International Finance and Open Economy Macroeconomics
International Finance and Open Economy Macroeconomics ECON 434
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Lecture Note on Crises Barry W Ickes Econ 434 Fall 2004 1 Introduction On July 2 1997 after months of asserting that it would do no such thing the government of Thailand abandoned its efforts to maintain a xed exchange rate for the baht The currency quickly depreciated by more than 20 percent within a few days most neighboring countries had been forced to emulate the Thai example On August 17 1998 the ruble was devalued three days after Boris Yeltsin stated that would never occur World markets were rocked yet no countries lost their pegs Later in the Fall however the real came under pressure and by January it was devalued What forced Thailand Russia and Brazil to devalue its currency was massive speculation against these currencies Speculation that in the Thai case over a few months had consumed most of what initially seemed an awesomely large war chest of foreign exchange In the case of Russia this occurred just a month after a large IMF loan and in Brazil after a huge IMF loan And why were speculators betting against these currencies Because they expected them to be devalued of course This sort of circular logic in which investors ee a currency because they expect it to be devalued and much though usually not all of the pressure on the currency comes precisely because of this investor lack of con dence is the de ning feature of a currency crisis We need not seek a more formal or careful de nition almost always we know a currency crisis when we see one And we have been seeing a lot of them lately Prior to these crises we were offered the spectacle of currency crises in Europe in 1992 3 and Latin America in 1994 5 This is a key point just before the crisis occurs nobody expected it Had they it would have occurred before This seems obvious but it is important to remember Prior to any crisis half of the market believes that the value of the currency is okay This contagion has been called the Asian u Asian u is the disease char acterized by the contagious spreading of out ows of capital in emerging market economies It is the successor to the Tequila effect When Mexico devalued the peso in December 1994 there were strong adverse reactions in other countries such as Argentina Brazil and the Philippines But other countries seemed to escape for example Chile and Columbia This experience raised the issue of how conta gious are these crises and what causes them to spread This question has become all the more important in the wake of the Asia u because the contagion appears in this case to be world wide 1ndeed Dornbusch has argued that contagion is always the issue The reason is that if every crisis were exactly as the preceding one they would all happen much earlier 1f currency crises all had the same characteristics it would be easier to discern the warning signs But this phenomena evolves there is always something new that dispels an old myth For example it used to be thought that large reserves were an effective antidote but this was proved wrong in the UK case in 1992 After the Thai case there is much more attention to currency forward contracts Another myth that seems to have gone by the way is that borrowing is not a problem if it goes to investment A closely related and perhaps even more important question relates to the cause of such currency crises Are these due to declining fundamentals or specu lative attacks Mexico had a growing current account de cit in 1994 that seemed a looming danger But other countries Malaysia and Thailand ran comparably larger de cits and emerged then unscathed in 1994 In that case then it seemed that fundamentals may have something to do with who gets hit Yet the Asian u struck countries that appeared to be have strong fundamentals There were few voices raising alarms about Asia A cursory look at the Thai situation where it all started is informative In table 1 we have some data for Thailand which indicates the extent to which fundamentals with the exception of the current account were rather strong This raises the question of how important are fundamentals and can fun damentals explain the magnitude of adjustments that take place And the two questions are related Whether or not the crisis spreads may have something to do with how strong are fundamentals in other countries Table 1 Thai Macro Performance 1981 90 1991 95 1995 1996 Growth 79 85 87 67 In ation 44 48 58 59 Saving 262 348 350 353 Budget 34 15 15 Current Account 69 76 75 External Debt 481 681 781 There are several interesting features of the current wave of currency crises that are especially noteworthy It is useful to collect these stylized facts of currency crises here for future reference 4 E0 9quot h 9quot 1 Government misbehavior does not seem to be the proximate cause This is evident in the Thai case from the budget surpluses Similar stories could be told for Mexico and the rest of Asia though less for Russia certainly This fact raises the relevance of rst generation models of currency crises A wide variety of macroeconomic circumstances are observed There appears to be no unique pattern of buildup to these crises This is what makes them so hard to forecast This raises some questions about the relevance of second generation models The same macroeconomic circumstances do not seem to always cause crisis In 1994 Malaysia and Thailand had large current account de cits Why did they not get drunk from Tequila but fell victim to the u Why were Brazil Chile Columbia and Peru immune in 1996 Exchange rate and banking crises appear highly associated Currencies seem to crash along with nancial systems Financial variables appear more highly correlated with currency crises than real variables Punishment appears to be much larger than the crime The real consequences of these crises are quite large Chile s GDP contracted by 14 in 1982 Mexico s by 7 in 1995 Asia has also seen huge turnarounds in GDP growth These seem large given the magnitude of current account de cits in these countries In Argentina output growth declined by more than 10 and investment declined by more than 40 1This particular list is due to One of the most important factors seems to be that crises often occur in countries that were doing very well macroeconomically This is especially true in the Asian crises Crises also seem to occur in countries that had large capital in ows Sometimes after nancial liberalization Are these the culprits What about the role of the IMF 2 Crises Why are nancial crises bad Huge losses in GDP and consumption Much larger than most Harberger triangles Loss of capital physical and human Bad policies Old style versus new style crises Emerging market crises have changed dramatically in recent times 21 Old Style Crises Cycle of overspending and real appreciation that weakens the current account This eventually causes reserves to decline Eventually a crisis ensues Exchange rate is devalued Not too much else happens The nance minister is red but not a big crisis in the economy The big issue is the fall of the real wage Because nance is repressed there is no change for balance sheets to get in bad shape In a world with xed nominal exchange rates and limited capital mobility excessive domestic credit creation leads to a trade de cit the depletion of inter national reserves and eventually a devaluation crisis 211 A Simple First Generation Collapse Model In the rst generation model the collapse is brought about by the loss of reserves due to excess credit creation Suppose that the exchange rate is xed at g and that the government prints money to nance a government budget de cit Let d be the log of domestic credit and let its growth rate be given by d M gt 0 Then we can de ne the log of the monetary base as h d R where R is the domestic currency value of foreign reserves Assume PPP and normalize the foreign price level to unity so that p e Uncovered interest parity implies that i f e For simplicity suppose the money multiplier is unity so the money supply equals the monetary base Then money market equilibrium requires that md d B What is money demand here To keep it simple let money demand be given by mdpy7m agt0 1 where f 0 so that using PPP expression 1 becomes m 7 e y 7 a 2 Thus if the exchange rate is credible 0 and thus money demand and money supply must equal m y hence the money supply is constant if there exchange rate is xed Now take into account credit creation Since mS md d R then Ry 7d 3 So if output is constant again for simplicity and the exchange rate is xed it follows that the growth rate of reserves is the negative of the growth rate of domestic credit I R 7M 4 In other words if the exchange rate is xed and the central bank is nancing the budget de cit by printing money at the rate M then reserves must be falling at that rate Clearly expression 4 implies trouble for a xed exchange rate regime Even tually the economy will run out of reserves 7 they will clearly be exhausted in a nite period of time Once reserves have reached zero or some minimum level Rm at which point they can fall no further and R 0 the exchange rate can no longer be pegged unless somehow the budget de cit could be eliminated so M 0 At that point the exchange rate will have to oat and will satisfy M Notice that when the exchange rate peg collapses holders of domestic currency will absorb a capital loss But if they are rational they can anticipate this They clearly will not simply wait till reserves run out to get out of domestic currency They will anticipate and sell sooner But this will cause the run on reserves to accelerate and bring the collapse sooner Can we say something intelligent here The answer is yes We can say exactly when this regime will collapse Absence of arbitrage means that the exchange rate just after the collapse of the peg must be equal to what it was just before the peg In other words no jump at the critical date tc when the collapse occurs How to nd this We need to de ne the shadow value of the exchange rate that is what value the exchange rate would take if there were no pegging Then just set this value to the peg to nd tc We de ne the shadow rate of the exchange rate as the value it would take if the exchange rate were not xed From 2 we can see this must be e m a recall y is not changing But we also know what is happening to the money supply 7 it is now growing at the rate of credit creation Hence we could write the shadow value of the exchange rate as d0MtRmnOZ where do is the initial value of domestic credit Hence setting 6 in 5 and solving for t we get a 7 d 7 R ta 0 mln 7 a 6 M where we can see that the time of the attack depends positively on the growth rate of credit creation and negatively on the initial size of the monetary base and the minimum level of reserves Now it is also possible to show that 7 d0 Bo ie the initial level of reserves So we could write 6 as R0 len 7 p which shows that the time to collapse depends positively on the initial level of reserves We can see this graphically in gure 1 In the upper panel the shadow exchange rate is upward sloping due to the steady depreciation of the currency The peg is given by E In the lower panel we have the time path of reserves with the minimum level of reserves being Rmm Now suppose that the exchange rate collapsed only when R Rmm Then at this point the exchange rate would jump up to the shadow rate by the amount A6 causing a capital loss So investors would not wait till time b to dump the domestic currency They would sell earlier Notice that at time tc there is no capital loss Reserves jump down at that point they follow the path ROAB but there is no anticipated capital loss Would speculators attack before ta The answer is also know Suppose they did Then they did dump domestic currency at some t lt t6 From gure 1 it is clear that the exchange rate would jump down 7 the domestic currency would appreciate Hence investors would be selling at e and then the domestic currency would rise in value They would lose this appreciation Hence they would want to hold the currency a bit longer to not forego these gains Only if they sell at tc would there be no jump in the exchange rate and hence no arbitrage pro ts This model of collapsing exchange rates is simple and informative But it has one big aw 7 while the agents are rational the government is completely ta e A shadow exchange rate Ae E time R A R0 A B Rmm A r t 1 time Figure 1 Time to Collapse mechanistic 7 they act like dumb robots losing reserves each period Shouldn t we model the policymakers as rational as well Moreover there is an empirical problem Countries that suffer a collapse often appear to have plenty of reserves left to purchase all of the outstanding monetary base In the UK for example foreign reserves were 116 of the monetary base and in Mexico they were 120 Why didn t the countries simply use all their reserves to purchase the outstanding money base and maintain the peg To ask the question is almost to answer it If the central bank purchased all its outstanding liabilities the domestic money supply would shrink to zero 7 this cannot be good for the economy Hence it is the con ict of internal and external balance all over again For this reason we need to look to second generation models 22 New Style Crises lnvolves doubt about the credit worthiness of the balance sheet and the exchange rate No matter how it originates implied capital ight makes it a question about both lmplied capital ight calls into question reserves In a world with high capital mobility even small adjustments in international portfolio allocations to the emerging economies result in very large swings in capi tal ows Sudden reductions in these ows in turn amplify exchange rate and or interest rate adjustments and generate overshooting further bruising credibility and unleashing a vicious circle This is the world of speculative attacks In the second generation type models speculative attack is the outcome of a prisoner s dilemma game as in the example below where each speculator sells the currency for fear that he will be left holding the bag if he is the only one not to sell A large trader could matter because he affects the probability that the others will undertake a speculative attack for any given set of fundamentals3 2Mendoza begins his discussion by arguing that Sudden Stop episodes are qualitatively different from standard balance of payments crises While in the latter the economy experiences a deep collapse 7 followed by a rather sharp recovery 7 in a run7of7the7mill BOP crisis the economy suffers a prolonged recession Mendoza develops a model of an economy subject to excess volatility which is able to capture the main features of Sudden Stops In this model under most states of nature the economy functions in a frictionless fashion There are some states of nature however when the economy becomes subject to a binding credit constraint More interestingly the economic frictions and distortions set in motion by this credit constraint can be triggered either by investors7 expectations or by foreign or domestic shocks 8Notice that it is not just information per se about the likelihood of a speculative attack What is important is how common this information is Even if agents are informed about 1vestor 1 Stay in Attack Example 1 Investor 2 Stay in 2 2 Attack 2 72 m Of course this only matters if the attack is likely to be successful If not there are better returns from staying in What causes the likelihood of attack to increase It is a rise in the cost of maintaining the peg For example if it becomes too costly for the government to keep raising rates to preserve capital in ows then it may make sense to attack Notice that if the domestic banking industry is strong or unemployment low then raising interest rates may be feasible If not however the cost is high and investors may believe that governments will not raise rates to protect the capital in ow But then attacking the currency is likely to be successful An important implication of the prisoners dilemma is that if all investors can be persuaded to stay in everybody bene ts This is where the bail in idea stems from But this requires some coordination Contagion becomes a big issue A statement by Mexico s Secretary of the Treasury Jose Angel Gurri a vividly captures and frustrations with nancial con tagion Ninety percent of Mexicans have never heard of the Duma and yet the exchange rate and interest rates that they live with every day were being driven by people with names like Kiriyenko and Chernomydrin and Primakov Gurri a 1999 Capital account plays a key role In the run up too much capital flows in The problem is when it stops It is not the speed that kills it is the sudden stop Consider Taussig s description The loans from the creditor countrybegin with a modest amount then increase and proceed crescendo They are likely to be made in exceptionally large amounts toward the culminating stage of a period fundamentals they may not be informed about the beliefs of other agents In that case a speculative attack still may not occur This reduces the multiplicity of equilibria and can help explain timing What shifts the expectations so that the attacks occur Most accounts suggest that there is a window when they could have succeeded but what explains why they took place when they did of activity and speculative upswingWith the advent of crisis they are at once cut down sharply even cease entirely The interest payments on the old loans thereupon are no longer offset by any new loans they became instantly a net charge to be met by the borrowing country 1 120 Because they involve national balance sheets these crises have much bigger impacts on the national economy This is true even if it is just illiquidity rather than insolvency Matters a lot what type of capital ows in FDI in ows are less likely to cause crises 221 Self fulfilling Models Second Generation A new class of models argues that self ful lling attacks are possible when countries face trade offs in their objectives In these models the government must decide whether or not to defend the currency A simple way to see this is to incorporate a loss function that the government minimizes Three characteristics of the situation are important First that there is some reason whey the government would bene t from depreciation perhaps to reduce unemployment with xed wages or to reduce the real value of debt Second the cost of maintaining the peg is directly related to expected depreciation4 Third there is a reputational loss that occurs from abandoning the peg5 This makes the government prefer not to see depreciation Write the loss function of the government as H ae 7 e belz RAe 7 where e is the log of the exchange rate 6 depreciate to if there were no cost to this 6 E GE 7 e is the expected rate of de preciation and RAe is the reputation cost which is equal to 0 if no depreciation takes place and equals C if the currency depreciates is the rate that the government would 0 ln expression 7 the term ae 7 6 represents the bene ts of depreciation Think of devaluation lowering the real wage with xed nominal wage con tracts or reducing the debt 4This would follow for various reasons for example expected depreciation causes interest rates to increase 5Without the reputational loss the government would always prefer to devalue and we would not have much of a problem With this cost the government faces a dilemma and must weigh costs and bene ts o The term 6 beE 7 6 represents the cost of maintaining the peg which are proportional to the expected depreciation For example if the expected depreciation is large the government will have to really tighten monetary policy to prevent speculation Notice that the costs of maintaining the peg are squared This represents the fact that small deviations from equilibrium are less costly than large and that large deviations are more than proportionately more costly This is intuitive Assume that the government can choose the exchange rate so we do not have to model monetary policy Let e be the current parity to which the government has staked its reputation Then if the government chooses to allow depreciation it will choose 6 6 immediately since this eliminates the rst two terms in 7 If the government does not depreciate then we have two possibilities Either agents expect depreciation next period so that 6E 6 or they expect no depreciation e E Then to see what the government does we must compare the loss from staying with the peg with the cost of depreciation C ie whether M 73WE73V O a Now suppose that agents do not expect depreciation The second term in 8 will vanish Then these expectations will be ful lled if a 7a lt C 9 Now suppose that agents expect the peg will be abandoned These expectations are rati ed if wwweargto am We thus have multiple equilibria if parameters are such that ae 7 2 lt C lt a be ea 11 Expression 11 thus establishes a range for which a currency crisis can occur if expectations are appropriate Again we have a crisis zone6 Notice that if the cost of depreciation is high enough or if the current rate is close to the equilibrium rate then the conditions that make an attack possible will not be present 6Notice that this does not establish that any xed exchange rate can be attacked but rather that it can be attacked if fundamentals are such that expression 11 is satis ed Notice that this argument so far lacks the element which allowed us to pin down the date of the attack in the standard model deteriorating fundamentals We can augment the model however There are a variety of reasons why we might expect this lnertial in ation could make the current peg increasingly unsustainable Or external debt may be accumulating which makes the peg less credible over time Any number of such factors would be expected to make 6 increase over time Thus let us suppose that it is known that at some date T the exchange rate 6T must be such that the peg will be abandoned even without an attack ie aeT 7 2 gt C 12 Now move back one period The currency will collapse if aeT 71 7 a beT 7 a gt 0 Continuing backwards we can nd the latest date t at which the currency must collapse aet 7 bet 1 7 2 gt C 13 Now let the time periods get small so that 6t 1 gt 6t Then we can approximate 13 by a W50 l2 gt C 14 Now compare 14 with 11 It is apparent that the gap between the time when the currency can collapse and when it must collapse has been eliminated Once a currency can be attacked it will be attacked The possibility of multiple equilibria has been eliminated by the presence of deteriorating fundamentals One might wonder where the phenomenon of throwing good money after bad has gone if speculative attacks occur as soon as feasible It would seem that this can occur only if there are multiple equilibria The central bank sell foreign exchange in the hopes of bringing about the good equilibrium but it fails and the bad one occurs But this is not necessarily the case Suppose that fundamentals are deteriorating but that we have not yet reached the point where a be t 7 2 gt C Investors are selling domestic currency but we are not yet at the point where a speculative attack will succeed There is an excess supply of domestic currency however and this is causing the central bank to intervene Now typically it practices sterilized intervention To prevent the domestic money supply from contracting it expands domestic credit though an open market operation This does not change fundamentals however so Loss r hme Figure 2 whatever is deteriorating continues to deteriorate Eventually we reach the zone At that point the currency does collapse and it appears that good money has indeed been thrown after bad The point from this is that the switch from the standard mechanical seignior age and reserve exhaustion models to models based on multiple objectives does not per se alter the conclusions about the timing of speculative attacks or mul tiple equilibria As long as there are declining fundamentals multiple equilibria disappear Of course this analysis is based on strong assumptions for example that there is certainty about the path of fundamentals These can change and reverse themselves There may also be uncertainty over the loss function lnvestors may not know how large C actually is Notice that pronouncements about this are meaningless All nance ministers attach total national will to the peg any lack of resolve would destroy all hope of preventing depreciation One only nds out the true magnitude of C in the wake of an episode This suggests that uncertainty over C can lead to probes of the central bank s willingness to defend 7Assume that there is some likelihood p that the cost of depreciation is low CL and thus with 1 7 p the cost of depreciation is high OH gt CL Then if the currency enters a zone de ned by CL speculators will attack If the true cost is CH however then the central bank will ght it off until OH is reached at which point collapse occurs Lack Of Warning One argument that is made in favor of the multiple equilibrium type models is the frequent absence of warnings in terms of interest differentials in many major crises Many crises such as the Mexican crisis seems to come out of the blue with little warning This is what causes the shock This is taken as evidence that the crises are self ful lling rather than due to fundamentals8 This argument is not however all that convincing Consider that if it is known that a currency is likely to be subject to a speculative attack investors must attach some probability to a discrete devaluation But this possibility should be re ected in markets just as weakening fundamentals Even if the attack does not occur the risk should be re ected in market prices so the absence of warning seems to be evidence against both approaches Obstfeld and Rogo provide an ingenious was out of this dilemma for the multiple equilibria story Their point is that the fact that speculative attacks have led to large depreciations means that large pro t making opportunities exist Since they were not re ected in prices this means that the ex ante probability of such events were very low But it is hard to nd such large shocks that were highly uncertain yet severe enough to cause large depreciations Obstfeld and Rogo then argue that if sunspots cause self ful lling attacks we would not have to look for large changes in the environment Of course one could argue that nancial markets are simply ine ective at forecasting the importance of political events The uprising in Chiapas and the assassination of Collosio should have revealed a troubled political environment in Mexico The fact that this was not re ected in prices suggests that markets do not correctly process such events In fact people did discuss deteriorating fundamentals in Mexico during 1994 What was surprising was how severe the crisis became 222 Third Generation Models Like Generals international nance economists ght the last battles The rst generation models were a response to the typical crises under Bretton Woods The second generation models helped us understand the ERM crisis where fun damentals were suspect but not certain to cause a crisis Now we have third generation models 8It is not clear how the fundamentals argument is affected by the absence ofwarning although many see this as direct evidence against Recall that once the currency is 7 attackable it is attacked so suddenness is not a surprise in these models The Third Generation is a response to crises in countries where fundamentals did not seem suspect In the Asian crisis countries that were attracting capital suddenly found their currencies attacked The currency crises were associated with banking crises and the economies sufferred severe contractions This led to the third generation models with focus on balance sheet problems Often these result from moral hazard Borrowers and lenders are less likely to be careful evaluating the true pro tability of investment opportunities if they believe they will be bailed out in the event that the project goes badly9 The Third Generation approach instead interprets recent crises as illustrations of the perils of moral hazard Borrowers and lenders are less likely to be careful evaluating the true pro tability of investment opportunities if they believe they will be bailed out in the event that the project goes badly The Third Generation model often start from the assumption that government o icials have a pot of resources that can potentially be used to bail out political cronies if they get into nancial di iculty This pot is mainly identi ed with the central banks holdings of foreign exchange reserves Well connected banks are able to borrow from abroad to nance risky projects 7 such as real estate development or a new factory in the already glutted steel industry They are aware of the risk But they believe that they will be bailed out by the government if things go badly Claim 2 Guarantees play the critical role of enhancing foreign borrowing The timing of the attack is straightforward 0 when the level of liabilities that have a claim on bail out protection rises to the level of reserves available for the bailing out Why does the crisis occur when it does Asian countries did not suddenly develop critical structural aws in their nancial systems for the rst time in 1997 The timing of the attack again comes out of the calculations of speculators who worry that if they wait too long there will not be enough foreign exchange reserves to go around 0 But there is a key difference from the First Generation models which watched reserves decline steadily over time and identi ed the timing of the attack as the point at which reserves sank to a particular critical level 9This is especially true with exchange rate pegs and high capital mobility o The Third Generation models watch liabilities rise steadily over time arti cially encouraged by moral hazard They identify the timing of the attack with the point at which the liabilities have climbed to the critical level given by the level of reserves At that point speculators suddenly cash in their investments If they waited any longer