Fletcher School of Law and Diplomacy, Tufts University The Economics of the European Union Professor George Alogoskoufis Lecture 10: Introduction to International Macroeconomics
Scope of International Macroeconomics International macroeconomics, deals with the determination of key macroeconomic variables (GDP, growth rate, unemployment rate, inflation, interest rates) in open economies. Open economies are interconnected through trade in goods and services, through migration flows and through international capital markets. An open economy can borrow or lend resources to the rest of the world. Domestic investment may thus differ from national savings. The difference determines the balance of payments. Transactions in the global economy are in many currencies. The relative prices of those currencies, exchange rates, are constantly changing in the current system of floating exchange rates. The majority of international transactions takes place through international financial and capital markets. Financial markets and capital markets allow households and businesses to exchange cash and securities (promises of future payment). 2
The Concept of External Balance The concept of external balance is a key concept in international macroeconomics. It requires a course for the balance of payments and external debt which does not threaten the ability of a country to service its international obligations. What constitutes external balance varies depending on the rules of the international monetary system and international financial markets. In different historical periods the concept of external balance has taken a different meaning. 3
National Accounting in an Open Economy There are three main points that need to be clearly understood: First, the relationship between domestic income, domestic spending and the trade balance in an open economy Second, the relationship between the trade balance, the fiscal balance and the balance of private savings and investment. Thirdly, the distinction between gross domestic product (GDP) and gross national income (GNI or GNP). 4
The Relationship between Domestic Income and Expenditure in an Open Economy Gross Domestic Product in an open economy is equal to the sum of private consumption, private investment, government expenditure and exports, minus imports. This identity takes the form, Y = C + I + G + ( X M ) (1) Υ is Gross Domestic Product (GDP), C is aggregate private consumption, I is aggregate private investment, G is government expenditure, Χ is exports and Μ is imports. 5
The Size of the EU Economy Population: 512 million (6.7% of World Population) Labor Force: 254 million GDP: 14 trillion (22% of World GDP) GDP per capita: 27,000 Private Consumption: 8.5 trillion Investment: 3 trillion Exports: 6.9 trillion Imports: 6.5 trillion 6
GDP Growth in the EU 10 9.5 9 8.5 8 7.5 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 GDP 2010 prices EU-15 (log scale) GDP 2010 prices EU (log scale) 7
GDP per capita Growth in the EU 3.6 3.4 3.2 3 2.8 2.6 2.4 2.2 2 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 GDP per capita 2010 prices EU-15 (log scale) GDP per capita 2010 prices EU (log scale) 8
The Relationship between Gross Domestic Product and Gross Domestic Expenditure and the Trade Balance Aggregate Gross Domestic Expenditure, sometimes called absorption, is equal to E = C + I + G (2) From (1) and (2), Υ = Ε + ( Χ Μ ) (3) The trade balance is by definition equal to the difference between Gross Domestic Product and Gross Domestic Expenditure. (3) can be written as, Υ Ε = Χ Μ (4) 9
The Trade Balance The trade balance is merely the difference of gross domestic product and expenditure. This is a very important observation because it directs our attention to the macroeconomic nature of external imbalances. The correction of external imbalances requires measures to restore the relationship between domestic income and domestic expenditure. One can analyze this connection to an even greater depth by subtracting from both sides of (1) total taxes T, and adding on both sides net income from the rest of the world R 10
The Current Account of the Balance of Payments Y + R T = C + I + ( G T ) + ( X + R M ) (5) The left hand side of (5) measures Gross Disposable National Income, while the right hand side measures the sum of private expenditure C + I, the fiscal deficit G T, and the current account of the balance of payments X + R M. (5) can be written as, X + R M = S I + ( T G ) (6) The current account is by definition equal to the sum of the difference between private savings and investment (Y+R-T-C)-I=S-I and the fiscal balance T-G. 11
The Current Account of the EU-15 (% of GDP) 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 196019621964196619681970197219741976197819801982198419861988199019921994199619982000200220042006200820102012201420162018-0.50% -1.00% -1.50% -2.00% 12
