International Linkages

Chapter #13

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 Introduction
• National economies are becoming more closely interrelated
– Economic influences from abroad have affects 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
• In this chapter we present the key linkages among open economies
and introduce some first pieces of analysis

13-2
 Introduction
• Economies are linked through two broad channels
1. Trade in goods and services
• Some of a country’s production is exported to foreign countries → increase
demand for domestically produced goods
• Some goods that are consumed or invested at home are produced abroad and
imported → a leakage from the circular flow of income
2. Finance
• 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
• U.S. residents can hold U.S. assets OR assets in foreign countries

13-3
 The Balance of Payments and
Exchange Rates
• Balance of payments: the record of the transactions of the residents of a
country with the rest of the world
• Two main accounts:
Current account: records trade in goods and services, as well as transfer
payments
Capital account: records purchases and sales of assets, such as stocks, bonds,
and land

13-4
 External Accounts Must Balance
• The central point of international payments is very simple:
Individuals and firms have to pay for what they buy abroad
– If a person spends more than her income, her deficit needs to be
financed by selling assets or by borrowing
– Similarly, if a country runs a deficit in its current account the deficit
needs to be financed by selling assets or by borrowing abroad
• Selling/borrowing implies the country is running a capital account surplus
→ any current account deficit is of necessity financed by an offsetting
capital inflow

Current account + Capital account = 0 (1)

13-5
 Exchange Rates
• Exchange rate is the price of one currency in terms of another
– Ex. In august 1999 you could buy 1 Irish punt for $1.38 in U.S.
currency → nominal exchange rate was e = 1.38
If a sandwich cost 2.39 punts, that is equivalent to

• We will discuss two different exchange rate systems:

13-6
 Fixed Exchange Rates
• In a fixed exchange rate system foreign central banks buy and sell
their currencies at a fixed price in terms of dollars
– Ensures that market prices equal to the fixed rates
No one will buy dollars for more than fixed rate since know that they can
get them for the fixed rate
No one will sell dollars for less than fixed rate since know can sell them for
the fixed rate
• Foreign 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

13-7
 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
• Ex. If the U.S. were running a current account deficit vis-à-vis Japan, the
demand for yen in exchange for dollars exceeded the supply of yen in
exchange for dollars, the Bank of Japan would buy the excess dollars,
paying for them with yen
→ Under a fixed exchange rate, price fixers 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

13-8
 Fixed Exchange Rates
• What determines the level of intervention of a central bank in a
fixed exchange rate system?
– With necessary reserves, Federal Reserve can continue to intervene in
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 on of foreign exchange
• Will be unable to continue its intervention
• Before this occurs, the central bank will likely devalue the currency

13-9
 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
• Bank of Japan stands aside and allows the exchange rate to adjust
Exchange rate could increase to 0.90 cents per yen
Japanese goods more expensive in terms of dollars
Demand for Japanese goods by Americans declines

13-10
 The Exchange Rate in the Long
Run
• In long run, exchange rate between pair of countries is determined
by relative purchasing power of currency within each country
– 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 (3), where Pf and P are the
price levels abroad and domestically, respectively
→ 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

13-11
The Exchange Rate in the Long
Run

→If R =1, currencies are at PPP

13-12
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
Spending by domestic residents is (4)
Spending on domestic goods is
(5)
Assume DS depends on the interest rate and income:
(6)

13-13
 Net Exports
• Net exports, (X-Q), is the excess of exports over imports
• NX depends on:
domestic income
foreign income, Yf (7)
R

→ A rise in foreign income improves the home country’s trade balance and
raises their AD
→ A real depreciation by the home country improves the trade balance and
increases AD
→ A rise in home income raises import spending and worsens the trade
balance, decreasing AD

13-14
 Goods Market Equilibrium
• Marginal propensity to import = fraction of an extra dollar of
income spent on imports
– IS curve will be steeper in an open economy compared to a closed
economy
– For a given reduction in interest rates, it takes a smaller increase in
output and income to restore equilibrium in the goods market

13-15
 Goods Market Equilibrium
• IS curve now includes NX as a component of AD
(8)
– level of competitiveness (R) affects the IS curve
• A real depreciation 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

13-16
 Goods Market Equilibrium
• Higher foreign spending on our
goods raises demand and requires
an increase in output at given
interest rates
– 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
• Figure 13-3 can also be used to
show the impact of a real
depreciation

13-17
 Capital Mobility
• High degree of integration among financial markets → markets in
which bonds and stocks are traded
• Start our analysis with the assumption of perfect capital mobility
– Capital is perfectly mobile internationally when investors can purchase
in any country, quickly, with low transaction costs , and in unlimited
amounts
– Asset holders willing and able to move large amounts of funds across
borders in search of the highest return or lowest borrowing cost
– 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

13-18
 The Balance of Payments and Capital
Flows
• Assume a home country faces a given price of imports, export
demand, and world interest rate, if, and capital flows into the home
country when the interest rate is above world rate
• Balance of payments surplus is:
(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

13-19