lecture 19: international capital flowswbrooks/lecture19.pdflecture 19: international capital flows....

Lecture 19: International Capital Flows

21 April 2020

Prof. Wyatt Brooks

AGGREGATE DEMAND AND AGGREGATE SUPPLY 1

COVID Projection


Stock Market


Initial Jobless Claims

Suggests the unemployment rate is something like 20%

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 4

How bad is it? Bad: highest unemployment rate since the

Great Depression

Not-so-bad: “separation” vs “furlough”

Most workers are not unemployed because firms are permanently closed

Should be able to return to work, hopefully

The ability of domestic governments to intervene to help the economy during recessions in an open world

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 5

International SavingsNext we want to understand how the following are interconnected:

The flows of capital between countries

The exchange rates between currencies

The ability of domestic governments to intervene to help the economy during recessions in an open world

Start by studying the connections between the savings behavior of countries.

A MACROECONOMIC THEORY OF THE OPEN ECONOMY 6

How NCO Depends on the Real Interest RateThe real interest rate, r, is the real return on domestic assets. A fall in r – for a given foreign r* – increases foreign demand for U.S. loanable funds (since return on U.S. savings can be with “low return” capital investments). NCO rises.

r

NCO

NCO(r*)

r2

Net capital outflow

r1

NCO1 NCO2


D = I + NCO

r adjusts to balance supply and demand in the LF market.

The Loanable Funds Market Diagram

r

LF

S = saving

Loanable funds

r1

Both I and NCOdepend negatively on r,

so the D curve is downward-sloping.


The Market for Foreign-Currency Exchange Another identity from last time:

NCO = NX

Net exportsNet capital

outflow

In the market for foreign-currency exchange, NX is the demand for dollars:

Foreigners need dollars to buy U.S. net exports. NCO is the supply of dollars:

U.S. residents sell dollars to obtain the foreign currency they need to buy foreign assets.


The Market for Foreign-Currency Exchange Recall:

The U.S. real exchange rate (e) measures the quantity of foreign goods & services that trade for one unit of U.S. goods & services.

e is the real value of a dollar in the market for foreign-currency exchange.


S = NCO

An increase in E makes U.S. goods more expensive to foreigners, reduces foreign demand for U.S. goods – and U.S. dollars.

The Market for Foreign-Currency Exchange

E

Dollars

D = NX

E1

An increase in Ehas no effect on saving or investment, so it does not affect NCO or the supply of dollars.


S = NCO

The Market for Foreign-Currency Exchange

E

Dollars

D = NX

E1

An increase in Ehas no effect on saving or investment, so it does not affect NCO or the supply of dollars.

E adjusts to balance supply and demand for dollars in the market for foreign-currency exchange.

Initially, the government budget is balanced and trade is balanced (NX = 0).

Suppose the government runs a budget deficit.

How does the budget deficit affect the U.S. real exchange rate? The balance of trade?

A C T I V E L E A R N I N G 2The budget deficit, exchange rate, and NX

12

A C T I V E L E A R N I N G 2Answers

13

D1

r

NCO

NCO

Net capital outflowr

LF

S1

Loanable funds

r1 r1

r2

S2

r2

Savings of LF decreases at each value of r.

NCO1NCO2


14

D1

r

NCO

NCO


LF

S1

Loanable funds

r1 r1

r2

S2

r2

r rises, causing NCO to fall.

NCO1NCO2


15

The budget deficit reduces NCO and the supply of dollars.

The real exchange rate appreciates,

reducing net exports.

Since NX = 0 initially, the budget deficit causes a trade deficit (NX < 0).

S1 = NCO1E

Dollars

D = NX

E1

S2 = NCO2

E2

Market for foreign-currency exchange

The Connection Between Interest Rates and Exchange Rates

r

NCO

E

dollars

NCO

D = NX

S1 = NCO1S2

E1

E2

r1

r2

Anything that increases rwill reduce NCOand the supply of dollars in the foreign exchange market. Result: The real exchange rate appreciates.

NCO1NCO2

NCO1NCO2

Keep in mind:The LF market (not shown)

determines r. This value of r

then determines NCO (shown in upper graph).This value of NCO then

determines supply of dollars in foreign exchange

market (in lower graph). 16

Suppose the government provides new tax incentives to encourage investment.

Use the appropriate diagrams to determine how this policy would affect: the real interest rate net capital outflow the real exchange rate net exports

A C T I V E L E A R N I N G 3Investment incentives

17


18

D1

r

NCO

NCO


LF

S1

Loanable funds

r1 r1

r2

D2

r2

Investment – and the demand for LF – increase at each value of r.

NCO1NCO2


19

D1

r

NCO

NCO


LF

S1

Loanable funds

r1 r1

r2

D2

r2

r rises, causing NCO to fall.

NCO1NCO2


20

The fall in NCOreduces the supply of dollars in the foreign exchange market.

The real exchange rate appreciates,

reducing net exports.

S1 = NCO1E

Dollars

D = NX

E1

S2 = NCO2

E2



Political Instability and Capital Flight 1994: Political instability in Mexico made world

financial markets nervous. People worried about the safety of Mexican

assets they owned. People sold many of these assets, pulled their

capital out of Mexico.

Capital flight: a large and sudden reduction in the demand for assets located in a country

We analyze this using our model, but from the prospective of Mexico, not the U.S.


