Lecture 8

International Finance
ECON 243 – Summer I, 2005
Prof. Steve Cunningham
 Capital Mobility
 Perfect Capital Mobility means that a practically
unlimited amount of international capital flows in
response to the slightest change in one country’s
interest rates.
 Absent political and macroeconomic risks, a
successful fixed exchange rate regime should make
perfect capital mobility more likely. (Exchange rate
risk is zero.)
 For a small country, perfect capital mobility implies
that the country’s interest rate must be equal to the
world interest rate.

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 Capital Mobility and Monetary Policy
 Under fixed exchange rates and perfect capital
mobility, international capital flows dictate the
country’s money supply.
 International conditions dominate domestic policy.
 If a country tries to reduce its money supply to raise its
interest rates for domestic policy reasons,
1. A slightly higher interest rate attracts a nearly unlimited capital
inflow.
2. The exchange rate must be defended by selling domestic currency,
thereby expanding the money supply.
3. It is impossible to sterilize in the face of such large capital flows.
4. The expanding money supply lowers the domestic interest rate.
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 Capital Mobility and Fiscal Policy

 Under fixed exchange rates, perfect capital

mobility enhances domestic fiscal policy.
 Because interest rates cannot rise, there is no
possibility for “crowding out”.
 If the government increases spending without
raising taxes, it incurs deficits.
 The deficits can easily be financed by in the
enormous capital inflows.

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 Trade-off?
Improved fiscal policy effectiveness is not a
good substitute for monetary policy.
Fiscal policy is cumbersome—slow to enact,
not so responsive as monetary policy.
Fiscal policy is very much influenced by short-
run political interests.
Not helpful for handling long-run inflationary
issues.

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 Monetary Policy Without FE

i LM1 i LM1
LM0 LM0

i1 i1
i0
i0 IS
IS
Y Y
Y1 Y0 Y0
?
Under normal conditions, ignoring Again ignoring international complications,
international complications, a reduction if investment is not sensitive to interest rate
in the money supply raises interest rates, changes, a reduction in the money supply
making investment more expensive, raises interest rates a lot, but this has little
slowing output. effect on output.
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 Monetary Policy
Under fixed exchange rates and perfect capital mobility
In this case, any change in the domestic
money supply causes a change in the
i
interest rate, leading to the movement of
enormous international capital flows.
These capital flows happen almost
instantly, and continue until the interest
rates are restored to their original level
FE —the same level as the world interest
i0
LM rate.
Thus, effectively, the interest rate is
IS
fixed at the world rate, and domestic
monetary policy cannot change the
Y0 Y interest rate, and therefore cannot affect
the domestic economy.

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 Fiscal Policy without FE

LM
i i
IS0 IS1
i1
LM0
i0
i0 IS1
IS0

Y0,1 Y Y0 Y1 Y

Under normal conditions, ignoring Again ignoring international complications,

international complications, if money
demand is very unresponsive to interest
rates, then fiscal policy simply raises
interest rates, and rendered weak as a
result of “crowding out”.
if money demand is sensitive to interest rate
changes, fiscal stimulus is powerful. Small
changes in interest rates have a large impact
on the money supply-demand equilibrium.
There is no crowding out.
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 Fiscal Policy
Under fixed exchange rates and perfect capital mobility

A stimulative fiscal policy shifts IS

i
to the right. Any tiny increase in the
interest rate generates enormous
changes in the domestic money
supply-demand equilibrium as a
result of the enormous capital
inflow. FE and LM are both
FE
i0
anchored at the world interest rate.
LM Thus there is no possibility of
crowding out, and fiscal policy is
IS powerful.

Y0 Y1 Y

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 Policy Effectiveness
 Under perfect capital mobility and fixed
exchange rates,
 Monetary policy is limited to defending the
fixed exchange rate, and
 Fiscal policy can be powerful.

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 Internal Shocks
 A domestic monetary shock alters the equilibrium
relationship between money supply and demand
because:
 The money supply changes, or
 People alter their personal systems of determining how
much money to hold (demand) perhaps as a result of
innovations or changes in the payments system.
 A domestic spending shock alters domestic real
expenditure by a change in one of its components
(C,I,G). An example is a fiscal policy change.

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 External Shocks
 An international capital-flow shock is an
unexpected shift of international funds in
response to political upheaval or fears of a
international policy change. Examples are:
 Fear of war
 Rumors of the imposition of capital controls
 Growing evidence of a likely currency
devaluation
 A form of capital flight

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 Adverse Int’l Capital-Flow Shock
1. FE shifts to higher
LM1 interest rates.
FE1 2. Official settlements
i balance is in deficit at
LM0 point E. Central bank
T must defend the fixed
FE0 rate.
3. If the central bank does
E not sterilize its
intervention, LM shifts
upward to left, and
external balance is
IS
restored.

Y1 Y0 Y 4. Internal imbalance is
created by falling
output and rising
unemployment. 13
 International Trade Shocks
 An international trade shock is a shift in a
country’s exports or imports arising from
causes other than changes in the real income
of the country.
 These are structural changes.
 British beef.
 A country that is found to use DDT in its
agriculture.
 It alters the current account.
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 Policy Responses

State of the Domestic Economy

High
Unemployment Rapid Inflation
Expansionary
State of Surplus
Policy
??
Balance of
Contractionary
Payments Deficit ??
Policy

In the situations marked by “??”, aggregate demand policy cannot deal

effectively with both the internal and external situations simultaneously.