they might not be able to get their money out The speculative attack as usual then forces the central bank to abandon the exchange rate Herding is an especially important problem in globalized markets Herding occurs when agents are imperfectly informed and when the bene ts to an action increase if others also do this In this situation an agent may learn from the behavior of others Think of a bank run It is like a bank run If nobody panics I am better keeping my money in the bank but if others run I had better do it too This can occur in international nancial markets when there are informational asymmetries The problem here is coordination failure To see this suppose we analyze it as a 2 X 2 game with the two agents being foreign investors F I and the government Of course foreign investors are not one player but many 7 this is what makes coordination hard Let the two actions for the F be to panic or not panic And for the government it is to default or not Then we have Government Default D No default ND FI Panic P 7x 790 7x 7290 15 No am where the payoffs to the F I are listed rst10 What is evident from these illustra tive payoffs in this payoff matrix 15 is that if the government chooses D then 10Notice that it would be more likely that the payoffs resemble Government Default No default F1 Panic No panic If the FI do not panic the government is better off in the default case than if there is panic They were able to borrow more before repudiating debt Not clear however about the outcome of panic plus no default Given that there is no default the foreign investors who panicked have lost some extra returns So one could argue that they are worse off now than if there had been a default the payoff to the F from panicking write this as 0 P D 7x is greater than if they do not panic 0H NP D 7290 Similarly the payoff to the government of defaulting is greater than that of not defaulting when investors panic since 0G0 D 790 gt 0G0 ND 7290 So the outcome of P D is an equilibrium Given that foreign investors panic government wants to default and given that government wants to default investors want to panic So there are two equilibria P D and N P N D Of course the latter dominates for everybody The question is how to get there The problem for policy is how to get out of the bad equilibrium and into the good one This requires government to do something to coordinate investors expectations In these models the original sin is foreign currency borrowing which constrains the hands of authorities when a crisis occurs Traditional monetary and scal policy is ineffective in this case The key point here is that with large foreign borrowing devaluation will devastate the banking system Balance sheets worsen It also hurts investment because of the need for working capital The currency mismatch then limits the options for policy The more the domestic currency worsens the worse the impact on the balance sheets 3 Crises of Confidence and Currency Mismatches Financial crises are bad They are associated with large drops in income Capital in ows reverse causing real decreases in consumption and investment to produce current account surpluses This is straightforward so it should be evident why countries would want to avoid currency crises But from the basic model we have studied so far this may seem puzzling11 After all if the currency collapses this makes the economy more competitive This should have an expansionary impact on output Why does a collapse in con dence in the currency cause the economy to go into recession lf investors expect the currency to depreciate this should raise competitiveness This certainly seems to be part of the logic underlying the second generation models 7 that is where the bene t from devaluation comes from But in more recent crisies those since the Tequila crisis of 1994 the collapse of the exchange rate has been associated with contraction not expansion Hence explaining why modern crises are contractionary is important 11See DeLong quotThe International Financial Crises of the 1990s Analyticsquot at httpwwwje bradfordedelongnetmacroionlineifcistubhtml It is clear that something is missing in the standard model The reason is that the standard model cannot accomodate contraction is that it does not have a channel for investor con dence to impact on the economy We would expect and we observe that crises in con dence have strong deleterious effects on investment spending We need to incorporate this into the model Before considering mismatch we should note that even if a rise in the real exchange rate improves competitiveness the sudden reversal in the current ac count will still be painful Moving from a current account de cit of 58 of GDP to a surplus of similar magnitude requires a real shift in expenditure Exports cannot rise that fast even if the economy is very open So much of the shift must occur via decreases in imports and increases in savings Note that the less open is the economy the greater the change in the real exchange rate that will likely be needed to shift expenditure by the required amount that is the amount required to restore con dence in the currency Nonetheless we still need to nd a channel for the exchange rate collapse to cause contraction First we could note that investment depends not only on interest rates but on exogenous factors such as Keynes animal spirits We can go further by con sidering the impact of such a crisis on investment Let 0 be the indicator of a crisis We will discuss its magnitude and determination shortly Now we write investment as I 97 70 0 i 917 i 920 16 What 16 says is that investment depends negatively on a crisis in con dence This makes sense During such a crisis banks don t lend and savers demand liquidity So this has a negative impact on the IS curve It shifts it to the left offsetting the gain from increased competitiveness But where does 0 come from It is good to start with currency mismatch We consider a hypothetical case where banks make sound loans but there is a mismatch between assets and liabilities This happens in many emerging markets where banks lend in domestic currency but borrow in dollars or Euros12 Consider a situation in which the peso dollar exchange rate is 51 and in which a hypothetical bank with 200 million pesos of capital has received 800 million pesos in deposits and has loaned out all of the 1 billion pesos it has in sound prudent loans to operating companies The bank s balance sheet is given in gure 3 12Of course this begs the question of why banks engage in this mismatch Another way to think about this is to ask why the banks do not hedge this risk by purchasing forward contracts By engaging in this currency mismatch the banks are exposing themselves to currency risk in the event of devaluation The question then is why do they do it Assets Loans 1000 million pesos Liabilities and Net Worth Deposits 800 million pesos Capital 200 million pesos Figure 3 A Bank Balance Sheet Now suppose the bank takes advantage of cheaper rates in New York on dollar liabilities and borrows 100 million This will support 500 million pesos in loans at the current exchange rate Again the bank makes sound loans The balance sheet is now given by gure 4 Notice that with an exchange rate of 5 pesos to the dollar assets and liabilities are balanced If the loans are sound so is the bank Borrowing in foreign markets is e icient We know this from our analysis of capital market liberalization lt accesses the economy to world savings not just domestic savings and this can be important for emerging market economies The cost of borrowing is likely to be lower in this case reasons for this 0 capital is less scarce in the richer countries 0 currency risk premium on domestic borrowing Assets Loans 1500 million pesos Liabilities and Net Worth Deposits 800 million pesos Borrowed 100 million dollars Capital 200 million pesos Figure 4 Balance Sheet with Currency Mismatch Notice that there are two The latter point is important here One reason why the cost of borrowing in dollars is lower than in pesos is because there is some risk that the peso will be de valued So part of the extra cost is a risk premium But then we have to consider the risk associated with foreign borrowing 7 currency mismatch The problem is that borrowing and lending take place in different currencies and changes in the exchange rate will effect the value of this lending Suppose for example that the value of the peso declines Say it moves to 10 pesos to the dollar All of a sudden the bank s balance sheet is in ruins Why Because the value of its liabilities has increased dramatically in peso terms It still owes 100 million dollars but these are now worth Pl billion 7 peso liabilities have doubled in value13 Given that the bank acquired assets worth only P500 million for these liabilities havoc is no surprise Indeed the bank s net worth has been wiped out as is evident in gure 5 Notice that the bank now has negative net worth of P300 million Assets Liabilities and Net Worth Loans 1500 million pesos Deposits 800 million pesos Borrowed 100 million dollars Capital 300 million pesos Figure 5 Balance Sheet after Exchange Rate Shock How will depositors respond to this shock They will clearly fear for their savings A run on the bank is likely It certainly cannot lend more The bank will have to call in loans to survive This will dampen lending further In other words investment spending will collapse There will be a race to liquidity And since the exchange rate shock is common to the country we should expect this to effect many banks14 18Of course the value of the peso could have increased In that case the peso value of the liabilities would have decreased and the bank would be more pro table Obviously there is no crisis in that case 14Even banks that have little mismatch may be affected if depositors fear that they may suffer The point of the story so far is that a collapse of investment can arise from a sudden depreciation of domestic currency when there is currency mismatch The larger the depreciation the greater the impact on balance sheets so the larger should be the impact on investment This suggests that we let the crisis variable depend on exchange rate depreciation according to something like 12 0 39f A lt 0 a 1 e 7 0 CAe2 if Ae gt 0 17 Expression 17 says that when the currency appreciates there is no con dence crisis and hence no impact on investment When the currency depreciates how ever the magnitude of the crisis will depend on the square of the exchange rate change and on the degree of currency mismatch b6 lnvestment will thus shift by AI 7920 igzl gtcA 2l 18 And the impact on the IS curve then depends on two opposing forces of the currency appreciation One is the traditional increase in competitiveness causing Is to shift to the right by bAq and the second is the shift to the left as in 18 So the nature of the shift depends on whether gtAq E gzl gtcAe2l 19 And given that prices are xed we can replace q with 6 so that 16 with gtA E 92l gtcA 2l 20 What does expression 20 imply Given that the RHS depends on the square of the exchange rate change the larger is the depreciation of the currency the more likely the impact on the IS curve will be negative15 This means that a large exchange rate change occasioned by a collapse in con dence in the currency will have a negative impact on demand The reason is that the effect of the mismatch on investment spending outweighs the competitiveness boost Since depositors have less information about bank liabilities they are likely to run on all banks 15And although this is not really in the model we may think that the loss of con dence effect can happen quite quickly before exporters can respond to a devaluation 31 Sudden Stops and the Capital Market Sudden stops lead to sharp reversals in the current account and in consumption and investment The need to switch expenditure requires large changes in the real exchange rate This leads to painful consequences which can include bank failures given the balance sheet consequences of currency mismatch Notice that it is not the poorest countries that are hurt 7 they have no access to capital in the rst place Nor is it the rich countries They do not suffer balance sheet problems when they devalue Probably because nobody expects them to monetize de cits It is the intermediate emerging market economies that suffer most This leads to several questions 311 Capital Market Liberalization Maybe the response should be to restrict capital ows Restrictions on capital in ows In the midst of the Asian crisis Malaysia implemented capital controls and it did not seem to suffer that much Hard for economists to see the bene ts But Krugman and Rodrik have argued its case16 ls there a reason why international nancial markets are different from domestic nancial markets Why shouldn t developing economies bene t from nancial smoothing One argument is that controls may be needed if nancial markets are under developed After all even a trapeze artist needs a net lf prudential regulation is insu icient then maybe some restrictions are needed at least until nancial markets develop A second argument has to do with emergencies17 Capital ows can prevent the use of scal and monetary policy in a recession If the authorities try to combat in ation capital will ow out But if there are controls then macro policy can be 16Frankel describes Rodrik s paper as failesafe econometrics That is de ne the hypothesis so failure to nd an effect in this case of capital market liberalization on growth is support for your hypothesis It could be you just did not explain who liberalizes the capital market 17But capital controls are not necessary to cope with emergencies as Rogoff points out quotYes the relatively closed Chinese and Indian economies did not catch the Asian u or at least not a particularly bad case But neither did Australia nor New Zealand two countries that boast extremely open capital markets Why Because the latter countries7 highly developed domestic nancial markets were extremely well regulated The biggest danger lurks in the middle namely for those economiesimany of which are in East Asia and Latin Americaithat combine weak and underdeveloped nancial markets with poor regulation quot used Of course such controls can lead to worse outcomes especially cronyism But there is any rationale One could argue that if investors are irrational maybe controls would be bene cial But it could be that investors really react to the expectations of bad policy After all investors do not ee the dollar when we go into recession This is be cause investors do not expect that de cits will be monetized or debt defaulted on But when an emerging market economy goes into recession it may be credible that they will default If times are rough it may not make sense for such an economy to export capital Hence default may be preferable Then investors are correct to ee But the problem is the expectation of bad policy Under such circumstances it makes more sense to correct policy deepen nancial markets and prevent the policies that cause investors to worry This may also require governments of such countries to signal that they are tough The problem of course is that you can only signal this when times are tough Of course this is what happened with the gold standard The question is how to get this in the modern period 0 Perhaps it is better with dollarization and no capital controls then the re verse Or more exibility in exchange rates Rich countries clearly bene t from international nancial liberalization And if you have democracy it is hard to implement capital controls anyway Why should emerging economies be denied the bene ts Clearly it is best if capital markets can be liberalized The key point is to do this in away that is e icient Ironically it is probably best if this is done rst with FDl then with securities markets and last with banks Yet the opposite order is more frequent 32 Moral Hazard It is because of the prevalence of the third generation type crises that calls for IMF reform and the end to moral hazard are heard The moral hazard argument is that the expectations of bailouts on the part of the IMF encourage countries to undertake policies that make them more likely to suffer speculative attacks Moral hazard induces risk taking and crises are the result More to the point because foreign investors quotknowquot that they will be bailed out in the event of a crisis they do not attach su icient risk premia to lending to such countries If investors knew they would not be bailed out they would not make such risky investments Notlce that rl the moral hazard problem was really severe then all oountrres cou d borrow at the same rate We would expect to see llttle vanatlon m mtexest rates on dollar denomrnated debt Thrs s not observed however as gure 5 makes clear cam 15 mt nlIIrdennminate nuht Viald Sp ruunuanrzt may 000 u lll I s 33 eggs sorts allnmluu uue VH1snludxmumhmMtnmuxllnqdumeslw s unlhrr I1rlcvvlllrlwm zhrldmus mun mmmumlnannsummnue Frgure 5 Interest Spreads on DollzlzDenomlnated Debt It s also hard to see enormous moral hazard problems lrom analysrs ol event studres Consrder gure 7 whlch shows the emergrng markets mdex and some events m the late 1990 s When Mexlco rs barled out we do not observe any e ex sugges Srmrlar lor other events though the Russran orrsrs rs an exceptlon Even ere rs lt the laot ol no barlout changmg expectatlons or the contaglon lrom Russra to other markets that rs cruclal7 Moreover there rs a lot ol evldence that nanoral rnstrtutrons lost money m these cxlses Accoldl to the Lnstrtute olInternatronal rnanoe prrvaternvestors lost some 225 bllllon durrng the Asran nanclal crlsls ol the late 1990s and some l One strrhe agarnst the moral hazard argument s that most oountrres generally do repay the IMF rl not on tlme then late but wlth lull rnterest H the F s oonsrstently pard hen prrvate lenders xecelve no subsrdy so there rs no barlout m any slmpllstlc sense mun 7 meimi mm mm uni sauna Emu mum 3 2 Mussa s Thearem Em 3 mm lrmxzud u a pmbhm mu m hndmi mu m a m mm the n u ma m Wm aha mam mm mm m w m 5 10 1 bn mnlxucmlmutuuun Nubudynxruutlrntmxummcu lawnmm b nhm Ldb uy mm lrmxzud EuttlrnxxLMXnuxd39uqmnmnuf x 1 m lrmxzud my mum xuuuu chm undnx mznnmi mmm m hndmi dnu m m mm lrmxzud 11 u nun xmum and mrpnnni w mm Lhu m exam 3 3 Swerexgn Bankruptcy Memmsms mm m BK mu m prubhm puma an ax u palm m mum Enme Th pmbhm mw u the manaan u a 3 landquot mm m n m m Wm 33 an so M 53mm mm nummmmc mm m chmd r mnjunty andnuntunx m mam Omxmhnm maltd m q mm any amaa u oud b prwmdfmm clrnlhxu n 11 m qu m 13 mm Wampum m wuuld mma cuxnm Amman law wmh um any bundhABx m full payment in the event of a default The idea is that this would enable some bail ins and thus lower the cost of debt crises The essential idea is to create an ordered bankruptcy system rather than the competition for the exits But it would still involve lots of lending Not as much progress on this as imagined 4 The Fragility of Fixed Exchange Rates It is often argued that the increase in global capital ows makes it di cult to peg exchange rates The argument is often heard that global capital ows exceed reserves of any central bank thus rendering xed exchange rates impossible The daily volume of foreign exchange transactions is typically greater than 1 trillion The Quantum Fund may have resources as high as 12 billion A group of hedge funds may have assets su icient to defeat any currency they focus on given the typical size of foreign reserves It is important to note that emerging market crises have occurred in countries with xed exchange rates 7 Mexico in 1994 Thailand Indonesia and Korea in 1997 Russia and Brazil in 1998 and Argentina and Turkey in 2000 Why are xed exchange rate regimes especially softer pegs so susceptible to crises Can t be just the absence of exchange rate risk 7 after all this is not really eliminated Instead there is a peso problem but still severe It must be more moral hazard If people believe the government will defend the exchange rate then borrowing in foreign currency makes sense 5 The Bipolar World Now we talk of a bipolar world Hard pegs and oat work but soft pegs do not Many crises are from that intermediate range We can see that the number of countries in the middle is falling The right statement is that for countries open to international capital ows i soft exchange rate pegs are not sustainable but ii a wide variety of exible rate arrangements remain possible and iii it is to be expected that policy in most countries will not be indifferent to exchange rate movements To put the point graphically if exchange rate arrangements lie along a line connecting hard pegs like currency unions currency boards and dollarization on the left with free oating on the right the intent of the bipolar view is not to rule out everything mm a Emhni 1m Faun m m mm mmquot but am 1m quotprquotmm m BK m mm hm mebh quot an a that a m mum nu Sm m mn mtnbly am law Runhm39 mm m 1 m pmmum mu m h nxm nuquot u luauHi m m dprcmtmxu wl ma m burn an mum am mm m vuw amum xhuwdl Wuymmm 1n mmumm mquot mun Inn 56 Hannah a m buymgnnmxnnd m nmm um mid m mum um J n 1mm 139 human um a Us a a mum am the monetary base once attackers recognize that the central bank is willing to subordinate all other goals to defending the peg the attack will cease Here is the crux of the problem to repel an attack a central bank must subordinate other goals It is the con ict between defending the currency and other goals that make currencies subject to attack To fully combat an attack means letting domestic interest rates spike dramatically In the short run this may have deleterious effects on the banking system because banks borrow short and lend long In the longer term higher interest rates will have adverse effects on the economy A government pledge to ght at any cost is thus unlikely to be credible This argument suggests that central banks face a trade off between defending the currency and domestic objectives Given this trade off it is argued specula tive attacks can be self ful lling This argument points to multiple equilibria The value of this argument is that the currency may come under crisis long before the markets display panic In many cases interest differentials prior to depreciation do not signal a time of trouble19 Models with multiple equilibria it is argued are better able to explain this 51 Why Defend Against Attacks We observe that countries take costly actions to defend against speculative at tacks This involves governments and central banks undertaking di icult policy adjustments sharp hikes in interest rates large scal cuts in order to defend their currencies despite objections that these policies may precipitate a recession Why do they do this Eichengreen and Rose nd that the output costs of the alternative 7 failure to defend the currency 7 can be even higher See gure 9 which shows the growth of output 3 years before and 3 years after speculative attacks They use data from 89 countries during 1960 1998 during which there were 92 successful attacks and 184 successful defenses The output effects of defense are striking Or course one might argue that this is due to the situation in defenses being less severe The problem however is that macroeconomic indicators are the same in both types of countries20 One cannot nd predictors of whether attacks succeed 19This is apparent in the 1992 ERM crisis Interest differentials showed little evidence of any erosion of con dence in the months leading up to the crisis 20The behavior of output appears to be no different prior to successful attacks and prior to successful defenses The behavior of other economic and nancial variables appears to be no different prior to successful attacks and prior to successful defenses or not Thrs rs not surprrsrng rl one could crrses would happen much less olten Thrs rs a rnportant ouestron Ln the us when we get rnto trouble we cut rnterest rates and let the dollar s e Thrs eas pressure on therr banks An to the extent the crrsrs rs older s xchange rate does nothrng to deal wrth the overvalued exchange rate B t u ls play Devaluatron rnay effects ol the crrsrs even worse rl the country has srgnr c m Argentrna lor exam le e balance sheet s e ocornes to u the make the balance sheet ant dollar lrabrlrtres as Thrs also explarns IMF exchange mle advice and oondltlonzllty Whrle the 1er has repeatedly urged rts members to abandon solt pegs m lavor ol greater trres seeklng to delend therr currencrss agarnst attach Agmn our ndlng e to explaln thls behavlor exltlng a peg m a crlsls tends to losses sornethrng that the IMF as well as the natronal authorrtrss wrsh to And rt explarns the Vrsthed recovery lrorn the Asran result In costly output avord crrsrs A number l snap u therr 199778 crrsrs sharp lalls ln output were lollowed by equally sharp recoverres olAsla s crrsls or lts econornles as sornetlrnes suggested we show that thrs pattern rs qulte general 2 It rs the typlcal response ol output to a successlul attack smlnnera Gmmh Ra39s Flgure 9 Growth Effects ol Successlul Attacks and Delenses h the dleference7 One lactor ls evldent ln looklng at MLgrowth and m Rr Both rlse m the wake ol successlul attacks but n the men growth both lall desprte the declrne m real lnterest rates that accompanles the acceleratlon m ln atlon lurther suggest rng a loss m con dence Interesvmte spreads de ned as the lendrng rate rnrnus LlBOR rise following successful attacks again suggesting declining con dence and rising risk perceptions However there are no comparable differences in the behavior of any of these variables in the three years preceding the event Growth is no different in the run up to successful attacks and successful defenses In ation and money growth are no different Budget de cits are no different It is not obvious in other words that differences in the pre crisis development of these macroeconomic variables explain the different outcome of the speculative attack One always wonders if differences are due to unobserved factors that explain why governments choose to defend or not 7 perhaps they know something that is not in the fundamentals Including the normal variables does not help The essential nding is thus Conclusion 3 failure to successfully defend the currency against attack has real costs in terms of GNP That postcrisis decline in growth is not obviously at tributable to precrisis characteristics of the economy compared to countries that successfully defend the currency against attack The proximate source of that decline in growth in turn is the fall decline in consumption and rise in the risk premium suggesting a deterioration in confidence I guess the key point is that if you are going to exit a peg do it voluntarily not when subject to a speculative attack 6 Fear of Floating Calvo and Reinhart introduced the notion of quot fear of oatingquot to describe exchange rate behavior in many emerging market economies This refers to the fact that in many such economies the exchange rate uctuates very little even when the de Jure exchange rate regime is oating In most emerging economies there is a fear of letting market uctuations govern the exchange rate One piece of evidence for this is the simple fact that exchange rates uctuate less and reserves uctuate more in emerging economies than in developed economies even though shocks are typically much larger for the former Consider gure 10 which presents the probability that the monthly variation in a country s exchange rate will fall within a 25 band It is evident that this prob ability is much higher in the US and Japan than in emerging market economies that are supposedly oating exchange rate regimes It also apparent from the gure how this revealed fear of oating is accomplished greater uctuations in international reserves interest rates and money stocks The facts in gure 10 indicate that in emerging markets actual uctuations of the exchange rate are discouraged and this results in greater uctuations in monetary variables Why do countries fear oating One reason is that they have large dollar liabilities References l Taussig Frank W International Trade New York MacMillan 1928 W M m 1 Wm WM m WW my my m mm W w W m mum my mm W39 w quotum I Mm gm m m mm m n m r mun x m m m m u m s 4 7 1w M r mm WW 7 l2 m r m m w x mm 7 5 n M WW mu mm A lt a x WNW mmquot gm M m 39 z mwmm mm mm m WWW Mm WWW Figure 10 The Foreign Exchange Market Barry W lckes Econ 434 Fall 2006 1 Introduction The market for foreign exchange involves the purchase and sale of national currencies A foreign exchange market exists because economies employ national currencies 1f the world economy used a single currency there would be no need for foreign exchange markets 1n Europe 11 economies have chosen to trade their individual currencies for a common currency But the euro will still trade against other world currencies For now the foreign exchange market is a fact of life The foreign exchange market is extremely active 1t is primarily an over the counter market the exchanges trade futures and option more below but most transactions are OTC 1t is dif cult to assess the actual size of the foreign exchange market because it is traded in many markets For the US the Fed has estimated turnover in traditional products in 1998 to be 351 billion per day after adjusting for double counting This is a 43 increase over 1995 and about 60 times the turnover in 1977 The Bank of 1nternational Settlements did survey currency exchanges in 26 major centers and this provides some evidence 1n gure 1 we present some evidence of the daily trading volume in the major cities This shows the size and growth of the market Daily trading volumes on the foreign exchange market often exceed 1 trillion1 which is much larger than volumes on the New York Stock Exchange the total volume of trade on Black Monday in 1987 was 21 billion The annual volume of foreign exchange trading is some 60 times larger than annual world trade 52 trillion and even 10 12 times larger than world GNP about 25 30 trillion in 1995 You can also verify from gure 1 that the UK still accounts for the largest share of actual trades more than 31 What accounts for this huge