.7EUR/PLNZloty / €

Source: Cezary Wójcik

Depreciation boosted net exports => Poland avoided recession

Exchange rate

Poland’s trade balance improved sharply in 2009while its European trading partners all went into recession.

Source: National Bank of Poland From FocusEconomics 2014

Trade balance in billions of euros

Contribution of Net X in 2009: 3.1% of GDP > Total GDP growth: 1.7%


End ofLecture 2:Elasticities

Approach to the Trade Balance

Lecture 3: Empirical effects of the exchange rate on the trade balance

• Elasticity Pessimism:Countries often fear their elasticities are too low for the M-L condition.

• Econometric estimation of elasticities • What is OLS regression?• Typical estimates• Lags.

• The J-curve • With fast pass-through to import prices• With slow pass-through to import prices.

• Application to the US TB: • The 1980s; • Effects of $ appreciation in 2014-15


How can we estimate sensitivity of export demand to exchange rate?

OLS regression

. . .

. . .

. . . . . . . . .

X ≡ Exports demanded

EP*/P ≡ Price of foreign goods relative to domestic goods

Common econometric finding• Estimated trade elasticities with respect to relative prices

often ≈ 1, after a few years have been allowed to pass.– => Marshall-Lerner condition holds in the medium run.

• Some face a higher elasticity of demand for their exports:– small countries, and– producers of agricultural & mineral commodities or other

commodities that are close substitutes for competitors’ exports.

Common empirical observation:After a devaluation, trade balance gets worse before it gets better.

Explanation:Even if devaluation is instantly passed throughto higher import prices,buyers react with a lag.

Also, in practice,it often takes time before the devaluation is passed through to import prices.


End ofLecture 3:Empirical Effects of

Devaluation on the Trade

Balance


• 1980 trade deficits (Reagan period)

• What effect might the $ appreciation of 2014 have in 2015?

Application:Determination of US TB

US trade & current account balances over 40 years

III II I IV III II I IV III II I IV III II I IV III II I IV III II I IV III II I IV III II I IV III II I IV III II I IV III II I IV III II I IV III II I IV III II

1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

-250000

-200000

-150000

-100000

-50000

0

50000

U.S. International Transactions 1974-2014

Balance on current account (line 1 less line 9) /4/ Balance on goods and services (line 2 less line 10)

Services always partiallyoffset the deficit in goods.

The US trade balance was on a downward trend, 1965-2008 (with NS)But improved during recessions: 1990-91, 2001, & especially 2008-09

PER QUARTER


Trade & Current Account Balances

-7.00%

-6.00%

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

2.00%

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

Trade Balance as % of GDP Current Account Balance of % of GDP

Trade & Current Account Balances

-7.00%

-6.00%

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

2.00%

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

Trade Balance as % of GDP Current Account Balance of % of GDP

Effects on US trade balance of: • $ appreciation of 1980-85 (“Reaganomics”)

• $ depreciation of 1985-87 (Plaza Accord).

• $ appreciation of 1995-97

US TB & CA, 2001-2010, $ millions

-900000

-800000

-700000

-600000

-500000

-400000

-300000

-200000

-100000

0

2001. 2002. 2003. 2004. 2005. 2006. 2007. 2008. 2009. 2010.

Balance on goods and services

Balance on current account

The deficits shranksharply in 2008-09,due to:• lagged effects of $

depreciation 2002-07 • and the recession.


The dollar rose about 10% in the 2nd half of 2014.

Jan. 9, 2015Dawsey/Cahill. US Economics Analyst 15/02 –“Dollars and Percent: How Big a Growth Drag from Stronger USD?”

What effect might the $ appreciation of 2014 have in 2015?

A 10% $ appreciation is estimatedto reduce US exports about 10% after 6 months.

Jan. 9, 2015Dawsey/Cahill. US Economics Analyst 15/02 –“Dollars and Percent: How Big a Growth Drag from Stronger USD?”

The appreciation is estimatedto reduce GDP growth about 0.6% after 1 year

including also some fall in imports & the multiplier effect on domestic demand.

Jan.9, 2015Dawsey/Cahill. US Economics Analyst 15/02 –“Dollars and Percent: How Big a Growth Drag from Stronger USD?”

Economics of International Financial Policy: ITF 220 Staff -- Professor: Jeffrey Frankel, Littauer...

Documents

Transcript of Economics of International Financial Policy: ITF 220 Staff -- Professor: Jeffrey Frankel, Littauer...