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Chapter 12
International Linkages
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McGraw-Hill/Irwin
Macroeconomics, 10e 2
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
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Introduction
• Economies are linked through two broad channels
1. Trade in goods and services
• A trade linkage:
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
• U.S. residents can hold U.S. assets OR assets in foreign countries
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
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The Balance of Payments and Exchange Rates
• Balance of payments: the [Insert Table 12-1 here]
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
Any transaction that gives rise to a
payment by a country’s residents is
a deficit item in that country’s
balance of payments.
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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 if of necessity financed by an
offsetting capital inflow:
Current account + Capital account = 0 (1)
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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 the equivalent of
• Discuss two different exchange rate systems:
• Fixed exchange rate system
• Floating exchange rate system
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Fixed Exchange Rates
• In a fixed exchange rate system foreign central banks
stand ready to 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 have to
to intervene in the foreign exchange market
• Intervention: the buying or selling of foreign exchange by the
central bank
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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
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Fixed Exchange Rates
• What determines the level of intervention of a central
bank in a fixed exchange rate system?
• As long as the central bank has the necessary reserves, it can
continue to intervene in the 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
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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
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The Exchange Rate in the Long Run
• In the long run, the exchange rate between a pair of
countries is determined by the 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
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The Exchange Rate in the Long Run
• Figure 12-2 shows the cost of [Insert Figure 12-2 here]
barley in England relative to
that in Holland over a long
time period
• Real barley exchange rate tended
towards equalization
• However, long time periods of
deviation from equality
• Best estimate for modern times
is that it takes about 4 years to
reduce deviations from PPP by
half
• PPP holds in the LR, but only one
of the determinants of the
exchange rate
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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)
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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
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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
• 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
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Goods Market Equilibrium
• Figure 12-3 shows the effect of [Insert Figure 12-3 here]
a rise in foreign income
• 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 12-3 can also be used to
show the impact of a real
depreciation
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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 they choose quickly, with low
transaction costs , and in unlimited amounts
• Under this assumption, asset holders are willing and able to
move large amounts of funds across borders in search of the
highest return or lowest borrowing cost
• Implies that 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
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The Balance of Payments and Capital Flows
• Assume a home country faces a given price of imports,
export demand, and world interest rate, if
• Additionally, capital flows into the home country when the
interest rate is above the 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
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Mundell-Fleming Model: Perfect Capital
Mobility Under Fixed Exchange Rates
• The Mundell-Fleming model incorporates foreign exchange under
perfect capital mobility into the standard IS-LM framework
• Under perfect capital mobility, the slightest interest differential provokes
infinite capital inflows → central bank cannot conduct an independent
monetary policy under fixed exchange rates
WHY?
• Suppose a country tightens money supply to increase interest rates
• Portfolio holders worldwide shift assets into country
• Due to huge capital inflows, balance of payments shows a large surplus
• The exchange rate appreciates and the central bank must intervene to hold the
exchange rate fixed
• The central bank buys foreign currency in exchange for domestic currency
• Intervention causes domestic money stock to increase, and interest rates drop
• Interest rates continue to drop until return to level prior initial intervention
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Monetary Expansion
• Figure 12-5 shows the IS-LM curves [Insert Figure 12-5 here]
in addition to the BP=0
• BP schedule is horizontal under
perfect capital mobility (i = if)
• Consider a monetary expansion that
starts from point E → shifts LM
down and to the right to E’
• At E’ there is a large payments
deficit, and pressure for the exchange
rate to depreciate
• Central bank must intervene, selling
foreign money, and receiving
domestic money in exchange
• Supply of money falls, pushing up
interest rates as LM moves back
to original position
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Fiscal Expansion
• Monetary policy is infeasible, but fiscal expansion under
fixed exchange rates and perfect capital mobility is
effective
• A fiscal expansion shifts the IS curve up and to the right →
increases interest rates and output
• The higher interest rates creates a capital inflow with the
tendency to appreciate the exchange rate
• To manage the exchange rate the central bank must expand the
money supply → shifting the LM curve to the right
• Pushes interest rates back to their initial level, but output increases
yet again
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Perfect Capital Mobility and Flexible
Exchange Rates
• Use the Mundell-Fleming model to explore how
monetary and fiscal policy work in an economy with a
flexible exchange rate and perfect capital mobility
• Assume domestic prices are fixed (this is relaxed in Ch. 20)
• Under a flexible exchange rate system, the central bank
does not intervene in the market for foreign exchange
• The exchange rate must adjust to clear the market so that the
demand for and supply of foreign exchange balance
• Without central bank intervention, the balance of payments must
equal zero
• The central bank can set the money supply at will since there is
no obligation to intervene → no automatic link between BP and
money supply
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Perfect Capital Mobility and Flexible
Exchange Rates
• Perfect capital mobility implies [Insert Figure 12-6 here]
that the balance of payments
balances when i = if (10)
• A real appreciation means home
goods are relatively more
expensive, and IS shifts to the left
• A depreciation makes home goods
relatively cheaper, and IS shifts to
the right
• The arrows in Figure 12-6
make the link between the
interest rate and AD
• When i > if, the currency
appreciates
• When i < if, the currency
depreciates
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Adjustment to a Real Disturbance
• Using equations 8-10 we can [Insert Figure 12-7 here]
show how various changes
affect the output level, interest
rate, and exchange rate
• Suppose exports increase:
At a given output level, interest
rate, and exchange rate, there is an
excess demand for goods
IS shifts to the right
The new equilibrium, E’,
corresponds to a higher income
level and interest rate
But don’t reach E’ since BP in
disequilibrium → exchange rate
appreciation will push economy
back to E
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Adjustment to a Real Disturbance
• Using equations 8-10 we can [Insert Figure 12-7 here]
show how various changes
affect the output level, interest
rate, and exchange rate
• Suppose there is a fiscal
expansion:
Same result as with increase in
exports → tendency for demand
to increase is halted by exchange
appreciation
Real disturbances to demand do
not affect equilibrium output
under flexible exchange rates
with capital mobility.
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Adjustment to a Change in the Money Stock
• Suppose there is an increase in the [Insert Figure 12-8 here]
nominal money supply:
The real stock of money, M/P,
increases since P is fixed
At E there will be an excess supply of
real money balances
To restore equilibrium, interest rates
will have to fall → LM shifts to the
right
At point E’, goods market is in
equilibrium, but i is below the world
level → capital inflows depreciate the
exchange rate
Import prices increase, domestic
goods more competitive, and demand
for home goods expands
IS shifts right to E”, where i = if
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Adjustment to a Change in the Money Stock
• Suppose there is an increase in [Insert Figure 12-8 here]
the nominal money supply:
Result: A monetary expansion
leads to an increase in output and
a depreciation of the exchange
rate under flexible rates
Under fixed rates, the central bank
cannot control the nominal money
stock.
Under flexible rates, the central bank
can control the nominal money stock,
and is a key aspect of that exchange
rate system.
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