The Relationship between National Income and Domestic Expenditure, and the Current Account While equation (4) directs our attention to the fact that external imbalances are of a macroeconomic nature (difference between domestic income and expenditure), equation (6) highlights that external imbalances are due to two factors: 1. The difference between domestic savings and investment. 2. The fiscal balance. In order to correct external imbalances, a country must either adjust the difference between domestic savings and investment, or the fiscal balance, or both. 13
The Current Account and the Capital Account In absolute terms, the current account is equal to the capital account. When the current account is in surplus the capital account is in deficit, i.e, there is accumulation of assets (capital) vis-a-vis the rest of the world. If the current account is in deficit, the capital account is in surplus, i.e. there is a de-cumulation of assets vis-avis the rest of the world, or a buildup of external debt. 14
Relationship between Gross Domestic Product (GDP) and Gross National Income (GNI) To the extent that a country has net income from the rest of the world, we distinguish between Gross Domestic Product (GDP) and Gross National Product (GNP) or, equivalently, Gross National Income (GNI). GDP is the value of domestic production and income, and GNI (GNP) the total income of the country's inhabitants. Net income from the rest of the world can be either net income from capital (interest and dividends), or net income from labor (labor supply of domestic residents of the rest of the world). When we come to issues of asset accumulation from the rest of the world and foreign debt, this distinction becomes central. 15
Difference between GNI and GDP in the EU-15 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 196019621964196619681970197219741976197819801982198419861988199019921994199619982000200220042006200820102012201420162018-0.50% -1.00% GNI GDP Difference (% of GDP) 16
Nominal and Real Exchange Rates The bilateral nominal exchange rate (E) is defined as the value of a country's currency in terms of another currency. E = 1,1 $ / means that it takes 1.1 US dollars ($) for the purchase of one euro ( ). If the rate changed to 1.2 then we say that the euro has appreciated against the dollar (or that the dollar has depreciated against the euro). The bilateral real exchange rate (Q) is defined as the ratio of the two countries' price levels expressed in a common currency. If P is the price level in Europe and P * the price level in the US, the real exchange rate between the $ and the is defined as Q=E (P/P*). 17
$/ Nominal Exchange Rate (monthly data) 1.70 1.50 1.30 1.10 0.90 0.70 0.50 1973.01 1973.12 1974.11 1975.10 1976.09 1977.08 1978.07 1979.06 1980.05 1981.04 1982.03 1983.02 1984.01 1984.12 1985.11 1986.10 1987.09 1988.08 1989.07 1990.06 1991.05 1992.04 1993.03 1994.02 1995.01 1995.12 1996.11 1997.10 1998.09 1999.08 2000.07 2001.06 2002.05 2003.04 2004.03 2005.02 2006.01 2006.12 2007.11 2008.10 2009.09 2010.08 2011.07 2012.06 2013.05 2014.04 2015.03 2016.02 2017.01 Dollar Euro Exchange Rate ($/ ) 18
$/ Nominal Exchange Rate (daily data) 19
/$ Nominal Exchange Rate (daily data) 20
Nominal and Real $/ Exchange Rate 1.800 1.600 1.400 1.200 1.000 0.800 0.600 0.400 0.200 0.000 1955.01 1956.04 1957.07 1958.10 1960.01 1961.04 1962.07 1963.10 1965.01 1966.04 1967.07 1968.10 1970.01 1971.04 1972.07 1973.10 1975.01 1976.04 1977.07 1978.10 1980.01 1981.04 1982.07 1983.10 1985.01 1986.04 1987.07 1988.10 1990.01 1991.04 1992.07 1993.10 1995.01 1996.04 1997.07 1998.10 2000.01 2001.04 2002.07 2003.10 2005.01 2006.04 2007.07 2008.10 2010.01 2011.04 2012.07 2013.10 2015.01 2016.04 Nominal $/ Real $/ 21
Effective Nominal and Real Exchange Rates The nominal effective exchange rate SE, is the weighted average of the bilateral nominal exchange rates of a country, against the currencies of all countries with which it has international transactions. The weights depend on the share of international transactions of the country with each of its trading partners. Thus, the nominal effective exchange rate is defined as, E E = π 1 E 1 + π 2 E 2 +...+ π N E N = N π i=1 i E i The real effective exchange rate QE, is the weighted average of the bilateral real exchange rates of a country, against the currencies of all countries with which it has international transactions. The weights depend on the share of international transactions of the country with each of its trading partners. Thus, the nominal effective exchange rate is defined as, Q E = π 1 Q 1 + π 2 Q 2 +...+ π N Q N = N π i=1 i Q i 22
Nominal and Real Effective Exchange Rate 115 110 105 100 95 90 85 80 1993.01 1993.06 1993.11 1994.04 1994.09 1995.02 1995.07 1995.12 1996.05 1996.10 1997.03 1997.08 1998.01 1998.06 1998.11 1999.04 1999.09 2000.02 2000.07 2000.12 2001.05 2001.10 2002.03 2002.08 2003.01 2003.06 2003.11 2004.04 2004.09 2005.02 2005.07 2005.12 2006.05 2006.10 2007.03 2007.08 2008.01 2008.06 2008.11 2009.04 2009.09 2010.02 2010.07 2010.12 2011.05 2011.10 2012.03 2012.08 2013.01 2013.06 2013.11 2014.04 2014.09 2015.02 2015.07 2015.12 Nominal Effec9ve Exchange Rate Real Effec9ve Exchange Rate 23
