International Economics II International Monetary Theory and Open-Economy Macroeconomics

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2 Giancarlo Gandolfo International Economics II International Monetary Theory and Open-Economy Macroeconomics With 50 Figures Springer-Verlag Berlin Heidelberg GmbH

3 Professor Dr. Giancarlo Gandolfo University of Rome Faculty of Economics and Commerce Via Castro Laurenziano Rome ISBN DOI / ISBN (ebook) This work is subject to copyright. All rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, re-use of illustrations, recitation, broadcasting, reproduction on microfilms or in other ways, and storage in data banks. Duplication of this publication or parts thereof is only permitted under the provisions of the German Copyright Law of September 9, 1965, in its version of June 24, 1985, and a copyright fee must always be paid. Violations fall under the prosecution act of the German Copyright Law. Springer-Verlag Berlin Heidelberg 1987 Originally published by Springer-Verlag Berlin Heidelberg New York in 1987 The use ofregis1ered names, trademarks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. Typesetting: With a system of the Springer Produktions-Gesellschaft. Dataconversion: Briihlsche Universitatsdruckerei, Giessen. Printing: Color-Druck, Berlin. 2142/

4 Preface There is no lack of good international economics textbooks ranging from the elementary to the advanced, so that an additional drop in this ocean calls for an explanation. In the present writer's opinion, there seems still to be room for a textbook which can be used in both undergraduate and graduate courses, and which contains a wide range of topics, including those usually omitted from other textbooks. These are the intentions behind the present book, which is an outcrop from undergraduate and graduate courses in international economics that the author has been holding at the University of Rome since 1974, and from his ongoing research work in this field. Accordingly the work is organized as two-booksin-one by distributing the material between text and appendices. The treatment in the body of this book is directed to undergraduate students and is mainly confined to graphic analysis and to some elementary algebra, but it is assumed that the reader will have a good knowledge of basic microeconomics and macroeconomics (so that the usual review material on production functions, indifference curves, standard Keynesian model, etc., etc. has been omitted). Each chapter is followed by an appendix in which the treatment is mainly mathematical, and where (i) the topics explained in the text are treated at a level suitable for advanced undergraduate or first-year graduate students and (ii) generalizations and/or topics not treated in the text (including some of those at the frontiers of research) are formally examined. The appendices can be read independently of the text and can, therefore, also be used by students who already know "graphic" international economics and want to learn something about its mathematical counterpart. Of course the connections between text and appendices are carefully indicated, so that the latter can be used as mathematical appendices by the student who has mastered the text, and the text can be used as a literary and graphic exposition of the results derived mathematically in the appendices by the student who has mastered these. The appendices require a working knowledge of cakulus, matrix algebra, optimization methods, and dynamic analysis for stability purposes. The traditional distinction between the pure theory of international trade and international monetary theory is maintained; note that, although trade theory is treated (in Book I) before turning to international monetary theory (in Book II), there is enough independence in the two parts to make it possible for a teacher who so prefers to deal with international monetary matters before trade matters. In any case, one chapter briefly indicates the problems that arise when one tries to integrate these two branches of international economics, a topic which is usually

