International Economics: Key Concepts and Relationships
International Economics: Key Concepts
E= (e·p)/p* r€ = r$ – (forward – e)/e Interest Rate Parity: r€-r$ = (Expect €/$ – e€/$)/e€/$ = 9 in order to satisfy interest parity… 9%
US iPhone 199, Spain 699, e=1.38$/€. 699·1.38=x, x/199=4. No arbitrage, E is not equal to 1.
An expansionary policy of China increases r*. In Spain, it reduces investment, increasing net capital outflow and the supply of € in the foreign exchange market, causing E to fall and NX to rise. Decrease supply of yuans (appreciate), € depreciation.
Policy that causes savings to rise: increase G, decrease T. Policy that causes exchange rate to drop: inflation, lower r, demand foreign currency, public debt…
GDP= C+I+G+ (X-M) nx = y-(c+i+g) Y-C-G=NX+I Y-C-G = S I+NX=s NX=S-I S=private y-c-t + public t-g
Apple imports to Spain 1000 iPads. Current account good import (-) and financial account asset export(+).
Exam Key Points
-An expansionary policy of US creates less savings, so $ appreciates, and the Chinese CB to avoid this can buy yuans to increase its demand or sell dollars to increase its supply.
-An expansionary fiscal policy by US: private savings and public savings do not vary; they do not depend on r. Aggregate savings do not depend on r. The interest rate would increase, net exports will increase, and the real exchange rate will decrease.
-The Spanish government, to increase GDP, has to decrease production costs by reducing salaries or improving productivity. They reduced salaries as a short-term policy.
-The European Stability Mechanism is a fund created with money from the countries of the EU, and it provides loans to countries with a bad financial situation. The bail-out that the mechanism provides must be paid back by the government, so the industry has to pay the government, or they have to increase taxes. Why did they have to create this? Because there were some economies (PIGS) with deep financial problems, and because of the lack of power of the ECB (it cannot bail out), the other countries had to finance the most affected economies in order to avoid a possible default.
The Impossible Trinity
Impossible Trinity: monetary independence (independent monetary policy), exchange rate stability (the ability to avoid volatility in the exchange rate), and capital mobility (the ability to take advantage of flows of foreign currencies). The US chooses to have an open capital market and an independent monetary policy, and they don’t have a fixed exchange rate. China has a fixed exchange rate and independent monetary policy; therefore, they must have controlled capital flows. The Eurozone has chosen to have open capital markets and a fixed exchange rate, so they cannot have independent monetary policies. The policies from the ECB are for the countries of the Eurozone.
Main Phases of European Economic Integration
- 1951: Treaty of Paris creates the European Coal and Steel Community.
- 1955: Treaty of Rome signed, establishing a common market, customs union, free movement of capital and labor, creating the European Economic Community and Euratom.
- 1979: European Monetary System to encourage countries to coordinate a central exchange rate mechanism (ERM).
- 1992: Maastricht Treaty turns the European Community into the EUROPEAN UNION and includes a treaty for development in the monetary union.
- 1997: Stability and Growth Pact instead of fiscal policy. Defines the rules and penalties for members in the Eurozone to make sure they keep the amount they spend and borrow under control in order to help create stable conditions for the new currency.
Gold Standard and Bretton Woods System
Gold Standard (Reserve Currency System): If I have a trade surplus, I supply $ and I get gold; gold inflows, capital outflows. Benefits: symmetry and limits on money creation. Drawbacks: In a gold recession, it’s desirable to expand the money supply; prices relative to gold and others have to be stable; it is difficult for CBs to increase their holdings of international reserves as their economies grow, and countries with potentially large gold production can influence macroeconomic world conditions.
Bretton Woods: IMF with the mission to achieve price stability and improve employment with international trade. $ has a special position; it never has to intervene in the foreign exchange market. The purchase of domestic assets by the CB of the USA leads to an appreciation of the reserve currency. If the CB of England increases the money supply by purchasing domestic assets, interest rates go down, foreign assets are more attractive than domestic assets, X,>
Fixed vs. Flexible Exchange Rates
Disadvantages of fixed rates: A country cannot follow macroeconomic policies independent of other countries. To maintain fixed rates, they need a common inflation experience. Advantages: Stable exchange rate and long-term price stability. Disadvantages of flexible rates: Increase the variability of exchange rates, self-fulfilling prophecy, and “evening out swings” in exchange rates.