volume and its rapid growth Although world trade has 1According to the BIS survey in 1998 turnover in traditional products spot forwards and fx swaps but excluding futures currency options and currency swaps was 149 trillion This represented an 80 increase from 1992 Fall 2006 E wrpmuldlsmhllluuAvllllnnl at out 29 mm Flgule l Folelgh Exchange Turnover by Regloh ml Currency L H l thoh guyth m the lolelgh exohohge muhet lhtemotlohol cooltol aws have lholemeel more dumnhcnlly Thls u leloted ooueohty u hard to mfg to mcxenses m ouneht ooouht de clm u mohy oouhtloe especully the US Although the world ouneht ooouht must sum to zero ll the US has huge desolte othel oouhtuee must have huge eulolueee ml the leooe to on lholeoee m mtemotlohol cooltol ows Moreover there has heeh oh exooheloh m mtemotlohol eeountloe muhete Bohhe have heoome more multmotlohol hd more bonds ole ueueel mtemotloholly thoh before Thls u dramahcall to molemhg otmtlee ol multmotlohol companies ole etlll too small to explzun the huge volume The reason he thot the turnover m lolelgh exohohge leoleeehte gross cooltol ows hut the explohotlohe locus on net cooltol ows Toke theUs case 39n w l doy But US GDP le only hout 10 tnlhoh ml oul ouneht ooouht de olt u only hout 5 ol thot or 9500 hllhoh shoes tloheootlohe ole thue hlg mulhple ol het tloheootlohe Thls re ects hedgmg behuvlox oh the out ol molhet outloloohte More helow The wet majoxlty ol tloheootlohe m the lolelgh exohohge muhet mvolve dollars In 1989 the share ol total tumovex that mvolved dollars was 90 By 1995 thus had fallen to 83 The Foreign Exchange Market Fall 2006 eaten ofdalars Peftemof GDP we m t 2 500 200 Imemanonal Bond Issues CrossBorder Securmes nansam 2000 7 m 1500 7 100 1000 7 500 7 5 0 0 was was us Japan Germany 39Oumuudrng umomr amemanana bendtssues a enaeenaa Grosspurchasesandsaes aneaumres Demecuvesrdemsundnonresideuh us Vauesare mm Figure 2 Growth in International Securities Markets As of April 2001 the dollars share of total turnover has reached 903 see gure 1 The next most active currency is now the Euro which has a share of 3762 Because of the high volume in trade in dollars and to a lesser degree in euros and yen many currencies do not directly trade against each other Other pairs those that do not include the dollar yen or euro account for only 23 of total trade If one wants to trade rubles for pesos it is cheaper to trade rubles for dollars and dollars for pesos rather than engage in the direct transaction If you think about it it is obvious that most trade will take place in one or a couple of currencies Suppose that there are 150 national currencies in the world Then if all countries trade with each other and if all currencies are used in these trades then the number of foreign currency markets that would be needed is 1 1502149 1117539 1 If on the other hand a single currency 7 sometimes called a vehicle currency 7 is used on one side of all these transactions you would only need 149 markets The savings in terms of transactions costs are enormous Of course which currency becomes the international standard is a matter of history and chance among other factors But the fact that one or two at the most ought to predominate is most plausible This tremendous volume of trade is relatively recent It has not always been the case 2Because it takes two currencies to trade these shares must add up to 200 The Foreign Exchange Market Fall 2006 Trading in currencies is much larger now than it was prior to the demise of Bretton Woods When exchange rates were xed there was less reason to trade Figure 1 Daily Volume of Trading by Location in billions of US April 1989 Country Turnover United Kingdom 184 United States 115 Japan 111 Singapore 55 Hong Kong 49 Switzerland 56 Germany NA France 23 Australia 29 Others 96 Total 718 Adjustments less cross border 184 Net net turnover 534 plus estimated gaps 56 estimated global 590 plus futures and options 30 Grant Total 620 April 1989 share 256 160 155 77 68 78 32 40 134 100 April 1995 Turnover 464 244 161 105 90 86 76 58 40 248 1572 435 1137 53 1190 70 1260 April 1995 Pet change share 198971995 295 60 155 46 102 34 67 43 57 49 55 32 48 39 37 74 25 37 158 36 100 46 45 45 17 45 1t turns out that foreign exchange trading is rather pro table Commercial banks that engage in currency trading make rather large pro ts though these are quite variable across banks and from year to year Some evidence in table 1 The fact that many commercial banks earn large pro ts is rather curious One might suspect that foreign exchange trading is a zero sum game Of course traders might like to argue that these pro ts are due to their The Foreign Exchange Market Fall 2006 expertise Can we think of an economic explanation One explanation for positive pro ts might be that the banks are providing a service for which they earn a positive return Only the speculative activities of the banks ought to be zero sum A back of the envelope calculation is informative We have seen that the foreign exchange market amounts to about 119 trillion per day or 300 trillion per year Now suppose that customer trading is only 10 of total trades actually it is larger than this with speculative positions the remainder Then if banks earn a fee of 2 basis points 0002 per transaction total pro ts would be 6 billion in spread income Now a sample of the 14 largest commercial banks pro ts sums to about 21 billion So it is quite likely that turnover income is the source of all pro ts and that trading is actually a net loss Another explanation that could account for the pro ts from foreign exchange trading could be the activities of central banks Central banks may engage in foreign exchange transactions that lose money as they unsuccessfully try to defend currencies Thus the losses of the central banks could be the source of the pro ts of the commercial banks Some studies have found these losses to be very large3 The Fed has been rather successful since the mid 1980 s4 but there have been some quite notable losses most famous perhaps the Bank of England defending the pound in the early 1990 s The Bank of Japan similarly lost quite a lot of money trying to prevent the yen from appreciating against the dollar during 2003 and 2004 3One study found that major central banks lost 16 billion on currency trading during the 1970 s 4The US was even more successful when it sold Carter bonds in the late 1970 s These were US debt denominated in foreign currencies For example the Fed sold debt denominated in DM in 1978 The interest rate on this debt was about 3 less than similar dollaredenominated debt The reason was fear of dollar depreciation When the debt matured however the dollar had appreciated so the US earned a capital gain as well as the lower interest You can think of this as trading on your inside information that monetary policy will be tighter than believed by the market The Foreign Exchange Market Fall 2006 Table 1 Foreign Exchange Trading Pro ts of Selected Commercial Banks millions of dollars 1985 1986 1987 1988 1989 1990 1991 Bank of America 170 141 140 135 143 207 246 Bankers Trust 1075 574 5128 1539 2965 425 272 Citibank 358 412 453 616 471 657 709 Morgan 1726 2296 2512 1868 1907 309 72 The exchange rate is the price that is determined in the foreign exchange market Of course there are many concepts of exchange rate we can consider These include 0 spot versus forward exchange rates versus future exchange rates 0 xed versus exible exchange rates 0 nominal versus real exchange rate We discuss these in turn 2 Spot and Forward Exchange Rates The exchange rate is simply the price of foreign currency in terms of domestic currency The typical fashion is to quote the foreign currency price of the dollar hence the yen has been trading at approximately Y111925 to the dollar on September 23 20035 Similarly the Brazilian real now trades at approximately 2898 to the dollar compared to the 12 before the exchange crisis Of course it is arbitrary how we quote the exchange rate it is equivalent to say that it takes 87Euro to the dollar or that a Euro is worth 1147 dollars To avoid confusion we will follow the convention that the exchange rate is the price of foreign exchange in terms of domestic currency6 For example the exchange rate with the Euro would be expressed as 5Although for some reason the value of the pound is usually quoted in terms of dollars per pound rather than the reverse 6Notice that if we refer to the exchange rate as dollars per DM it means that an appreciation of the exchange rate is equivalent to a depreciation of the dollar When e goes up it takes more dollars to buy a DM which means the dollar is worth less The Foreign Exchange Market Fall 2006 the number of dollars per Euro because for the US the Euro is foreign exchange Often we will simply treat the rest of the world as one country and hence we will simply refer to foreign exchange rather than specify the speci c country 1n that case the exchange rate 6 is just the domestic currency price of foreign exchange domestic currency foreign exchange The spot or nominal exchange rate refers to the current price of foreign exchange 1t is a contract for immediate delivery though that might actually take a day or two A forward contract refers to a transaction for delivery of foreign exchange at some speci ed date in the future Suppose for example that a US company say Ford Motors expects to receive Eu100 000 60 days from now The value of these receipts will vary with the actual value of the spot exchange rate in the future The rm may wish however to hedge 1t may wish to reduce the risk that the dollar will appreciate during these 60 days Consequently it signs a contract to deliver Eu100 000 in 60 days at the current exchange rate The company has locked in the current rate and hedged the exchange rate risk Similarly if Microsoft commits to invest GBP1m in 6 months time it may wish to x the dollar amount of this investment now Hence it could purchase a contract today to deliver pounds six months from now Suppose that the forward price of pounds in this transaction is 16377 Then Mcrosoft pays 1637000 today to obtain GBP1m in 6 months time 1f the pound appreciates this is a pro table transaction8 Even if it does not Microsoft has reduced its risk So far we have only analyzed Microsoft s interest But the risk that Microsoft has hedged the bank has absorbed But the bank actually is acting like a dealer Simultaneously it will be looking for other agents who need to hedge against the dollar depreciating For example suppose that Coca Cola expects to earn GBle in six months from exports to the UK 1t will then have to convert the pounds into dollars To avoid the currency risk Coca Cola would 7The spot price on September 21 2003 was 16479 8For example if the pound happened to trade at 173 in six months then Microsofts hedge would have saved them 93000 minus transactions fees The Foreign Exchange Market Fall 2006 like to sell the pounds forward accept dollars today for the commitment to deliver pounds in six months Notice that Coke is hedging against the risk that the pound will depreciate while Microsoft is hedging the risk that the pound will appreciate Trade is thus mutually bene cial the bank is merely the intermediary9 In this example the intentions of Coke and Microsoft exactly balance More typically a bank will have many clients whose interests differ The intention of the bank is to balance the two sides of the market and pro t from the fees Notice that the forward price of a currency need not be equal to the spot price If the market expects that the franc will depreciate over the next 6 months the forward price will be lower than the spot price The forward premium is a measure of the market s expectation and it can be expressed as f M 2 e where m is the number of days from today and Fm is the forward exchange rate Clearly if fm gt 0 it means that more dollars will be required to purchase foreign exchange m days from now than today Forward contracts are usually offered by commercial banks and this helps to explain the difference with futures contracts Banks offer their important customers forward contracts as part of their business relationship It enables rms to engage in international trade with limited exposure to foreign currency risk Now in the late 1960 s many observers expected the British government to devalue the pound Milton Friedman wanted to bet on this and he tried to purchase forward contracts to sell the pound short that is he would receive dollars today for the obligation to deliver pounds in several months time If the pound were devalued he would be able to purchase the pounds for fewer dollars in the future and hence would pro t 9Notice that there is no need for Coke and Microsoft to have different expectations for this trade to be pro table if the rms are risk averse Risk averse agents are willing to pay to obtain certain future outcomes If the rms were risk neutral on the other hand then for trade to occur they would need to have different expectations about the future value of the pound Thus if Coke expected depreciation and Microsoft expected appreciation they would both prefer to hedge even if they were risk neutral This would not be the case for risk lovers In that case some differences in expectations are needed for trade To see this consider betting on sports events If everyone believed the outcome of the game would be the same no one would bet The Foreign Exchange Market Fall 2006 on this transaction To his surprise however Friedman found no banks that were willing to make this contract The reason is that banks only sold forward contracts to their commercial clients Friedman then was instrumental in creating the futures market A futures market is a clearinghouse where goods for future delivery are sold In such markets standardized commodities are sold In a forward exchange transaction the names of the parties and amounts are negotiated 1n futures contracts the commodity is standardized and anyone can buy or sell it The clearinghouse acts as the third party guarantor This means that agents trading in the futures market do not need to know the identity of the agents they trade with the exchange stands behind the trades 1n the forward market on the other hand the contract is between the bank and the rm so the bank requires information about the creditworthiness of the customer to protect themselves against default If banks protect against default by knowing their customers how does the exchange stand to guarantee trades Futures markets rely on margin requirements These are best thought of as deposits or bonds placed by traders with the exchange Buyers and sellers post bonds with the exchange as guarantees against default Futures contracts are marked to market This means that the daily gains and losses on outstanding contracts are recorded and either added or deducted from an investor s margin account If a margin account falls below some critical level the exchange requires replenishment10 Margin requirements represent a key difference between forward and futures markets and this is why most rms use the forward market it is cheaper The futures market is dominated by speculators Forward markets are much larger but futures markets are more liquid Of course there is arbitrage between the markets so the prices cannot deviate very far from each other In addition to futures contracts one can also purchase options The key difference be tween a futures contract and an option contract is that the former is an obligation to deliver something in the future while the latter confers the opportunity If Microsoft is not certain it will make the investment in 6 months it may prefer to purchase an option rather than a fu 10Unless you are Hillary Clinton The Foreign Exchange Market Fall 2006 tures contract Microsoft would be paying some dollars today for the right to purchase francs within some future period at the prearranged exchange rate A call option for example would provide Microsoft the right to purchase francs at the prearranged price during the life of the option If the value of the franc increased holding the option would bene t Microsoft 1f the value of the franc decreased Mcrosoft would choose not to exercise the option It would lose what it paid for the option but it would not have locked itself into an unpro table transaction An option contract thus includes a measure of insurance It allows the investor to avoid potential losses that would accompany unfavorable movements in currencies 2 Covered Interest Parity The existence of forward markets for foreign exchange bene ts not only rms that expect to have foreign currency transactions in the future but also investors who wish to invest in foreign currencies Suppose that the domestic interest rate on say 3 month T bills to provide speci city is given by 239 and that the foreign interest rate is 239 and that 239 gt 239 1 might wish to invest in foreign assets rather than domestic assets But if 1 do so 1 would face the risk that 3 months from now the dollar may appreciate so that when 1 convert my foreign currency into dollars 1 would take a capital loss The forward market allow an alternative called a covered transaction which eliminates currency risk11 Letting Q be the spot exchange rate dollars per euro and E the current forward price for euro three months hence I could hedge my risk by purchasing a forward contract Speci cally assume that 1 choose to invest a dollar 1 can convert this into 5 euro 1 then invest this and at the end of three months 1 have 5 1t1 euro Because 1 purchased the forward contract F this yields me 570 dollars This transaction is called covered because 1 have already closed the transaction The covered transaction indicates the dollar return to investing in 11Notice that a covered transaction implies no currency risk So arbitrage will equalize returns even if agents are risk averse This is certainly true for US and German transactions But in the summer of 1998 ruble forward transactions were anything but certain And for good reason most sellers of forward contracts in dollars were unable to honor their contracts Because of high ruble yields on Russian Tibills called GKO S foreign investors ocked to Russia and purchased forward contracts to convert pro ts back into dollars But in the wake of the currency crisis the banks could not buy the dollars needed to honor the contracts 10 The Foreign Exchange Market Fall 2006 foreign assets Of course 1 could always invest in domestic assets and earn 1 239 Hence arbitrage should insure that 12 F1239 3 5t which is called the covered interest parity condition CIPC12 A host of studies have shown the high degree to which this condition is satis ed by market rates The CIPC can be used to reveal an interesting relationship between interest rates and the exchange rates by using the expression for the forward premium From the de nition of fm it follows that 1i Ft Ct 1 m 1 4 12 at f f In other words when the forward premium is positive domestic interest rates are higher than foreign interest rates and vice versa The forward premium re ects the capital gain on my covered transaction and by arbitrage this must equal the difference in interest rates in the two countries It is easier to interpret 4 if we take logs of 3 to obtain log1239 logE log 6t log1239 and then use the fact that for small x log1 x w x we obtain 239logFt loget239 12In practice this is an approximation because of transaction costs 13This follows from taking a rstiorder Taylor approximation to ac which yields ac g 753 3 m ac The Foreign Exchange Market Fall 2006 14 i ilogFt logetft 5 which says that the interest differential is essentially equal to the forward premium15 The market s guess about the path of exchange rates thus affects current interest rates Expecta tions matter 22 Uncovered Interest Parity We can obtain a further relationship between interest rates if we consider the uncovered version of the transaction An investor always has the option of investing in an uncovered fashion by neglecting to purchase the forward contract What is the expected return to this transaction Let EH be the exchange rate expected to hold when the investment expires Then the expected return to by uncovered investment equals 51 1 H so that arbitrage 16 requires i a 127 12 6 5t which is called the uncovered interest parity condition UIPC We can again take logs of both sides of 6 which yields A e e 239 239 logeHl loget tt Edi 7 where we have de ned 6t as the expected depreciation of the domestic currency It is useful to compare expression 7 with the ClPC condition which looks similar Note the difference between covered and uncovered interest parity In the former there is no currency 14We could alternatively derive the 5 by taking logs of 4 log1 log1 239 log1 fm and again using the fact that for small ac log1 ac N no we obtain 239 2quot fm 15Recall that fm Eng so that 1fm Hence7 if we take logs of both sides we get the approximation fm log Fm log e 16If investors are risk neutral that is7 they care only about expected yields 12 The Foreign Exchange Market Fall 2006 risk hence arbitrage occurs whether or not agents are risk averse Uncovered interest parity on the other hand results only if agents are risk neutral17 lf agents are risk averse then they will demand a risk premium to hold the risky return In this case the only differential risk is the currency risk associated with holding foreign assets Hence arbitrage would result not in 6 but rather in 5t1 1ie 1il t 8 t where pt is the risk premium Finally notice that if expected future exchange rates are equal to forward rates ie E EH it follows that the UlPC must hold It is an important item of research to test for this Although we often assume it in practice UlPC tends not to be supported by the data If risk premia are important then the forward rate is not equal to the expected exchange rate Rather we have ft at pt The forward premium differs from the expected rate of currency depreciation by the risk premium In this case we cannot recover the market s expectation about the exchange rate directly from interest rate differentials We will return to this later Testing for Uncovered Interest Parity How can one test whether the UlPC holds Notice that if both conditions held it follows that E EH We have data on the former but not on the expected spot rate To form a test we therefore need an hypothesis about exchange rates Hence to test for UlPC we then impose the rational empectations hypothesis This says that the expected value of a variable is given by the conditional expectation of that variable using the appropriate economic model For our purposes the key implication is that expectations will be unbiased This implies that EH will be an unbiased predictor of 6t1 Now we can test for UlPC lf UlPC and rational expectations hold then H should be an unbiased predictor of 6t1 1 can always collect a time series of spot and future exchange 17At the margin 18This also explains why investors demand a large premium to hold Brazilian reals in February 1999 even when the real has severely depreciated Presently interest differentials are close to 36 while the real has probably reached a trough relative to the dollar But investors are worried that Brazil may default on its debt so a large risk premium is required to induce agents to hold Brazilian assets The Foreign Exchange Market Fall 2006 rates A regression of the form 5t1 1 f Ft f YXt f 5t 9 should according to our hypotheses result in estimates of 62 0f 0 and E 1 where Xi are any other variables we may include in the regression Tests usually reject this hypothesis typically nding E lt 1 For technical reasons 7 the fact that e and F have a common trend 7 it is preferable to test this in a different manner Note that UlPC implies that EH 6t 239 H From ClPC we can replace the interest differential with E 6t Hence we have EH 6t E 6t Of course we still cannot observe EH but rational expectations implies that 6t1 EH E Et1 the forecast error will be uncorrelated with any information known at time t Hence we can write 5t1 5t1 5t Ft 5t which can be tested by estimating 5t1 5t CY 5t YXt 5t1 10 where the null is that y 0 and E 1 Notice that this is then a joint test we are testing the assumption that the forward rate is an unbiased estimator of the spot rate 7 ie that agents have rational expectations 7 and that agents are risk neutral A rejection of the hypothesis could thus arise from one of two reasons 1 expectations are not rational 2 risk neutrality One way to view the evidence is to look at a plot of E and CH1 According to the hypothesis the difference between these two variable should be random error But the plot shows in fact that the differences are systematic lndeed the spot rate seems to lead the forward rate This is evident in gure 3 which plots the Yen forward and spot rate versus the dollar 14 The Foreign Exchange Market Fall 2006 94 953996 97 93 99 00 m 02 03 i VENJ mv VEILSJMF Figure 3 Yen Forward and Spot Rate Another way to look at this is to look at the relationship between the actual change in the exchange rate 5H1 7 5 and the forward discount Ft 7 5 We might expect that the latter would be less noisy than the former7 but that there should be no systematic relationship But when we plot this we see the noise but also that the deviations do not appear random This is eVident in gure 4 which plots this relationship Notice that if UlPC does not hold one perhaps can make money How One can employ the carry trade borrow in the currency that has lower interest rates Let y be the amount of dollars borrowed Then this strategy implies gt 0 if it lt 3 11 lt 0 if it gt i and the payoff to this strategy is gt et1i 7 1 2 12 5t1 Suppose7 for example7 that i gt 2 Then if we borrow abroad and invest at home we should earn money since the actual change in the exchange rate is less than what is required by the arbitrage condition My pro t in this case should be 12 1i 71i iii 2 0 5t 15 The Foreign Exchange Market Fall 2006 and when i lt i I follow the opposite route My pro ts in this case are p 71i71ietli7ilt0 5 94 95 96 97 98 99 00 01 02 03 i DLNS I15 I Figure 4 Realized exchange rates and the forward premium Another version of the carry trade would be to sell domestic currency forward going short on domestic currency whenever there is a forward premium F gt 5 and buying the domestic currency forward going long on domestic currency whenever it is at a forward discount E lt 5 That is gt 0 if E gt at It 13 lt 0 if E lt 5 where It is the number of dollars sold forward The payoff to this strategy is It i 7 1 14 5t1 lf UlPC holds then this strategy 13 yields positive pro ts whenever the conventional carry trade 11 yields positive pro ts and vice versa This might be more pro table however as there are fewer transactions costs Suppose you followed this strategy this is sometimes called the carry trade Would you make money Suppose you did this from September 1993 to August 2003 Bet each month for 16 The Foreign Exchange Market Fall 2006 Date f s yenSB 199818 0001005 1443200 199819 0004189 1351500 1998110 04004547 1190400 Figure 5 the ten years7 so you have 120 observations Turns out you Would make money The average value of p 0041 We can plot the distributions of realized pro ts in gure 6 You can see that they are volatile7 but you do make money But the pro ts are risky The standard deviation of 0337 which implies that the Sharpe ratio is 01219 This appears risky the Sharpe ratio for the SampP 500 is about 06 LTCM and Tiger Management Fund made this type of bet and lost in 19988 and 1998920 Were they unlucky Here are the numbers We use covered forward interest parity for the interest differential since that does hold In August 1998 the monthly interest rate in the US Was 01 higher than in Japan So invest in the US Bad move7 the dollar depreciated by 7 yen appreciated 7 and LTCM lost 64 a 2 std deviation event on the bet21 And September Was even Worse The interest differential Was 04 in favor of the US7 but the dollar depreciated by 13 yen appreciated 13 and LTCM lost 127 a 35 std deviation outlier7 and the minimum pro t in the sample The estimate is that Tiger lost 2 billion on one day in October on such trades Suppose that We nd that E lt 122 What does this mean It is important to recall that mn an asset dmded by the standard deviation of the excess return Thus let BA be the return on asset A and let B be the return on a benchmark riskrfree asset The the Sharpe ratio of asset A is given by EBA Rh 7 SA where F p t t p t d d tion U7IaTBABb12 Note that If asset b is really riskrfree then 17 vaTRAgt12 Thus the Sharpe ratio is a riskradjustment measure of excess return Suppose you have two assets With the same expected excess return If one of the assets has less volatile returns its Sharpe ratio will be higher You can think of it as reward per umt of risk 20Many of LTCM s bets were swaps but Tiger seems to have engaged in the pure carry trade 21It seems that the central banks of both governments decided to intervene to prop up the yen that summer e this was unexpected by the markets 22Thrs is referred to as forward rate bias e the forward rate overepredrcts the future spot rate 17 The Foreign Exchange Market Fall 2006 this is a test of a joint hypothesis 1 that markets are e icient 2 the absence of a risk premium If markets are not e icient then there is no reason to believe that UIPC will hold In that case there are systematic errors7 and agents can possibly make pro table trades Even if markets are e icient7 however7 the condition may fail because of the presence of a risk premium If the future exchange rate overipredicts the spot exchange rate it may be evidence of a risk premium Risk averse agents are purchasing future contracts for the delivery of foreign currency because they wish to eliminate currency risk In that case they bid up the future price of foreign currency above the spot rate This is a case of a positive risk premium on the foreign currency Of course7 it could also go the other way And one could nd that varies over time Figure 6 Realized Pro ts on Yen Arbitrage If we can identify the risk premium we could then test whether this accounts for the