International Leakages (part 3) By Misha Lee Soriano
Highlights of the Report• Economies are linked internationally through trade in goods and through financial markets. The exchange rate is the price of a foreign currency in terms of the dollar. A high exchange rate (a weak dollar) reduces imports and increases exports, stimulating aggregate demand.• Under fixed exchange rates, central banks buy and sell foreign currency to peg the exchange rate. Under floating exchange rates, the market determines the value of one currency in terms of another.
Highlights of the Report• If a country wishes to maintain a fixed exchange rate in the presence of a balance of payments deficit, the central bank must buy back domestic currency, using its reserves of foreign currency and gold or borrowing reserves from abroad. If the balance of payments deficit persists long enough for the country to run out of reserves, it must allow the value of its currency to fall.• In the very long run, exchange rates adjust so as to equalize the real cost of goods across countries.
Highlights of the Report• With perfect capital mobility and fixed exchange rates, fiscal policy is powerful. With perfect capital mobility and floating exchange rates, monetary policy is powerful.
Exchange Rate Terminologies NAMES DEFINITION Balance of The record of transactions of the residents of a Payments country with the rest of the world Current Records trade in goods and services, as well as Account transfer payments Records purchases and sales of assets, such asCapital Account stocks, bonds, and land Balance-of- Occurs when more money is leaving the country Payments than entering it Deficit Balance-of- Occurs when more money is entering the Payments country than leaving it Surplus
Exchange Rate Terminologies NAMES DEFINITION A system in which exchange rates are determined byFixed Exchange governments and central banks rather than the free Rate System market, and maintained through foreign exchange market intervention Sales or purchases of foreign exchange by the Intervention central bank in order to stabilize exchange ratesFlexible/Floating A system in which exchange rates are allowed to Exchange Rate fluctuate with the forces of supply and demand System Flexible exchange rate system in which the central Clean Floating bank does not intervene in foreign exchange markets Flexible exchange rate system in which the central Dirty Floating bank intervenes foreign exchange market in order to affect the short-run value of its currency
Exchange Rate Terminologies NAMES DEFINITION Decrease in the value of the domestic currency Devaluation relative to the currencies of other countries; used when exchange rates are fixed Increase in the value of the domestic currency Revaluation relative to the currencies of other countries; used when exchange rates are fixed Decrease in the value of the domestic currency Depreciation relative to the currencies of other countries; used when exchange rates are flexible Increase in the value of the domestic currency Appreciation relative to the currencies of other countries; used when exchange rates are flexible
Capital Mobility• One of the striking facts about international economy is the high degree of integration or linkage among financial/capital markets – the markets in which bonds and stocks are traded.• If foreign exchange rates are permanently fixed, taxes are the same everywhere, and international asset holders never face political risks (nationalization, restrictions on transfer of assets, default risk by foreign governments). There would be strict equality in the world capital markets.
Capital Mobility• In reality, there are tax differences among countries. Exchange rates can change, perhaps significantly, and thus affect the payoff of a foreign investment.• Interest rate dissimilarities among major industrialized countries that are adjusted to eliminate the risk of exchange rate changes are partially practiced.• Henceforth, capital is very highly mobile across borders.
Capital MobilityPerfect Capital Mobility • Capital is perfectly mobile internationally when investors in search of the highest return, can purchase assets in any country they can choose, quickly, with low transaction costs, and in unlimited accounts.The high degree of capital market integration impliesthat any one country’s interest rates cannot get too farout of line without bringing about capital flows thattend to restore yields to the world level.
Capital Mobility FIXED FLEXIBLE When capital POLICY EXCHANGE EXCHANGE mobility isperfect, interest RATES RATES rates in the Output home country No outputcannot diverge expansion; change; trade balance from those Monetary reserve losses improves; abroad. This Expansion has major equal to money exchangeimplications for increase depreciation the effects of monetary and No output fiscal policy Output change;under fixed and Fiscal expansion; reduced net floating exchange Expansion trade balance exports; rates. worsens exchange appreciation
Capital MobilityThe introduction of trade in goods means that some ofthe demand for our output comes from abroad andthat some spending by our residents is on foreigngoods. The demand for our goods depends on thereal exchange rata as well as on the levels of incomeat home and abroad.A real depreciation or increase in foreign incomeincreases net exports and shifts the IS curve out to theright. There is equilibrium in the goods market when thedemand for domestically produced goods is equal tothe output of those goods.