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 Policy Responses
 When confronted with one of the situations
marked with ??, the government is in a trap.
Internal imbalance solutions worsen the external
balance, and vice-versa.
 It has three choices:
1. It can abandon the goal of external balance, which will
require eventual abandonment of the fixed exchange
rate.
2. It can abandon the goal of internal balance, at least on
the short run.
3. It can search for other solutions, like…?
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 Alternative for the Short Run
 Robert Mundell and J. Marcus Fleming realized
there might be a possibility of using an appropriate
“policy mix”.
 Stimulative monetary policy lowers interest rates;
stimulative fiscal policy raises interest rates.  Maybe a
combination, each offsetting the worst of the other?
 It is the changes in interest rates that affect the payments
balance.
 So with a combined policy, one could have fiscal policy
stimulus and lower interest rates!
 More generally, monetary and fiscal policies can be
mixed so as to achieve any combination of internal and
external goals in the short run.
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 Assignment Rule
 According to Mundell’s assignment rule:
 Assign fiscal policy the task of stabilizing the domestic
economy (only),
 Assign to monetary policy the task for stabilizing the
balance of payments (only)
 Each arm of policy concentrates on a single task,
making coordination of policy trivial.
 Also each arm of policy is addressing the issues it cares
most about.
 Timing, though, remains critical. Lags from either side
could result in unstable oscillations.
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 Monetary-Fiscal Recipes

State of the Domestic Economy

High unemployment Rapid Inflation

Easier monetary policy, Easier monetary policy,

State of Surplus
easier fiscal policy tighter fiscal policy
Balance of
Payments
Tighter monetary policy, Tighter monetary policy,
Deficit
easier fiscal policy tighter fiscal policy

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 Exchange Rates
and the Trade Balance
 What is the effect of a change in the
nominal exchange rate on the volumes of
exports and imports?
 As long as the change in the exchange rate alters
the int’l price competitiveness, it should change
the volume of trade.
 What is the effect on the value of trade?
 This is more difficult. (Remember both prices
and volumes are changing.)

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 Devaluation (Surrender)
 The devaluation should improve international price
competitiveness as long as any changes in the
domestic price level or foreign price level do not
offset the exchange rate change.
 Exports increase as goods become cheaper to foreign
buyers.
 Imports decrease as foreign goods become more
expensive to domestic buyers.
 OVERALL, the current account tends to improve. The
result on the capital account is less clear.

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 Consider a devaluation

Consider a devaluation of the dollar, where the CA

balance is measure in pounds per year:

CA balance = P£X • X - P£m • M

£ price of Quantity £ price of Quantity

Exports of Exports Imports of Imports

   
Effect = No No No No
change change - change • change
or down
• or up or down
or down
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 Problem?
 In the case of perfectly inelastic demand for
exports and imports, devaluing the dollar could
result in a worsened trade balance.
 The foreign price of exports fall, but quantities
demanded are NOT responsive to price, so the
volume stays the same.
 Thus P£X is lower, but X is unchanged, and
P£X • X is lower. The value of exports declines.

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 More Likely Result
 On the short run, prices will be able to adjust more quickly
than quantities. (Export demand is more inelastic in the
short run.)
 So immediately following a devaluation or depreciation,
the value of exports will fall, worsening the trade balance.
 Over the longer term, prices can adjust. (Export demand is
more elastic in the long run.) So longer term, the trade
balance would improve.
 In fact, the longer the elapsed time since the devaluation
or depreciation, the more likely the trade balance is to be
improved.

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 J Curve
 It is more likely that the drop in the value of the
home currency will improve the trade balance,
especially in the long run.
Net change in
+ trade balance

0
Months since
devaluation
- 18 months

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 Flexible Exchange Rates
 Under a clean float, external balance is
maintained by the changing exchange rates.
 Policy focuses on internal balance.
 Remaining questions:
 What are the effects of shocks?
 How does the exchange rate change resolve
external imbalances?
 How do fluctuations in the exchange rate affect the
macroeconomy?
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 Expansionary Monetary Policy

Capital flows out

Current
Money Interest Our currency account GDP
supply rate drops depreciates balance rises
increases improves more

Spending Current
and output account
increase balance
worsens

Price level
rises

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 Expansionary Monetary Policy (2)
 Under floating exchange rates, monetary policy
is powerful in its effects on internal balance.
 The induced change in the exchange rate
reinforces the domestic effects of monetary
policy.
 Monetary policy is a more powerful tool for
managing the domestic economy under flexible
exchange rates.

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 Expansionary Monetary Policy

LM0
FE0 Following
i expansionary monetary
LM policy, the currency
E0 1 depreciates to correct
FE1
the deficit payments
balance—FE moves to
E1 the right. IS moves to
T1 the right as the current
IS1 account improves.
IS0

Y0 Y1 Y

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 Expansionary Fiscal Policy

Interest Capital
rate rises flows in
Our currency may
appreciate at first, GDP falls,
Gov’t but probably then rises
spending depreciates more
increases eventually

Spending Current
and output account
increase balance
worsens

Price level
rises

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