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Economics of International Financial Policy: ITF 220
Times – Lectures: Mon. & Wed., 2:40-4:00 p.m., Littauer 382 Review sessions: Fridays, 11:40-1:00, Littauer 332 Final exam: Monday, May 11, 2014, 2:00-5:00 p.m.
Requirements -- Textbook: World Trade & Payments + Readings. 7 Problem Sets (20%) + Midterm (30%) + Final exam (50%).
Professor Jeffrey Frankel, Kennedy School, Harvard University
Big topics covered in the courseI) ELASTICITIES & THE TRADE BALANCE
II) THE KEYNESIAN MODEL OF INCOME
III) THE MONETARY APPROACH TO THE BALANCE OF PAYMENTS
IV) GLOBALIZATION OF FINANCIAL MARKETSV) FISCAL & MONETARY POLICY UNDER
INTERNATIONAL CAPITAL MOBILITYVI) INTERDEPENDENCE AND COORDINATIONVII) SUPPLY, INFLATION & MONETARY UNION
VIII) EXPECTATIONS, MONEY, & DETERMINATION OF THE EXCHANGE RATE
• Lecture 1: Balance of Payments Accounting
• Lecture 2: Supply & demand for foreign exchange; export and import elasticities
• Lecture 3: Empirical effects of devaluation on the trade balance
TOPIC I: ELASTICITIES & THE TRADE BALANCE
Professor Jeffrey Frankel, Kennedy School, Harvard University
Lecture 1:Balance of payments accounting
• Definition: The balance of payments is the year’s record of economic transactions between domestic and foreign residents.
• The rules:– If you have to pay a foreign resident,
normally in exchange for something that you bring into the country, then the something counts as a debit.
– If a foreign resident has to pay you for something, then the something counts as a credit.
NOW CALLED “FINANCIAL ACCOUNT”
“Primary income,” mainly investment income
≡ “secondary income”
I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
-250000
-200000
-150000
-100000
-50000
0
U.S. International Transactions
Balance on current account (line 1 less line 9) /4/ Balance on goods and services (line 2 less line 10)
Seasonally Adjusted
Goods
Goods &Services
CurrentAccount
Measures of external balanceUS 2004-2013
US services surplus partially offsets the deficit in goods.
PER QUARTER
Professor Jeffrey Frankel, Kennedy School, Harvard University
Examples on the current account:• You, an American, import software CD-roms from India
=> debits appear on US merchandise account.• You import services (electronically) of an Indian software firm
=> debit appears on US services account. (This is the famous and controversial “overseas outsourcing.”)
• You buy the services, instead, from a subsidiary that the Indian software firm set up last year in the US. This is not an international transaction, and so does not appear in the accounts. But assume the subsidiary sends some profits back to India => debit appears on US investment income account. (It is as if the US is paying for the services of Indian capital.)
• Employees of the subsidiary in the US (or any other US resident entities) send money to relatives back in India => debit appears under unilateral transfers.
Professor Jeffrey Frankel, Kennedy School, Harvard University
Examples on the long-term capital account: Instead of buying software CD-roms from India,
you buy the company in India that makes them. => debit appears on US capital account, under FDI. (You have imported ownership of the company.)
Instead of buying the entire company in India, you buy some stock in it => debit appears on US capital account, under equities.
(You have imported claims against an Indian resident.)
Instead of buying stock in the company, you lend it money for 2 years => debit appears on US capital account, under bonds or bank loans. (Again, you have imported a claim against an Indian resident.)
Professor Jeffrey Frankel, Kennedy School, Harvard University
Examples on the short-term capital account: You lend to the Indian company in the form
of 30-day commercial paper or trade credit => debit appears on US short-term capital account. (Again, you have acquired a claim against India.)
You lend to the Indian company in the form of cash dollars, which they don’t have to pay back for 30 days => debit appears on US short-term capital account.
You are the Central Bank, and you buy securities of the Indian company (an improbable example for the Fed – but some central banks, acting like “Sovereign Wealth Funds,” now make international investments of this sort) => debit appears as a US official reserves transaction.
The rules, continued
• Each transaction is recorded twice: once as a credit and once as a debit.– E.g., when an importer pays cash dollars,
• the debit on the merchandise account is offset by • a credit under short-term capital:
the exporter in the other country has, at least for now, increased holdings of US assets, which counts as a credit just like any other portfolio investment in US assets.
• At the end of each quarter, credits & debits are added up within each line-item;
• and line-items are cumulated from the top to compute measures of external balance.
Professor Jeffrey Frankel, Kennedy School, Harvard University
Some balance of payments identities• CA ≡ Rate of increase in net international investment position.
– CA-surplus country (Japan) accumulates claims against foreigners;– CA-deficit country (US) borrows from foreigners.
