Lecture 19 Interdependence & Coordination International Interdependence Theory: Interdependence results from capital mobility, even with floating rates. Empirical estimates of cross-country effects. International Coordination The institutions of international cooperation Theory: Prisoners dilemma
Interdependence under floating exchange rates Revisited Two of the results derived previously were too strong to be literally true: When we first looked at the question, floating rates insulated countries from each other s economies. (Lect.6). But that was when KA=0 (+ORT=0 => CA =0). o Since then, capital mobility has changed things. o CA 0. => Floating doesn t completely insulate. o US, euroland, Japan, UK, etc., are still visibly correlated. Under κ=, we found G leaked abroad 100%, through offsetting TD. No effect remained at home. (L17) o This overly strong result was a consequence of the assumption i = i.
The restriction i = i is in reality too strong, even for modern conditions of low international capital flow barriers. Why? Reasons: (1) i i*, when investors are aware of the likelihood of future exchange rate changes (=> Lecture 22); and (2) i* is not exogenous, if domestic country is large in world financial markets (as are US & EU). => Two-country model. Implication: Effects of AD expansion are partly felt in domestic country, partly transmitted abroad through TD.
Two-country model with perfect capital mobility For now, retain i=i* ; but drop i* = i <= domestic country is big enough to affect i*. Fiscal expansion, shifting IS US out, o thereby appreciating $ and worsening TB, o now also depreciates and raises TB*. o So Y rises (crowding out < 100% ), despite κ=, o Y* rises (international transmission), despite floating, o as i and i* rise in tandem.
US expansion drives up interest rates worldwide, because US is large in world financial markets. G $ => Expansion is transmitted from US to Europe.
Transmission in practice in 12 large econometric models, on average: US fiscal expansion -> Multiplier 1.5 in US 1/ and ½ in EU & Japan. US 4% monetary expansion -> Effect on GDP 1% in US and 0 in EU & Japan. 1/ Most relevant in recession with liquidity trap (US 2009-15). Multiplier is lower in normal times, esp. under full employment (or under default risk, or in small open economies).
The econometric models agree that US fiscal expansion, via TB US <0 and TB* >0, G is transmitted positively to the rest of the world.
More disagreement regarding international effects of monetary policy. A US monetary expansion, domestically, raises output & inflation. But the models divide regarding the effects on TB, TB RoW and Y RoW. Reason: two effects go opposite directions. Y => TB, but $ => TB M
International macroeconomic policy coordination, continued Institutions of coordination: G7 Leaders Summit & Finance Ministers 1975 Rambouillet: ratified floating 1978 Bonn: locomotive theory 1985 Plaza: concerted intervention to depreciate $ 2013 No currency war: Members agree won t intervene. BIS & Basel Committee on Banking Supervision 1988 Basel Accord: set capital adequacy rules for intl. banks 2007 Basel II: Gov.t bonds should not necessarily get 0 risk weight. 2011 Basel III: Higher capital requirements. G20 includes big emerging markets; 2009 London: G20 replaced G7/G8, responded to global recession with simultaneous stimulus. OECD for industrialized countries. IMF for everyone ( Surveillance ).
International policy coordination is an application of game theory. In one game, the players choose their level of spending. Dilemma: Each is afraid to expand alone. Cooperation here means joint expansion. In another game, the players choose the monetary/fiscal mix.
A third game is what Brazilian Minister Guido Mantega had in mind in 2010 when he warned of Currency Wars. THE GAME OF COMPETITIVE DEPRECIATION U.S. lowers i Japan lowers i* Global i too low => Excessive flows (to EMs) $ depreciates, US TB rises depreciates, Japan s TB rises
Applications of the theory of coordination Name of the game: Exporting unemployment Competitive appreciation Competitive depreciation Noncooperative Everyone contracts Everyone raises i Everyone lowers i } Nash equilibrium: Cooperative Everyone expands (locomotive) Everyone refrains from changing the exchange rate.
End of Lecture 19: International Interdependence and International Coordination
Appendix: Transmission in practice, continued: When the stimulus originates outside the US Fiscal expansion: again, 12 large econometric models show that the transmission (to the US) is positive. Monetary expansion: again, the econometric models disagree whether transmission is positive or negative. because the income effect and exchange rate effect on the TB go opposite directions.
A fiscal expansion in the rest of the OECD countries via TB RoW <0 and TB US >0, is transmitted positively to the US. G
Disagreement regarding international effects of monetary policy. A foreign monetary expansion raises output & inflation there. But the models divide regarding cross-border transmission. Reason: 2 effects go opposite directions. Y RoW => TB RoW, but => TB RoW M