Macroeconomics

Session 14-15-16
International Linkages
 Introduction

• National economies are becoming more closely interrelated

• Economic influences from abroad have effects on the U.S. economy

• Economic occurrences and policies in the U.S. affect economies abroad

 When the U.S. moves into a recession, it tends to pull down other economies
 When the U.S. is in an expansion, it tends to stimulate other economies

• This session presents the key linkages among open economies and
introduce some first pieces of analysis
 Balance of Payments
• Economies are linked through two broad channels

1. Trade in goods and services

• A trade linkage:
 Exports  increase demand for domestically produced goods and services
 Imports  a leakage from the circular flow of income

2. Finance
• Purchase and sale of foreign assets and liabilities
 Portfolio managers shop the world for the most attractive yields
 As international investors shift their assets around the world, they link assets markets here and
abroad  affect income, exchange rates, and the ability of monetary policy to affect interest
rates
 Balance of Payments

• The measurement of all international economic transactions

between the residents of a country and foreign residents is called
the balance of payments (BOP)

• The two major sub accounts of the balance of payments are:

• Current account
• Capital account
 Balance of Payments

• Two additional subaccounts of the BOP include:

• Net Errors and Omissions Account

• Official Reserves Account
 The Current Account
• This account includes all international economic transactions with income or
payment flows occurring within the year, the current period

• It consists of four subcategories:

• Goods and Services trade
• Net Factor Income or Income
• Current transfers

• It relates to all activities which do not alter the values of assets and liabilities
of a country.
 Net Factor Income or Income

• NFI includes:
• Income earned on foreign assets owned by a nation's residents and
businesses - interest and dividends earned on investments held overseas
• Outflows: Indian subsidiaries of MNCs like Google or Coca-Cola repatriate
profits to their home countries.
• Inflows: Tata Group earns dividends from its Jaguar Land Rover operations
in the UK.
• If the income account is negative, the country is paying more than
it is taking in interest, dividends, income, etc.
 Current Transfers

• Current transfers take place when a country simply sends/receives

currency to/from another country with nothing in return.

• Typically, such transfers are done in the form of donations, aids, or

gifts and personal remittances
• Inflows: India is the world’s top recipient of remittances, with $111 billion
received in 2022. A significant portion comes from Indian workers in the
Gulf region.
• Outflows: India sends aid or donations to neighboring countries during
crises, like assistance to Sri Lanka during its economic crisis.
 Current Account Balance

CAB = X - M + NFI + NCT

X = Exports of goods and services

M = Imports of goods and services
NFI = Net income abroad
NCT = Net current transfers
 The Capital and Financial Account

• This account of the BOP measures all international economic

transactions related to purchase and sale of foreign assets and
liabilities during a year.

• Capital account flows consist of investments, loans, commercial

borrowings, etc.
 The Capital and Financial Account
• Components of Capital and Financial Account:

• Foreign direct investment - purchasing an asset and acquiring control of the same
• Inflows: Apple manufacturing iPhones in India or Walmart’s acquisition of Flipkart
• Outflows: Infosys setting up a development center in the U.S.

• Foreign portfolio investment - acquisition of an asset that does not give control over asset
• Inflows: Foreign Institutional Investors (FIIs) investing in Indian equity markets during periods of economic
growth
• Outflows: During global uncertainties, these investors withdraw, leading to stock market volatility.

• Foreign Loans and borrowings - credit granted/received to/from foreign governments and
international institutions
• Inflows: India taking loans from the World Bank for projects like rural electrification.
• Outflows: Repayment of debt by developing countries.
 The sum of the two accounts

• Sum of current account and capital account should be zero

• A deficit (or surplus) on current account is always matched by an
equal surplus (or deficit) in capital account.
India’s Balance of Payments Account
 Exchange Rates
• Exchange rate is the price of one currency in terms of another

• Two different exchange rate systems:

• Fixed exchange rate system
• Floating exchange rate system
 Fixed Exchange Rates
• In a fixed exchange rate system central banks stand ready to buy and
sell their currencies at a fixed price in terms of dollars

• Central banks hold reserves to sell when they have to intervene in the
foreign exchange market
• Intervention: the buying or selling of foreign exchange by the central bank
 Fixed Exchange Rates
• What determines the level of intervention of a central bank in a fixed
exchange rate system?