forward rate bias But there is no way to observe this directly What is possible is to look at the variance of the exchange rate and plausible estimates of risk aversion and see if this could produce the risk premium that is observed One problem is that the required risk premium is going to be timeivarying it is not constant over time 18 The Foreign Exchange Market Fall 2006 Most studies are unable to nd such a systematic relationship Indeed it turns out that some of the X variables are useful for explaining forecast errors This is surprising For example historic forecast errors seem to be signi cant in explaining current forward rate forecasting errors This ine iciency is important If markets were e icient then the case for intervention in currency markets would be much weaker Of course the converse is not necessarily true 7 intervention could still be counter productive But it does open the door So it is important to know why markets are ine icient What explains this ine iciency One explanation could be that noise traders can cause the deviation from fundamental values This could result from insu ieient speculation lf arbi tragers are liquidity constrained they may be unable to pro t from short selling quotovervaluedquot assets Now this may seem surprising given how large these markets are But many of the participants may not be interested in short run pro ts Why Banks tend to close out their positions each night And corporations though they hold for long periods may not be able to readjust their hedges in response to shocks due to their nancial policies They may be informed but they may be unable to make speculative transactions when market prices stray from fundamentals Economists prefer to think that markets are e icient so the typical explanation centers on the risk premium p as in expression In particular it is thought that this may vary over time Why would risk matter Risks arise because the future value of currencies are uncertain If you engage in currency arbitrage for example you do not know what the value of the exchange rate will be when you have to convert your interest earnings back to your home currency lf currencies are volatile then such risks are larger lf agents do not like risk if they are risk averse then they will pay to reduce them 7 that means they are willing to sacri ce some income to avoid the risk 7 we observe that people buy insurance after all This means that they will demand a premium to bear a risk To see this consider gure 7 where we plot income against utility U y is concave because the individual is risk averse certain incomes are preferred to uncertain ones Suppose that 19 The Foreign Exchange Market Fall 2006 an individual is presented with an uncertain income stream Speci cally with probability 1 income will equal yl and with probability 1 1 income will be yg Then average income will be g ayl 1 192 The utility an individual obtains from this gamble is Compare this to the utility that the individual obtains from the certain level of income ya lt g that is uy3 Because Uy is concave 7 that is because the agent is risk averse 7 uy3 gt This means that the individual prefers to have a lower level of income with certainty to the uncertain gamble The individual would pay to reduce risk Notice that the maximum amount that the agent would pay to reduce the risk is equal to 344 which is referred to as the certainty equivalent level of income Clearly the individual would be willing to pay any amount up to 3 14 to be relieved of this uncertainty Alternatively one can think of this amount as the risk premium that the agent demands to go from the certain prospect 14 to the uncertain prospect Utility OJ U67 03 3 11gt quotquotquot quot 1 J4 J3 T y y jaJi 0700 Figure 7 Certain and Uncertain Income We can note two important points about the risk premium from gure 7 0 First the size of the risk premium clearly depends on the extent of volatility To see this simply make the difference between yl and 12 smaller without changing You can see for yourself that the size of the risk premium that will be demanded will fall So one 20 The Foreign Exchange Market Fall 2006 point is that the risk premium depends on the volatility or variance of returns in the case at hand on the variance of the future exchange rate Second the size of the risk premium depends on the degree of risk aversion Suppose the person was not risk averse 1f agents are not risk averse then uy will not be concave If they are neutral to risk it will be linear It is is easy to see that with a linear uy the certainty equivalent level of income is equal to the average income So the agent will pay nothing to be relieved of risk23 Thus if agents are risk neutral they will not demand a risk premium This means that all excess returns would be arbitraged away Since we see that they are not in fact fully arbitraged 7 that is we see that uncovered interest parity fails 7 perhaps this is due to the risk premium And we clearly see that the degree of risk aversion effects the size of the risk premium that is demanded This reasoning suggests that if the volatility of income varies over time perhaps with policy and if attitudes towards risk vary that the risk premium that agents demand to engage in uncovered arbitrage will also vary And this explains why there might a be a timewarying risk premium and why you uncovered interest parity fails Central bank behavior may be another reason why markets are ine icient They may be able to move exchange rates in the short run 7 they certainly think so often losing large amounts of money in the process They battle with arbitragers and may win some times It could be that when central banks are heavily intervening the risk premium rises There seems to be evidence that in periods of higher central bank intervention that is when their purchases or sales of foreign exchange are signi cantly above average that the departure from UIPC increases Also it appears that the puzzle is greater in oating rate regimes than in xed exchange rate regimes Some evidence for this may be that it is harder to reject UIPC at longer horizons This 23Some people like to sky dive for example For them would be convex they would pay to have risks We know that people go to Las Vegas or gamble with bookies The house makes a pro t so people are willing to pay to absorb risk Hence some people are risk lovers The puzzle are the people who drive to Las Vegas in an insured automobile That is a bit harder to understand One possibility is that is S shaped with both convex and concave portions Try to draw this and see if you can explain why an insured motorist purchases a lottery ticket 21 The Foreign Exchange Market Fall 2006 025 06 O 4 0 2 412 414 0 6 708 Figure 8 Estimated Beta Coefficients at Different Horizons could mean that the risk from central bank intervention is less important at longer horizons This is evident in gure 8 which shows the value of the estimated beta coefficient at different horizons We can see that as the horizon lengthens the data seems to support interest parity Another explanation could be peso problems discussed below The problem with the risk premium hypothesis is that nobody seems able to estimate a risk premium that ts the data that is not timeivarying Moreover it seems that the forward premium puzzle is more apparent with regard to industrialized countries compared with emerging market economies This makes no sense as a risk premium since the latter ought to be more risky 221 Fama Pmblem Fama showed why the risk premium is unlikely to explain the forward discount We have seen that typically researchers nd estimated values of 3 lt 12 and most often negative The problem is that 3 lt 12 requires that the risk premium be more volatile than expected future exchange rates and 3 lt 0 implies that the covariance between the risk premium and the expected future exchange rate should be negative This is an important result so it is worth a bit of slogging The Foreign Exchange Market Fall 2006 To see this rst note the least squares estimate of in a regression like 10 converges to 0012E 6t6t1 6t 1 15 p 1mm Wm at lt gt as the sample size gets large24 This standard result is just telling us that the coef cient on the independent variable of interes in the regression like expression 10 depends on the extent to which the dependent and independent co vary relative to the variation in the independent variable Obviously if they did not move together at all the coef cient would have a value of zero Now we can de ne the risk premium as pt E E111 the idea being that under risk neutrality arbitrage drives E gt E111 so that pro ts from market speculation is zero 1f E gt E111 then investors incur a risk premium from investing in foreign currency so Ft 5t 5t1 5t Pt 16 We assume rational expectations This means that the expectations error eHl E111 must be uncorrelated with all variables observable at t or earlier including E Thus our expecta tional errors cannot be correlated with the forward premium or discount else we would use that information so E m e EH1 am o 17 which implies that under rational expecations we can write 15 as CONE 5t7 t1 5t l 18 p 1mm Wm at lt gt Now if we use 16 to substitute for E St in the numerator of 18 we have CONE 5t7 t1 5t COWEH 5t Pt7 t1 5t 19 WNQH 5t CO 31 5m Pt 20 24The symbol plim is shorthand for probability limit It means that as the sample size goes to in nity the estimator converges to this value With enough ips of the coin the average number of heads converges to 12 The Foreign Exchange Market Fall 2006 where the latter follows from the simple properties of covariance25 Now note that variances are non negative the only way that the RHS of 19 and therefore p lim can be negative is if C01 6111 6t pt lt 0 which is Fama s second claim 1n words this means that a negative coe icient on can occur only if expectation errors and the risk premium are negatively related When the risk premium is high expecational errors are low and vice versa To see Fama s rst claim multiply both sides of 18 by MIME 6t and again use 16 to substitute for E 6t phmwmm e Covlta1 etptal etgt phmwwama etw mew etgtoovlta1 etptgt now multiply out the LHS plimw ware at vamp 2Covlta1 em at Gov em pt i var t1 Q 001 EH 6t pt thW i A A varet1 Q varp 2001 et1 6t pt so that if plim lt 12 it follows that26 mr EH Q varpt gt var EH 6t 21 25To see7 let ac and y be any two random variables Then we can write the expression in the text simply as 001190 3 y 001196 ac 0011907 y But Covacx varx so 001190 2 y varx 001190 y which is the expression we sought to show More simply7 note that Covac yyy yx Eac2 my Eac2 26This follows because obviously ML C07 7 l 2C0v t1 etapt 239 24 The Foreign Exchange Market Fall 2006 and thus var EH Q varpt gt 212a EH 6t so that varpt gt var EH 6t 22 which is Fama s rst claim This says that the variance of the risk premium must be greater than the variance of the expecation errors So we need a lot of risk and it should be volatile it seems Expression 22 seems quite unlikely to hold and thus would appear to be a serious ar gument against the risk premium assumption One should note however that 22 can hold either if the LHS is large or the RHS is very small Indeed if expected changes in exchange rates are small then 22 is not so puzzling And if exchange rates are a random walk then var EH 6t 0 Thus the surprise may not be that the variance of the risk premium is so large but rather that the expected change in the exchange rate is so small 2 2 2 Other issues Frankel and Poonawala looked at the forward discount puzzle in emerging economies They found that while the bias in the forward discount as a predictor of the future change in the spot exchange rate is present among emerging market currencies and advanced country currencies alike the bias is less severe in the former case than in the latter Unlike major currencies which generally show a coe icient signi cantly less than zero suggesting that the forward rate actually points in the wrong direction the coe icient for emerging market currencies is on average slightly above zero and even when negative is rarely signi cantly less than zero One implication for traders is that the yen carry trade and dollar carry trade on average may not be as pro table when the strategy is to go long in emerging market currencies as when it is to go long in major currencies An implication for international nance theorists in light of the intuitively high riskiness of emerging currencies is that the source of forward discount bias may not lie entirely in the exchange risk premium It could be that bid ask spreads are such that one cannot make money taking advantage of it We have seen that carry trade is pro table but it could be that exploiting these small 25 The Foreign Exchange Market Fall 2006 gains would require trading of suf cient volume to make the anomaly go away Why would this be the case Typically we have ignored bid ask spreads as they are small The problem is that although they are small so are the returns on the carry trade When we take these into account the amount we need to trade to make money on the carry trade is large A speculator who be one pound on an equally weighted portfolio of carry trade strategies across the USA Canada Belgium France Germany Japan Netherlands Switzerland and the euro from 1976 to 2005 would earn an monthly payoff of 00025 pounds To earn an average annual payoff of 1 million pounds would require a bet of 3333 million pounds per month Now suppose that you actually try to trade this much Is there an effect It turns out that the price in the foreign exchange market tends to be affected by the order ow That is if trading is really high the price rises 7 this is called price pressure Price pressure occurs when the price at which an investor can buy or sell depends on the size of the transaction The magnitudes are not large but they eat into the returns So what might you do You could break up the sales into smaller chunks But that would require more trades which adds tiny transactions costs So it could be that there are average excess returns but there is no money left on the table if you try to earn them Peso Problems A peso problem arises when the underlying variables that affect some asset price are subject to very different discrete possibilities In this case expectations are likely to turn out incorrect even when made properly Think of rain or shine In one case you need an umbrella in the other you do not If there is 70 chance of rain you take the umbrella But if it does not rain your guess was wrong In such cases you will likely make many mistakes even if your prediction mechanism is pretty good The term peso problem is often attributed to Milton Friedman in comments he made about the Mexican peso market of the early 1970s At that time the exchange rate between the US dollar and Mexican peso was xed as it had been since 1954 At the same time the interest rate on Mexican bank deposits exceeded the interest rate on comparable US bank deposits This situation might seem like a aw in the nancial markets since investors could The Foreign Exchange Market Fall 2006 borrow at the low interest rate in the United States convert dollars into pesos deposit the money in Mexico and earn a higher interest rate then convert the proceeds back into dollars at the same exchange rate and pay off their borrowings making a tidy pro t Friedman noted that the interest rate differential between Mexico and the United States must have re ected nancial market probabilities of bad or good things happening concerns that the peso would be devalued Otherwise the interest rate differential would soon disappear as investors increasingly took advantage of it ln August 1976 those concerns were justi ed when the peso was allowed to oat against the dollar and its value fell 46 percent The difference in return on comparable US and Mexican assetsiwhich looked like an anomaly to analysts who thought the exchange rate would remain xed because it had been xed for 20 yearsicould be explained once investors recognition of the possibility of a large drop in the value of the peso was factored in Example 1 Suppose the spot exchange rate is 20 cents to the peso and this has been red for a while Suppose that investors believe that there is a 95 chance it will remain at 20 cents and a 5 chance it will fall to 10 cents per peso What is the empected value of the peso EV 95 gtllt 20c 05 gtllt 10c 195c As long as the peso is not devalued what is the forecast error It is at 20c 195c 05c Notice that this forecast error will persist for every period until the devaluation A casual observer may conclude that the forecasters are irrational since they are consistently wrong But this is a result of the zeroeone possibility here Example 2 Suppose that the current interest rate in the US is 5 Then UlPC implies that 2 Ai1i 1 5t1 20 105 1076923 195 l The currency markets will signal a depreciation of the peso but each period that it does not 27 The Foreign Exchange Market Fall 2006 happen will imply the market is ine icient 223 Comparison to Real Interest Parity Uncovered interest parity suggest that interest differentials nominal are equal to expected changes in the currency What about real interest differentials The real interest rate 7 is equal to the nominal rate minus expected in ation i i 7T5 So i i 7T5 7T lf PPP holds then Ase 7T5 7T so i i Ase But uncovered interest parity implies that Ase 07 so that real interest differentials are equal to zero Real interest differentials are arbitraged away But PPP is a restrictive assumption What happens in general The assumption of PPP is equivalent to assuming that the real exchange rate is constant Yet we know it is not So how is the theory modi ed Recall that the real exchange rate is de ned as Qt 55 We are interested in an expression for the empected growth rate of t the real exchange rate Suppose that in ation was expected to equal in the US and euroland Then clearly we would have Q ZQfl Of course expected in ation rates are not equal however so how is the expression altered Suppose that the exchange rate was not expected to change Then clearly we would have ngfl 7T5E new If US in ation is higher than in euroland the real exchange rate depreciates Put these two factors together and it is clear that Q5Q 65 6 5 e tQt ltl tTltl 7Tus 7TE 23 The expression is intuitive27 27To prove this take logs of the expression for the real exchange rate expression log Qt log at log PtE log PtUS Now differentiate both sides with respect to time and we obtain i wd wl 1 dP US Qt dt et dt PtE dt PtUS dt But these expressions are just the continuous time growth rates of the real and nominal exchange rate and of the price levels in euroland and the US respectively So as the period shrinks we obtain the expression in the text The Foreign Exchange Market Fall 2006 239U5 239E Using this to replace the Now recall the interest parity condition 56 1 1 expected rate of depreciation in 23 we obtain 239E was W79 24 which implies that interest differentials depend on expected movements in the real exchange rate in addition to differences in expected in ation When the real exchange rate is not expected to change we have the same expression as before But in general nominal interest differentials are explained by movements in the real exchange rate as well Of course you can think of the latter as capturing all the reasons for exchange rate movements other than differential price levels This now lets us derive an expression for real interest parity While nominal returns are those that are the actual components of exchanges it is real returns or rather impacted real returns that govern decisionmaking That is you may earn a nominal interest rate of 10 from an asset but whether you choose to hold it or not depends on how the real return relates to the opportunity cost of the funds So an investor thinking of where to hold her wealth must consider the expected real returns We know that nominal interest differentials are related to expected changes in the real exchange rate and expected in ation We obtain the real interest parity condition by rst using the Fisher equation239t n 7T5 It follows that the expected real rate of interest in the US 7 wa 2115 gs and likewise for Euroland Tilt iEt it Using these in expression 24 yields the real interest parity condition 5 5 Q5 Q 1 TUS TE 25 Qtil which says that expected real interest rate differentials are equal to expected changes in the real exchange rate Why should 25 hold Suppose that people expect the real exchange rate to appreciate say because Euroland productivity growth in tradables is expected to be higher than in Eu roland non tradables and also higher than in the US Thus people expect the real value of The Foreign Exchange Market Fall 2006 the dollar to depreciate relative to the euro To compensate for this the real return on dollar assets must exceed those of Euroland assets Does this mean that there are pro t opportunities that are not being arbitraged away No The differences in the real rates do not re ect different returns on the same asset It re ects different returns on two bundles of goods The absence of arbitrage opportunities is guaranteed by interest parity since any investor that compares relative returns has a unique consumption basket When 1 compare the rate of return on holding dollars or euros the real return is computed by subtracting my expected rate of in ation whatever consumption basket is relevant for me But the expected real differential on the left hand side of 25 is comparing two expected in ation rates that re ect two di erent consumption baskets Notice that if all agents were identical PPP would hold and we would not have real interest differentials But because people in different countries consume different baskets of goods there is no way for them to arbitrage away any difference Why is this interesting Recall when we spoke of the Feldstein Horioka puzzle we com mented that a direct way to test for capital market integration would be to look at whether excess returns were arbitraged away So that would suggest looking at real interest differ entials in different countries If capital markets are integrated these should go to zero But as we have just seen this is only true if PPP holds If it does not hold then real interest differentials should be expected to persist Suppose for example that US savings was so low that people expected the real exchange rate to appreciate in the future Then real returns on US assets would have to exceed those in the rest of the world according to 25 3 Fixed Flexible and Managed Exchange Rates Finally let us distinguish among exchange rate regimes There are two polar cases to consider 7 xed versus exible 7 along with various gradations Usually in economics xed prices are considered problematic exible prices is the norm and ideal In the exchange 28Why do they expect Q to appreciate We have to pay back the debts we have incurred so current account de cits must become surpluses So the relative price of our goods must fall relative to the rest of the world to allow us to export more and import less The Foreign Exchange Market Fall 2006 market however it is not so simple There is no simple correlation between free market principles and the exchange rate regime The range of opinion on this issue can perhaps be best illustrated by the contrasting views of Robert Mundell and Milton Friedman Mundell believes that any departure from xed exchange rates is an abomination because exchange rate changes by de nition imply reneging on the promised value of a currency29 Friedman on the other hand believes that xing any price is wrong and the exchange market is no different30 Indeed Friedman makes an interesting analogy with regard to exible exchange rates likening them to the argument for daylight savings time First he notes that exchange rates are potentially more exible than internal prices If internal prices were as exible as exchange rates it would make little economic difference whether adjustments were brought about by changes in exchange rates or by equivalent changes in internal prices But this condition is clearly not ful lled The exchange rate is potentially exibleAt least in the modern world internal prices are highly in exible The Case for Flexible Exchange Rates in Essays in Positive Economics Friedman went on to offer a famous analogy The argument for exible exchange rates is strange to say very nearly identical with the argument for daylight savings time Isn t it absurd to change the clock in summer when exactly the same result could be achieved by having each individual change his habits All that is required is that everyone decide to come to his o ice an hour earlier have lunch an hour earlier etc But obviously it is much simpler to change the clock that guides all than to have each individual separately change his pattern of reaction to the clock even though all want to do so The situation 29Then it is not surprising that Mundell is a strong advocate of the gold standard SONeil Wallace disputes this last contention Unlike goods markets the foreign exchange market involves trade in at currencies This is fundamentally different than trade in goods 7 there are no fundamentals driving market clearing The supplies of at currencies must be controlled for them to have value but the level is irrelevant If there is more money each unit has less value but money has the same value Hence it is legal restriction that keeps people using pesos or dollar In the absence of this or in the absence of expected government intervention in the exchange market oating exchange rates are indeterminate 31 The Foreign Exchange Market Fall 2006 is exactly the same in the exchange market It is far simpler to allow one price to change namely the price of foreign exchange than to rely upon changes in the multitude of prices that together constitute the internal price structure We will return to this discussion later when we compare the advantages and disadvantages of various exchange rate regimes For now we want to see how the exchange rate is determined It is useful to begin with a partial equilibrium analysis of the market for foreign exchange to x ideas Let the demand for foreign exchange be given by De Y7 CD where Y is domestic national income and lgt is meant to capture all other factors that affect the demand for foreign exchange The demand for foreign exchange depends negatively on the exchange rate because a higher value of 6 means that it takes more dollars to purchase a unit of foreign exchange D depends positively on Y because higher income means more imports and this requires the purchase of foreign exchange The supply of foreign exchange is given by SeY1 where Y is income in the foreign country and 1 represents shift variables for supply31 Clearly Se gt 0 since a higher exchange rate means that exports are cheaper Similarly higher foreign income also increases the supply of foreign exchange because it increases our exports The market clearing exchange rate is given by way 1 53 Y1 1 26 and in gure 9 by E If the exchange rate regime was pure oating then the exchange rate would be determined by this market clearing condition 26 This is the regime of purely exible exchange rates32 Shocks to the demand or supply of foreign exchange would result in movements of the exchange rate For example if Y increased this would cause D to shift to the right and E would increase In a regime of purely exible exchange rates central banks do not intervene in the exchange market Hence the only ows are those created through the current account and the capital 31Notice that capital ows can affect the supply and demand for foreign exchange and the variables that affect such ows are subsumed in I and 11 Of particular importance in this regard are interest rate differentials 32The essential point is that central banks do not intervene in the market for foreign exchange 32 The Foreign Exchange Market Fall 2006 perunit ofFE Se W31 8 De Y c1 gt FE Figure 9 The Supply and Demand for Foreign Exchange account that is by private flows33 Thus a regime of pure oating can also be characterized by setting the of cial settlements balance AIR equal to zero so that CAt KOt 0 27 We will have occasion to return to this expression Fixed exchange rates occur when the central bank commits to a particular exchange value for domestic currency and stands ready to buy or sell foreign exchange to maintain that rate34 Hence with xed exchange rates any excess demand for foreign exchange is met by sales of foreign exchange by the central bank DtE7 Y StEYI AIRt 28 where E is the xed exchange rate and AIR is the change in foreign reserves held at the central bank Thus if at E there is an excess demand for foreign exchange the central bank sells its reserves of foreign exchange to prevent the exchange rate from increasing the currency from depreciating hence its supplies of international reserves are going down AIR lt 0 SSTechnically even with exible rates governments may purchase foreign currency to affect foreign transacae tions 7 for example to pay for expenses of embassies The key point however is that the central bank does not alter its holding of foreign exchange 34The gold standard is one example of a xed exchange rate and we shall examine it in more detail Notice that under such a regime E would be the dollar price of gold and foreign exchange would refer to gold A country on the gold standard stands ready to convert domestic currency into gold at the xed parity E The gold standard is thus a special case of a xed exchange rate regime Of course in a pure gold world there is just a single monetary unit gold But under a gold standard there is a domestic currency that trades to gold at a xed rate supported by the central bank 33 The Foreign Exchange Market Fall 2006 While the central bank can x the exchange rate in this manner by passively responding to the excess demand on the LHS of 28 this is not the only way The central bank could also peg the exchange rate by using monetary or scal policy to affect the market clearing rate By raising interest rates the central bank could attract capital ows and thereby increase the demand