5 VI Preface omitted from comparable textbooks. Other topics treated here which are seldom present - at least not simultaneously present - in international economics textbooks include: international trade under uncertainty; illegal transactions in international trade ( a theory of smuggling) ; Dutch disease and deindustrialization; neo-ricardian versus orthodox theories of international trade; imported intermediate goods in the multiplier mechanism; international transmission of perturbations in n-country models; the new Cambridge school of economic policy; integration between portfolio and macroeconomic equilibrium under fixed and flexible exchange rates; the inflation-devaluation vicious circle; etc. The bibliographies appended to each chapter, though far from exhaustive, may seem unduly long for a textbook, but they have been compiled to serve a double purpose. They aim to help all those who wish to read the original sources (both classic and very recent) to find these: in fact, many (though not all) items in these lists are quoted throughout. And secondly they can be a teaching aid insofar as they can help the teacher to prepare selected reading lists. International economics - and especially international monetary theory - is in a state of flux. The author has tried to give a balanced treatment of the various approaches, in the beliefthat they all have something to teach us. This undogmatic and eclectic presentation will, it is hoped, have the advantage of serving a wider audience than the believers in one specific creed, thus leaving the reader free to form a personal opinion and to choose an approach without ignoring the others. The book is mainly analytical, and no detailed description of the international monetary system and of its evolution over time has been included. This is a deliberate omission, made for various reasons. A single chapter on this topic would not suffice and, furthermore, it would quickly become obsolete, given the rapid succession of events occurring in our time. The student interested in these matters would do best to read one of the several good books available of the institutional-descriptive type. It should however be stressed that this decision does not at all mean that the real world has been excluded. Firstly, the author has given a very brief treatment of the key events of the international monetary system since the second world war, so as to provide the minimum amount of information necessary to set the theoretical problems against their institutional and historical background. Thus, for example, when dealing with optimum currency areas a treatment of the EMS (European Monetary System) is included, and when dealing with the issue of fixed versus flexible exchange rates, a concise evaluation of the experience of the managed float is given. Secondly, the results of empirical tests of some of the theories of international trade and finance are briefly discussed. However, by stressing the analytical aspects, the author hopes to give the student the tools for an understanding of facts and policies - tools that will survive the circumstances of the passing day. In writing this textbook I have been fortunate enough to benefit from comments, criticism, and suggestions coming from all levels. The students of my international economics courses, who served as guinea pigs in my testing of this material throughout the years, performed their task admirably well by indicating unclear points and suggesting amendments, and they even survived the experiment!

6 Preface VII Colleagues who have been using my lecture notes in other universities were kind enough to let me know their own reactions as well as those of their students. I am particularly indebted to Flavio Casprini, with whom I have discussed this work in detail ever since the preparatory planning phase down to a close scrutiny of the final version. I am also very grateful to Pietro Carlo Padoan, Maria Luisa Petit and Francesca Sanna Randaccio, who read the entire first draft with painstaking care and made innumerable and invaluable comments. Helpful observations on single points came from Claudio Gnesutta, Cristina Mastropasqua, Giancarlo Martinengo and Ferruccio Marzano. Derrick Plant went through the entire final version to check my English: as he is a wonderful linguist but not a mathematical economist, I must apologize for having caused him many a nightmare in forests swarming with such horrible creatures as lacobians, Hessians, and the like (he was particularly awed by the lacobians). It goes without saying that none of the persons mentioned has any responsibility for possible deficiencies that might remain. Last, but not least, I wish to thank Anna Maria Olivari who, in addition to carrying out all the secretarial work, transformed my scribblings into beautiful typescripts. Her collaboration has been indispensable for the completion of this work. University of Rome "La Sapienza" Summer 1986 Giancarlo Gandolfo Preface to the Soft-Cover Edition The present soft-cover edition, which follows the one-volume hard-cover one, has been published in two independent volumes with the intention of making the book more suitable for teaching purposes. University of Rome "La Sapienza" Spring 1987 Giancarlo Gandolfo

7 To the memory of my father Edgardo Gandolfo

8 Table of Contents Index of Tables. Index of Figures. XVIII XIX 10 The foreign exchange market Introduction The spot exchange market The forward exchange market and swap transactions Introduction Various covering alternatives; forward premium and discount Covered interest arbitrage Swap transactions The transactors in the foreign exchange market A digression on speculation Other transactors The various exchange-rate regimes. The two extremes..... The Bretton Woods system.. Other limited-flexibility systems The current nonsystem... Euro-dollars and Xeno-currencies: an introduction Appendix A.10.1 N-point arbitrage A.10.2 On the measure of the approximation error of the interest differential 32 A.10.3 Marginal conditions and portfolio selection theory in speculative equilibrium A Proof of the marginal conditions A Marginal conditions and portfolio selection theory 37 References Balance of payments and national accounts Balance of payments accounting and presentation Introduction Accounting principles Standard components Current account Capital account The meaning of "surplus", "deficit", and "equilibrium" in the balance of payments The balance of payments and national accounts... The international adjustment process and open-economy macroeconomics: an overview