• The balance of payments measures the amount of foreign exchange

intervention needed from the central banks

® Under a fixed exchange rate, price fixers (the central bank) must make up the excess
demand or take up the excess supply
® Makes it necessary to hold an inventory for foreign currencies that can be provided in
exchange for the domestic currency
 Fixed Exchange Rates
• What determines the level of intervention of a central bank in a fixed
exchange rate system?

• As long as the central bank has the necessary reserves, it can continue to
intervene in the foreign exchange markets to keep the exchange rate constant

• If a country persistently runs deficits in the balance of payments:

• The central bank eventually will run out of reserves of foreign exchange
• Will be unable to continue its intervention
• Before this occurs, the central bank will likely devalue the currency
 Flexible Exchange Rates
• In a flexible (floating) exchange rate system, central banks allow the
exchange rate to adjust to equate the supply and demand for foreign
currency
• Suppose the following:
 Exchange rate of the dollar against the yen is 0.86 cents per yen
 Japanese exports to the U.S. increase
 Americans must pay more yen to Japanese exporters
 Demand for Yen goes up
 Bank of Japan stands aside and allows the exchange rate to adjust
 Exchange rate could increase to 0.90 cents per yen
 Short-Run Exchange Rate Fluctuations
• Exchange rates in the short run fluctuate due to changes in demand and
supply in the foreign exchange market.
• Major reasons:
• Interest Rate Differentials
• Fed raises interest rates > investment inflow to US increases > demand for USD
increases > Dollar appreciates from ¥115/USD to ¥150/USD
• Speculation and Market Sentiments
• Post-Brexit, speculators expected weaker economy and GBP > sold GBP in large
quantities > oversupply led sharp drop pound from $1.50 to $1.30.
• Trade Imbalances:
• Sharp rise in oil prices in 2018 > India needed more USD for oil imports > bought
more USD increasing supply of Rupee > rupee weakened from ₹64/USD to ₹74/USD
Comparative Examples of
Fluctuations
Exchange
Country Rate Fluctuation
System
Managed
India Float 2022: Rupee depreciated to ~₹83/USD due to oil prices and FPI outflows.
United 2022: Dollar Index rose to a 20-year high due to Fed rate hikes and safe-
States Floating haven demand.
Managed
China 2019: Yuan depreciated past 7 CNY/USD during U.S.-China trade tensions.
Peg
2022: Yen depreciated to a 24-year low, prompting central bank
Japan Floating intervention.
Saudi
Arabia Fixed 2014: Maintained peg despite falling oil revenues by using foreign reserves.
 The Exchange Rate in the Long Run
• In the long run, the exchange rate between a pair of countries is
determined by the relative purchasing power of currency within each
country

• The theory of purchasing power parity (PPP) explains movements in

the exchange rate between two countries’ currencies by changes in
the countries’ price levels.
The Exchange Rate in the Long Run
• Two currencies are at purchasing power parity (PPP) when a unit of domestic
currency can buy the same basket of goods at home or abroad

• The relative purchasing power of two currencies is measured by the real exchange rate

• The real exchange rate, R, is defined as R  ePf (3), where P f and P are the price levels
abroad and domestically, respectively P

® If R =1, currencies are at PPP

® If R > 1, goods abroad are more expensive than at home
® If R < 1, goods abroad are cheaper than those at home
Long-Run Adjustments Toward PPP
• In the long run, exchange rate adjustments toward PPP are
determined by economic fundamentals, particularly differences in
inflation, productivity, and trade flows
• Inflation: Higher inflation in one country > goods more expensive in
international market > Import increases and export decreases > currency
depreciates aligning with PPP

• Trade Flows: Undervalued currency boosts exports > large trade surpluses >
increases demand for currency > currency appreciates aligning with PPP