for domestic currency We will discuss this in more detail later Suppose however that policy has not succeeded in moving the market clearing rate to equal the xed exchange rate 1nstead suppose that E lt E the dollar is over valued and there is an excess demand for foreign exchange We can see from 28 that reserve sales will offset this excess demand 1n this setting the reserve ow appears to be passive or induced When capital ows were much restricted in the early Bretton Woods period this was referred to as an induced capital ow This led to the practice whereby the changes in the o icial reserves settlement balance was treated as caused by the current and capital account Today central banks do not act so passively so this terminology is no longer common 1t is important to note an important asymmetry When an exchange rate deviates from the market clearing rate one currency is overvalued while another is undervalued 1f E lt E the dollar is over valued and the Fed must sell foreign exchange At the same time the DM must be undervalued so the Bundesbank would be accumulating dollars35 Neither country s market for foreign exchange is in equilibrium but the positions are not symmetric The reason is that reserves are declining in the US but accumulating in Germany The Bundesbank is selling DM and accumulating dollars 1t can do this forever since the Bundesbank can print as many DM as needed The only cost is that of building warehouses to hold dollars But the Fed has only a nite quantity of foreign reserves 1f reserves were to run out the Fed would have to let 6 adjust Notice that we might have E lt E for two different reasons First it could be just a temporary deviation due for example to a transitory decline in Y ansitory uctuations 35The countries with the largest foreign reserves are Japan 844 billion September 2005 China Mainland 769 billion Republic of China Taiwan 254 billion Hong Kong 123 billion September 2005 the Republic of Korea 207 billion September 2005 Russia 160 billion September 2005 India 143 billion September 2005 Singapore116 billion August 2005 Germany 100 billion September 2005 and Malaysia 80 billion September 2005 The Foreign Exchange Market Fall 2006 in the excess demand for foreign exchange would not have any persistent effect on reserves Alternatively exchange rates could be out of equilibrium due to some permanent change This means that the reserve changes will continue until some adjustment takes place Note however that the burden of adjustment is much greater on the de cit country A country that is experiencing a persistent balance of payments de cit 7 we use that terminology again to refer to the status of AI R 7 will presumably adjust before reserves reach zero After all if the exchange rate is going to be changed there is no reason to let all reserves be wiped out But what the exact level of that threshold happens to be is unknown until it happens Moreover central banks may wish to keep the actual level of reserves secret precisely when under such pressure to keep speculators from turning on the currency 3 Reserve Accumulation under Fired Rates One might ask if there is any effect of sterilizing reserves There is an effect on the money supply To see this it is useful to think of a simple version of the central bank s balance sheet assets liabilities Foreign reserves IR Currency in circulation Domestic securities DS Bank reserves Because assets must equal liabilities we can note that the assets of the central bank IR DS sum to equal to the monetary base MB or high powered money Note that the money stock is equal to the product of the monetary base and the money multiplier M MMMBMIRDS 29 Now let us consider what happens when the Federal Reserve purchases foreign exchange with dollars There are four cases to consider 4 purchase from homecountry banks in this case alongside the increase in IR is an increase in bank reserves E0 purchase from homecountry non bank residents in this case residents would receive payment in the form of currency in circulation 35 The Foreign Exchange Market Fall 2006 3 purchase from foreign banks or central banks 2 in these cases currency in circulation rises immediately if the payment is made in cash 4 purchase from foreign banks or central banks via changes in the foreign bank s deposit at the Fed In this case once the bank uses this deposit to purchase some interest bearing security from a domestic bank bank reserves will rise The key point in any case is that reserve transactions must result in simultaneous changes in the money base This makes the stock of money endogenous lf foreign reserves are increasing so is the domestic money stock and vice versa Sterilization There is one way that the domestic money stock can be insulated from reserve changes Suppose that at the same time the Fed purchases foreign exchange it also sells domestic securities that is it engages in an open market operation The latter transaction will decrease the money stock and total central bank assets will be unaffected This action is called sterilization because the domestic economy is insulated from the foreign reserve transaction This can be costly however as the country must borrow from domestic citizens at a higher rate that it earns on its reserves So there is a scal cost36 In practice however it turns out that sterilization is very dif cult to achieve To sterilize the Central Bank must change the stock of domestic securities to maintain unchanged the stock of high powered money That is AH AIR ADS 0 30 Thus if the Central Bank is purchasing foreign exchange so that reserves are increasing it must simultaneously sell domestic securities ie AIR ADS Notice that to persist in sterilized intervention requires large stocks of both foreign reserves and domestic securities The reason for the former that of a de cit country is obvious But consider the case of a surplus country It is accumulating reserves Presumably it can do this forever But to 36Notice that a country like China which has capital controls can reduce this cost because it limits the investment options of its citizens But it cannot eliminate them entirely 36 The Foreign Exchange Market Fall 2006 sterilize such a ow it must be selling domestic securities But this requires that the Central Bank have a very large stock of debt to sell This condition is unlikely to be satis ed in most economies 4 Gold Standard and the SpecieFlow Mechanism The gold standard is an important historic example of a xed exchange rate regime To some it is the ideal system because it takes central banks out of the exchange rate business It is also seen as a natural system as opposed to one that derives from government behavior This is really a simpli cation of how the gold standard really worked And it ignores the fact that the gold standard only really worked under peculiar historic circumstances It is useful nonetheless to examine Hume s specie ow mechanism This is really the rst general equilibrium adjustment model in economics It is a powerful model and it is still useful though it is based on simpli ed assumptions which produce the sharp predictions37 Consider a world where prices are exible and where all transactions take place with gold coins Also assume that there is a xed supply of gold in the world These coins are minted at a xed parity in each country There are no banks and no capital ows38 Whenever goods are exported a merchant receives payment in gold Not wanting gold the merchant takes this to the mint and receives gold coins at the xed parity To purchase imports a merchant pays with gold To get the gold the merchant takes coins to the mint and sells them for gold at the xed parity which is then used to pay for the imports The recipient in the foreign country takes the gold to the mint and obtains coins Now consider the case of a country with a trade surplus This means that more gold is coming in to the country than is leaving Hence the supply of gold coins in the domestic S7Hume wrote 7 Suppose fouri f ths of all the money in Great Britain to be annihilated in one nightwhat would be the consequence Must not the price of all labour and commodities sink in proportion and everything be sold as cheap as they were in those ages What nation could then dispute with us in any foreign market or pretend to navigate or to sell manufactures at the same price which to us would afford sufficient pro t ln how little time therefore must this bring back the money which we had lost and raise us to the level of all the neighbouring nations Where after we have arrived we immediately lose the advantage of the cheapness of labour and commodities and the farther owing in of money is stopped by our fullness and repletion Hume Of Money 38Or you can think of banks with 100 backing of notes by gold 37 The Foreign Exchange Market Fall 2006 economy is increasing With more circulating medium specie the price level will increase This follows from the assumption of price exibility and full employment39 The increase in domestic coinage increases aggregate demand and pushes up prices But this reduces the competitiveness of exports and increases the attractiveness of imports Hence the ow of gold will be reversed until prices return to their equilibrium levels This is Hume s specie ow mechanism a complete explanation of the adjustment of price levels to shifts in the money supply across countries Notice that extending this model to a world with banks and paper money is not all that di icult Assume that paper currency exists but that central banks stand ready to convert paper currency into gold at the xed rate as is the case in the foreign country Suppose that Great Britain runs a trade surplus with France That means that British exporters are accumulating franc notes Not needing that many notes they present the excess to the Bank of France for exchange into gold40 They then take the gold to the Bank of England and get more sterling notes The domestic money supply rises and the same adjustment as before takes place The systems works pretty much like it does with coin Gold ows cause relative prices to change in Britain and France in a manner that reverses the gold ow Notice that because gold ows offset trade imbalances through adjustments in price levels movements in prices tended to be cyclical rather than trending Without growth in the world supply of gold in ation could not be sustained Of course discoveries of gold such as the Spanish discoveries in the Americas did lead to increases in general prices but the world trend in prices depended on the balance between the growth in production of goods and the growth in the production of gold A Model To better understand the gold standard it is good to rst ask how the gold standard works in a single country Because we have a gold standard the dollar price of gold PG is given In the short run the gold supply is xed at Go We also have a demand function SgThough Hume did not argue that this would happen automatically rather it would take some time so that at rst output would increase before prices 40This probably involves the intermediation of British banks which transfer to their correspondents in France The Foreign Exchange Market Fall 2006 M Figure 10 Pricelevel determination with a given Gold Stock for gold as in gure 10 which is drawn with a negative slope What determines the demand for gold Gold is used for two purposes non monetary such as jewelry dentistry etc and monetary The non monetary demand for gold will be a decreasing function of its relative price P PG It will also depend on real income y H economic activity increases so should the non monetary demand for gold Monetary demand for gold depends on its use for transactions Suppose that gold is used to back the currency Then if G M is the quantity of gold used as reserves and M is the stock of money then A Pi is the reserve ratio lf gold were used as money then A would equal unity In general it satis es 0 lt A S 1 This implies that the quantity of monetary gold demanded depends on the public s demand for dollars Thus AM E 31 GM But this depends according to standard theory on real income and the price level Hence M PLy where L gt 0 Hence using this in 31 we obtain 7 APLy M 7 pa 32 The Foreign Exchange Market Fall 2006 9 Gold ow Figure 11 Flow supply and demand for gold which implies that the monetary demand for gold depends positively on real income and A and negatively on the relative price of gold in terms of goods Because both the monetary and non monetary demand for gold depends negatively on the relative price and positively on y A we obtain the function as in gure 10 Notice that because the price of gold is xed the supply of gold determines the price level If the stock of gold increased or real income decreased this would increase the price level We have examined the consequences of a given stock of gold but what determines the stock Consider gure 11 which shows the ow supply and demand for gold The ow supply depends positively on the relative price of gold because it is more pro table to produce gold when its price is higher Subtractions from the gold stock depend on wastage We denote by 6 the depreciation of the gold stock in non monetary use and f g 1 is the non monetary demand for gold We are assuming that money held as reserves does not depreciate At the relative price Pgr the ow supply and demand are equal so the stock of gold is not changing If the relative price were higher than this then the ow supply would exceed demand and the stock would grow and vice versa 40 The Foreign Exchange Market Fall 2006 w 5U w 5U k DNDM Figure 12 Gold Standard Model We now put the two analyses together Consider gure 12 1f the initial gold stock is Go then the price level is gt0 This is the short run equilibrium price level But at this price the ow supply of gold is greater than its demand This causes the stock to rise Once the stock of gold increases to Cr however ow supply and demand are equal so that we are in long run equilibrium Suppose that a new gold eld was discovered increasing the ow supply of gold Suppose we were initially in long run equilibrium The discovery shifts to the right causing the stock of gold to increase at the initial relative price of gold As the stock increases the relative price of gold falls until the ow supply equals demand What about a shift in A Suppose that the Central Bank reduces A This would cause the demand function for monetary gold to fall shifting the demand function to the left At the given stock of gold this would cause the relative price of gold to fall But this would cause the ow supply to fall below demand causing the stock of gold to fall Eventually the stock of gold falls suf ciently so that the relative price of gold returns to its initial level We should note however that if the CB starts to use A too much as a policy instrument we cease to have the gold standard Now how do we modify the model for the open economy This turns out to be quite easy 41 The Foreign Exchange Market Fall 2006 is L P A P DNDM T Pray Pale P h w L WAVE la 91 Figure 13 Gold Standard in the Open Economy All we do is replace the ow supply function Instead of depending on production we now have it depend international trade in goods and services If exports exceed imports the supply of gold increases and vice versa But what will the trade balance depend on Clearly this will depend on the relative price of gold If the domestic price level increases then imports y will increase It will also depend on the domestic and foreign income y f So we can now write the ow supply function as h ID 15i with 711 gt 0 and 712 lt 0 we know have gure 13 The key difference now however is that the ow supply of gold will adjust much faster lt no longer depends on production but on the ow of gold due to trade The key feature of the gold standard model is that the price level depends on the stock of gold We can see here the specie ow mechanism at work If the stock of gold increased due to some discovery the relative price of gold decreases which is the same thing as saying that our price level rises relative to foreigners who are also tied to gold This means that the ow supply will be less than demand causing G to fall The decrease in G causes our prices to fall until we return to the initial equilibrium Notice that under the gold standard changes in the demand for money or changes in income can have short run effects but no long run effects on in ation Suppose money demand increases This would shift the stock demand for gold to the right causing the relative price of gold to rise This would imply that we are more competitive and the gold 42 The Foreign Exchange Market Fall 2006 Figure 14 An increase in money demand in ow would exceed its depreciation The ensuing increase in the stock of gold would cause our prices to rise until we returned to the initial equilibrium relative price This is analyzed in gure 14 Our model of the gold standard works quite well to explain the automatic adjustment of the system It can 7 unlike Hume s version 7 account for capital ows as well since we have paper money We would only need to make the ow supply of gold depend on the interest differential in addition to the relative price of gold and relative income 71 13 15 1 ff where 713 gt 0 because a positive interest differential would cause capital to ow into the economy This would require foreigners to purchase domestic currency with their currency which would then be traded for gold increasing the supply at home The major way in which this model departs from the actual operation of the gold standard is that gold ows were not in fact as large as the model suggests The model suggests that gold ows are on the order of magnitude of the trade balance or the trade balance plus the capital account if we consider capital ows In fact however gold ows were much smaller than this level How could this be The explanation for the missing gold ows is monetary policy Although the ideal system is passive in fact monetary authorities could intervene to speed up monetary adjustment Rather than wait for gold ows to move the price level a central bank could undertake policy 43 The Foreign Exchange Market Fall 2006 to move the money supply in anticipation of the gold ows Suppose that our price level is too high at the initial relative price of gold we are running a trade de cit Over time gold would ow out of the country reducing our money supply and restoring external balance But this could take time To speed this up and to avoid the loss of gold the central bank could act to tighten monetary policy in anticipation of the gold out ow This could occur via an increase in the discount rate for example When the central bank was tightening in anticipation of an out ow and vice versa this was referred to as playing by the rules of the game The phrase is Keynes s and thus postdates the classical system in real time there were no written rules this is just what was expected41 Of course once we allow for the central bank to intervene there is always the possibility that they could do this in the wrong way 7 against the rules 7 by trying to prevent the domestic money supply from responding to gold ows 1n modern parlance this is called sterilization But this could only be conducted for short periods of time because eventually a country would run out of gold Moreover it was inconsistent with the rules and prior to 1914 countries treated the gold standard as an institution that could not be discarded Evaluation The advantage of the gold standard is that it ties the world price level to the world supply of gold This is an advantage because it prevents in ation unless there is a gold discovery Notice that the gold standard does not prevent uctuations in the price level however What it does produce is long run price stability But the gold standard is also problematic 1t ties the world money supply to the production of a commodity There is no inherent reason why the growth in gold supplies will be related to the needs of international liquidity When gold discoveries are rare the world supply of gold will not increase as fast as real income This would be de ationary Between 1873 and 1896 the frequency of gold discoveries was rare while economic growth was rapid With the world demand for money exceeding the growth in its supply the price level had to fall That 41Of course playing by these rules meant augmenting gold ows not sterilizing them This is very unpopular potentially as it involves sacri cing internal balance for external balance 44 The Foreign Exchange Market Fall 2006 explains why price levels fell dramatically 53 in the US Gold rushes led to the opposite effect Bimetallism When gold production lagged the growth in output the pressure on the world price level was de ationary This had two effects One was to increase the reward to further gold discovery and to conservation of non monetary uses of gold The second effect was to increase the use of silver as a medium of exchange By maintaining a xed rate of exchange between gold and silver say 155 to 1 as in France in the rst half of the 19th century silver production could make up for shortages of gold As gold became scarcer the return to silver discoveries increased because countries on bimetallic standards exchanged gold and silver at the xed rate Two types of money circulated simultaneously Notice that as long as the production of gold and silver did not get too far out of line bimetallism was feasible But if gold became scarcer a country like France could quickly run out of one metal Agents would go to the mint in France with silver and exchange it for gold Of course the mint could raise the price of gold in terms of silver But this would reduce the return to silver miners and it would reduce the world supply of media of exchange Political interests that supported debtors would agitate in favor of silver coinage 1n fact the saga of the Wizard of OZ is42 in fact an allegory about bimetallism Wholesale prices in 1890 were about 55 of their 1869 level Real output had grown during the 1870 s by about 50 while the stock of money grew only by about 26 The problem was the lack of specie Congress responded in 1890 with the Sherman Silver Act which began coining some silver in limited amounts at a rate far above 16 to 1 This caused panic that the US would leave the gold standard and Grover Cleveland achieved its repeal Unemployment in 1892 96 was over 12 so when Democrats met in Chicago their cry was for bimetallism at 16 to 143 Recall Bryan s call that Thou shall not crucify mankind upon a cross of gold And thus Baum told the story in his book Oz in fact stands for ounces of gold Dorothy 42See Hugh Rockoff JPE 98 4 August 1990 43The market rate at that time was closer to 31 to 1 Hence free coinage would have led to some out ow of gold But notice that free coinage really amounts to increasing the total stock of specie like painting silver gold which undoubtedly was in short supply at the time 45 The Foreign Exchange Market Fall 2006 from Kansas is the honest American from the heartland and the Scarecrow stand for farmers44 The Tinman is the worker and the Cowardly Lion is Bryan45 The Wicked Witch of the East is Wall Street 7 the advocates of tight money and most especially Grover Cleveland The Wicket Witch of the West is drought 7 at that time ruining farms in Kansas and Nebraska hence destroyed by water46 Emerald City is Washington where people must wear green shaded glasses thus they are forced to see the world through the shade of money Toto stands for teetotaler the prohibitionists who agreed with the populists on silver The Wizard is really just a man and his solution for Dorothy s problem 7 the balloon 7 vanishes like hot air Dorothy is eventually saved by Glinda the Good witch from the South the region the populists hoped to ally with and all she has to do is click together her silver shoes Thus when silver is coined along with gold all is solved While free coinage of silver would offset the shortage of gold and would have offset the de ationary effects of the gold standard in the last quarter of the 19th century the gold standard was on its way This was partly due to the dif culties of operating a bimetallic standard47 Another factor was increased gold discoveries 7 primarily South Africa 7 that alleviated the gold shortage at the appropriate moment It was also due to the fact that the strongest economy Britain had adopted the gold standard and countries that traded with Britain found it advantageous to adopt the same system to facilitate trade Was Bryan foolish Who could have known that gold would be discovered And wasn t the money stock too tight Moreover given the size of the US is it unlikely that the market rate could have stayed at 31 1 while the US coined at 16 1 The price of silver would have risen and the world money stock as well 44He complains of no brain 7 not understanding what the moneymen from the east tell him 7 but of course he nds that he has one by the end 45This apparently is because by 1900 in his second race with McKinley Bryan no longer fought the bimet7 allism issue Baum is thus picturing him as a coward 46Would in ation serve like water to end the problems of the farmer What about the Fisher effect 47Though these were probably overstated given the size of the US The so7called instability of a bi7metallic standard was illusory Two legs are better than one 46 The Foreign Exchange Market Fall 2006 401 Interwar Period Between the wars the gold exchange standard was developed This basically differed from the classical gold standard in several ways 0 withdrawal of gold coins from circulation and concentration of gold stocks in central banks 0 emergence of the dollar as a second reserve currency 0 reduced wage and price exibility especially in US and UK 0 central banks no longer wished to play by the rules 7 emergence of popular democracy Mundell argued that the primary failure of this system in the interwar period was too low a price of gold The dollar price of gold was left unchanged even though prices had risen A higher gold price would have increased liquidity Example 3 Too low a price of gold What happens when the gold price is set too low relative to the price level as in the US and UK after WW1 Too low a price of gold means that there is excess demand for gold domestically and that the gold ow will be negative 7 our prices are too high so we lose gold to our trading partners Notice that adjustment requires the gold stock and hence domestic prices to decline If this happens then the relative price of gold returns to its equilibrium level The problem in the interwar period is that prices were rigid downward so the de ationary pressure lead to unemployment Consider gure 15 Initially the gold stock is at Go Given the price level equilibrium requires a price of gold high enough so that the relative price is ID PG But suppose that the gold price is set too low so that we are at P7fgt0 Then there is excess demand for gold at this low price and we are running a balance of payments de cit 7 the ow of gold is negative equal to the distance yx To relieve the excess demand 7 to make the gold standard function 47 The Foreign Exchange Market Fall 2006 amp P A PG A 1 v 0 1 ya in 2 In W lav GI GU Figure 15 Too low a price for gold at all 7 the demand for gold must fall either by a decrease in income as in the gure or a decrease in A o By the rules of the gold standard we must eventually get to point C Here the price level has fallen so that we are once again in stock ow equilibrium This happens as g lt 0 causes G0 gt G1 The fall in gold leads to lower prices and we end up at C De ation saves the day Playing by the rules the CB could tighten monetary policy to hasten the fall in prices so that less gold must leave the country That is policy reinforces the de ation But if the CB is unwilling or unable to sacri ce internal balance for external balance then problems arise lf they sterilize the gold ow prices do not fall and we stay at B losing gold This cannot go on forever lf they conduct expansionary policy to combat the recession it is even worse But contrary to this are two points rst the gold cover ratio was little changed second foreign exchange reserves could substitute But the problem of foreign exchange reserves was that they only work when gold prices are stable lf gold prices were to be changed central banks may try to exchange foreign exchange for gold Remark 4 This is the Tri in dilemma Increased liquidity needs are met by foreign emehange reserves This works as long as people are willing to trust the gold stocks But this erpansion threatens the credibility of the system 48 The Foreign Exchange Market Fall 2006 Two other problems are important First most gold was concentrated in three countries 7 US France and Germany From 1927 to 1930 the share of world gold in these three countries rose from 56 to 63 This pushed de ation on the rest of the world Second central bank credibility declined as they no longer played by the rules of the game This threatened con dence in the system 1ncreasing pressure for domestic stabilization Central banks started to liquidate foreign exchange reserves 7 the ratio of foreign exchange reserves to gold fell from 37 in 1930 to 11 by the end of 1932 More de ationary pressure Moreover there were insu icient discoveries of gold Perhaps the system was saved earlier by fortuitous gold discoveries The gold rush after all was not caused by prospectors but by the accidental discovery at Sutter s M11 Periodic gold discoveries offset the de ationary bias in the system By the interwar period luck had run out Only pyramiding reserves could help but this leads to Tri in dilemma Eventually US left gold then revalued gold to 35 per ounce but the system really collapsed 402 Bretton Woods The Bretton Woods system was not exactly the gold standard but what is called the gold exchange standard All countries xed their currencies in terms of the dollar while the dollar was xed to gold Central Banks held reserves in the form of dollars but these were claims on US gold supplies Four differences from the previous system 0 pegged exchange rates became adjustable subject to the existence of a fundamental