9 X Table of Contents Appendix A.11.1 The presentation of the US balance of payments. 68 A.11.2 Illegal transactions in the balance of payments. 75 References The role of the exchange rate in the adjustment process in a partial equilibrium framework Introduction Critical elasticities and the so-called Marshall-Lerner condition The balance of payments in domestic currency The balance of payments in foreign currency Partial vs total elasticities A note on terminology The equilibrium exchange rate; multiple equilibria and stability Derivation of the demand and supply schedules; stability Multiple equilibria Monetary authorities' intervention to peg the exchange rate Interrelations between the spot and forward exchange rate The various excess demand schedules Forward market equilibrium and the spot rate The monetary authorities' intervention 100 Appendix A.12.1 The critical elasticities condition. 101 A The simple case A The general case A Effects on the terms of trade A.12.2 The stability of the foreign exchange market 109 A.12.3 A framework for the simultaneous determination of the spot and forward exchange rate 110 References The role of income changes in the adjustment process Introduction The multiplier without foreign repercussions and the balance of payments The basic model Balance-of-payments adjustment in the case of an exogenous increase in exports Balance-of-payments adjustment in the case of an exogenous increase in imports Foreign repercussions A simplified two-country model An alternative graphic representation and stability analysis Multipliers and balance-of-payments adjustment Intermediate goods and the multiplier Introductory remarks Different requirements of intermediate goods Identical requirements of intermediate goods Some empirical results Appendix A.13.1 The multiplier without foreign repercussions 133 A Basic results

10 Table of Contents XI A The balance of payments....,. 135 A.13.2 A The multiplier with foreign repercussions. The basic model A Stability analysis A The various multipliers: a comparison. 140 A The balance of payments A.13.3 A A A Foreign repercussions in a n-country model. The general model Stability analysis Comparative statics. A comparison between the various multipliers A The balance of payments A.13.4 Concluding remarks. The empirical relevance of the foreign multiplier 147 References The absorption approach and interactions between exchange rate and income in the adjustment process The absorption approach Elasticities versus absorption: controversy and synthesis A dynamic model of interaction between exchange-rate and income in the adjustment process The basic model A graphic representation Stability and comparative statics. The J-curve Appendix A.14.1 Alexander's synthesis A.14.2 A simplified version of the Laursen and Metzler model 165 A The RR and BB schedules. 166 A The dynamics of the system 167 A Comparative statics A.14.3 The J-curve A.14.4 A The original two-country version of the Laursen and Metzler model. 172 The basic model A Stability A Comparative statics 175 References Money and other assets in the adjustment process under fixed exchange rates Introduction The classical (Humean) price-specie-flow mechanism Introductory remarks A simple model of the classical theory Concluding remarks The monetary approach to the balance of payments The basic propositions and implications A simple model Concluding remarks Macroeconomic equilibrium in a standard Keynesian-type open model Introductory remarks Graphic representation of the equilibrium conditions Simultaneous real, monetary and external equilibrium; stability

11 XII Table of Contents Observations and qualifications Comparative statics Monetary and fiscal policy for external and internal balance. The assignment problem. The coordination problem Introductory remarks Internal and external balance and the assignment problem Observations and qualifications The policy coordination problem across countries 15.6 Portfolio equilibrium in an open economy Introduction Asset stock adjustment in a partial equilibrium framework Portfolio equilibrium and macroeconomic equilibrium Introductory remarks A simple model Momentary and long-run equilibrium. Appendix A.15.1 A formal interpretation of the classical theory. A.15.2 The monetary approach to the balance of payments. A A simple model..... A A two-country model A The effects of a devaluation A.15.3 Macroeconomic equilibrium in a standard Keynesian-type model. A The slopes of the various schedules. A The study of dynamic stability A Comparative statics A.15.4 Monetary and fiscal policy and internal and external balance A The static model.... A The assignment problem.. A.15.5 The problem of coordination A The basic model..... A International coordination compared to simple pairing. A International coordination compared to internal coordination A.15.6 Portfolio equilibrium in an open economy A The case of partial equilibrium.... A Portfolio and macroeconomic equilibrium A The dynamics of the long-run equilibrium A The stability conditions. References Money and other assets in the adjustment process under flexible exchange rates Introduction The critical elasticities condition is neither necessary nor sufficient The basic model Non-necessity and non-sufficiency of the critical elasticities condition Monetary and fiscal policy for internal and external balance in the standard Keynesian macroeconomic model, and the choice of instruments. Perfect capital mobility The normal case The alleged insulating power of flexible exchanges rates and the international propagation of disturbances. The alleged insulating power The propagation of disturbances in a simple model

