long run international macroeconomics - berkeley-haasfaculty.haas.berkeley.edu/arose/macro6.pdf ·...

Long Run International Macroeconomics

The Balance of Payments

1Andrew Rose, Global Macroeconomics 6

Accounting

• Y = C + I + G + (X‐M) implies

• [Y – (C + G)] ‐ I = S – I = X – M

– Recall National Saving is defined as S = [Y – (C + G)]

• (X ‐ M) Net Exports (NX); trade of goods, services

• (S ‐ I) Net Capital Flows, public and private


Balance of Payments

• Current Account + (Private) Capital Account + Official Reserve Settlements = 0

• Algebraically c/acc + k/acc + ORS = 0

– Current Account: net sales of goods and services

– Capital Account [sometimes “Financial Account”]: net sales of privately‐held assets (debt, equity, real estate)

– ORS: net sales of public assets (money for foreign exchange intervention)

• Works at any level of aggregation (including individual)


Balance of Payments Accounting Rule

• Anything (goods/services/assets) that gives

rise to a receipt from (payment to) the rest of

the world is a credit (debit) and enters as a

positive (negative) entry

– Ex: exports of goods, services, or assets


Small Open Economy (SOE)

• A Small Economy takes international prices as given

• Key: takes price of money as given from abroad

(interest rate exogenous)

– Most countries are small

• Note: We treat phenomena like country size as a

discrete feature – a country is either small or large (not

medium), when it is really continuous


Large Economies

• Interest Rate Setters

• US, EMU (Germany before 1999), and Japan

• US and Germany/EMU are interest‐rate

makers over “sphere of financial influence”

(small open economies)


Open Economy

• No (substantial) barriers to international flows of (private) capital– Why not barriers to international trade of goods (and services)?

• Richer countries are open, but only recently– Growing Number of Emerging Markets recently too

• Can measure openness by examining: a) de jure rules/capital restrictions (“inputs”), or b) prices (“outcomes”) of similar assets in different locations– Examining quantities implies most countries closed; “home bias”


Floating Nominal Exchange Rate

• e measured as foreign exchange/domestic currency – a bilateral nominal exchange rate– Rise in e: appreciation of the domestic currency– Fall: depreciation

• A floating nominal exchange rate implies that the “authorities” (government and central bank) do not intervene on the foreign exchange markets to affect the level of the exchange rate (so ORS = 0)

• Assume: floating exchange rate is not expected to change (reasonable empirically for many countries – Meese and Rogoff)


Exchange Rate Regimes

• Many countries float (vis‐à‐vis a large economy), often with inflation target

– Ex: Canada, Korea, UK

• Many economies fix the nominal exchange rate

– Ex: Saudi Arabia, Hong Kong, Denmark

– Deal with later

• In practice, clean float and perfect fix are end‐points on a continuous distribution of degree of intervention


Real Exchange Rate

• ε ≡ eP/P* where P* denotes foreign prices– Nominal exchange rate adjusted for inflation (both home and abroad)

• Increase in ε is a real appreciation/loss in competitiveness– Domestic goods become more expensive compared to foreign goods

• Real exchange rate is always flexible in long run (since prices flexible)


Purchasing Power Parity

• Real exchange rate (ε) = 1 “PPP value” (eP=P*)

• Same goods cost same home and abroad

– Easily testable with good‐specific data

– Usually rejected, except for highly‐tradables

• Perhaps valuable for long run, or short run for

homogeneous goods


Modeling International Flows

• Capital flows react fast– Interaction between S(avings) I(nvestment) and (exogenous large open economy) interest rate

• Exchange rate affected by capital flows• Current Account affected by real exchange rate (ε=eP/P*; nominal exchange rate matters)

Andrew Rose, Global Macroeconomics 6 12

Perfect Capital Mobility

• Leads to i = i* (set by large open economy) or

r=r* (without inflation)

– Otherwise massive capital flows

– Implicit: assets compared are similar in other

respects, including risk, liquidity, taxes …


Capital Account

• Consumption (hence savings) depends only on (disposable) income, so independent of interest rate

• Interest rate given from abroad (relevant large open economy)– So investment is determined (by foreign=domestic interest rate)

• Thus capital flows determined by gap between savings and investment– High foreign interest rate leads to high domestic interest rate, domestic savings in excess of investment, capital outflow


r

S, I

I(r)

S = Y – C(Y) - G

Br*


Capital Flows: S ‐ I

autarky

B

Current Account• Exports determined by X=X(ε, Y*)

– ε (=eP/P*) as relative price

– Demand by foreigners for our goods (often luxuries, sometimes

intermediates)

• Similarly, imports M=M(ε, Y)

– Our demand for foreign goods

• Net exports determined by NX = (, Y, Y*)

– Foreign income is exogenous

– Rise in real exchange rate is loss in competitiveness, lower net exports


c/acc

A

ε

Graphically


Deficit Surplus

Current account = NX

0 = balance

Domestic Fiscal Expansion

• Raise direct government spending (G), implicitly financed via bonds

• S falls, (S‐I) falls, NX falls, ε rises– “Twin Deficits”


r

S, I

B

I(r)

S = Y – C(Y) - G

Ar*

C

Graphically: Capital Account


0 = balance

c/acc

ε

0 = balance

Current Account


B

C

Foreign Fiscal Expansion• Foreign interest rate (of large economy) rises• I falls, (S‐I) rises, NX rises, ε falls


r

S, I

A

I(r)

S = Y – C(Y) - G

Ar*

BBr*'

c/acc

ε

0 = balance

Current Account


B

A

Key Takeaways

• The Balance of Payments: an accounting framework

• Countries differ in: a) size (small/large); b) openness (open/closed); c) exchange rate regime (fixed/floating)

• PPP: a poor “model” of the real exchange rate• Savings, Investment and the foreign interest rate jointly determine capital flows; these then drive the real exchange rate and thus the current account


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