• Productivity: producing more goods with the same resources > goods
become more competitive globally > higher exports > increased currency
demand > currency appreciating aligning with PPP
 Trade in Goods, Market Equilibrium,
and the Balance of Trade
• Need to incorporate foreign trade into the IS-LM model
• Assume the price level is given, and output demanded will be supplied (flat
AS curve)
• With foreign trade, domestic spending no longer solely determines
domestic output  spending on domestic goods determines domestic
output DS C  I  G
 Domestic spending is DS  NX (C  I(4)
 G)  ( X  Q)
 Spending on domestic goods is (C  I  G )  NX
(5)
Assume DS depends
DS onDS (Yinterest
the , i) rate and income:
(6)
 Net Exports
• Net exports, (X-Q), is the excess of exports over imports
• NX depends on: 
 domestic income 
 NX  X (Y f , R )  Q (Y , R )  NX (Y , Y f , R )
 foreign income, Y 
f (7)

R

® A rise in foreign income improves the home country’s trade balance and raises AD
® R>1 - improves the trade balance and increases AD
® A rise in home income raises import spending and worsens the trade balance, decreasing
AD
 Goods Market Equilibrium

• IS curve now includes NX as a component of AD

IS : Y  DS (Y , i )  NX (Y , Y f , R ) (8)

• level of competitiveness (R) affects the IS curve

• R>1 - increases the demand for domestic goods  shifts IS to the right

• An increase in Yf results in an increase in foreign spending on domestic

goods shifts IS to the right
• Figure shows the effect of a rise in
foreign income
• Higher foreign spending on our goods raises
demand and requires an increase in output
at given interest rates

Interest Rate
• Rightward shift of IS
• Full effect of an increase in foreign demand is
an increase in interest rates and an increase
in domestic output and employment

Income, Output
• Figure can also be used to show the
impact of a real depreciation
 Capital Mobility
• High degree of integration among financial markets

• Start our analysis with the assumption of perfect capital mobility

• Capital is perfectly mobile internationally when investors can purchase in any
country they choose quickly, with low transaction costs , and in unlimited
amounts
• Under this assumption, asset holders are willing and able to move large
amounts of funds across borders in search of the highest return or lowest
borrowing cost
• Implies that interest rates in a particular country can not get too far out of
line without bringing capital inflows/outflows that bring it back in line
 The Balance of Payments and
Capital Flows
• Assume a home country faces a given price of imports, export
demand, and world interest rate, if
• Additionally, capital flows into the home country when the interest rate is
above the world rate
• Balance of payments surplus is: BP  NX (Y , Y f , R)  CF (i  i f ) (9), where CF is
the capital account surplus
• The trade balance is a function of domestic and foreign income
• An increase in domestic income worsens the trade balance
• The capital account depends on the interest differential
 An increase in the interest rate above the world level pulls in capital from abroad,
improving the capital account
 Policy Dilemmas: Internal and External
Balance
• Interest rate diff. < capital in/outflows < BoP surplus/deficit
• Implications for stabilization policies – fiscal and monetary

• Monetary and fiscal policies < interest rates < capital account < BoP

• Monetary and fiscal policies < domestic income and spending < current
account < BoP
 Policy Dilemmas: Internal and External Balance

• Policy dilemma: a policy designed to deal

with one problem worsens another
problem E4 E3
Surplus Surplus
• External balance exists when the balance unemployment overemployment

Interest Rate
of payments is close to balance E
• Else CB loses or gains reserves
• Internal balance exists when output is at E1 E2
the full employment level. Deficit Deficit
unemployment overemployment