12 Table of Contents XIII The propagation of disturbances in a two-country model The new Cambridge school of economic policy Introductory remarks The basic model Observations and qualifications; other versions Portfolio and macroeconomic equilibrium in an open economy Introductory remarks The basic model Static expectations Rational expectations. 293 Appendix A.16.1 The critical elasticities condition is neither necessary nor sufficient 296 A.16.2 On the choice of policy instruments A Fiscal policy A Monetary policy A.16.3 On the alleged insulating power of flexible exchange rates and the propagation of disturbances 302 A The one-country model A The two-country model A.16.4 The new Cambridge school. 308 A A The basic model..... An extension A.16.5 Portfolio and macroeconomic equilibrium 315 A The basic model A Static expectations.. A Short-run equilibrium A Long-run equilibrium. 320 A Rational expectations. 324 A.16.6 Forward market intervention. 326 References International capital movements and other problems Introduction Short-term capital movements and foreign-exchange speculation The main types of short-term capital movements Flexible exchange rates and speculation Long-term capital movements The transfer problem Introductory remarks The traditional setting Observations and qualifications Exports, growth, and the balance of payments Export-led growth Growth and the balance of payments. 347 Appendix A.17.1 Speculation A.17.2 The transfer problem A.17.3 Exports, growth, and the balance of payments. 353 References Fixed versus flexible exchange rates Introduction The traditional arguments 357

13 XIV Table of Contents Limited flexibility and intermediate exchange-rate regimes The experience of the managed float Introduction New light on an old debate?..... The vicious circle of depreciation-inflation Introductory remarks..... The depreciation-inflation circle.... Is the circle really "vicious"?..... Optimum currency areas and monetary integration. The traditional approach The cost-benefit approach The common monetary unit and the basket-currency The European Monetary System. Introduction The ECU.... The indicator of divergence... Monetary cooperation within the EMS The EMS and the theory of optimum currency areas The equilibrium exchange rate: competing theories and an eclectic approach.... The Purchasing-Power-Parity theory..... The traditional flow approach The modern approach: money and assets in the determination of the exchange rate.. Introductory remarks The monetary approach The portfolio approach Interaction between current and capital accounts. Concluding remarks: towards an eclectic approach Appendix.... A.18.1 A disequilibrium model of real and financial accumulation in an open economy A.18.2 Some properties of basket-currencies in general and of the indicator of divergence in particular A The basket-currency... A The sum of the weights.. A Solution for the quantities. A Other properties.... A The indicator of divergence. A The asymmetry in the bilateral margins A.18.3 The modern approach to exchange-rate determination. A The monetary approach. A The portfolio approach A Empirical studies.. A Currency substitution. References International liquidity and international financial markets Introduction: key events in the postwar international monetary system 418 Introductory remarks Convertibility Euro-dollars Special Drawing Rights

14 Table of Contents XV Collapse of Bretton Woods. Petrodollars..... Demonetization of gold.. The EMS International liquidity and the demand for international reserves Introductory remarks The descriptive approach The optimizing approach The problem of the composition of international reserves The traditional analysis of Euro-markets General remarks and the simple multipliers More sophisticated multipliers The portfolio approach to Euro-markets An evaluation of the costs and benefits of Xeno-markets 444 Appendix A.19.1 The optimum level of international reserves and the theory of economic policy A The cost-benefit approach A A The maximization of a welfare function... Intertemporal maximization and the normative theory 448 of economic policy A.19.2 The composition of international reserves 455 A.19.3 A portfolio model of the Euro-market References The problem of integration between the pure theory of international trade and international monetary economics Introduction An epistemological problem 465 References. 466 Bibliography. 467 Name Index. Subject Index I IX