Mundell-Fleming ModelPerfect Capital Mobility Under Fixed Exchange Rates • The model first proposed by Robert Mundell and Marcus Fleming that explores economy with flexible exchange rates and perfect capital mobility. • Under fixed exchange rates and perfect mobility, a country cannot pursue an independent monetary policy. Interest rates cannot move out of line with those prevailing in the world market. Any attempt at independent monetary policy leads to capital flows and need to intervene until interest rates are back in line with those in the world market.
Mundell-Fleming ModelPerfect Capital Mobility Under Fixed Exchange Rates Monetary Expansion Under Fixed Rates and Perfect Capital Mobility
Mundell-Fleming ModelPerfect Capital Mobility and Flexible Exchange Rates • Under fully flexible exchange rates the absence of intervention implies a zero balance of payments. Any current account deficit must be financed by private capital inflows. • A current account b account surplus is balanced by capital outflows. Adjustments in the exchange rate ensure that the sum of the current and capital account is zero.
Mundell-Fleming ModelPerfect Capital Mobility and Flexible Exchange Rates The Effect of Exchange Rates on Aggregate Demand
Mundell-Fleming ModelPerfect Capital Mobility and Flexible Exchange Rates Effects on An Increase in the Demand for Exports
Mundell-Fleming ModelPerfect Capital Mobility and Flexible Exchange Rates• If an economy with floating rates finds itself with unemployment, the central bank can intervene to depreciate the exchange rate and increase net exports and thus aggregate demand.• Such policies are known as beggar-thy- neighbor policies because the increase in demand for domestic output comes at the expense of demand for foreign output.
ECONOMIC IMPLICATIONS OF INCREASINGINTEGRATION• Economic integration is the elimination of tariff and nontariff barriers to the flow of goods, services, and factors of production between a group of nations, or different parts of the same nation.• It involves at least two countries to abolish customs tariffs on inner border between the states. This causes a number of effects while the phenomenon itself has specific properties for its successful development.
ECONOMIC IMPLICATIONS OF INCREASINGINTEGRATION• It requires coherence of the policies (customs, tax, financial, social policies etc. and entity registration) applied in integrated states. Economic parameters (domestic savings rate, tax rates, etc.) are striving to one single multitude. Coherence policy finally leads to equal multi-dimensional economic space within integrated area.• It needs permanency of economic integration stages applied to unified states (free trade area, customs union, economic union, political union). Otherwise integration process declines, finally leading to termination of economic unions.
ECONOMIC IMPLICATIONS OF INCREASINGINTEGRATION• Economic integration leads to Pareto-reallocation of the factors (labor and capital) which move towards their better exploitation. Labor moves to area of higher wages, while capital – to area with higher returns.• Domestic saving rates in the member states of economically integrated region strive to the one and same magnitude, described by the coherence policy of economic blocks. At the same time, practical observation shows that this phenomenon is taking place before formal creation of economic unions.
ECONOMIC IMPLICATIONS OF INCREASINGINTEGRATION• Formulation of economic integration theory has been initiated by Jacob Viner who described trade creation and trade diversion effects caused by economic integration meaning a change in direction of interregional trade flows respectively caused by the change of tariffs within and outside economic union.• The dynamics of trade creation and diversion effects was mathematically described by R.T. Dalimov. The finding shows that trade flow (an output moving from region to region) may be described with the goods flow caused by the price difference.
ECONOMIC IMPLICATIONS OF INCREASINGINTEGRATION• Economic integration of states leads to the creation of the terms of trade. Economic union of states obtains more privileged position in trade negotiations.• Economic integration benefits (growth of economy, specifically the GDP; raise of productivity) depend on the level of development as well as a scale of unifying states.• If there are two states being economically integrated, then the larger the size of economy the less it receives from integration and vice versa.
ECONOMIC IMPLICATIONS OF INCREASINGINTEGRATION• The same principle is observed regarding the level of development of integrating states, although it is not as clear as the firstly mentioned principle.• Productivity in the unified area is increased. Remarkably, it is increased more in less developed states, and vice versa (Dalimov, 2008), i.e. according to the principle observed in practice.
ECONOMIC IMPLICATIONS OF INCREASINGINTEGRATION• Among the main benefits for the countries which decided to be unified is a free access to markets of the other member states.• Since the stage of the common market, or since supranational bodies of the union are created, specific regional funds are created to reallocate revenues from more developed states to less developed ones.
ECONOMIC IMPLICATIONS OF INCREASINGINTEGRATION• This way, development of the member states is equalized, with less developed ones developing faster, leading to an increase of their earnings per capita and thus purchasing more from more developed partner states.• Consequently, economic integration unites nations, leading them to prosper with each other.