• CA + KA + ORT ≡ 0 .• BoP ≡ CA + KA .• => BoP ≡ -ORT ≡ excess supply of FX coming from private sector,
(i.e., all credits from exports of goods, services, assets… minus all debits)which central banks absorb into reserves, if they intervene in FX market).– A BoP surplus country adds to its FX reserves – A BoP deficit country
• either runs down its FX reserves • or, is lucky enough for foreign central banks to finance the deficit,
if its currency is an international reserve asset (US $) .– A floating country does not intervene in the FX market
• => BP ≡ 0;• Exchange rate E adjusts to clear FX supply & demand in private market
Professor Jeffrey Frankel, Kennedy School, Harvard University
End ofLecture 1:Balance
of Payments Accounting
Professor Jeffrey Frankel, Kennedy School, Harvard University
Lecture 2: The Elasticities Approach to the Trade Balance
• Primary question: Under what circumstances does devaluation improve the trade balance (TB), and how much?
• Secondary question: If the currency floats (i.e., the central bank does not intervene in the forex market),how much must the exchange rate (E) move to clear the trade balance by itself ?
Professor Jeffrey Frankel, Kennedy School, Harvard University
Example (ii) to illustrate Marshall-Lerner condition
for TB* = (/E) XD(/E) - (*) IMD(E *) .
• If εx = 0, then E ↑ cuts export revenue in proportion• because of valuation effect (3).• In that case, is εM > 1 necessary to improve TB* ?
• Yes, because of Marshall-Lerner condition • -- fall in import spending then outweighs
fall in export revenue: effect (1) > effect (2) --• provided initial X revenue > import spending.
• But if initial TB*<0, elasticities need not be as high.
How the TB is affected by the exchange rate (continued)
EXPERIMENT : E↑ Þ THREE
EFFECTS (2) IMD( ) falls.
TB = () XD(/E) - (E *) IMD(E *) .
TRADE BALANCE EXPRESSED IN DOMESTIC CURRENCY
EFFECT ON TB
+ +
-(1) XD( ) rises.
(3) Price of IMports in terms of domestic currency rises.
NET EFFECT ON TB is determined by the same Marshall-Lerner condition.
Again, assume that initially TB=0.
Then devaluation improves the TB iff: εX + εM > 1 .
Professor Jeffrey Frankel, Kennedy School, Harvard University
• Two examples when it worked: • Italy after 1992;
• Poland after 2008.
• To be continued in Lecture 3 …
What is the effect on TB in practiceof increases in the exchange rate?
Professor Jeffrey Frankel, Kennedy School, Harvard University
1992 devaluation
Rise in trade balance
Effect of Italy’s 1992 devaluation (in the European ERM crisis), as measured by the lira’s Real Effective Exchange Rate value, on its Trade Balance.
Poland’s exchange rate rose 35% in the 2008-09 global crisis.
I III V VII IX XI I III V VII IX XI I III V VII IX2008 2009 2010
3.2
3.5
3.7
4.0
4.2
4.5
4.7EUR/PLNZloty / €
Source: Cezary Wójcik
Depreciation boosted net exports => Poland avoided recession
Exchange rate
Poland’s trade balance improved sharply in 2009while its European trading partners all went into recession.
Source: National Bank of Poland From FocusEconomics 2014
Trade balance in billions of euros
Contribution of Net X in 2009: 3.1% of GDP > Total GDP growth: 1.7%
Professor Jeffrey Frankel, Kennedy School, Harvard University
End ofLecture 2:Elasticities
Approach to the Trade Balance
Lecture 3: Empirical effects of the exchange rate on the trade balance
• Elasticity Pessimism:Countries often fear their elasticities are too low for the M-L condition.
• Econometric estimation of elasticities • What is OLS regression?• Typical estimates• Lags.
• The J-curve • With fast pass-through to import prices• With slow pass-through to import prices.
• Application to the US TB: • The 1980s; • Effects of $ appreciation in 2014-15
Professor Jeffrey Frankel, Kennedy School, Harvard University
How can we estimate sensitivity of export demand to exchange rate?
OLS regression
. . .
. . .
. . . . . . . . .
X ≡ Exports demanded
EP*/P ≡ Price of foreign goods relative to domestic goods
Common econometric finding• Estimated trade elasticities with respect to relative prices
often ≈ 1, after a few years have been allowed to pass.– => Marshall-Lerner condition holds in the medium run.
• Some face a higher elasticity of demand for their exports:– small countries, and– producers of agricultural & mineral commodities or other
commodities that are close substitutes for competitors’ exports.
Common empirical observation:After a devaluation, trade balance gets worse before it gets better.
Explanation:Even if devaluation is instantly passed throughto higher import prices,buyers react with a lag.
Also, in practice,it often takes time before the devaluation is passed through to import prices.
Professor Jeffrey Frankel, Kennedy School, Harvard University
End ofLecture 3:Empirical Effects of
Devaluation on the Trade
Balance
Professor Jeffrey Frankel, Kennedy School, Harvard University
• 1980 trade deficits (Reagan period)
• What effect might the $ appreciation of 2014 have in 2015?
Application:Determination of US TB
US trade & current account balances over 40 years
III II I IV III II I IV III II I IV III II I IV III II I IV III II I IV III II I IV III II I IV III II I IV III II I IV III II I IV III II I IV III II I IV III II