The International Monetary System International monetary systems are sets of internationally agreed rules, conventions and supporting institutions, that facilitate international trade, cross border investment and generally the reallocation of capital between nation states. They provide means of payment acceptable between buyers and sellers of different nationality, including deferred payment. To operate successfully, they need to inspire confidence, to provide sufficient liquidity for fluctuating levels of trade and to provide means by which global imbalances can be corrected. The systems can grow organically as the collective result of numerous individual agreements between international economic factors spread over several decades. Alternatively, they can arise from a single architectural vision as happened at Bretton Woods in 1944. 24
Characteristics of International Monetary Systems Whether international trade in goods, services and capital is free. How international transactions are settled and what are internationally accepted means of payments. Whether the exchange rate is fixed or flexible. Whether the international monetary system is symmetric or asymmetric. Whether it is based in precious metals or not. These are some of the most critical institutions and rules concerning the international monetary system and the correction of external imbalances. 25
Monetary Policy, Exchange Rates and Capital Mobility in an Open Economy The ability of the central bank of a country to pursue an independent monetary policy differs depending on the exchange rate regime and the regime of capital mobility. When there is free mobility of capital, the central bank has two basic options. It can either let the exchange rate fluctuate freely (floating exchange rates) without interventions in the foreign exchange market, or it can make interventions in the foreign exchange market (fixed or managed exchange rates). In the latter case, it transpires that it cannot pursue an independent monetary policy. To enable a central bank to pursue an independent monetary policy under a fixed or managed exchange rate regime, the country must impose restrictions on capital movements (capital controls). 26
The Trilemma of Open Economies 1. Fixed (or Managed) Exchange Rate 2. Independent National Monetary Policy 3. Free Mobility of Capital Only two of the three options are available in a country. All three options are simultaneously incompatible. 27
International Money Unlike in national states, in international economic transactions there is no single government that can impose the use of a single currency. Thus, the global economy ends up with a plurality of currencies, although usually only a few of them are fully acceptable internationally. Thus, only a few currencies are used as international units of account, international means of payment and international stores of value. Perhaps one of the most important lessons of international monetary history is that the world almost never ends up with a single international currency. 28
The US Dollar, the Japanese Yen, the Euro and other Currencies The international monetary system today is basically tripolar, with a dominant role for the US dollar ($). The other two major currencies are the Euro ( ) and the Japanese Yen ( ). In addition, the pound sterling ( ), the Swiss franc and the Chinese renmimbi, or yuan, are international currencies. Competition among currencies does not result in the predominance of a single international currency, a situation that implies the lowest possible transaction costs and a lesser degree of monetary and financial instability. Yet, some currencies tend to become dominant. The dollar remains the dominant international currency for about a century. It is the major unit of pricing international imports and exports, and is widely used in foreign exchange intervention by most central banks. 29
International Reserve Currencies The international monetary system is not symmetric. Not all currencies are equivalent. Usually, one or a few currencies dominate as international reserve currencies. The dominant such currencies were sterling in the period of the international gold standard (1880-1914) and the dollar since the end of the First World War. International reserve currencies typically are issued by large or extremely open economies with a large share in international trade and international portfolios of assets. 30
Currency Convertibility Convertibility is the quality that allows money or other financial instruments to be converted into other liquid stores of value. Convertibility is an important factor in international exchanges, where instruments valued in different currencies must be exchanged. After World War I, convertibility of a currency is defined relative to the dominant international reserve currency, i.e. the dollar, and not necessarily in relation to gold. If the international reserve currency is convertible into a precious metal such as gold, the international monetary system is considered to be based on metallic standard. The international monetary system was based on a metallic standard until 1968. In that year the US abolished the convertibility of the dollar into gold at a fixed price of $35 per ounce, resulting in the international monetary system getting delinked from gold. 31
