International Finance Economics 8423

University of Colorado at Boulder JoAnne Feeney

Fall 1998

Course Description

The goal of this course is to address the core issues in international finance (otherwise known as open­economy macroeconomics or international macro) using the modem analytical approach which recognizes the importance of adhering to microfoundations. The questions that practitioners of international finance confront have shifted over the decades since the abandonment of the Bretton Woods Monetary System. Modem international finance must attempt to understand sustained current account deficits and surpluses, national indebtedness of developing countries, international capital market imperfections and related implications, international business cycles, cross-country income and growth differentials, exchange-rate behavior, monetary-policy coordination, and a host of additional issues.

Our study of international finance will treat these questions in a framework that recognizes that nations interact through international asset markets. These markets permit borrowing and lending between countries and also allow each country to pool the risk it faces (in, e.g., productivity) with other countries in the world . Nations are also linked through trade in commodity markets and factor markets and this interdependence will also be important for the understanding of international macroeconomic issues.

This course is divided into four sections. In Section I we will focus on the two roles that international financial markets (IFM) play for nations:

(i) International borrowing and lending: IFM allow a country to consume more in aggregate than it produces in any given time period. In other words, IFM permit borrowing and lending at the national level. (otherwise known as trade across time)

(i i) International risk sharing: IFM permit countries to pool risk. (referred to as trade across states of nature)

In each of these contexts we want to understand the gains from trade on international financial markets and the consequences of such trades for macroeconomic issues. For example, we want to know how a country's access to IFM is likely to affect the welfare of its citizens and how it may influence production decisions of its firms. We will fi nd that IFM will, in general, affect the pattern over time of aggregate consumption in a country, as well as investment, capital accumulation, and output.

In addition, we will examine current account dynamics to try to understand how different types of shocks -­productivity, preferences, or terms of trade shocks (for a small country) -- often create different patterns over time in a country's current account. We a lso want to understand the correlations among the current account and (real and nominal) exchange rates, consumption across countries, output across countries, etc.

In Section II we study the determination and behavior of real and nominal exchange rates. We examine the behavior of exchange rates in the modem floating-rate period and we consider some models that attempt to explain this behavior. We analyze the relative merits of fixed versus flexible exchange rates in theory and in practice and consider the consequences of monetary policy coordination. We also examine speculative attacks and currency crises. In Section III we examine the related issues of country debt and stabilization policies.

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In Section IV we examine patterns of growth and business cycles across countries. Models of growth and cyclical fluctuations will be introduced to determine the importance of international markets for understanding observed patterns of macroeconomic aggregates across time and countries.

Course Readings and Requirements

Required Text: Maurice Obstfeld and Kenneth Rogoff, Foundations of International Macroeconomics, MIT Press, Cambridge, 1996.

Recommended Text: Gene Grossman and Kenneth Rogoff, editors, Handbook of International Economics, Volume 3, North-Holland Publishers, Amsterdam, 1995.

Some of the readings on this list will be discussed in class, although you are responsible for all of them unless otherwise noted. In addition to these readings, I have prepared some supplementary notes which offer further explanation of some sections of the material. These will be made available. Articles and the supplemental notes will be placed on reserve at Norlin Library or links wi ll be provided to the papers on the course webpage. Please pay attention to the webpage for announcements and problem sets.

Grading:

There will be two examinations in this course. The midterm exam will be administered in class during the term (tentatively scheduled for October 29). The final exam is scheduled for Thursday, December 17, 3:30pm-6:30pm. Each exam constitutes 50% of your final grade.

Problem sets will be suggested throughout the term. They are not graded, but I strongly suggest that you complete the exercises and do so in small study groups.

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Reading List

I. INTERNATIONAL FINANCIAL MARKETS, CURRENT-ACCOUNT DYNAMICS, AND RISK DIVERSIFICATION

I.I INTERTEMPORAL TRADE AND CURRENT-ACCOUNT DYNAMICS

Chapters 1 and 2, Obstfeld and Rogoff.

Torsten Persson and Alan C. Stockman, The Theory of International Financial Markets, "Two By Two Trade Across Time," Chapter 1 of incomplete manuscript, (1987).

Maurice Obstfeld and Kenneth Rogoff, "The Intertemporal Approach to the Current Account," Handbook, Ch. 34.

Linda Tesar, "Savings, Investment, and International Capital Flows," Journal of International Economics 31 (1991) 55-78.

Kenneth Beauchemin and Betty Daniel, "The Current Account and the International Distribution of Wealth under Uncertainty," University of Colorado Working Paper# 98-11 , August 1998.

