Transcript Lecture 7 Slides - Central Web Server 2

Lecture 7
International Finance
ECON 243 – Summer I, 2005
Prof. Steve Cunningham
Extended IS-LM Model

Goods market equilibrium requires:
Y s = Yd
Ys = C + Id + G + (X – M)
Ys – C – G = Id + (X – M)



S
= Id + If
But S = S0 + sY, so that S = S(Y).
Id + If = I, and I = Io – αi, or I = I(i)
So this condition is essentially S(Y) = I(i).
Extended IS-LM (Continued)

But, S(Y) = I(i) is essentially a statement that
saving = investment in the loanable funds
market.
Compare this to the neoclassical
model, wherein S(i) = I(i), and we
could draw:
i
In this model, there is no one
variable on which to adjust, and
S(Y) = I(i):
i
S
i*
i*
IS
(I=S)
I
S*,I*
S,I
Y
Y*
Extended IS-LM (Continued)



Clearly S(Y) = I(i) implies an infinite number
of possibilities, of combinations of Y and i
that bring the capital market (and
therefore goods market) into equilibrium.
But which combination (Y,i) is the one that
will actually happen?
To answer this, we need to look at the
money market.
Extended IS-LM (Continued)

The demand for money (on the short run) is
related:



Positively to nominal GDP (PY), since this is a
measure of the volume of the transactions that
people want to make with money, and
Negatively to interest rates (i) because holding
money involves foregoing interest, hence there is
an opportunity cost.
Thus the demand for money L = L(PY,i) .
(“L” is used for “liquidity”, Md = L.)
Extended IS-LM (Continued)



The supply of money is controlled (more or less) by
the central bank—in the U.S., that is the Fed.
So Ms is essentially “exogenous”.
So equilibrium in the money market requires
Md = Ms, or L = Ms. Thus, Ms = L(PY,i).



The demand for money rises with transactions volume
and PY.
The demand for money falls with the opportunity cost of
holding money, i.
If we hold prices constant, then Ms = L(Y,i).
Extended IS-LM (Continued)
Compare to the
neoclassical model
wherein Ms = L(Y)
since M = kPY.
In this model, again
there are two
variables (Y,i) that
can adjust:
i
i
LM
(L=M)
i*
i*
M*
M
Y
Y*
Extended IS-LM (Continued)





In this model, the nominal interest rate is set in the
money market.
This is compared to the returns on capital in the
capital market.
Decision makers decide on how much to invest (I)
based on the comparison of the cost of investment
and its expected return.
The real interest rate follows from the capital
market (S=I).
So it takes both money market and
goods/capital-market to resolve the economy.
Extended IS-LM (Continued)
For an economy without trade:
i
LM
i*
IS
Y*
Y
Extended IS-LM (Continued)

Mathematically, simultaneously solve the
two equations:

I(i) = S(Y)
Y*, i*, S*, M*, I*
M = L(Y,i)
With Y* compute C* = C(Y*)

Back out employment, wages, etc.



From C, you get labor supply
From Y, you get labor demand
Labor supply = labor demand tells you the
wages.
Extended IS-LM (Continued)



To extend this to an open economy, we add
the foreign exchange (FE) or balance of
payments(BP) market.
To do this, we examine how the official
settlements balance (B) is affected by
income (Y) and interest rates (i).
It turns out that :
B = CA(Y) + KA(i)
with Y negatively related to B, and
i positively related to B.
Extended IS-LM (Continued)

Raising Y lowers the current account
because:



It creates more demand for imports,
Leads to trade deficits (or lower trade
surpluses).
Raising the interest rate (i) raises the capital
account because it:


Attracts capital from abroad
Creating a capital account surplus (or lowering
the capital account deficit).
Extended IS-LM (Continued)


We construct the FE curve which is the
combinations of Y and i that bring the
official settlements balance to zero.
In other words, FE is all the combinations of
Y and i that create a balance of payments
equilibrium (without any official reserve
transactions).
+
-
B = CA(Y) + KA(i)
Extended IS-LM (Continued)
+
B = CA(Y) + KA(i)
-
 Note that for B to stay the same,
increases in Y must be met with
offsetting increases in i.
 This means that both must increase and
decrease together.
Extended IS-LM (Continued)
FE
i
At this point, i is
too high for Y.
This raises the
capital account
and B=CA+KA>0.
At this point,Y is
too high for this
level of i. Thus
imports are
driven too high,
lowering the
current account.
This leads to
i
B=CA+KA<0
Y
Y
Extended IS-LM (Continued)

What determines the slope of the FE line?


Answer: the sensitivity of capital flows to
interest rate changes.
If capital flows are very sensitive to interest
rates, then FE is relatively flat.