disequilibrium 0 controls on capital ows to add credibility given that monetary policy would be driven by domestic concerns 0 1MF created 0 limits imposed on private holdings of gold 49 The Foreign Exchange Market Fall 2006 These innovations dealt with the problems that were thought to have plagued the previous system 7 de ationary bias from overvalued pegs a mechanism to contain destabilizing cap ital ows a global liquidity shortage and a mechanism to in uence governments that were pursuing unstable policies But these innovations did not deal with the fundamental di iculty 7 how to cope with increased liquidity needs Fast economic growth increased liquidity demands lnelastic gold supply and limited price exibility made this more acute Only pyramiding foreign exchange could cope 7 now essentially increased dollar holdings The problem with this system again had to do with international liquidity If the rest of the world is growing faster than the US 7 which was the result of the greater reconstruction after WW2 and postwar parities 7 then they would experience more rapid increased in the demand for money Given their xed exchange rates with the dollar the only way for them to expand their money supplies was to increase their holdings of dollars Hence the only way for world liquidity to go up was for the US to run balance of payments de cits This would increase the holdings of dollars in the rest of the world The world was enmeshed in the Tri in dilemma To keep the supply of international liquidity equal to demand the US had to run balance of payments de cits But the increasing stock of dollars held outside the US increased the likelihood that Fort Knox had insu icient gold to back up the dollar If all foreigners tried to cash in their dollars we would not be able to meet demand If the US acted to curb de cits on the other hand there would be insu icient liquidity in the rest of the world Note the di iculty o If the US continued to run de cits it supplied liquidity but this threatened the gold backing o If the US cut back on de cits there would be a liquidity shortage o If the US raised the price of gold it would be going back on its commitment and threaten The Foreign Exchange Market Fall 2006 the system18 To meet this problem two possibilities emerged First an arti cial asset could be created to act as a reserve currency paper gold This was the function of SDR s issued by the IMF Second the US could devalue In fact both occurred The latter was the ultimate demise of the system US in ation meant that other countries had to import in ation Those that did not want this threatened to exchange their dollars for gold But there was not enough We ended up with the non system that has existed since 1973 48If a country does it once it may do it again Hence countries would prefer to hold gold rather than dollars But then the system would revert to the gold standard from gold exchange 51 Introduction to International Finance Barry W Ickes Econ 434 Fall 2008 1 Introduction International macroeconomics or international nance as a subject covers many topical issues What has happened what will happen to the dollar Is the current account de cit too large Should China devalue its yuan1 Should it rst liberalize nancial ows Should Sweden give up its currency to join the euro Should emerging market economies liberalize their nancial markets Is this good for world economic growth or a source of instability How if at all should we reform the IMF What about globalization These are interesting questions To answer them we need to learn some international nance What is this eld about As with international trade international macro is the result of the fact that economic activity is affected by the existence of nations If there were no national economies then we would not have this eld If there was no international trade we would not need international macro either But countries do trade with each other and because countries not all but many use their own currencies we have to wonder about how these goods are paid for and what determines the prices that currencies trade at More subtly however we have to also consider the fact that countries borrow and lend from each other in other words they trade inter temporally 7 consumption today for consumption in the future Because of international borrowing and lending economic opportunities are expanded and households have better op tions to smooth their incomes These are good things But just as the existence of banks make bank panics possible the existence of an international nancial system makes international nancial crises possible This is where all the interesting action of the course comes from In order to understand such crises we need to understand the nature of the international nancial system 1The reminbi has been pegged to the dollar at the rate 828 since 1995 Intzoducuon Fall 2008 qurIZJ unm states Cunenl mat nelwn ax Share av mm summses lm mun on u no as mm am Mr mmquot mm mun Flguze 1 US Cuuent Account as Shale of Global Suzpluses 1t 15 useful to begin With some genexa1 facts about the mtemauonal economy Fust some magnitudes 2 Fozelgn Exchange 15 the biggest maxket m the woxld 1 5 Lulllon pex day US GDP 15 about 13 14 Lulllon as of 2005 2 Expoxts and Imports axe much smallex about 1437 and 2 220 o tulllon annuallya Net expoxts axe thus about 783 1 buhon Compaxed to that fedezal govemmem expendmuzes axe about 921 8 buhon of which 517 buhon 5 defense spendtngwh11e gxoss pxnate Investment 15 about 2 237 txtlhon gxoss pxnate savings 15 1 795 tulllon gxoss govemmem savmgs 15 107 buhon so gxoss savmgs as a pet of GDP 15 13 8 Of eouxse most of that 15 xeplaeement of capltal so net savmgs 247 buhon as a pezcent of GDP 15 about 1 95 Intemauonal txade 15 unpoxtant Even moxe so With globallzauon Not Just the shaxes of expoxts and unpoxts but the shaxes of Impoztecompetmg goods In xeeent yeaxs the US has moved fzom being the 1axgest mtemauonal czedmoz to the 1axgest mtemauonal debtox Does that have consequences zNxmonxm A h t iFlguxes xe ox 2005 2 unless othexwme noted A good some ox thu ts the BEA website http www hex govhesdnmpswehSeleothhle mp7Fopulzu tnlhon t39 9 tnlhon gxnnst spenehng o 52 3 tnlhon lexmng 400 huhon de cit 5522 ox example http www hex gov uendnmpawelJTnlalerew spde Introduction Fall 2008 Rmo of the Cunem Ammt to GDP Figure 2 US Current Account Balance as Share of GDP US now absorbs almost 70 of global current account surpluses see gure 1 The current account de cit of the US is now about 6 of GDP This is quite large by historic standards especially for the world s reserve currency country You can see that this is a recent trend though quite strong We can see in gure 2 that in the 1960 s and early 1970 s the current account balance was positive We were acquiring net foreign assets Since then foreigners have been accumulating our lOU s Most observers believe that for the US to eliminate its current account imbalance the dollar will have to adjust signi cantly Why How much will it have to adjust What about interest rates What effect will this have on the global economy Clearly to understand this we have to have some theory of the current account how it is determined and what effects it Notice the irony The rest of the world is supplying the largest economy with low cost nancing It is hard to know what the excess reserves of the rest of the world are but suppose that they are twice the level of their short term debt one year We can see how large these excess reserves have grown recently see gure 3 Then it amounts to some 15 trillion and earns perhaps a zero real return if those currencies are expected to appreciate Given that those countries could perhaps earn 6 easily if they invested this wealth this is a large transfer to the US6 Note that 6 of 15 trillion is close to 100 billion As Dani Rodrik has 6Of course another way to think about it is as an insurance policy against future crises and the price paid Introduction FaIl 2008 Figure 3 Exoess Reserves Beyond 2X Short Term Debt Due Within 1 Year Developing countries pointed out this is comparable to the gains thought to be achievable from the next round of trade hberah39zation to global foreign aid or to spending on key social sectors in a number of oountlies Conelusion 1 Thus we hd the world economy rh the oddest of artwdtrohs the rest of the world prowrdrho lowrcost hdhee to rte tweet power Absent hweledr wedpohs how ooh thrs hoppeh 2 Some Questions of International Finance 0 International nanoe a oonsequenoe of multiple eurreneies e multiple at eurreneies e less of an issue with oompeting oommodity eurreneies a It is also a oonsequenoe of rhterterhpordl trdde to avoid havmg to go to the IMF Inczoductlon Fall 2008 e Thls could be the subleec ofclaole cheoly but we scuoly ll because chls claole often ls manlfesceol ln Secuuhes 1c ls a subject of nance These ows ale vely lalge much lalge chan claole on a gloss basls Flgule 4 shows that gloss capltal ows ale abouc o co 7lees nec ows And ll ls pllmallly gloss ows that unsettle malkecs rlnmza umslnnslcalllmrluwlmlallll lll nu mm mm new ll Duranquot 7 mn was my Mmz mmmllnnlsllslllr Mlmslnelnmelsslm lolllllnswslmmnllssllllnnllllmusm nunslsllmlmslsnllaellllnllllnnlnlm Flgule 4 1c ls che lncelacclon of the two that ls leally lmpolcanc e the face that many counclles bouow ln cuuencles that dlffez fzom then domesch ones Thls 15 what sets the stage f0 cuuency anol nanclal ellses Globallzaclon ls noc new As we shall see the lasc pan onhe 19Lh eenculy was che peak of globally lnceglaceol capltal malkecs e A scyllzeol Vlew ofche hlscoly of capltal ows ls seen ln guze 5 Thls ls a styllzed Vlew but ll ls baseol on what we obselveol ln global oullenc aeeouncs Nome that capltal ows wele vely lazge uncll 1913 Then Lheze ls a blg Lzough that oloes noc leally leeovel Llll che mld71980 s though che poscrlg45 pellool ls beccel chan the 1930 s Olwlously WWl enoleol che golden yeals of wollol capltal moblllcy The 39 Fall 2008 Gold Sznzdard 13343 2914 Float 197172500 3mm Vams 294571 19J5 2quot 1320 1900 1920 2an 1955 195 In D Figure 5 A Schematic History of Capital Flows Depression years though WWII were very bad The big recovery starts with the oil shocks Only recently are We back to the levels of pre7WW1 7 This tells us that it is not only technology that fuels globalization and capital ows7 but also institutions 0 International Financial System is crucial to efficient organization of international economiesI There are several periods to identify 7 rst system is bimetallism 7 gold standard this is the peak of the integrated global capital market if it Worked so Well7 Why can t it be put back together This is a very good question 7 WW17 Depression breaks the system 7 Bretton Woods Works until it breaks down in the Wake of Vietnam War and OPEC u is globalization the culprit Introduction Fall 2008 7 hard to gure since international capital mobility was very high in the 19th century 7 Does globalization cause debt crises or does it enhance growth in poorer countries a breakdown has led to our current non7system of oating and currency areas 7 Some major countries oat like US and Japan 7 Some major countries have eliminated their currencies to form a union the euro 7 Some countries peg to the dollar or another major currency eg China and many Asian countries 7 Some countries have dirty oats or managed exchange rates 7 Some countries have currency boards 3 Brief Tour of Recent US Data It is useful to look at some recent US data to get a feel for what international nance is about We can look at bilateral exchange rates which are simply the price of one currency in terms of another In gure 6 1 have plotted the price of one dollar in terms of the yen over 5cl191519151519191511915151191511919 20 20 20 7 72 74 76 7E 80 82 E4 86 88 90 92 54 56 98 DD 02 04 Figure 6 Yen7Dollar Rate since 1970 the period since 1970 You can see that over time the dollar has generally depreciated but that it has also been Unlatile This becomes more apparent when we look at the Yendollar rate over a shorter horizon say since 1990 What is striking about gure 7 is how volatile is Introduction Fall 2008 the exchange rate between the two largest economies in the world Notice both shorteterm and longereterm Volatility 8019 15 18 19 19 1B 19 19 19 15 20 20 20 20 20 2 9 5152 93 94 95 56 97 98 95 DD 1 02 03 D4 05 Figure 7 Japanese YeneDollar Rate since 1990 We can similarly look at the dollar 7ECU rate in gure 8 In both pictures the late 197039s and early 198039s stand out as periods of extreme Volatility The ECU is the European Currency Unit a basket of EU currencies and a precursor to the Euro European economies haVe tried to stabilize the uctuations of their currencies amongst each other while letting the basket oat against the rest of the world The EMS was a precursor to the euro It kept the individual currencies but the governments were obliged to narrow bands The system suffered a huge crisis in 1993 when the UK Italy and Sweden dropped out This fueled the driVe to the euro where there would no longer be individual currencies to speculate against7 Notice that joining the euro is still a serious political issue in both the UK and Sweden see section 61 below The latter is soon to hold a referendum on joining All new EU members must adopt the euro Interestingly Italy managed to make it in despite lots of ex ante skepticism And now it is Germany and France that Violate the rules Besides looking at bilateral rates it is useful to look at effective or tradeeweighted exchange rates Looking at a single currency is often misleading as the current account balance is the outcome of trade with many countries Tradeeweighted exchange rates giVen an aVerage for a he euro had already been agreed to m the Maastricht treaty before the EMS crisis Indeed uncertainty over the eetahhahmeht of the euro fueled the crisis 39 Fall 2008 USDullars to on EuFOFIan Currency Unit Figure 8 group of countries based on their shares of trade with the US the case of a tradeweighted exchange rate for the dollar For example7 the Fed calculates an index of the dollar s value based on 10 major currencies If we look at this picture we see that there are two periods pre71971 and post71973 In the former period the dollar was rather stable8 In the period after the collapse of Bretton Woods we see much greater volatility In particular7 we see a huge appreciation in the mid71980 s that followed depreciation in the late 1970 s7 and preceded an even larger depreciation in the late 1980 s This is clear in gure 9 which plots the trade weighted value of the dollar since 1973 Notice the long swings in this rate It is clearly not rapidly moving to some longerun equilibrium rate One might think of various reasons for this behavior in the posteBretton Woods period Of course7 the elimination of xed exchange rates should have led to more volatility But should it have been this large One factor7 we shall see is that in ation became much more volatile post719737 and differences in national in ation rates play an important role in the determination of nominal exchange rates 4 Current Account We might also look at what happened to the current account during this period We will proceed to de ne this much more carefully below For now I just want to point out some 8 he shock1n194915 due to the revaluation of the pound and subsequent realignments of several currencies traditionally tied to the pOuD 39 Fall 2008 lllyl nuwxwmuvnmmi sew 2m 1919151915151915151815191915 20 20 2 7 75 77 75 6183 85 87 89 9153 95 97 55 H1 quot3 05 Figure 9 TradeeWeighted Exchange Value of the Dollar Against Major Currencies patterns Suf ce it for now to consider the current account balance as the sum of net exports exports minus imports of goods and services for a country plus any net transfers It is a measure of a country s relations With the rest of the World If a country has a current account surplus it is acquiring assets from the rest of the World In the opposite case its debt is increasing In gure 10 We have the US current account from 1960 to the present You can see that the CA balance used to be near zero but slightly positive Of course this gure gives the absolute balance It is more useful to look at the current account as a share of GDP as in gure 11 We used to be a large international creditor and We earned net interest income which offset a tiny de cit in the trade balance9 Recently it has become negative and quite large Now We are the largest international debtor in the World10 If We look at the period from 1960 to 1973 We see that US current account balances used to be rather small but on average slightly positive Rarely did the balance exceed 1 of GDP until the 1980 s During this period the overall US position was a net creditor to the 5In 1985 US data showed that we had become a net international debtor for the rst time since WWI In 1989 US data again showed that we had become a net international debtor for the rst time since WWI How is this possibiev In the interim a revision had raised the imlue of US assets overseas by recognizing appreciation of eapitai assets This points to a probierri With such data We collect better data on what ows in that on the value of what ows out 10In 1996 the market value of net foreign wealth was 753831 I bilhon about 12 of GDP This was larger than the total foreign debt of aii Western Hemisphere developing countries But that debt represented 37 of their collective GDP s Innoductlon Fall 2008 Ealancl ol Paymlnts Ealancl on Currant Account Billions ol Dollars S n Spenser tapNutmrrmamastmaw l9 l9 l9 l9 l9 l9 l9 l9 l9 l9 l9 l9 l9 l9 9 2a 2a re quotsate c art emu l9 l9 l9 l9 9 en 62 to as ea 70 72 70 vs 7a su s2 at at as an 92 so 96 9a an 02 Flgure 10 rest of the world In the 1980s we see rather huge de clts 1n the current account gures of almost 4 of GDP When the current account de clts got so large 1n the mld7805 1t vms qulte a shock Now they are even larger 2 These are very large magmtudes 1n terms of recent hlstory hut slmllar gures were experlenced 1n the 19th century Flgure 11 Current Account Balance as Share of GDP We can also conslder the current account an global context Suppose that we look at the change an the current account balance across economles between 1996 and 2004 The mam thlng we observe as the huge lncrease 1n the US current account de clt and the blg swlng nNoLlce a rather smular pattern fox Germany Japan and the UK 12Netlce how the CA lmpzoves dunng receaslens Why ls thls 11 Introduction Fall 2008 Axxtmlza Canaa39a Korza Thatand Figure 12 Global Current Account Balances 1996 and 2003 Billions of US dollars in the developing countries current account balances 1t seems rather odd that developing countries would become large net lenders to the rich world But this seems to be the case One reason this occurred is the currency crises of the late 90 s Developing countries reacted by building up reserves Oil producing countries have also had big changes in their current accounts as oil prices were much lower in the mid 90 s Notice also that some advanced countries have large surpluses notably Japan and Germany One reason is saving for their demographic problems to come But then what about 1taly One other thing to note about the data in gure 12 is the statistical discrepancy Shouldn t they all add up to zero We will discuss this shortly 1s a large current account de cit bad Often it is spoken of that way But then it is interesting to note that Japan 7 in a 8 year economic slump 7 has a CA surplus of 25 of GDP Russia which some term an quot economic basket casequot has a CA surplus of 137 of GDP 12 Introduction Fall 2008 25 billion13 Who is better off The country that is lending 13 of its GDP to foreigners7 or the country that can borrow that from the rest of the world That is an interesting question The other side of the large current account de cit is a surplus in the capital account It is interesting that most people seem to think that a current account de cit is bad and a capital in ow is good But these are two sides of the same coin This is eVident in gure 13 which giVes the capital account since 1960 Notice how the patter ofthe current account is reVersed Notice also the Very recent downturn Many people speak of the current account de cit as being nanced by the capital in ow Then they worry what happens if the latter dries up Of course7 we could also say that the current account de cit is caused by the capital in ow The excess demand for US assets causes a current account de cit Spoken this way the CA de cit is a sign of strength Think of it this way7 who is better able to borrow General Electric or a poor family in an urban ghetto Note that the longeterm debt of GE is around 82 billion at the end of 2000 Foreign Assets in the us Net Capital In owmg Billions ol Dollars SA 35 392 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 22 22 Figure 13 The reason why capital ows into this country is because domestic investment exceeds national saVings The current account de cits 7 the capital account surpluses 7 re ect the spending boom in the US economy14 We are spending more than we produce and the rest of the world is nancing it They do this Via our current account de cits Our export industries are crowded out Notice that popular opinion might explain our trade de cits by improper 18Perhaps the appelation of basket ease 1s misleading 14For much of the 1990s this was due to a boom 1h investment spehthhg as we shall see Slnce the tech bubble started investment SpeDdJDg has fallen hot so has the public savings 13 Introduction Fall 2008 trade practices in other countries But in fact they are the result of our desire to live beyond our means and the willingness of the rest of the world to nance that This raises the important question of how is the US able to get away with such large de cits seemingly without end Other countries would certainly face a crisis in such a situation 1s it important that the world uses the dollar as the international currency Will our de cits erode this role Given that exchange rates were allowed to oat after 1973 it may seem puzzling that the current account balances are so large in the latter period One may have suspected that with markets determining exchange rates that exports and imports would be brought into balance 1n fact the opposite seems to have happened The important point to draw from this is that the current account represents more than just trade behavior with the rest of the world 1t also depends on savings and investment Large scal de cits combined with low national savings may lead to net borrowing from the rest of the world in other words a current account de cit We will examine this in more detail The huge uctuations in exchange rates is one reason why many economists call for a return to xed rates 5 Recent Events Recent events include the Asian currency crisis and the emergence of the Euro We can see the effect of the currency crisis in a super cial way by looking at the exchange value of the baht We observer the huge depreciation of the baht in 1997 in gure 14 This triggered the Asian u and it eventually spread throughout emerging markets Similar problems are evident in Brazil and Turkey today You can see the large depreciation of the baht We want to understand the causes conse quences and the reason for contagion This is an example of a sudden stop and a reversal of capital ows What we have is a sudden reversal in the ows across economies and this is re ected in the price To see this more clearly let us look at current account balances in developing and emerging economies in gure 15 Notice that for these economies de cits mean in ows of capital You can see that 14 Introduction Fall 2008 Thai Baht to one US Dollar Exchange Rate Economuc Chart Dispenser http 9 19 19 19 19 19 19 19 19 19 2U 2U 20 n 91 92 93 9a 95 9s 97 9e 99 an 01 E2 Figure 14 the 1990 s were especially good for these economies 7 capital owed in But in 1998 there was a sudden reversal in the direction of these ows You can also see the earlier debt crisis of the early 1980 s though the magnitudes are much smaller One question we will want to ask about is why the size of these ows are so much larger since the early 1990 s and is this good for the world economy Figure 15 Current Account Balances Emerging and Developing Economies 6 Argentina Argentina is a case in point why this is important A currency crisis has turned into an economic and social crisis Governments replaced A few days ago Sept 1 the interim agreement with the IMF expired Perhaps there will be a default on outstanding loans to the 15 Inhoductlon Fall 2008 IMF What happened7 The problem ls evldent when we look at what has happened to GDP ln recent years see gure 16 Argentma experlenced a major depresslon a look at the fall ln output and lts components ln 2002 slnce the trough lt has also experlenced a recover as a result of the depreclated exchange rate that resulted iconsumvllun investment uup Mn ax Mn as Mn nu Mn m Mn n2 Mn m Flgure 16 Consumptlon Investment and GDP ln Argentlna o Argentma ls sufferlng from an even more dlf cult dllemnna How to exlt a currency board7 Clearly lt falled the exam Argentlna ls currently negotlatlng another large program wlth the IMF and there are protests ln Buenos Alres over crlsls pohcles r Argentma has a large forelgn debt a about 128 hllllon or three tunes Its annual forelgn earnmgs It appears that lt cannot pay Its dehts unless lt earns more But the peso cannot depreclate due to Its currency hoard And most Argentmes do not want to lose the currency hoard hecause lt saved the country from hlgh m atlon But thls also makes lt easier for capltal to ow out of the country ln antlclpatlon of default 7 To understand thls we rst need to see why countrles would estahhsh a currency board 39 Fall 2008 Us l Euro Foreign Exchange kale us Dollars to One Euw 92010202024320th 99 O 01 02 03 04 05 DE 11 OOOHPHV D HHH gt m o Figure 17 Dollar price of one euro 61 Euro One of the interesting questions in international monetary economics is when should a group of countries share the same currency Why should countries have different currencies Doesn t this just make trade more difficult The US is a monetary union 7 states do not have their own currencies Now Europe has formed a monetary union What are the costs and bene ts of such arrangements This question is topical again for two reasons First the ten accession countries to the European Union must adopt the euro as a condition of joinging But they are not sure when it will be advantageous for them to join Britain similarly has postponed a decision about adopting the euro The second reason is that some politicians in Italy have begun to ask Whether Italy should drop out of the euro They attribute their economic difficulties to the Value of the euro and they see Italy as facing a conundrum like Argentina Exit from the euro rather than from a currency board but similar problems may ensue All this comes against the backdrop of difficulties in getting the stability pact to operate properly But What is the stability pact and Why was it needed for the euro to Work Introduction Fall 2008 7 International Financial Architecture A major issue is reform of the IMF Some question Whether the IMF introduces more risk into the system The issue is moral hazard Another criticism is that IMF remedies With regard to crises are too painful Some look for reform to make the system work better Is it broke HOW to x it These are complex questions and require an examination of international capital ows There are related questions regarding the Whole issue of globalization Should the IMF encourage nancial liberalization in emerging markets Do international nancial institutions make the system better or worse The Current Account Balance Part One Barry W lckes Econ 434 Fall 2008 1 Introduction The current account balance is a measure of a country s transactions with the rest of the world It includes all current transactions hence the name lts counterpoint is the capital account which measures transactions involving lOU s We will look at the capital account when we turn to the balance of payments which includes both the current and capital accounts Now our attention is on the determinants of the current account 1 00 0 00 71 00 72 00 V3 00 V4 00 75 00 76 00 Figure 1 Current Account Balance of the US as a Share of GDP One thing we know is that the current account balance of the US is negative and that this de cit keeps growing see gure 1 We want to understand why a country would run a current account de cit and what are the implications This will enable us to later study how a country can adjust to restore balance to the current account If a country runs a current account de cit it must be borrowing from the rest of the world Hence if the US has been running current account de cits for some time it must mean that Current Account Part one Fall 2008 Source BEA International investmem Posmun Figure 2 US Net International Investment Position share of GDP our debt has increased or our net international investment position has decreased1 This is evident in gure 2 One can see that until the mid71980 s the US net position was positive 7 the US was a net international creditor Since then however the US has become the world s largest debtor So the question about sustainability of the current account de cit can be framed another way for how long will the rest of the world allow the US to keep going further into debt There is a limit to how long a private agent can do this What about a country What about a reserveecurrency country One way to think about the net international investment position or net foreign assets of a country is just the cumulative sum of the current account ie NFA 210AM where N FA are net foreign assets at time t and GA is the current account balance of the country at time t This would be good intuition a person s debt is the cumulative total of past borrowing and lending But there is an additional consideration changes in the value of assets Valuation effects can occur because the returns on assets we own abroad may differ from those foreigners own here and also from capital gains and losses