International Finance

Econ 356Karine Gente

kgente@interchange-ubc.ca

• Web page: http://www.econ.ubc.ca/directory/sess/sfackg.htm

Office room: Buch tower 1099 D

• Teaching Assistant: Kang ShiEmail: kangshi@interchange.ubc.caOffice room: Buch tower 1099COffice 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)

10

15

20

25

30

1960 1965 1970 1975 1980 1985 1990 1995 2000

579

111315

France Japan

Canada

468

101214

United States

15

20

25

30

35

40

45

1965 1970 1975 1980 1985 1990 1995

International trade

Table 1.5 Top 15 international trade ($bn.), 1999

country exports % of world country imports % of world

1 USA 956 13.7 USA 1,116 15.9

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

Percentageof GDP

40

35

30

25

20

15

10

5

0Canada France Germany Italy Japan U.K. U.S.Imports Exports

Imports and Exports as a percentage of output: 2000

International trade (1999)

0

200

400

600

800

1000

1200

0 200 400 600 800 1000 1200

export value

impo

rt v

alue

Netherlands

Japan

Germany

USAExports

relative to

imports

• 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.

Domestic Country

Rest of the World

Money (I)

Imports

Domestic Country

Rest of the World

Exports

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

Canada

Current account balance (% of GDP)

-6

-5

-4

-3

-2

-1

0

1

2

3

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

Measures of Financial Integration

Industrial Countries

0.0

0.2

0.4

0.6

0.8

1.0

1970 1974 1978 1982 1986 1990 1994 1998

0.0

0.3

0.6

0.9

1.2

1.5

Restriction Measure (left scale) Openness Measure (right scale)

Source: WEO, Lane and Milesi-Ferreti (2003)

Measures of Financial Integration

Source: WEO, Lane and Milesi-Ferreti (2003)

0.00

0.10

0.20

0.30

0.40

0.50Developing Countries

0.0

0.2

0.4

0.6

0.8

1.0

1970 1974 1978 1982 1986 1990 1994 1998

Restriction Measure (left scale) Openness Measure (right scale)

• 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)

Source: WEO

100

120

140

160

180

All Developing Economies

-20

0

20

40

60

80

1970 1975 1980 1985 1990 1995

Year

Bank Lending

Portfolio Flows

FDI

Net Private Capital Flows(Billions of USD)

Source: WEO

More Financially Integrated Economies

-20

0

20

40

60

80

100

120

140

160

180

1970 1975 1980 1985 1990 1995

Year

Bank Lending

Portfolio Flows

FDI

Less Financially Integrated Economies

-2

-1

0

1

2

3

4

5

6

7

8

9

1970 1975 1980 1985 1990 1995

Year

Bank Lending

Portfolio Flows

FDI

• 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 real- sector 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

Higher 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

International economic integration could help growth and development

International Economic Integration and ContagionInternational 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

↑ Demand (country A)- Domestic goods

- Imports

Country B’s Exports ↑ Country B’s Income ↑

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

EX = exports = foreign spending on domestic goods

IM = imports = C f + I

f + G f

= spending on foreign goods

d fC C C d fI I I d fG G G

superscripts:d =spending on

domestic goods

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

d d dY C I G EX

( ) ( ) ( )ff fC C I I G G EX

( )ff fC I G EX C I G

C I G EX IM

C I G NX

The national income identity in an open economy

YY = = CC + + II + + GG + + NXNX

or, NX = Y – (C + I + G )

net exports

domestic spending

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

NXNX = = YY – – ((CC + + II + + GG ))

impliesimplies

NXNX = ( = (YY – – CC – – GG ) – ) – II

= = SS – – II

trade balancetrade balance = = net capital outflowsnet capital outflows

NXNX = = YY – – ((CC + + II + + GG ))

impliesimplies

NXNX = ( = (YY – – CC – – GG ) – ) – II

= = SS – – II

trade balancetrade balance = = net capital outflowsnet capital outflows

Long-run Equilibrium

• An open economy model :– Two countries

– Small open economy

Country ASA,IA

Country BSB,IB

IA+IB=SA+SB

Domestic Country

Rest of the Worldr*

Saving and Investment in a Small Open Economy

production function: ( , )Y Y F K L

consumption function: ( )C C Y T

investment function: ( )I I r

exogenous policy variables: ,G G T T

National Saving: The Supply of Loanable Funds

r

S, I

To simplify,national saving

does not depend on the interest

rate

( )S Y C Y T G

S

Assumptions re: capital flowsa. 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*

aa & & bb imply imply rr = = r*r*

cc implies implies r*r* is exogenousis exogenous

aa & & bb imply imply rr = = r*r*

cc implies implies r*r* is exogenousis exogenous

Investment: The Demand for Loanable Funds

Investment is still a downward-sloping function of the interest rate,

r *

but the exogenous world interest rate…

…determines the country’s level of investment.

I (r* )

r

S, I

I (r )

If the economy were closed…r

S, I

I (r )

S

rc

( )cI r

S

…the interest rate would adjust to equate investment and saving:

But in a small open economy…r

S, I

I (r )

S

rc

r*

I 1

the exogenous world interest rate determines investment……and the difference between saving and investment determines net capital outflows and net exports

NX

Three experiments

1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

1. Fiscal policy at homer

S, I

I (r )

1S

I 1

An increase in G or decrease in T reduces saving. 1

*r

NX1

2S

NX2

Results:

0I

0NX S

2. Fiscal policy abroadr

S, I

I (r )

1SExpansionary fiscal policy abroad raises the world interest rate.

1*r

NX1

NX2

Results: 0I

0NX I

2*r

1( )*I r2( )*I r

3. An increase in investment demandr

S, I

I (r )1

EXERCISE:Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow.

NX1

*r

I 1

S

3. An increase in investment demandr

S, I

I (r )1

ANSWERS:I > 0,S = 0,net capital outflows and net exports fall by the amount I

NX2

NX1

*r

I 1 I 2

S

I (r )2

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