If capital flows are extremely sensitive to interest
rates, then there must be little in the way of
obstacles to these flows. When the FE line is nearly
flat, we have “perfect capital mobility.
If capital flows are insensitive to interest rates,
then FE is relative vertical.
Extended IS-LM (Continued)
The official
settlements
balance is in
deficit.
i
The official
settlements
balance is 0.
FE
i
FE
LM
i*
The official
settlements
balance is in
surplus.
i
LM
i*
Y
LM
i*
IS
Y*
FE
IS
Y*
Y
IS
Y*
Y
Using the Extended Model


If the country is on a fixed exchange rate
regime, official settlements imbalances
indicate that the fixed exchange rate must
be defended. Intervention is required. (The
settlements balance is not zero.)
If the country is on a clean float, then some
shifting of curves will occur to bring the
three curves together at the same point.
Price Level Changes


So far we assumed that prices are fixed.
(Short-run “stickiness.”)
Price levels do change for three reasons:



Domestic inflationary pressures related to
money supply growth rates.
Aggregate demand changes.
Shocks.
Trade and Prices



Imports and exports depend upon
production levels and incomes in the
country under analysis and in the rest of
the world.
Demand for imports is also related to the
price of the imported goods relative to the
price of similar domestic goods. That is, it
depends upon the real exchange rate.
The price ratio is (Pf r )/P.
Trade and Prices (Continued)


Thus M = M(Y) is not really complete.
We add the relative price term:
+
-
M = M(Y, Pf r/P)


Our demand for foreign goods is less if the
prices of the imports makes them relatively
expensive.
Our demand for foreign goods is higher if our
incomes are higher (Y).
Trade and Prices (Continued)

Likewise, for exports we have:
+
+
X = X(Yf , Pf r/P)


Foreign demand for our goods are higher if
they are enjoying higher incomes (Yf ).
Foreign demand for our goods is higher if our
goods are relatively cheaper.
Fixed Exchange Rates


Once a gov’t decides to fix its exchange
rate, it must defend that rate.
The first line of defense is official
intervention

Intervention: the monetary authority buys or
sells foreign currency in the foreign exchange
market to keep the rate within the allowable
band around the central value chosen for the
fixed rate.
Problems with Intervention


Buying or selling foreign currencies causes
changes in official reserves.
The country’s money supply may change as
a result of exchanging the foreign currency
for domestic currency.
Central Bank Assets


International Reserve Assets (R)
Domestic Assets (D)



Denominated in the domestic currency
Bonds and related debt of the domestic
government
Loans made by the central bank to domestic
banks or financial institutions
Central Bank Liabilities


Domestic Currency (paper money and coins)
Deposits of domestic banks with the central
bank.


These are be required to facilitate check
clearing processes
These deposits are required as reserve
requirements. These are play a role in the
system known as fractional reserve banking.
Fractional Reserve Banking



Banks only maintain (in reserve) a small
fraction of their total deposits.
The required ratio of these reserves is to
deposits is called the required reserve ratio,
and is set by the Fed.
Because of fractional reserve banking,
money is expanded through the money
multiplier process.
Intervention and the Money Supply





A country is running an official settlements surplus, creating
upward pressure on the exchange rate (the exchange rate is
too low).
The central bank intervenes by buying foreign currency,
selling domestic.
Buying foreign currency increases int’l reserve holdings (R).
Since it was bought with domestic currency, its liabilities
increase as the domestic money supply is increased.
If the money is received by a domestic bank, then it will
increase bank reserves, and be multiplied via the multiplier
process.
Thus foreign exchange intervention has the effect of
changing the domestic money supply.
Money Supply and BOP


The linkage can run the other direction.
If the money supply increases, that will lower the interest rate,
affecting capital flows, but also the domestic economy.
Capital flows out
Ms
i
Y
P
CA worse
Y? = C + I + G + (X – M)
Payments
balance
worsens
Payments Adjustments
Surplus Country with Fixed Exchange Rates
LM0
i
LM
FE
IS
Y
Intervention under fixed rates changes the domestic money supply. The supply
change causes adjustments that lead the country back toward external balance.
Problem?


It requires changes in international reserves,
which may not be desirable.
Solution:


If the central bank is willing to let the domestic
money supply change, it may be able to
accelerate the process by deliberately engaging
in open market operations to increase the
domestic money supply and accelerate the shift
of LM.
This raises the issue of inflation.
Problem?

The adjustment toward external balance may
not be consistent with internal balance.


The shift of LM caused by the increasing money
supply may cause upward pressure on prices.
Inflation in undesirable, a shift toward internal
imbalance.
Rising prices may put backward pressure on LM,
and also affect exchange rates.
Sterilization



To avoid internal imbalance occurring as the
central bank fights external imbalance, they
may decide to attempt to resist the domestic
money supply change.
Sterilization is the practice of taking an action
to reverse the effect of official intervention on
the domestic money supply.
Because the domestic money supply does not
change, LM does not move. There is no
movement toward external balance.
Domestic Policy Independence


Because intervention generally means
changing the domestic money supply,
maintaining a fixed exchange rate interferes
with a country’s ability to engage freely in
domestic monetary policy.
Domestic policy has to be limited to actions
that will support the fixed exchange rate.
Expansionary Monetary Policy
LM0
LM
i
FE
Both current account and
capital accounts deteriorate
IS
Y0 Y
Y
Expansionary Fiscal Policy
Capital
inflows
increase
i
Overall payments
balance may
improve at first, but
worsens eventually.
Gov’t spending rises
or taxes fall (deficit
spending stimulus)
Current
account
balance
worsens
Imports
increase
Y
P
Exports
fall
Expansionary Fiscal Policy
Responsive Capital Flows
Unresponsive Capital Flows
FE
LM
LM’
FE
i
i
IS
Y0 Y1 Y2
Payments in surplus
LM’
LM
IS’
IS’
IS
Y
Y0Y2 Y1
Payments in deficit
Y