Demand for LF = I + NCO. The increase in NCO increases demand for LF.

D1

Capital Flight from Mexico

r

NCO

NCO1

r1


LF

S1

r1

Loanable funds

D2

r2

NCO2

r2


As foreign investors sell their assets and pull out their capital, NCO increases at each value of r.

D1


r

NCO

NCO1

r1


LF

S1

r1

Loanable funds

D2

r2

NCO2

r2


The equilibrium values of r and NCO both increase.

D1


r

NCO

NCO1

r1


LF

S1

r1

Loanable funds

D2

r2

NCO2

r2



The increase in NCOcauses an increase in the supply of pesos in the foreign exchange market.

The real exchange rate value of the peso falls.

S2 = NCO2


E

Pesos

D1

S1 = NCO1

E1

E2

Examples of Capital Flight: Mexico, 1994

0.10

0.15

0.20

0.25

0.30

0.35

10/2

3/19

94

11/1

2/19

94

12/2

/199

4

12/2

2/19

94

1/11

/199

5

1/31

/199

5

2/20

/199

5

3/12

/199

5

4/1/

1995

US

Dol

lars

per

cur

renc

y un

it .

Examples of Capital Flight: S.E. Asia, 1997

0

20

40

60

80

100

120

12/1

/199

6

2/24

/199

7

5/20

/199

7

8/13

/199

7

11/6

/199

7

1/30

/199

8

4/25

/199

8

7/19

/199

8

US

Dol

lars

per

cur

renc

y un

it.1/

1/19

97 =

100

South Korea WonThai BahtIndonesia Rupiah

Examples of Capital Flight: Russia, 1998

0.00

0.04

0.08

0.12

0.16

0.20

5/5/

1998

6/14

/199

8

7/24

/199

8

9/2/

1998

10/1

2/19

98

11/2

1/19

98

12/3

1/19

98

US

Dol

lars

per

cur

renc

y un

it .

Examples of Capital Flight: Argentina, 2002

0.0

0.2

0.4

0.6

0.8

1.0

1.27/

1/20

01

9/19

/200

1

12/8

/200

1

2/26

/200

2

5/17

/200

2

8/5/

2002

10/2

4/20

02

1/12

/200

3

U.S

. Dol

lars

per

cur

renc

y un

it .


Exchange Rate Stability There are many reasons that countries pursue

stable prices for their currencies: Encourages foreign investment Increases confidence in the government Large swings in currency values damage trade

relationships Make it easier for the government to borrow

abroad

However, trying to stabilize currencies has historically led to problems


Exchange Rate Regimes A floating currency regime is the price of a

currency is allowed to fluctuate with international supply and demand

A pegged currency regime is when the price of a currency is fixed to the price of some other currency (e.g., the US dollar, or a basket of currencies)

There are many variations that are combinations of the two (“managed float”)


Currency Management We have already discussed the benefits of a

stable currency; what are the risks?

Running large trade imbalances makes pegging the exchange rate difficult

Suppose you are running a large trade surplus You can use the extra foreign exchange to buy

foreign assets (China’s strategy) You can guarantee a rate of exchange and pay

the difference (Argentina’s strategy)


Argentina, 2001 Argentina was pegged to the US dollar, and its

foreign debt was denominated in US dollars

The economy unexpectedly shrank, and huge budget cuts led to massive strikes and riots

Interest rates on government debt got very high

Argentines were able to convert their money to dollars at parity, and they started doing so

The central bank ran out of dollars and were unable to “defend the peg” Led Argentina to default on its debt


The Exchange Rate “Trilemma” Three desirable objectives to pursue: Free Capital Flows: Allow money unrestricted

flows through the country, which allows foreigners to invest in your country and you to invest wherever you want Fixed Exchange Rate: Stability in currency

markets Flexible Monetary Policy: Ability to use

monetary policy as a tool for stabilization

“Trilemma”: It is impossible to do all three at once.


Suppose you have…1) Free Capital Flows + Fixed Exchange Rate If money is flowing freely through the country,

monetary policy must be used to keep the exchange rate fixed Therefore, it isn’t available for stabilization policy

2) Fixed Exchange Rate + Active Monetary Policy If monetary policy is used to stabilize the

economy, the only way to control exchange rates is to control the amount of foreign currency flowing into the country

36

Suppose you have…3) Free Capital Flows + Active Monetary Policy If neither the amount of foreign currency in the

country nor the amount of domestic currency is being targeted, then the exchange rate fluctuates with the market

China does #1: restricted capital flows and fixed exchange rate

Germany does #2: open capital flows and fixed exchange rate

The US does #3: free capital flows and active monetary policy


Intuitive Explanation

Domestic Money

Foreign Money

Interest Rates

ExchangeRates

Capital Controls

If the domestic government uses capital controls, they may control both the amount of domestic money and foreign money, which gives them the ability to control both interest rates and exchange rates.

government controlled

Targetted

Targetted



Domestic Money

Foreign Money

Interest Rates

ExchangeRates

Capital Controls

If the domestic government does not use capital controls, they only have one policy instrument, so can only target one policy objective.

market determined

Targetted

Not Targetted



Domestic Money

Foreign Money

Interest Rates

ExchangeRates

Capital Controls

If the domestic government does not use capital controls, they only have one policy instrument, so can only target one policy objective.

market determined

Not Targetted

Targetted

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