due to movements in the dollar Normally one would think that these factors would balance out 7 why should a t t Vin tm nt position is L i r the current account This Would be good intuition A person s debt is the cumulative total of past borrowing and lending But there is an additional consideration changes in the value of assets Valuation effects can oeeur because the returns on assets We oWn abroad may differ from those foreigners oWn here and also from capital gains and losses due to movements in the dollar It turns out that these valuation effects are quite Current Account Part one Fall 2008 country enjoy such an advantage But the US is a bit different after all the dollar is the world s reserve currency The US borrows in its own currency something other countries cannot do2 And other countries may forsake returns to invest in a safe haven like the US It turns out that these valuation effects are quite large so it is worth some mention It is interesting to compare the naive measure with one that corrects for differences in returns and capital gains and losses In gure 3 we have the naive and two estimates that include these valuation adjustments Several things are apparent from the gure First the US in the mide50 s was a huge net creditor with a stock of NFA equal to almost 15 of GDP while now the US is a big debtor the stock of NFA almost 726 of GDP Second notice that on the naive measure the US becomes a net debtor sooner than actual 7 in other words the exorbitant privilege has helped our true status Third when the US was a creditor the naive measure overstated the true position 7 it made the US net foreign position seem more positive and now the opposite This last point means that the valuation effects have been stabilizing lll 5560657075 umulale rem Account FA llP market value Figure 3 US NFA Relative to GDP To see this de ne the valuation effect as simply the difference between our quottruequot net foreign assets NFA and the naive measure VE NFA 7 21 GAE The valuation effects 2De Gaulle was reputed to have ealleel this an exhorbltant prlvelege but apparently ll was his nance mmlaler Glscard d Estamg who really sad ll Current Account Part one Fall 2008 55 60 GS 70 75 ED 5 90 85 00 Figure 4 Valuation e ects are displayed in gure 4 and we can see that during the Bretton Woods period they were in fact negative while since the breakdown of Bretton Woods they are positive Essentially valuation e ects were negative when the US was a net creditor and are positive now that the US is a net debtor The interesting question is to explain the source of the privilege but we leave that for a bit later Now we turn to the determination of the current account balance The current account balance is comprised of the trade balance and other current types of transactions such a ows of investment income tourism and foreign aid one important determinant therefore is the real exchange rate which is the relative price of foreign goods relative to domestic goods But that puts the cart before the horse It is most useful to start by considering an intertemporal framework that is by thinking about choices over time We can ignore for the moment the relative price of goods produced in dj erent countries and focus on goods produced at dj erent points of time We can learn a surprising amount with such a simple approach 11 The Cumnt Account in an Inte39rtempoml Framework Typically we think about trade in goods and services when we speak about the current account but this is not the simplest way to begin More basic in fact is trade across periods intertemporal trade This gives us an alternative way to think about the current account Current Account Part one Fall 2008 from the conventional focus on imports and exports It shows us a different causal factor with regard to the current account And it is very useful for thinking about capital ows Consider a small economy with identical consumers They choose consumption to maxi mize utility UMQM MQ D where is the discount factor Agents desire to smooth consumption and this behavior extends to the economy as a whole3 lncome in each of the two periods is given by Y1 and Y2 We can think of these at rst as endowments 7 manna from heaven If the economy were closed then the problem would be trivial C1 Y1 etc But if borrowing and lending are allowed then consumption possibilities are subject to the intertemporal budget constraint 02 Y2 C Y 11T 11T Consumption does not have to be at the endowment point but can be at a preferred point as in gure 5 Welfare is clearly higher due to access to world capital markets We maximize equation 1 subject to the constraint The rst order conditions imply 01 1 7 u02 3 01 ucz i 1 an 71 Q where us1 is the marginal utility of consumption in period one Expression 4 is just the familiar condition that the marginal rate of substitution between the present and future con sumption and the right hand side is the price of future consumption in terms of present consumption Expression 3 is called an Euler equation Notice what it implies At an optimum the agent must be indifferent between consuming today or tomorrow Otherwise it could not be 3We abstract from differences among households in the economy to focus on differences across economies Current Account Part one Fall 2008 an optimum Now suppose an agent reduce consumption by one unit this period Utility would fall this period by the marginal utility of consumption ucl the left hand side of But consumption would be higher next period By how much A unit saved today raises consumption by 1 7 next period And so utility rises by 1 7 ch But we have to discount this back to the current period so we multiply by and this gives the right hand side of Now suppose that then it follows that consumption would still equal income in 1 lw each period We can call this interest rate the autarchy rate of interest 7 94 Notice that is the rate at which future consumption can be transformed into present consumption and is the rate at which we discount future over present consumption When these two are equal we do not want to alter our consumption pro le Everybody has an autarky rate of interest though it will be different for different individuals or economies It is a benchmark interest rate that we can use to assess whether the economy will borrow or lend in the current period Whether this economy will engage in international borrowing or lending depends on the actual terms of trade in our case the world interest rate Suppose that the world interest rate is less than the autarchy interest rate 7 lt Ta This means that the premium required to induce people to smooth consumption is greater than what can be had with international lending Hence current consumption will rise relative to autarchy while second period consumption will decrease Thus we will have borrowing in period one equal to B1 C1 7 Y1 In the next period the borrowing must be repaid Hence C2 Y2 7 1 7 B1 Now the current account balance in an economy is the change in the value of its net claims on the rest of the world In our simple model with only consumption the current account balance is equal to national savings which is negative in our example In a model with investment the current account would equal the difference between savings and investment In general if At is the economy s net foreign assets at the end of period t then the current 4Notethatif 11w then1raandthusr 717116716 m Current Account Part one Fall 2008 A 7 Q QK0MQK X C C 2 aozn Y z Y 1Jr Z 1r gt K Yl AzC1 C1 CAI Figure 5 Consumption over Time and the Current Account account can be de ned as CAt A liiu 6 KHArC 6 NXrAt 7 Where NX is the net exports exports less imports also called the trade balance Remark 1 It is useful to recall national income accounting In this model without inuestment 07 gouernment we have only two uses for output consumption and net ewports Hence YECNX The economy Will run a current account de cit today the rest of the world acquires claims on the economy s future income Next period the economy s current account Will be in surplus this must occur in a two period model That is the current account in period two Will be equal to the negative of the current account in period one plus interest CA2527 A202Y27 Y2C2C2 8 Current Account Part one Fall 2008 But in a two period model A2 must be zero so CA2NX2Y2702 in period two the current account is equal to net exports as there is no further lending But we know from 2 that C2 Y2 7 1 rC1 7 Hence NX2 52702 323271r017Y1 71rY170171rNX1 9 NX2 NX110 10 the present value of the country s borrowing must be zero This is just an intertemporal budget constraint5 Remark 2 Strictly 10 is true because we started the rst period with zero assets More generally we should assume that we enter the initial period with some leuel of assets that could be positiue or negatiue Suppose we entered period one with net foreign assets equal to A0 Our intertemporal budget constraint would thus be 02 Y2 C Y 11r 11r 140 Thus our lifetime resources are augmented by whateuer assets we are born with or debt burdened with if A0 lt 0 Second7period consumption is now 02 Y2 7 1 r01 7 Y1 7 A0 Then the last line in empression 9 aboue is now NX2 17 Y1 Cl17 140 17 NX1 1rAo 5It may be easier to see this by noticing that if a country runs a current account de cit today it will have to repay the debt next period plus interest There will be a debt equal to CA1 and in period two the debt will equal CA11 r So CA2 71 rCA1 or CA1 0 which is just expression 10 8 Current Account Part one Fall 2008 and thus equation 10 is now NXZ 1r JVle l f f flo 11 which says that the present ualue offuture net emports the left hand side is equal to principal and interest payments on initial net foreign assets Thus if we start initially with a debt born with debt A0 lt 0 the present ualue of future net emportss must be positiue If we are born with positiue net foreign assets A0 gt 0 then the present ualue of future net emports can be negatiue Erpression 1 will be useful for thinking about the US Currently we have an initial leuel of debt Hence the present ualue of future net emports must be positiue So euen if currently we have a negatiue net emports soluency implies that somewhere in the future it will turn positiue We will return to this later 12 Longere Time Horizon ln a model with a longer time horizon we would modify the constraints which would allow periods of surplus and de cit to persist for several periods This is straightforward lt is useful to begin with the de nition of the current account balance CAt AHl 7 At Yt rAt 7 Ct 12 This can be rewritten as 1 JV TlAt Yt Ct At1 13 NX 7 AH1 14 This is true for any period so we can now move this forward one period 1 7 At1 NXt1 At2 Current Account Part one Fall 2008 01 7 NXt1 At2 At1 15 Now use expression 16 in 13 to eliminate At 71 7 At NXt 7 At1 17 NXti 71A 18 and if you do this again you will get NXt1 NXt2 At3 17 17 2 17 27 71 7 At NXt keep doing this and we have NXH1 NXH2 NXH3 AH 71 A NX quot7 7 17 lt1Tgt20Tgt3 Omar Notice that each time we keep moving the net foreign debt term farther to the future Suppose we kept doing this all the way to some T far in the future We would have tT 1 set 1 T 1 7 At 2 1 7 NXS 7 1 H AM 20 5t Expression 20 is interesting The rst term is just the present value of net inquotpo7 ts6 The second term is the present value of net foreign debt sometime far in the future Let s examine this term rst How should we think about this quotterminalquot value of net foreign assets 1n a nite horizon model we know this would have to be zero we cannot have negative net assets in the last 6Or the present value of the negative of net exports Or the present value of the negative of the trade balance Current Account Part one Fall 2008 period of life since there is no future in which to pay it back But it could not be optimal to have positive net foreign assets in the last period because we would never get to consume So in a nite horizon model we would have something like 1 T TAtT1 0 Of course this can be true only if AHTH 0 Now in the in nite horizon we just let T gt 00 As T gt 00 we require the present value of future net foreign assets to go to zero lianoo AHTH 0 7Why These considerations imply that our intertemporal budget constraint can be simpli ed It now can be written as tT 1 set 17 At 2 1 NXS 5t so the present value of future trade surpluses is equal to the initial debt we start with The key principle is that periods of de cit can only be sustained if lenders expect offsetting future surpluses We shall see in fact that for a country to be able to borrow lenders must believe that the intertemporal constraint expression 10 or its equivalent will be satis ed It is when lenders no longer believe that it can be satis ed that they stop lending If they stop lending current account de cits fall immediately so the constraint is satis ed but in a rather painful way 7Why There are two cases to consider 0 If lianoo 7 TAtT1 lt 0 we would be running a Ponzi scheme8038ltp typequottexparaquot tagquotBody Textquot gtCharles Ponzi duped investors by offerring incredible returns7 which he at rst paid from the deposits of new investors He originally planned to use the resources to arbitrage inter national postage stamp prices But he never did Once the source of new deposits slowed7 his scheme unravelled But his name is now attached to the Ponzi game If you examine 20 it is apparent that with lianoo AtT1 lt 0 that the present value of what we spend is forever greater than what we produce Foreigners would be lending to us continuously without end Obviously our debt T would have to grow faster than the rate of interest for lianoo 141M AtT1 to be strictly negative But they would not do so7 since they could consume resources themselves No economy will provide resources to another for free forever Hence7 we cannot have lianoo 141M AtT1 lt 0 What about the opposite what if lianoo T TAtT1 gt 0 This would mean that the present value of all the resources the home country uses never converges up to the present value of output We would be making an unrequited gift to foreigners This cannot be optimal We would never consume all we produce Since we have shown that the present value of net foreign assets cannot become strictly negative or strictly positive as T goes to in nity7 it follows that we have to have the condition that lianoo AtT1 0 Current Account Part one Fall 2008 As we shall see determination of exchange rates and interest rates in the global econ omy are determined by these key factors the time pattern of income the desire to smooth consumption and expectations about future consumption and income possibilities9 15 Investment So far the only way to provide for future consumption was to hoard or to lend to another country at the world interest rate 7 Now suppose that economies can also invest 7 that is accumulate capital goods Capital goods may be purchased because they yield a return 7 output is higher if more capital is used lnvestment is the process of increasing the stock of capital The decision to invest involves a comparison of the rate of return from investing with that of lending We have production function that relates output to capital FK We note that the marginal product of capital is positive notationally F K gt 0 but that there are diminishing marginal returns that is F K declines as K increases How does a country raise K By investing in other words by using some of the endowment to raise tomorrow s capital stock Consider gure 6 with initial endowment point A By using some of Y1 for investment we can achieve the production point 13 The difference Y1 7 Q1 is equal to rst period investment The point P is the pro t maximizing production point given the interest rate You can see that by noting that any other point on the curve AB with the same slope has an intercept that is to the left of point E Point E is the present value of production at point 13 and point D is the present value of the endowment point A Hence you can think of the difference E 7 D as the present value of the pro ts from investing until point 13 9The rst discussion of consumption7smoothing behavior is probably the biblical story of Joseph in Egypt Recall his forecast dream about 7 good years followed by 7 bad years He proposed storing a fth of grain production each year of plenty was appointed Prime Minister by Pharoh and helped Egypt avoid famine Notice that he engaged in domestic investment at a zero rate of return prior to depreciation Why not invest abroad Interest rates in Babylonia at the time were 2033 At such rates consumption could have been higher in all periods That is why didn t Joseph advocate international consumption smoothing Presumably it is because of the insecurity of such contracts at the time Similarly in the fall of 2002 Brazil had trouble borrowing even though interest rates are very high compared with world rates When the central bank of Brazil tried to roll over its debt the auction opped after election7wary investors demanded interest rates as high as 50 percent for the paper maturing after the Oct 6 vote It is not just the interest rate that counts but that returns related to risk Current Account Part one Fall 2008 Qz Q Y Figure 6 Production Possibilities Notice that we have said nothing about consumption yet The reason is that consumption choices depend on whether or not we can borrow or lend internationally If the economy is closed then we are stuck to consume somewhere along AB In gure 6 consumption in each period is also at 13 there is noway to obtain more resources Notice that consuming along the budget line between point P and E is impossible in a closed economy So in the closed economy case you can see that Y C I which follows since we already noted that Y1 7 Q1 I and we noted that Q1 C Now suppose that we can borrow or lend at the rate of interest 7 then our position is greatly augmented Now investment and consumption decisions in a given period can be separated We can invest more than the difference between current income and consumption We can borrow from abroad We now have gure 7 which has the same production possibilities as in gure 6 but we have added borrowing and lending Given the interest rate and the preferences the consumption choice 6 is separated from the production choice Notice that point C would not be feasible in a closed economy 1 lays outside the production frontier So international borrowing and lending in this case borrowing in period one improves welfare Current Account Part one Fall 2008 Pig Figure 7 Production Possibilities in a Small Open Economy We can see that in period one there is a current account de cit equal to C1 7 Q1 ln period two this is repaid as C2 lt Q210 ln period two we are repaying principal plus interest but we are better off for it given the preferences as represented here What if there was initial debt We would still separate decisions but our consumption possibilities would be reduced by the level of initial debt Suppose initial debt is A0 We know that the present value of consumption is now reduced by 1 7 A0 So given our endowment at point A and the world interest rate production is still maximized at point 13 This leads to a present value of E But we subtract from this the initial debt level and we have point W in gure 8 The optimal consumption C Allowing investment means that we now have two ways in which wealth can be held foreign assets A and capital K Total domestic wealth at the end of period t is now AHl Kt 10lncleecl7 we can see more Since the slope of a right triangle is the rise over the run7 you can see that 1 7 Now it is obvious that CCQ iccAAzl so 32 1 7 7 WhiCh W9 can arrange as CA1 7 or CA1 f f 0 as in expression 10 above Current Account Part one Fall 2008 B I Q2 y Cz 9 Y2 A Q Y C D W E 71 l 214 Figure 8 Production and consumption with initial debt 1gnoring depreciation11 the capital stock evolves according to Kt Kt It 21 We can write the change in domestic wealth or national saving as Am Km 7 A K K M 7 C 7 G 22 where 1 have added government spending G for completeness The key point of 22 is that domestic wealth increases sometimes called accumulation only if earnings exceed spending on consumption government included Now we can rearrange 22 using 21 to obtain the current account CA AH1 7 A K TAt 7 C 7 Gt 7 It 23 Notice that the rst equality says that the current account surplus is equal to net accumulation of foreign assets12 And if we de ne savings St E Yt 7 At 7 Ct 7 Gt then the current account 11Let 5 be the rate of depreciation Then expression 21 stands for the case of 5 0 If 0 lt 5 lt 1 then we would re7write expression 21 as Kt1 1 75Kt It If there is 100 depreciation 5 1 then Kt1 It 12It is important to recognize that this is the negative of net capital in ow Capital ows into a country as it accumulates liabilities The lender acquires foreign assets 15 Current Account Part one Fall 2008 can also be written as CAt St 7 It 24 In words national saving in excess of domestic capital formation ows into net foreign asset accumulation This points to the important point that the current account is fundamentally an tntertemporal phenomenon How is investment related to the rate of interest Notice that a higher interest rate means that the present value of future pro ts is lower 1n the two period model the net return to investment can be written as 7T5 7 t1 25 P t 1 7n where 7Tf1 is expected future pro ts13 A higher interest rate means that p is lower hence the demand for investment should decrease with the rate of interest and rise with higher expected future pro taloility14 This gives us the negatively sloped investment function in gure 12 It is interesting to look at the experience of Norway in this regard In the mid 70 s the Norwegian current account went into large de cit as investment increased to exploit energy resources Savings also dropped for permanent income reasons The increased value of energy resources caused Norway to borrow against higher future income This is evident in the time path of the current account as in gure 9 Separation Theorem and the Small Economy In a small open economy the invest ment decision is separate from the consumption decision Given the world interest rate 7 investment takes place where the marginal rate of transformation is equal to l 5 Suppose that i lt TA Then the country would invest to take advantage of productive opportunities 13Notice that if there were more periods I could sell the capital good But in the twoiperiod case the world ends so the value of the capital good at the end of that period is zero7 and pro ts are the only return 1 fActually what we have actually shown is that the demand for capital goods depends negatively on the rate of interest Investment is the change in the demand for capital goods It is not immediately clear why this also depends on the rate of interest Economists usually assume there are some adjustment costs that explain this We will just assume it Current Account Part one Fall 2008 Fraction of GDP 0 4 lnveslmenl 03 0 2 Saving 01 Current account 02 1973 1976 1979 1982 1985 1983 1991 1994 Figure 12 Norway s savinginvestmem balance 197394 Source OECD Figure 9 Savings Investment and the Current Account in Norway Consumption need not be reduced however Indeed a current account de cit can allow for greater consumption and investment than would be the case in autarchy In gure 10 the optimal production point is at B 9r and the optimal consumption point is at 0 Notice that utility is higher at C than at the autarchy point The economy runs a current account de cit in period I equal to C1 7 Y1 while in period two there is a current account surplus Two important implications follow from gure 10 0 production is more valuable at point 3 than at the original endowment point 0 welfare is higher at point C So access to the world capital market is bene cial for the small open economy 7 production and consumption opportunities are enhanced 14 A TwoiCountry World Economy Dealing with small open economies we could take the world interest rate as given Let us brie y see how our analysis must change in a two country model Abstract from investment Current Account Part one Fall 2008 02 Y1 01 01 Figure 10 Investment and the Current Account and let their be two economies home and foreign with exogenously given endowments Notice that equilibrium in the global market requires YYCC 26 at each date t This is equivalent to the statement that world savings must be zero St 5 0 27 Notice that this is also equivalent because of the absence of investment to the statement that the world current account must sum to zero CAt CA 0 How is the world interest rate determined in this model We make use of expression 27 Notice that savings in each country is an increasing function of 7 Moreover savings is negative when 7 lt TA and savings is positive when 7 gt TA Suppose that 7quot gt TA the foreign country has a higher autarchy rate of interest than the home country Equilibrium in the goods market thus requires that the world interest rate satisfy TA lt 7 lt 7quot This is evident in gure 11 Notice that at the equilibrium rate of interest SH 75F What happens if home output in period 2 increases exogenously This raises the home country s borrowing at every interest rate This amounts to a shift to the left of SS The world interest rate must increase Although the increase in Y2 makes people better off due to increased total output the home country must pay a higher rate of interest this period for its borrowing Current Account Part one Fall 2008 sH Home 3 sF Foreign s Figure 11 Interest Rate Determination in the Two Country Model One can interpret this as shift in the terms of trade The home country imports current consumption from the foreign country The increase in the world interest rate causes the terms of trade to move to the foreign country s advantage The commodity that it exports is now more valuable than it used to be It should be clear that world welfare is enhanced when intertemporal trade is opened between these economies You should be able to show that starting at the autarky points in both countries intertemporal trade raises welfare in each Thinking about gure 11 one might characterize emerging economies as those where Ta is very high and the more mature economies as those where it is lower This ts with the earning consumption pro les of economies as well as individuals The ability to transfer savings from the mature to the young enhances the opportunities of both 14 Investment in the TwoiCountry Model Now let us add investment once again lnvestment in each country is a negative function of the rate of interest This follows from the principles of pro t maximization more below We can plot savings and investment for each economy but note that in an open economy savings and investment need not be equal in each country only in sum We have gure 12 Notice that the excess of savings over investment in the home country is equal to the excess of investment over savings in the foreign country This is what determines global equilibrium 19 Current Account Part one Fall 2008 gt gt IH SH s home sF IF s foreign Figure 12 Global Equilibrium with lnvestment Another way to express this is that world savings equals world investment StSf It 1 28 which is equivalent to CAt CA 0 We can examine the impact of a change in foreign savings in the same way now Consider gure 13 Initially the world interest rate is equal to 7 84 When foreign savings falls to Sf there is an excess demand for world savings at rgv Hence the world interest rate must rise to 7 14 which causes both home savings to rise and reduces the demand from the foreign country Notice that we could equally well describe this in terms of current accounts At 7 84 the home country has a current account surplus and the foreign country a current account de cit When foreign savings falls the current account de cit in the foreign country increases At the old rate the current account de cit in the foreign county is larger than the current account surplus in the home country This causes world interest rates to rise to 7 14 At this new equilibrium world interest rate the current account balance in the home country SH 7 H 751 7 IF the current account balance of the foreign country 15 Global Savings Glut We can use the two country model to investigate some questions about global imbalances The basic feature of the global environment is the large US current account de cit and large 20 Current Account Part one Fall 2008 W 7 1 W v 70 1 SH 81 home 8 1 81 fomgn 3H IH F F Figure 13 A Decrease in Foreign Savings I I 3 5 51 home 51 foreign Figure 14 US Fiscal Expansion current account surpluses in the rest of the world This raises the question of what is the cause of the imbalance Notice that the same pattern of imbalances could arise if the US is the quotcausequot say by excessive scal expansion or if the rest of the world is the cause by saving quottoo muchquot In either case there will be a current account de cit in the US and a current account surplus in ROW There is one major difference with these two scenarios however and this relates to the world interest rate Suppose we start with zero current account balances in both countries at interest rate 7 34 as in gure 14 Now suppose that the US has a scal expansion shifting the investment function to the right Io At the old world interest rate there is an excess demand for funds at 7 84 the US has a current account de cit and ROW does not The world interest Current Account Part one Fall 2008 W p c a b 7 Io I ID 31 home 31 foreign Figure 15 A Global Savings Glut rate has to rise to 7 14 to satisfy the global market clearing condition CAt CA 0 1n the new equilibrium CAt lt 0 and CA gt 0 But the key point is that 7 14 gt Tgv Now consider what happens if the primary mechanism is a glut of foreign savings This could occur either if foreign savings increases or foreign investment falls In gure 15we again start at 7 84 with zero current account balances in both countries Now shift 1 to the left This creates a current account surplus in ROW and to satisfy the global market clearing condition the world interest rate must fall to 7 14 in gure 15 Notice that