International Macroeconomics a Concise Course for Advanced Undergraduates
Total Page：16
File Type：pdf, Size：1020Kb
International Macroeconomics A Concise Course for Advanced Undergraduates Gregor W. Smith April 2021 Preface Welcome! This book studies issues in international macroeconomics (also known as international finance or open economy macroeconomics) and examines the interaction of national economies through international financial markets. We try to understand and explain things like capital flows (international borrowing and lending), sovereign debt and default, and how goods prices are related across countries. On the financial side we shall study floating nominal exchange rates (spot and forward), speculative attacks, and interest- rate differentials. We also learn about the history of the international monetary system and policy issues such as exchange-rate management, currency unions, and speculative currency crises. The emphasis is on predictions and empirical evidence. Overall the book aims to help you learn some new and thought-provoking things about the world, while putting to work your toolkit from previous economics courses. This course introduces these central topics in international macroeconomics for ad- vanced undergraduate students. For the book to be useful, you should have courses in intermediate microeconomics and macroeconomics and an introductory statistics course. We shall make some of our discoveries using basic econometrics (in the form of linear regressions) and so we'll rely on your knowing how to run a regression in any statistical software package you like. I should warn you about some omissions, first in content then in form. First, the emphasis is mostly on developed economies with open capital markets. There is not as much focus on EMEs (emerging market economies) as yet. Also, we do not assemble all the elements into a general-equilibrium model with multiple shocks. That interesting task is left to graduate-level courses. Second, the book does not yet include pictures that help us understand the theory. Sorry. This is a low-budget operation. We'll fill those in as we go along. It also does not include time-series plots of data even though we discuss those at various points. That omission is by design. Books in this field rapidly become out-of-date, so we shall learn how to produce our own, up-to-date plots at several points and in the exercises. The table of contents is up next. Each chapter ends with some suggestions for further reading and references cited in the chapter. And then most chapters really end with a set of practice questions. Answers to the questions are collected at the end of the book. The book is based on a 12-week course (ECON 426) at Queen's University, Canada. I am grateful to the cohorts of students in that course who have offered me feedback, whether in writing or in the form of a raised eyebrow or a gently rolled eye, that has helped me to improve the course. Now a warning, dear reader: The material in this book is copyrighted and is for the sole use of students registered in Economics 426. The book may be downloaded for a registered student's personal use, but shall not be distributed or disseminated to anyone other than students registered in Economics 426. Failure to abide by these conditions is a breach of copyright, and may also constitute a breach of academic integrity under the University Senate's Academic Integrity Policy Statement. Table of Contents Page 1. Mysteries, Trilemma, and Tools 1 1.1 Four Mysteries of International Macroeconomics 1 1.2 The Open-Economy Trilemma 9 1.3 Ten Mathematical and Statistical Tools 13 Part A: Capital Flows 2. Basics of International Capital Flows 18 2.1 Accounting 18 2.2 Consumption Plans 24 2.3 Recipe 25 2.4 Results 27 2.5 Fiscal Policy 29 2.6 Large Economies 31 2.7 Global Imbalances 32 3. Sovereign Debt 38 3.1 Sanctions 38 3.2 Reputation 44 3.3 Debt Overhang and Debt Relief 47 4. Measuring Capital Market Integration 56 4.1 Savings-Investment Correlations 56 4.2 Home Bias 57 4.3 Consumption Correlations in Seven Steps 63 Part B: Exchange Rates and Asset Prices 5. Real Exchange Rates 72 5.1 Predictability and Persistence 72 5.2 PPP 77 5.3 Decomposing the Real Exchange Rate 83 5.4 China's Exchange-Rate Policy 89 6. Floating Nominal Exchange Rates 94 6.1 ISO 4217, Data, Volume, and Floating Incidence 94 6.2 CIP and UIP 94 6.3 Monetary Model 97 6.4 Evidence on Floating Exchange Rates 102 6.5 Bubbles 105 6.6 Currency Transaction Tax 107 6.7 Testing UIP or Unbiasedness 108 7. Asset Pricing 115 7.1 Deriving the Euler Equation 116 7.2 Asset pricing using the Euler Equation 116 7.3 A Discount Bond 118 7.4 Equities and Risk Premia 120 7.5 Bond Default Risk 123 7.6 Nominal Bonds 125 7.7 The Term Structure