I.2 INTERNATIONAL FINANCIAL MARKETS, UNCERTAINTY, AND RISK SHARING

Chapter 5, Obstfeld and Rogoff

Alan C. Stockman, "On the Roles of International Financial Markets and Their Relevance for Economic Policy," Journal of Money, Credit, and Banking 20, vol 3, August, 1988, 531-49.

Torsten Persson and Alan C. Stockman, The Theory of International Financial Markets, chapter 5, "Two-By-Two Trade Across States of Nature," (1987).

Alan C. Stockman and Harris Dellas, "Tariffs, Asset Markets, and Political Risk," Journal of International Economics 21 (November 1986), 199-214.

Jonathan Eaton and Gene Grossman, "Tariffs as Insurance: Optimal Commercial Policy when Domestic Markets are Incomplete," Canadian Journal of Economics 18, No. 2 (May 1985), 258-272.

Avinash Dixit, "Trade and Insurance with Moral Hazard," JIE 23, No. 3/4 (November 1987), 201-20.

Karen Lewis, "Puzzles in International Financial Markets," Handbook, Ch. 37.

JoAnne Feeney, "Goods and Asset Market Interdependence in a Risky World," International Economic Review 35(3) (August 1994), 551-563.

Harold L. Cole and Maurice Obstfeld, "Commodity Trade and International Risk Sharing: How Much do Financial Markets Matter?" Journal of Monetary Economics 28, 3-24 (1991).

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II. EXCHANGE RATES, ASSET PRICES, AND THE CURRENT ACCOUNT

II.1 EXCHANGE-RATE DETERMINATION WITH FLEXIBLE PRICES

Robert Lucas, "Interest Rates and Currency Prices in a Two-Country world," Journal of Monetary Economics 10 (1982), 728-54.

Alan C. Stockman, "The Equilibrium Approach to Exchange Rates," Economic Review, Federal Reserve Bank of Richmond, (March-April 1987), 12-31.

Chapter 8, Obstfeld and Rogoff. (flexible price models)

Chapter 4, Obstfeld and Rogoff. (real exchange rates and the terms of trade)

Lars E.O. Svensson, "Currency Prices, Terms of Trade, and Interest Rates: A General Equilibrium Asset-Pricing, Cash-in-Advance Approach," Journal of International Economics, 1985.

Alan Stockman and Harris Dellas, "International Portfolio Nondiversification and Exchange Rate Variability," Journal of International Economics 26, no. 3/4, May 1989, 271-90. 1989.

Alan C. Stockman, "A Theory of Exchange Rate Determination," Journal of Political Economy 88 (1980), 673-98.

Milton Friedman, "The Case for Flexible Exchange Rates," in Essays in Positive Economics, University of Chicago Press, (1951).

Alan C. Stockman, "Risk, Information, and Forward Exchange Rates," in J. Frenkel and H. Johnson (ed.) The Economics of Exchange Rates, 1978.

Eugene Fama, "Forward and Spot Exchange Rates," Journal of Monetary Economics 14, No. 3, November 1984, 319-338.

Robert Hodrick, "Risk, Uncertainty, and Exchange Rates," Journal of Monetary Economics 23, May 1989, 433-59.

Froot, K. and R.H. Thaler, "Anomalies: Foreign Exchange", Journal of Economic Perspectives, Summer, 1990

II.2 MODELS WITH NOMINAL RIGIDITIES

Chapter 9, Obstfeld and Rogoff. (sticky-price models and empirical observations)

Rudiger Dornbusch, "Expectations and Exchange Rate Dynamics," Journal of Political Economy 84 (1976), 1161-76.

Maurice Obstfeld and Kenneth Rogoff, Foundations of International Macroeconomics, ch. 9

Maurice Obstfeld and Kenneth Rogoff, "Exchange Rate Dynamics Redux, Journal of Political Economy 103, June 1995, 624-60.

Chari, V.V., Pat Kehoe, and Ellen McGrattan, "Monetary Shocks and Real Exchange Rates in Sticky Price Models of International Business Cycle," Minn. Fed working paper, December 1996.

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Il.3 EMPIRICAL EVIDENCE ON EXCHANGE-RA TE BEHAVIOR

Jeffrey A. Frankel and Andrew K. Rose, "Empirical Research on Nominal Exchange Rates," Gene Grossman and Kenneth Rogoff (eds.), Handbook of International Economics Volume 3, ] 995.

Mark Taylor, "Exchange Rate Behavior", Journal of Economic Literature, March, 1995.

Chapter 4, section 2; Chapter 9, section 3; Obstfeld and Rogoff.

Rogoff, Kenneth, "The Purchasing Power Parity Puzzle," Journal of Economic Literature 34 (June 1996), 647-668.