Fixed, Managed and Flexible Exchange Rates Between the end of World War II and 1973 the industrial countries operated a system of fixed exchange rates, the Bretton Woods system. In fixed rate systems, the required level of cooperation between central banks and governments of the major economies is high, as it requires coordination of monetary, and budgetary policies in order to maintain and operate the system. From 1973 until today, the US, the Euro Area, Japan, the United Kingdom and Switzerland have chosen free capital mobility, and domestic monetary autonomy, resulting in a system of flexible exchange rates. China has chosen capital controls in order to combine managed exchange rates with domestic monetary autonomy. 32
Dollar Euro Exchange Rate 1.6000 1.5000 1.4000 1.3000 1.2000 1.1000 1.0000 0.9000 0.8000 4/1/99 4/1/00 4/1/01 4/1/02 4/1/03 4/1/04 4/1/05 4/1/06 4/1/07 4/1/08 4/1/09 4/1/10 4/1/11 4/1/12 4/1/13 4/1/14 4/1/15 4/1/16 33
Yen Dollar Exchange Rate 140.000 130.000 120.000 110.000 100.000 90.000 80.000 70.000 4/1/99 4/1/00 4/1/01 4/1/02 4/1/03 4/1/04 4/1/05 4/1/06 4/1/07 4/1/08 4/1/09 4/1/10 4/1/11 4/1/12 4/1/13 4/1/14 4/1/15 4/1/16 34
Renminbi Dollar Exchange Rate 8.500 8.000 7.500 7.000 6.500 6.000 1/4/05 1/4/06 1/4/07 1/4/08 1/4/09 1/4/10 1/4/11 1/4/12 1/4/13 1/4/14 1/4/15 35
Swiss Franc Euro Exchange Rate 1.8000 1.7000 1.6000 1.5000 1.4000 1.3000 1.2000 1.1000 1.0000 0.9000 4/1/99 4/1/00 4/1/01 4/1/02 4/1/03 4/1/04 4/1/05 4/1/06 4/1/07 4/1/08 4/1/09 4/1/10 4/1/11 4/1/12 4/1/13 4/1/14 4/1/15 4/1/16 36
Dollar Sterling Exchange Rate, 1791-2014 $11.00%% $10.00%% $9.00%% $8.00%% $7.00%% $6.00%% $5.00%% $4.00%% $3.00%% $2.00%% $1.00%% 1791% 1796% 1801% 1806% 1811% 1816% 1821% 1826% 1831% 1836% 1841% 1846% 1851% 1856% 1861% 1866% 1871% 1876% 1881% 1886% 1891% 1896% 1901% 1906% 1911% 1916% 1921% 1926% 1931% 1936% 1941% 1946% 1951% 1956% 1961% 1966% 1971% 1976% 1981% 1986% 1991% 1996% 2001% 2006% 2011% $/ % 37
International Macroeconomics: From the Classical to the Keynesian Approach Classical analysis of the price specie flow mechanism from Hume (1752). The mechanism leading to adjustment of external imbalances was the flow of precious metals (specie) from country to country, which affected the money supply and the price level and led to the correction of current account imbalances. After WWII the Keynesian approach became the dominant approach. Main difference of Keynesian models from the analysis of Hume, was that in these models there was no automatic external adjustment mechanism. If there was a conflict between policies to achieve internal and external balance, then the only solution was a devaluation. 38
International Macroeconomics: The Keynesian Approach and Capital Mobility The major analysis of external balance in the original keynesian approach was presented by Meade (1951). This approach was comprehensive, and allowed for monetary factors. It dominated international macroeconomics until the early 1960s. In the early 1960s, in a series of important papers, Mundell showed that even in the Keynesian model, when allowing for monetary factors and capital mobility, there is a tendency for correction of external imbalances, (Mundell 1961). This class of Keynesian models, where there is perfect capital mobility, is known as the Mundell-Fleming model. 39
International Macroeconomics: Flexible Exchange Rates, the Monetary Approach and the Portfolio Balance Approach Following the adoption of flexible exchange rates, the emphasis in international macroeconomic moved to whether the adjustment of exchange rates would automatically lead to external balance. One approach was the monetary approach (Frenkel and Johnson 1976, Dornbusch 1976) and a second approach was broader and was based on portfolio balance models (Obstfeld and Stockman 1985). A natural development of these models, especially after the adoption of the hypothesis of rational expectations, was the intertemporal approach to external balance (Obstfeld and Rogoff 1996). 40
The Intertemporal Approach to International Macroeconomics The inter-temporal approach, which is the dominant approach today, is based on the assumption that households and firms maximize their inter-temporal utility and the present value of their profits respectively (Ramsey 1928, Fisher 1930). It begins by identifying the technological and market possibilities of an economy to choose the optimal intertemporal path of consumption. These possibilities are described by the inter-temporal budget constraint, which describes the conditions under which the economy can lend and borrow internationally, and by the domestic investment technology. Separate analysis of the intertemporal budget constraints of the private and the public sector illuminates the relationship between public finance and external balance. 41