of Interest Rates 125 7.8 Forecasting with the Term Structure 128 7.9 Risk Premia in the Foreign Exchange Market 130 Part C: Monetary Policy 8. Currrency Wars 136 8.1 Case Studies 136 8.2 Intervention 139 9. Fixed Exchange Rates 143 9.1 Operating a Fixed Exchange Rate System 143 9.2 Speculative Attacks 149 9.3 Exchange-Rate Crises in EMEs 155 10. Currency Unions and Exchange-Rate Regime Choice 160 10.1 Arguments for Exchange-Rate Stability 160 10.2 Arguments for Floating 163 10.3 Varieties of Exchange-Rate Stability 166 10.4 Actual Regime Choices 169 Answers to Exercises 173 Chapter 1. Mysteries, Trilemma, and Tools We'll do three things in this introductory chapter. First, we'll look at four mysteries or puzzles, to introduce the field and to help you decide whether you want to read on. Second, we'll learn about the open-economy trilemma, a feature of macroeconomic policy that helps us understand the international financial arrangements followed in different countries and over the span of history. Third, we'll list some mathematical and statistical tools that will be used later on so you can have an early view of anything unfamiliar and (I hope) be reassured that nothing too daunting lies ahead. 1.1 Four Mysteries of International Macroeconomics 1.1.1 Why Doesn't Capital Flow from Rich to Poor Countries? Before we begin we need to take a moment to discuss the word capital. In economics it means things like machinery, equipment, and buildings: the K that enters the produc- tion function. This concept is sometimes broadened to include human capital, meaning accumulated skills or education. (In other social sciences people sometimes use the word differently, to refer to a social class.) But, confusingly, capital can also mean financial assets. It is this second meaning we usually study when we talk about capital flowing betwen countries. Imagine a loan from one country to another. (Of course that could be used to buy or rent physical capital). The same ambiguity arises with the word investment. The first meaning refers to the change in the physical capital stock, I, that also shows up in the national accounts. The second meaning, which we focus on in this book, refers to the flow of investment capital between countries. That occurs when citizens of one country buy assets located in another country. On to our first mystery. Hispaniola is an island in the West Indies that is shared by two countries: Haiti and the Dominician Republic. Take a moment and look up the population and GDP per capita of each country. 1 I would guess that you find the populations are roughly similar but that GDP per capita on the east side of the island is roughly ten times larger than on the west side. It is very important to pause and think about why that is so. But for now let us consider the implications for capital flows. According to growth theory, rich countries have a high ratio of physical capital to labour (K=L) and poor countries have a low ratio. And thus the marginal product of capital (the slope of the intensive-form production function) is higher in poor countries than in rich countries which means the real interest rate is higher there too. The basic growth model from intermediate macroeconomics thus predicts that fi- nancial capital should flow from a rich country to a poor one, to take advantage of the higher returns there. (The same model predicts labour should flow in the opposite di- rection, whether temporarily or permanently. We could also study the evidence for that occurring.) Here is the first mystery: In practice these capital flows are very small. For example, private capital inflows to Haiti are very small, and its GDP per capita does not seem to be converging towards the value in the Dominican Republic. International capital flows are enormous, as we'll see in chapter 2. But they almost all are between relatively rich countries. In fact, there even are examples of large capital flows from middle-income countries (like China) to rich countries (like the US). Implictly here we're defining a mystery or puzzle as a discrepancy between an economic theory and the evidence. So I suppose this is just a polite way of saying the theory is missing something. When you think about what that thing is, I suspect two things come to mind. First, perhaps returns (or the real interest rate) really are not higher in Haiti than they are in the Dominican Republic. In turn, that could be because Haiti lacks a third factor that matters in the production function, like good roads or reliable electricity. If you put this third factor in the production function and make it scarce (rather than relatively abundant, like labour) you can see that that might deliver a low marginal product of capital and real interest rate.