Economics of International Financial Policy: ITF 220 Staff -- Professor: Jeffrey Frankel, Littauer 217 Office hours: Mon.& Tues., 3:00-4:00. Faculty Asst.: Minoo Ghoreishi, Belfer 505 (617) 384-7329 Teaching Fellow: Martin Kessler Course Assistant: Ed Cuipa Times Lectures: Tues. & Thurs., 1:15-2:30 p.m., L 280 Review session: Final exam: Fridays, 11:45-1:00, Starr Wed., May 4, 2016, 3:00-6:00 p.m. Requirements -- Textbook: World Trade & Payments + Readings. 7 Problem Sets (20%) + Midterm (30%) + Final exam (50%).
Big topics covered in the course I) ELASTICITIES & THE TRADE BALANCE II) THE KEYNESIAN MODEL OF INCOME III) MONEY AND THE BALANCE OF PAYMENTS IV) GLOBALIZATION OF FINANCIAL MARKETS V) FISCAL & MONETARY POLICY UNDER INTERNATIONAL CAPITAL MOBILITY VI) INTERDEPENDENCE AND COORDINATION VII) SUPPLY, INFLATION & MONETARY UNION VIII) EXPECTATIONS & DETERMINATION OF THE EXCHANGE RATE Professor Jeffrey Frankel, Kennedy School, Harvard University
TOPIC I: ELASTICITIES & THE TRADE BALANCE 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
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. Professor Jeffrey Frankel, Kennedy School, Harvard University
Primary income, mainly investment income secondary income NOW CALLED FINANCIAL ACCOUNT
Examples of a debit on the current account: You, an American, buy DVDs from India => import appears as debit on US merchandise account. You import services (electronically) of an Indian software firm => debit appears on US services account ( 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 then sends profits back to India => US reports payments of investment income. 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 => US reports paying unilateral transfers. API-120 - Prof.J.Frankel, Harvard University
Examples of debits on the financial account (previously capital account ), long-term Instead of buying DVDs from India, you buy the company in India that makes them. => acquisition of assets (debit) under Foreign Direct Investment (FDI). Instead of buying the entire company in India, you buy some stock in it => acquisition of portfolio investments (equities). Instead of buying stock in the company, you lend it money for 2 years => acquisition of portfolio investments (bonds or bank loans). API-120 - Prof.J.Frankel, Harvard University
Examples of debits on the financial account, short term: You lend to the Indian company in the form of 30-day commercial paper or trade credit => acquisition of short term assets (Debit: You have imported a claim against India.) You lend to the Indian company in the form of cash dollars, which it doesn t have to pay back for 30 days => acquisition of short term assets. You are the Central Bank, and you buy securities of the Indian company (an improbable example for the Fed but some central banks now diversify international investments) => increase in US official reserve assets. API-120 - Prof.J.Frankel, Harvard University
The rules, continued Each transaction is recorded twice: an import of a good or security has to be paid for. E.g., when an importer pays cash dollars, the import on the merchandise account is offset under short-term capital: the exporter in the other country has, at least for the moment, increased holdings of US assets, which counts 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. API-120 - Prof.J.Frankel, Harvard University
Measures of US external balance, 2006-2015 PER QUARTER US surplus in investment income is partially offset by outward transfers. Current Account US trade deficit in goods is partially offset by a surplus in services. Goods & Services 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 bank absorbs into reserves, if it intervenes 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
End of Lecture 1: Balance of Payments Accounting Professor Jeffrey Frankel, Kennedy School, Harvard University
Lecture 2: The Elasticities Approach to the Trade Balance Question: Under what circumstances does devaluation improve the trade balance (TB), and how much? Model: Elasticities Approach Key equation: Marshall-Lerner Condition Professor Jeffrey Frankel, Kennedy School, Harvard University
Supply & demand for foreign exchange E price of foreign exchange in $/ D S FX supply arises from exports, capital inflows FX demand arises from imports, capital outflows Quantity of foreign exchange, Professor Jeffrey Frankel, Kennedy School, Harvard University
Professor Jeffrey Frankel, Kennedy School, Harvard University Assume demand for forex shifts out e.g., to due to increase in demand to buy foreign goods or assets Depreciation (increase in price of foreign currency) Deficit (excess demand for foreign currency)
The Elasticities Approach to the Trade Balance derives the supply of foreign exchange from export earnings, and derives the demand for foreign exchange from import spending. Capital flows are not considered (until later), so no supply of, or demand for, FX comes from international borrowing or lending. Professor Jeffrey Frankel, Kennedy School, Harvard University
How the Exchange Rate, E, Influences BoP ASSUMPTIONS : 1) No capital flows or transfers => BoP = TB 2) PCP: Price in terms of producer s currency; Supply elasticity =. 3) Complete exchange rate passthrough: 4) Demand is a decreasing function of price in => consumer s Net supply currency of FX = TB expressed in foreign currency TB* Supply of FX determined by EXPORT earnings => Domestic firms set P. Price of X in foreign currency = P / E Demand for FX determined by IMPORT spending & Foreign firms set P. Price of Imports in domestic currency = E P. => X = X D ( P/ E ). => M = M D (E P ). = (P/E) X D (P/E) - (P ) M D (EP ).