Ken Froot and Kenneth Rogoff, "Perspectives on PPP and Long-Run Real Exchange Rates," Handbook of International Economics vol. 3, Gene Grossman and Kenneth Rogoff (eds.), (Amsterdam: Elsevier Science Publishers B.V., 1995): 1647-88.

Charles Engel, "Long-Run PPP May Not Hold After All ," NBER working paper. 5646, July 1996

David C. Parsley and Shang-Jin Wei, "Convergence to the Law of One Price without Trade · Barriers or Currency Fluctuations," Quarterly Journal of Economics 11 1, November 1996: 1211-1236.

Charles Engel and John H. Rogers "Regional Patterns in the Law of One Price: The Roles of Geography versus Currencies," Board of Governors of the Federal Reserve System, International Finance Discussion Papers, Number 533, January 1996

Charles Engel and John Rogers, "How Wide is the Border?" American Economic Review 86 (December 1996), 11 12-1125.

Charles Engel, "Accounting for US Real Exchange Rate Changes," NBER WP #5394, December 1995.

Charles Engel, "ls Real Exchange Rate Variabili ty Caused by Relative Price Changes? An Empirical Investigation," Journal of Monetary Economics 32, August 1993, 35-50.

Alan Stockman, "New Evidence Connecting Exchange Rates to Business Cycles," Federal Reserve Bank of Richmond Economic Quarterly, 84(2), Spring 1998.

II.4 EXCHANGE RATE REGIMES AND ALTERNATIVE MONETARY SYSTEMS

Elhanan Helpman, "An Exploration in the Theory of Exchange Rate Regimes," Journal of Political Economy 89 (October 1981), 865-890.

Alan Stockman, "Real Exchange Rates Under Alternative Nominal Exchange Rate Systems," Journal of International Money and Finance 2 (August J 983), 147-66. ·

Flood, R. and A. Rose, "Fixing Exchange Rates: A Virtual Quest for Fundamentals," Journal of Monetary Economics 36 no. I , August 1995, 3-38.

Alan C. Stockman, "Real Exchange Rate Variabili ty under Pegged and Floating Nominal Exchange Rate Systems: An Equilibrium Theory," in K. Brunner and A.H. Meltzer (eds.), Carnegie-Rochester Conference Series on Public Policy 29 (Autumn 1988), 259-94.

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Marianne Baxter and Alan C. Stockman, "Business Cycles and the Exchange Rate Regime: Some International Evidence," Journal of Monetary Economics 23, No. 3 (May 1989), 377-400.

Ehsan U. Choudri and Levis A. Kochin, "The Exchange Rate And The International Transmission Of Business Cycle Disturbances: Some Evidence From The Great Depression," Journal of Money, Credit, and Banking 12, 1980, 565-74.

Vittorio Grilli and Graciela Kaminsky, "Nominal Exchange Rate Regimes and the Real Exchange Rate: Evidence from the US and Britain, 1885-1986," NBER wp 3067, August 1989; revised version: Univ. Pennsylvania wp, #19, October 1988.

Alan Stockman and Lee Ohanian, "Short-run Independence of Monetary Policy under Pegged Exchange Rates and Effects of Money on Exchange Rates and Prices," Journal of Money, Credit, and Banking, 1997.

Harris Dellas, "Time Consistency and the Feasibility of Alternative Exchange Rate Regimes, Journal of Monetary Economics 22, No. 3 (November 1988), 461-72.

Tornell, Aaron and Andres Velasco (1995) "Fixed versus Flexible Exchange Rates: Which Provides More Fiscal Discipline?", NBER W.P. No.5108.

Andres Velasco, "When are Fixed Exchange Rates Really Fixed?", NBER w.p. 5842, November 1996.

II. 5 SPECULATIVE ATTACKS; CURRENCY CRISES; STABILIZATION

Garber, Peter B., and Lars E.0.Svensson. "The Operation and Collapse of Fixed Exchange Rate Regimes," in Gene Grossman and Kenneth Rogoff (eds.) The Handbook of International Economics, vol. 3 (Amsterdam: Elsevier, 1995).

Flood, R. and P. Garber (1984) "Collapsing Exchange Rate Regimes: Some Linear Examples", Journal of International Economics.

Obstfeld and Rogoff, 554-556 (the classical Krugman model of speculative attacks.)

Obstfeld and Rogoff, 648-653 (a multiple equilibrium interpretation of speculative attacks.)

Barry Eichengreen, Andrew K. Rose, Charles Wyplosz, "Contagious Currency Crises," NBER Working Paper 5681, July 1996

Maurice Obstfeld, "Rational and Self-Fulfilling Balance-of-Payments Crises," American Economic Review 76, No. l March 1986, 72-81.