we have the same pattern of current account balances in the two cases But there is one key difference in the glut case world interest rates are low in the US party case world interest rates are high Current global imbalances are a mixture of both cases The US has experienced a large scal expansion And ROW seems to have an excess of savings over investment The latter seems important because currently world real interest rates are low not high The fact that ROW is willing to buy US iou s at a rapid rate keeps interest rates low and fuels spending in the US do homebuyers thank the Chinese for low interest rates It is rather easy to understand the causes of scal expansion But why a global savings glut One point that will be important to consider is that countries elsewhere are building up reserves to use as insurance against future currency crises Countries that experienced large output losses as the result of the Asian crisis or countries that just observed this want to have reserves they can use in case another crisis is likely Thus they save and hold dollars rather than invest in productive capacity If this is true then the lack of alternative means to cope with currency 22 Current Account Part one Fall 2008 crises is leading to expensive self insurance schemes The cost to each country is the difference between the return to investment and the meager return on US Treasury bills Of course the US gains as we are the quotsellersquot of this insurance 16 The Missing Surplus The world economy as a whole is closed so one would expect that world savings would equal world investment While individual countries can run current account surpluses and de cits overall these must balance out This seems obvious but if we look at the sum of the current accounts from all countries we observe a persistent world current account de cit This is evident in the following table Table 1 Measured World Current Account Balance 1980 1993 Billions of US year World Current Account Balance 1980 385 1981 683 1982 1002 1983 612 1984 734 1985 808 1986 767 1987 623 1988 789 1989 1081 1990 1438 1991 1224 1992 1224 1993 888 1t is also evident in gure 16 which shows that the statistical discrepancy has grown in Current Account Part one Fall 2008 2001 2002 2003 2005 Billions of Dollars 73400 73600 73800 Advanced OtherEmexgmg US 4 Smmucal Economies Mmi 39 an Discrepancy Figure 16 Current Account Balances by Major Grouping more recent times as well Notice that the discrepancies in the table or in the gure are quite large larger in fact than the current accounts of many countries One would expect errors to cancel out if they are random Yet the discrepancies here are systematic the world runs a persistent current account de cit What might account for this One factor could be statistical errors but a little re ection suggests that this cannot account for the systematic bias A second factor might re ect timing Goods that are exported in late December of a given year might not reach their destination until January of the next year Hence the exports and imports may show up in different years If we think about oil exports this could explain why this is so large but it still does not exactly explain the persistent de cit indeed it seems to predict a surplus A more convincing explanation concerns misreporting of interest income lnterest pay ments earned abroad are often not reported to government authorities in the recipient coun try This happens if the recipient wishes to evade taxes But the payor of the interest will report the transfer So there will be a debit in the current account of the payor but not corresponding credit for the recipient who evades This could cause a persistent negative balance Consistent with this explanation is the fact that world interest payments have risen greatly since the early 1980 s As world interest rates declined in the mid 1980 s so did the world Current Account Part one Fall 2008 current account de cit and as world interest rates rebounded in the late 1980 s the world de cit increased again So the pattern seems correct This also is evident in gure 16 since world interest rates have been lower in the recent period than in the 1980 s A recent lMF study shows that in addition to this factor it appears that most of the world s shipping eets are registered in countries that do not report maritime freight earnings to the IMF This accounts for another good part of the de cit 2 Some Dynamics Same Theory An alternative way to see this is looking at the dynamic analysis of the transition to the steady state We continue with a two period model but focus on lifecycle aspects Suppose output is given by Yt AthLiiB This is a Cobb Douglas production function It is convenient has constant returns to scale and diminishing marginal productivity It is useful to write this in per capita terms 7 simply divide through by labor Then we have 371 K I LAK 3L1quot3 A Zr 29 or y AM 30 We can represent this graphically in gure 17 Y AH Figure 17 A Nicely Behaved Production Function 25 Current Account Part one Fall 2008 Agents work consume and save when they are young and spend when they are old Assume they leave no bequests to make life simple What do agents earn We suppose that the wage is equal to the marginal product of labor15 wt 1 i 14ka 31 and the rate of interest is equal to the marginal product of capital 73 Atk l These derive from pro t maximization and are standard assumptions What do these expressions mean Because lt 1 the wage rises with increases in k but less than proportionally This makes sense 7 if you add capital workers are more productive but how many computers can one person use With regard to the rate of return notice that 7 1 lt 0 so increases in k lead to a fall in 7 This also makes sense This is the most important thing to think about these expressions16 Now we further assume that agents consume a of their incomes when young17 So savings is equal to 1 7 001 Capital wears out each period so the capital stock per worker in period t 1 is equal to savings of the young ie kt1 st 1 7 04wt Now substitute from 15To see this note that the marginal product of labor is the derivative of the production function with respect to labor 2 1 7 3 AK L and since k g by de nition it follows that 1 7 AK BL Q 1 7 3 AM 16Notice that 73kt kt Atkfbl Atkf is capital s share of income the rate of return times the capital stock Now add to this the expression for the wage and we get Atkf 1 7 MAM Atkf 9 17This is obviously makes life simpler It follows if utility is given by u c fc a with the budget constraint cl 621 7 1 w The FOO for this utility maximization problem are 171 17a 7 0461 62 7A 1 7 16306 A1 7 1 1 7 1611 0461171621 7 1 which implies that 2 7 1 Now using the budget constraint substitute for 62 and obtain c1 n rgt1lt1 mm 7 cm lm i 011 Cl which can be simpli ed to Current Account Part one Fall 2008 expression 31 for wt We obtain kt1 1 7 Oowt 1 7 500 7 yltkf 32 GUM 33 which we refer to as the transition equation Why is the transition equation expression 32 interesting Notice that it tells us how the capital stock evolves over time More speci cally notice that a higher capital stock today means more next period because it leads to more income and savings but that there are diminishing returns since lt 1 This expression is useful for understanding capital accumulation It also tells us when the process stops that is when we are in the steady state This is the equilibrium where all variables grow at the same rate so the capital labor ratio is constant To nd this value we set kt kt1 in the transition equation 17 107 mmquot 17 am 7 MW 34 where g is the steady state value of the capital labor ratio the value where the transition equation intersects the 45 degree line in gure 18 Notice that if the capital labor ratio is initially below its steady state value kt lt then savings leads to increases in the capital labor ratio Similarly if we start off with too high a capital stock we decumulate until we reach Notice that at E however savings is just su icient to keep the capital labor ratio constant There is no net savings or net investment at this value of the capital labor ratio Current Account Part one Fall 2008 km G06 P 7 I P 7 I Figure 18 The Transition Equation We can see some interesting comparative statics from gure 18 Suppose that the level of productivity At increases This shifts up the transition curve and we have a higher steady state value of k Similarly for a rise in the savings rate We could think of economies having different steady states because of different values for these parameters Now consider the two country world with the US and Japan In gure 19 we show the autarkic equilibrium We suppose that E gt gus which could arise due to a higher savings rate in Japan Notice that without trade in capital Japan would have higher output consumption and savings per person that in the US As long as Japan had a higher savings rate this would persist Now suppose that capital markets are liberalized Now Japanese savers can invest in the US Why would they want to Because the rate of return on capital is lower in Japan with its higher value of k Recall that the interest rate is given by n Atk l so given that E gt US W Atkfff lt Atkfff W5 35 It follows that the Japanese would earn a higher return investing in the US But this would raise capital accumulation in the US and lower it in Japan With open capital markets this process continues until the rates of return are equal in the two countries But from expression 35 it is clear that this occurs when the E gus Notice that this also means that wages are 28 Current Account Part one Fall 2008 km A 45 Ja an k J P 4JS PT I Figure 19 Autarkic Equilibrium equalized in the two countries Economists refer to this as factor price equalization We can see this in gure 20 where we converge to the world steady state capital labor ratio gm How is w determined It is as if there is one country since factor prices are equalized So just sum total savings in each country and divide by total population Letting N be the population in Japan and let at1 be the assets accumulated Then Nat1 NW kt1 N N 36 where this is now the world capital labor ratio How about the world transition equation Notice that factor price equalization implies that wages are equalized in the two countries So asset accumulation differs only by the different savings rates But world capital accumulation will depend on the world savings rate which is the weighted average of those in each country a 37 and the transition equation for the world is given by kt1 1 7 a MAM 38 Current Account Part one Fall 2008 km A 45 EJ Japan World US k gt kt k k W kJ Figure 20 Equilibirium in the Two Country Model and which gives the world steady state in the same way as before This de nes the world transition path in gure 20 and we can obtain the steady state capital stock in a similar fashion as before Note however that in the new steady state the capital labor ratio for each country will be equal to gm If this were not the case then the return to capital would differ in the two countries Since the US saves less than Japan this means that some of the savings required to have a capital labor ratio equal to w will have to come from Japan Thus Japan will have positive net foreign assets and the US will have negative net foreign assets How about the transition to the new steady state Suppose that the world capital labor ratio is greater than its steady state value k1 gt gm To be speci c suppose that initially the US and Japan had equal savings rates so initially the transition curve was the one labelled Japan in gure 21 Notice that at k1 we can see that asset accumulation is higher in Japan than in the US using gure 21 Now let the US savings rate fall The new world steady state is at gm but the transition involves a decrease from E to gm We want to understand this transition To see this start at k1 and read upwards Using the transition curve for the US we can see that assets in the next period will be ags a2J for Japan while the world capital labor ratio will be k2 It is apparent that the US saving is too low agS lt k2 lt aZJ The difference is made up by Japanese investment in the US So the US has a negative net foreign asset 30 Current Account Part one Fall 2008 km Japan VVo d US Figure 21 Adjustment to the Steady State Fall in US Savings Rate position while for Japan this is positive Notice that this will still be true in the steady state given the position of the transition curves in gure 21 2 Bene ts of Capital Mobility When we move from autarky to capital mobility both countries are better off The simplest way to see this is to suppose that Japan and the US are equal in size N N which makes the pictures simpler And continue to suppose that under autarky E gt hug We know that if capital ows are allowed that we move to a new steady state kw where E gt gw gt EUs 1n the new steady state capital ows from Japan to the US The US is better off because it attracts capital and Japan is better off because it earns a higher rate of return This is evident if we look at the production function as in gure 22 In the new steady state both countries have the common capital labor ratio kw so both produce the same output level QW Clearly 3W gt 115 so the US is better off But so is Japan To see this notice that it transfers E 7 gw AB ED to the US It earn a rate of return that is higher than it could domestically This is clear because the rate of return to capital the tangent at point A in the open steady state is greater than that at the autarky level for Current Account Part one Fall 2008 Y A 45 7 Ay c W yAk 8 y A G B yW F n yUS E Bk kUS kW kJ Figure 22 Autarky versus Capital Mobility Japan the tangent at point G Japan s new level of income is thus W Ag gt y because of the transfer of income from the US But notice that the US is also better off net of the transfer because its per capita income rises by DA but it only has to transfer FD BC to Japan Thus Japan gains CG and the US gains FA from capital mobility in the new steady state Capital mobility improves incomes in both countries because it expands opportunities We shall have moment to discuss some caveats to this below What about a small country It is easy to think about a small country in the model The only change in the analysis is that capital accumulation in the small country does not impact the world capital labor ratio So the transition curve for the world is given and changes in the small country effect only its capital labor ratio For example suppose that a small country Benin was closed from the rest of the world and was in steady state with E gt w as in gure 23 Now suppose that Benin opens up to the world capital market Since Benin is small its behavior cannot effect world interest 32 Current Account Part one Fall 2008 rates and since initially its capital labor ratio was higher than gm this means that interest rates in Benin were below world rates So savers in Benin will want to hold less capital and more foreign assets Hence after opening to the world capital will ow out until k1 gm and Benin savers will hold net foreign assets 61 In fact this will happen right away in the model because capital wears out each period Notice that though the capital labor ratio falls in Benin its citizens are better off They are getting a higher return on their savings so they can afford higher lifetime consumption The only odd part of the story is that usually we think of emerging economies as having lower capital labor ratios But then opening tells this story in reverse18 km Benin w aVI y Figure 23 A small country case 21 Caveat Notice that the transition to the new steady state gm requires capital to ow from Japan to the US This leads to factor price equalization Assuming that capital can move freely between the US and Japan is not a bad assumption But this may not be true generally How mobile is capital internationally is an important questions Not only may countries impose barriers to capital mobility but there may be institutional barriers as well Bad policy may 18But see the caveat below Current Account Part one Fall 2008 lead to large risk premia which must be paid to attract capital to emerging economies One reason for this may be currency risk something we will discuss at length Another point to keep in mind is that we have assumed that productivity A is equal in both countries This is unlikely to be true especially for developing countries We consider this below in section 23 22 Net Foreign Assets We can say something else about net foreign assets and the trade balance First note that net foreign investment the current account balance in any period is equal to the change in US net foreign assets Kf between periods If Kf t1 39 Now if we started in autarky in period 0 then Kg 0 With open markets we know that for the US Klf lt 0 as the US will import capital from abroad That means net foreign investment will also be negative given expression 39 Eventually we will reach a steady state however and then th 1 th by de nition So eventually net foreign investment will be zero To recap then if starts negative and is zero in the steady state Now look to the de nition of the current account If X 7 M nth 40 It follows that in period 0 we must be running a trade de cit Xi 7 Mt lt 0 Why Well we know that of lt 0 and Kf 0 so from expression 40 there must be a trade de cit Can this continue forever Clearly the answer is no In the steady state we have seem that if 0 But we have also seen that in the steady state th lt 019 Then from expression 40 it follows that Xi 7 Mt gt 0 We can see this graphically in gure 24 We are in autarky until to With opening we have negative net foreign assets 7K1 and negative current account 7X0 7 M0 Eventually 19The important point is that K is the stock of net foreign assets and I is the change in the stock of net foreign assets In the new steady state the stock is constant and it is negative 34 Current Account Part one Fall 2008 net foreign assets reach the steady state level if at time E In the new steady state clearly AK I 0 But with F lt 0 7 lt 0 So clearly we must have Xi 7 Mt 77 gt 0 Figure 24 Adjustment to the Steady State The intuition is clear Initially the US runs a trade de cit to import capital But the US must pay interest on the capital Since net foreign assets are negative in the steady state the US will have to pay interest each period Hence in steady state the US must earn a trade surplus to pay Japan the interest on the capital they invested If you have followed the argument to this point you may wonder about the path of the current account Itf It starts at zero then becomes negative then rises back to zero and stays there forever This may seem to violate the intertemporal budget constraint Shouldn t the current account be positive in the future to offset the de cit in the initial periods This is certainly true in any model with a nite time horizon In a nite horizon model there is a last period and nobody is ever going to plan to hold positive debt after death since you cannot get paid back after you are dead If we know that next period is the last period we will arrange our affairs so that accounts are balanced when time is up But in an in nite timehorizon model the intertemporal budget constraint is a bit different There is an in nity of future periods You can always borrow this period and pay it back next period That is you roll over the debt as long as people will lend to you When will they lend to you As 35 Current Account Part one Fall 2008 long as you can service the debt The constraint is now that the debt not rise so fast that it cannot be serviced If the debt grew faster than the economy for example then eventually the debt would be so large that interest payments would exceed production 7 an impossible situation20 But if the debt is constant and the economy is growing the burden is falling each period making repayment easier In the case we consider net foreign assets are constant in the steady state Since it is constant the present value of this amount is going to zero 23 A Rise in Productivity What about an increase in productivity in the US To make life simple suppose that initially Japan and the US have the same savings rate productivity level and technologies and that we are initially in steady state equilibrium Then we know that E U5 and HUS mfg AtkEf 73 41 Now suppose that Aim gt A2 This will cause the transition curve to shift up for the US At the initial capital stock the rate of return is now higher in the US than in Japan Japanese savers will want to invest in the US rather than in Japan which will increase the rate of capital accumulation in the US and speed the adjustment of the capital stock Japanese savers still save their income at the same rate 04 as before But they hold more foreign assets and less domestic capital Notice that immediately after the productivity change we must have TtUS AgskE gt Agki Ti because Aim gt A2 and nothing else has changed The only way returns can become equalized is if 121 rises21 This raises the return to investing in Japan and reduces it in the US So Japan will spend less domestically and acquire more foreign assets In other words its current account balance will improve 20This would be a Ponzi game 7 a process that is only feasible if one can nd an increasing number of gullible people each period But the number required would be exponential That is why a Ponzi game always collapses Economists thus refer to the intertemporal budget constraint as a noiPonzi game condition For more on Ponzi see httpenwikipediaorgwikiPonziischeme 21 Notice that this means that an improvement in technology in a country leads to more capital accumulation After the fact we would observe that y increased and that k increased We might like to know how much of the growth in income was due to technology and how much to capital accumulation But our measurement could be distorted by the induced investment that was the result of the improvement in A Why is this important Because in practice economists measure A as a residual after measuring the effect of the growth in k on y 36 Current Account Part one Fall 2008 Since we started with 41 net capital ows were zero in the initial equilibrium The increase in productivity will cause a net capital in ow so thH gt th for Japan and thH lt th for the US That is Ifquot gt 0 and IZUS lt 0 This follows because Japanese savers are acquiring more US assets than they are selling and vice versa From 39 and 40 it follows that the current account in Japan must become positive and in the US it must become negative The deterioration of the US current account is of course just another way of noting the in ow of foreign capital 7 the net capital in ow The current account de cit is enabling the US to adjust to the productivity improvement Japanese savers whose preferences recall are identical to American savers preferences will hold more US assets to improve the average return on their savings To do so requires them to accumulate foreign assets and this can only be done through current account surpluses 1n the steady state E and F115 will be constant so no further net foreign accumulation is necessary The adjustment of the current account and net foreign assets looks the same as in gure 24 Future US current account surpluses are needed to repay the current account de cit This response of the current account to a rise in productivity may be a good explanation of why the US had a current account de cit in the 1990 s Capital owed to the US in response to a rise in productivity This seems less likely to explain the situation in the last several years as is evident in gure 25 You can clearly see that investment was increasing in the 1990 s but that it has declined as a share of GDP since 2000 Meanwhile there has been a big decline in net public savings In the new steady state output is higher in the US than before This new higher level of output allows the US to service the debt or transfer the income on foreign owned capital to Japan This transfer allows Japan to have higher consumption than would be possible in autarky since in that case Japan would not be able to share in the productivity gains in the US Is the US also better off in the open case Certainly 1n the autarchic case there would be less savings available so it would take longer to get to the new steady state E The present value of consumption would thus be lower With open capital markets we get to the new steady state value sooner so total consumption possibilities are increased The Japanese 37 Current Account Part one Fall 2008 1970 97 1274 me ms 193 7932 1954 1555 ISBB team I952 ass L39lES 39958 me 232 In u n H a Source BEA US International Transactions Figure 25 US Savings and Investment 19702003 obtain some of these gains but not all 7 will decrease Thus the interest differential will fall until Notice that as 1 4ka increases we reach the new steady state In the new steady state we must have E lt Egg It is the capital stock that adjusts to the difference in productivity levels If these differences remain so will capitalelabor ratios That helps explain why capital ows do not equalize capital labor ratios in the US and India If you ignored the differences in productivity then you would expect the return to capital to be higher in the poorer country as it has less capital Then you might expect capital to ow from rich to poor countries This does not seem to happen One reason is risk of course and we shall have lots of reasons to discuss this But another is productivity and it is worth a mention here A little arithmetic will go a long way right now me be than Japan s clearly depends on p which determines the rate at which the interest rate changes as k does 2 Notice that now we have different steadyrstate capitalrlabor ratios in the two countries This was not the case when we looked at different savings rates The reason as that differences in productivity affect the marginal product of capital So for factor pnee equalization k s will have to d er 38 Current Account Part one Fall 2008 First let us suppose that there were not differences in productivity India s per capita income is about that of the US If AIndZa AUS it follows that 55 k5 India 15 Now a good estimate of capital s share of national income would be 04 a rough average of the two countries This would imply that the capital labor ratio in the US is 1525 m 871 times greater than it is in India This is obviously way too high It would imply that we save at a rate per worker that is 800 times higher than that of India Moreover if the capital labor ratio were really this much higher in the US than in India the return to capital in India would be about 58 times higher24 But this should mean that capital should ow from the US to India at quite a rapid rate Some does but not that much25 Why One reason could be TFP differences AIndZa lt AUS would alter the rate of return calculation26 Explaining these differences is one of the most important issues in development economics But we will ignore them here for the most part 24 War and the Current Account War provides an interesting way to test some of the predictions of the model During a war expenditure rises above its long run level while savings typically decreases Future income is borrowed against to ght the war It is a period of temporarily high spending so we would expect the current account to deteriorate 1n non belligerent countries on the other hand the terms for lending improve In terms of gure 11 the SS curve shifts to the left for the belligerents The world interest rate must rise This increases the return to the neutral countries from lending We should expect the current 24To see this note that if we ignore A the marginal product of capital per worker is 7 le8 1 From expression 30 it follows that k ylB Now using this in the expression for 7 we obtain 7 y 71 Since yUS 15 yIndia we have Tfndia 717515 Now 151395 is about 58 so the rate of return would have to be 58 times higher in India than the US 25This is sometimes referred to as the Lucas Paradox Robert Lucas rst pointed out that capital ows to developing countries were too small compared with predictions of standard economic mo e s 26You can see this by taking the opposite assumption TUS rma and letting differences in A explain the higher US output Current Account Part one Fall 2008 Frac un 0 our 015 0J5 um 1m 1973 was I397 15m ms 92 was ma mum 16 Curran new u hymn and chdcn llslrladz Figure 26 Current Account Balances in Japan and Sweden accounts of the neutral countries to improve This feature is indeed evident in the experience of Japan and Sweden irl WW17 as in gure 26 Lending by neutrals to belligerents is an old feature of history But there is one limitation A sovereign borrower may repudiate his debts27 There is no enforcement mechanism you can use against a sovereign borrower short of war28 This is what Edward Ill did after his invasion of Rance yielded poor results A a 39 39 lendin 39 quot 39 d by fear of repudiation as well Success in war increases borrowing ability This means that the observed effect of war on the current account is attenuated somewhat by the fear of repudiation 27Accordung to Adam Snuth HWhen national debts have once been accumulated to a certain degree there 1s scarce lbeheve a single instance of their having been fairly and completely paid The liberation of pubhc revenue 1f1t has ever been brought about at all has always been brought about by a bankruptcy sometimes by an avowed one but always by a real one though frequently by a pretended payruent 1n a depreciated currency When it becomes necessary for a state to declare itself bankrupt 1n the same manner as when it becomes necessary for an individual to do so a fair open and avowed bankru tcy 1s always the measure which 1s both least ddshonourable to the debtor and least fruitful to the credltor Wealth of Nations Book V Chapter III 882 28Yo may wonder then why people lend to sovereigns that 1s why don t they always repudiate debts the RussorJapanese war broke out Japan borrowed at an annual rate of 7 5 but by 1905 once it was clear that Japan was going to win the war its cost of borrowing fell to 5 5 40