How the TB is affected by the exchange rate (continued) TRADE BALANCE EXPRESSED IN FOREIGN CURRENCY EXPERIMENT : E THREE EFFECTS TB* = (P/E) X D (P /E) - (P ) IM D (E P ). (2) X D ( ) rises. (1) IM D ( ) falls. (3) Price of X in terms of foreign currency falls. Net effect on TB* is determined by Marshall-Lerner condition. Add one more assumption: Before the devaluation, TB*=0, so export earnings cancel out import spending, Then devaluation improves the TB iff: ε X + ε M > 1. EFFECT ON TB* + + -
Example (i) to illustrate Marshall-Lerner condition for TB* = (P/E) X D (P/E) - (P ) IM D (EP ) If ε x =1, then E leaves export revenue unchanged. Because effects (2) and (3) cancel out. In that case, so long as ε M > 0, Marshall-Lerner condition is satisfied: Import spending falls -- effect (1) -- => TB* improves. Professor Jeffrey Frankel, Kennedy School, Harvard University
Example (ii) to illustrate Marshall-Lerner condition for TB* = (P/E) X D (P/E) - (P ) IM D (E P ). If ε x = 0, then E cuts export revenue in proportion because of valuation effect (3). In that case, is ε M > 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 THREE EFFECTS TRADE BALANCE EXPRESSED IN DOMESTIC CURRENCY TB = (P) X D (P/E) - (E P ) IM D (E P ). (1) X D ( ) rises. (2) IM D ( ) falls. (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: ε X + ε M > 1. EFFECT ON TB + + -
Example (iii) to illustrate Marshall-Lerner condition for TB* = (P) X D (P/E) - (E P ) IM D (EP ) If ε M =1, then E leaves import spending unchanged. Because effects (2) and (3) cancel out. In that case, so long as ε X > 0, Marshall-Lerner condition is satisfied: Export revenue rises falls -- effect (1) -- => TB improves. Professor Jeffrey Frankel, Kennedy School, Harvard University
End of Lecture 2: Elasticities Approach to the Trade Balance Professor Jeffrey Frankel, Kennedy School, Harvard University
Lecture 3: Empirical effects of the exchange rate on the trade balance Elasticity Pessimism: Countries often fear their elasticities are too low for M-L condition. An example when it worked: Poland after 2008. Econometric estimation of elasticities What is OLS regression? Typical estimates The J-curve With fast pass-through to import prices With slow pass-through to import prices. Income as another determinant of the trade balance.
4.7 4.5 Poland s exchange rate rose 35% in the 2008-09 global crisis. Depreciation boosted net exports => Poland avoided recession Zloty / EUR/PLN Exchange rate 4.2 4.0 3.7 3.5 3.2 I III V VII IX XI I III V VII IX XI I III V VII IX 2008 2009 2010
Poland s trade balance improved sharply in 2009 while its European trading partners all went into recession. Trade balance in billions of euros Source: National Bank of Poland From FocusEconomics 2014 Contribution of Net X in 2009: 3.1% of GDP > Total GDP growth: 1.7%
X Exports demanded How can we estimate sensitivity of export demand to exchange rate? OLS regression............... EP*/P Price of foreign goods relative to domestic goods Professor Jeffrey Frankel, Kennedy School, Harvard University
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 through to higher import prices, buyers react with a lag. Also, in practice, it often takes time before the devaluation is passed through to import prices.
Another historical example: Mexican & Korean trade balances improved after 1994 & 1997 devaluations, respectively
But in crises like Mexico 1994 or Korea 1997, much of the improvement in the trade balance is due to a fall in income Y, which reduces imports. Imports & exports depend on both income and prices: X = X D [(P/E P ), Y*] M = M D [(E P / P), Y] or, more simply: X = X D (E, Y*) M = M D (E, Y). ITF220 - Prof. J. Frankel, Harvard University
Econometric estimates of elasticities. Estimated income elasticities are mostly between 1.0-2.0. Estimated price elasticities (LR) satisfy the Marshall-Lerner Condition.
End of Lecture 3: Empirical Effects of Devaluation on the Trade Balance Professor Jeffrey Frankel, Kennedy School, Harvard University