Giancarlo Corsetti and Nouriel Roubini, "What Caused the Asian Currency and Financial Crisis?", Yale University, January 1998. Guillermo A. Calvo, "Balance of Payments Crises in a Cash-in-Advance Economy," Journal of Money, Credit, and Banking 19, February 1987.

Andrew Atkeson and Jose-Victor Rios Rull, "The Balance-of Payments and Borrowing Constraints: At:i Alternative View of Mexico's Recent Crisis," Journal of International Economics, 1997.

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Kenneth A. Froot and Maurice Obstfeld, "Exchange Rate Dynamics under Stochastic Regime Shifts: A Unified Approach," Journal of International Economics 31 No. 3/4, November 1991, 203-30.

Robert Flood and Peter Garber, "The Linkage between Speculative Attack and Target Zone Models of Exchange Rates," Quarterly Journal of Economics CVI No. 4, November 1991, 1367-72.

III. DEBT AND STABILIZATION

Chapter 6, Obstfeld and Rogoff. (Sovereign risk, international capital market imperfections)

Eaton, John and Raquel Fernandez (1995) "Sovereign Debt", Gene Grossman and Ken Rogoff (eds.), Handbook.

Jeremy Bulow and Kenneth Rogoff, "A Constant Recontracting Model of Sovereign Debt," Journal of Political Economy 97, 1989, 155-78.

Jeremy Bulow and Kenneth Rogoff, "Sovereign Debt: Is to Forgive to Forget?" American Economic Review 79, 1989, 43-50.

Jeremy Bulow and Kenneth Rogoff, "The Buyback Boondoggle," Brookings Papers on Economic Activity: no. 2, 1988, 675-698.

Harold L. Cole, James Dow, and William B. English, "Resumption of Lending in a Reputational Model of Sovereign Debt," University of Pennsylvania, 1989

Harold L. Cole and Patrick J. Kehoe, "Reputation Spillover across Relationships: Reviving Reputation Models of Debt," Journal of Monetary Economics 1996

English, William, "Understanding the Costs of Sovereign Default: American State debts in the 1840's" American Economic Review 86 (March 1996): 259-275.

Andrew G. Atkeson, "International Lending with Moral Hazard and Risk of Repudiation." Econometrica , vol. 59, number 4 (July) 1991, 1069-1089.

Jeremy Bulow and Kenneth Rogoff, "A Constant Recontracting Model of Sovereign Debt," Journal of Political Economy 97, (1989).

Alberto Alesina and Allan Drazen, "Why are Stabilizations Delayed?" American Economic Review, 81, pp. 1170-88.

Hal Cole and Tim Kehoe, "Self Fulfilling Debt Crises," FRB Minneapolis, December 1996.

Hal Cole and Tim Kehoe, "A Self-Fulfilling Model of Mexico' s 1994-95 Debt Crisis," April 1996 Federal Reserve Bank of Minneapolis staff report 210.

Torsten Persson and Guido Tabellini, "Double-Edged incentives: Institutions and Policy Coordination," in Handbook.

Rebelo, S. and C. Vegh, "Real Effects of Exchange-Rate-Based Stabilization: An Analysis of Competing Theories," NEER Macro Annual, 1995

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IV. GROWTH, FLUCTUATIONS, AND INTERNATIONAL MARKETS

Chapter 7, Obstfeld and Rogoff.

Michael Devereux and Gregor Smith, "International Risk Sharing and Economic Growth," International Economic Review 35(3) (August 1994), 535-550.

JoAnne Feeney, "International Risk Sharing, Leaming by Doing, and Growth," University of Colorado Working Paper, 1997; revised version, July 1998

Maurice Obstfeld, "Risk-taking, Global Diversification, and Growth," American Economic Review 84( 5) (December 1994 ), 1310-13 29.

David Backus, Patrick Kehoe, and Finn Kydland, "International Business Cycles: Theory and Evidence," Ch. 11 in Thomas Cooley (ed.) Frontiers of Business Cycle Research, Princeton University Press, 1995.

Alan C. Stockman, "Sectoral and National Aggregate Disturbances to Industrial Output in Seven European Countries," Journal of Monetary Economics (March/May 1988), 387-410.

Donna Costello, "A Cross-Country, Cross-Industry Comparison of Productivity Growth," Journal of Political Economy, (1993).

Marianne Baxter, "International Trade and Business Cycles," Ch. 35 in Handbook.

Alan Stockman and Linda Tesar, "Tastes and Technology in a Two-Country Model of the Business Cycle: Explaining International Comovements," AER, 1995.

Harris Dellas, "A Real Model of the World Business Cycle," Journal of International Money and Finance 5, September 1986, 381-94.

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