Y*
Income, Output
 Mundell-Fleming Model: Perfect
Capital Mobility Under Fixed
Exchange Rates
• The Mundell-Fleming model incorporates foreign exchange under perfect capital
mobility into the standard IS-LM framework
• Under perfect capital mobility, the slightest interest differential provokes infinite capital inflows
 central bank cannot conduct an independent monetary policy under fixed exchange rates
WHY?
• Suppose a country tightens money supply to increase interest rates
• Portfolio holders worldwide shift assets into country
• Due to huge capital inflows, balance of payments shows a large surplus
• The exchange rate appreciates and the central bank must intervene to hold the exchange rate
fixed
• The central bank buys foreign currency in exchange for domestic currency
• Intervention causes domestic money stock to increase, and interest rates drop
• Interest rates continue to drop until return to level prior initial intervention
 Monetary Expansion
• Figure shows the IS-LM curves in addition
to the BP=0
• BP schedule is horizontal under perfect capital
mobility (i = if)
• Consider a monetary expansion that starts

Interest Rate
from point E  shifts LM down and to the
right to E’
• At E’ there is a large payments deficit, and
pressure for the exchange rate to depreciate
• Central bank must intervene, selling foreign
money, and receiving domestic money in Income, Output
exchange
• Supply of money falls, pushing up interest
rates as LM moves back to original
position
 Fiscal Expansion
• Monetary policy is infeasible, but fiscal
expansion under fixed exchange rates and
perfect capital mobility is effective
• A fiscal expansion shifts the IS curve up and to

Interest Rate
the right  increases interest rates and output
• The higher interest rates creates a capital
inflow with the tendency to appreciate the
exchange rate
• To manage the exchange rate the central bank
must expand the money supply  shifting the Income, Output
LM curve to the right
• Pushes interest rates back to their initial level, but
output increases yet again
 Perfect Capital Mobility and Flexible
Exchange Rates
• Use the Mundell-Fleming model to explore how monetary and fiscal
policy work in an economy with a flexible exchange rate and perfect
capital mobility
• Assume domestic prices are fixed
• Under a flexible exchange rate system, the central bank does not
intervene in the market for foreign exchange
• The exchange rate must adjust to clear the market so that the demand for
and supply of foreign exchange balance
• Without central bank intervention, the balance of payments must equal zero
 Perfect Capital Mobility and Flexible Exchange
Rates
• Perfect capital mobility implies that the
balance of payments balances when i = if
• A real appreciation means home goods are
relatively more expensive, and IS shifts to the
left

Interest Rate
• A depreciation makes home goods relatively
cheaper, and IS shifts to the right

• The arrows in Figure make the link

between the interest rate and AD Income, Output
• When i > if, the currency appreciates
• When i < if, the currency depreciates
 Adjustment to a Real Disturbance
• We can show how various changes affect
the output level, interest rate, and
exchange rate
• Suppose exports increase:
 At a given output level, interest rate, and

Interest Rate
exchange rate, there is an excess demand for
goods
 IS shifts to the right
 The new equilibrium, E’, corresponds to a
higher income level and interest rate
 But don’t reach E’ since BP in disequilibrium  Income, Output
exchange rate appreciation will push economy
back to E
 Adjustment to a Real Disturbance
• We can show how various changes affect
the output level, interest rate, and
exchange rate
• Suppose there is a fiscal expansion:
 Same result as with increase in exports 

Interest Rate
tendency for demand to increase is halted by
exchange appreciation

Real disturbances to demand do

not affect equilibrium output Income, Output
under flexible exchange rates
with capital mobility.
 Adjustment to a Change in the Money Stock

• Suppose there is an increase in the nominal money

supply:
 The real stock of money, M/P, increases since P is
fixed
 At E there will be an excess supply of real money
balances

Interest Rate
 To restore equilibrium, interest rates will have to fall
 LM shifts to the right
 At point E’, goods market is in equilibrium, but i is
below the world level  capital outflows depreciate
the exchange rate
 Import prices increase, domestic goods more
competitive, and demand for home goods expands Income, Output
 IS shifts right to E”, where i = if
 Adjustment to a Change in the Money Stock

• Suppose there is an increase in the

nominal money supply:
 Result: A monetary expansion leads to an
increase in output and a depreciation of the
exchange rate under flexible rates

Interest Rate
Under fixed rates, the central bank
cannot control the nominal money
stock.

Income, Output
Under flexible rates, the central bank
can control the nominal money stock,
and is a key aspect of that exchange
rate system.