15 General Overview of International Economics I The Pure Theory of International Trade Index of Tables Index of Figures 1 Introduction. 2 The classical (Ricardo-Torrens) theory of comparative costs. 3 The neoclassical theory of international trade 4 The Heckscher-Ohlin model Tariffs, protection, economic integration 6 International trade and economic growth. 7 Some refinements of the orthodox theory. 8 The "new" theories of international trade 9 Neo-Ricardian theories of international trade Bibliography Name Index Subject Index

16 Index of Tables Table 10.1 Exchange rate arrangements, as of July 31, Entries in the balance of payments accounts in the five typical cases A simplified accounting framework for real and financial flows. 59 A.l1.1 Summary of US international transactions - Seasonally adjusted (millions of dollars). 69 A.11.2 US international transactions - Seasonally adjusted (millions of dollars) Exchange rate depreciation and balance of payments: 13.1 a numerical example 83 Coefficients of imports of intermediate goods and open economy multipliers Effects of a devaluation according to the absorption approach Non-necessity of the critical elasticities condition Non-sufficiency of the critical elasticities condition Composition of the ECU, central weights and rates, threshold of divergence Grid of bilateral parities in the EMS and compulsory intervention points (as of 4th August 1986) Estimated Euro-currency market size (at end of period, billions of dollars) and growth rates World international reserves and their composition (millions of US dollars at end of period). 425 A19.1 Optimal and actual currency composition of foreign exchange reserves, 1976 and 1980 (per cent). 457

17 Index of Figures Figure 12.1 Various forms of the supply curve of foreign exchange and stability Multiple equilibria and stability Pegging of the exchange rate and monetary authorities'intervention The arbitrageurs' excess demand for forward exchange Commercial traders' excess demand for forward exchange Speculators' excess demand for forward exchange Determination of the equilibrium in the forward market The multiplier without foreign repercussions and the balance of payments The balance of payments and national income: exogenous increase in exports The balance of payments and national income: exogenous increase in imports, case (i) The balance of payments and national income: exogenous increase in imports, case (ii) The multiplier with foreign repercussions The multiplier with foreign repercussions: alternative representation 14.1 and stability analysis Flexible exchange rates and the level of income: 125 the real-equilibrium schedule Flexible exchange rates and the level of income: the balance-of-payments schedule Flexible exchange rates and the level of income: a dynamic analysis of the adjustment process Flexible exchange rates and the level of income: effects of an exogenous increase in domestic demand Graphic representation of the classical theory of the adjustment mechanism of the balance of payments A diagram of the adjustment mechanism according to the MABP Effects of a devaluation according to the MABP Macroeconomic equilibrium under fixed exchange rates: the real-equilibrium schedule Macroeconomic equilibrium under fixed exchange rates: the external balance schedule Macroeconomic equilibrium under fixed exchange rates: the monetary equilibrium schedule Variations in the quantity of money and shifts in the LL schedule Determination of real and balance-of-payments equilibrium Determination of general macroeconomic equilibrium in an open economy under fixed exchange rates General macroeconomic equilibrium in an open economy under fixed exchange rates:-dynamic analysis of the adjustment process The burden of interest payments and the BB schedule Effects of an exogenous variation of domestic expenditure (case 1) 209

18 XX Index of Figures A.19.1 Effects of an exogenous variation of domestic expenditure (case 2) 209 Effects of an exogenous variation in exports Internal and external balance and monetary and fiscal policy under fixed exchange rates Internal and external balance and monetary and fiscal policy under fixed exchange rates: the assignment problem Determination of portfolio equilibrium in an open economy 223 Monetary policy, portfolio equilibrium and capital movements 224 Macroeconomic equilibrium under flexible exchange rates: the dynamics of the adjustment process Perfect capital mobility and monetary policy Perfect capital mobility and fiscal policy International transmission of perturbations under fixed exchange rates Static expectations: short-run equilibrium and economic policy. 292 Rational expectations: short-run equilibrium and economic policy. 294 Rational expectations and long-run equilibrium Rational expectations and "news" An example of destabilizing speculation An example of profitable and destabilizing speculation. 332 The transfer problem in the context of the standard macroeconomic model under fixed exchange rates Growth and the balance of payments according to the MABP. 348 Interaction between the current account and the capital account 400 The portfolio approach to the Euro-market 443 The dynamics of the optimum reserve level