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MacroLecture12 International Linkages

Lecture Highlights
All countries are linked internationally through trade in goods and
through financial markets. The exchange rate (ER) is the price of
a foreign currency in terms of domestic currency (ringgit). A high
exchange rate a week ringgit reduces imports and increases
exports, stimulating AD.
Under fixed exchange rates, CB buys and sells foreign currency
to fix the exchange rate. Under floating exchange rates, the
market determines the value of one currency in terms of another.
If a country wishes to maintain a fixed ER in the presence of a BP
deficit, the CB must buy back domestic currency, using its
reserves of foreign currency and gold or borrowing reserves from
abroad.
In the LR, ER adjust so as to equalize the real cost of goods
across countries.
With perfect capital mobility and fixed ER, fiscal policy is
effective. With perfect capital mobility and floating ER, monetary
policy is effective.
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International Linkages
Any economy is linked to the rest of
the world through two broad channels:
(i) Trade (in goods & services)
(ii) Finance
The trade linkage means that some of a countrys production is
exported to foreign countries, whole some goods that are
consumed/ invested at home are produced abroad and
imported.
The basic IS-LM model of income determination must be amended
to include international effects.
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Contd.
The prices of Malaysian goods relative to those of our
competitors have direct impacts on demand, output
and employment.
A decline in the ringgit prices of our competitors,
relative to the prices at which Malaysian firms sell,
shifts demand away from Malaysian goods toward
goods produced abroad.
e.g. exchange rate from US$1 = RM3 to US$1 =
RM2
Our imports
Our exports
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International links in the area of
finance
Malaysian citizens whether households, banks, or
corporations, can hold Malaysian assets such as
Treasury bills or corporate bonds or they can hold
assets in foreign countries.
International investors shift their assets around the
world, they link asset markets here and abroad
affect income, exchange rates, and the ability of
monetary policy to influence interest rates.
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The balance of payments and
exchange rates
The balance of payments (BP) is the record of the
transactions of the residents of a country with the
rest of the world.
2 main accounts in BP:
(i) The current account
- Records trade in goods and services, as well as
transfer payments. Services include freight,
royalty payments, and interest payments. Transfer
payments consist of remittances, gifts, and grants.
trade balance records trade in goods + trade in
services and net transfers current account
balance
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Contd.
(ii) The capital account records purchases and sales of assets, such
as stocks, bonds, and property.
net capital inflow capital account surplus.
External accounts must balance
if a country runs a deficit in its current a/c the deficit needs to be
financed by selling assets or by borrowing abroad. These sales
of assets or borrowing the country is running a capital a/c
surplus.
Current a/c deficit + net capital inflow = 0
Capital a/c has 2 components:
(i) The transactions of the countrys private sector
(ii) Official reserve transactions the CBs activities
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Contd.
A current a/c deficit can be financed by private residents selling
off assets abroad or borrowing abroad or
Current a/c deficit can be financed by the government, which
runs down its reserves of foreign exchange, selling foreign
currency in the foreign exchange market.
The increase in official reserves the overall BP surplus
BP surplus = increase in official exchange reserves = current a/c
surplus + private net capital inflow
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Exchange rates and the market for foreign
exchange
Demand for foreign currencies by domestic residents
DD for foreign exchange
Foreign exchange market
- The market in which national currencies are traded
for one another.
The link between the BP a/c and transactions in the
foreign exchange market.
- All expenditures by all Malaysian on foreign goods,
services or assets represent DD for foreign
currencies.
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Contd.
- Malaysian buying a computer from US pays it
in ringgit, but the American exporter will
expect to be paid in dollar. So ringgit must be
exchanged for dollar in the foreign exchange
market.
- Malaysian exporters will expect to be paid in
ringgit, and to buy our goods, foreigners must
sell their currency and buy ringgit.
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DD & SS in the Foreign Exchange
Market (FOREX)
We assume that CBs do not intervene in the FOREX market. We
relax this assumption later.
We assume that there are only 2 countries Malaysia and the USA.
Malaysia ringgit
USA dollar
The exchange rate the relative price of the two currencies.
We express as the price of the dollar in terms of ringgit.
e.g. if the price of the dollar is
US$1 = RM3.50 OR RM1 = US$0.28
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Contd.
A higher exchange rate means that the price of
FOREX has risen.
When ex.rate foreign currency has
appreciated or
the ringgit has depreciated.
ex.rate the price of FOREX has declined.
The dollar has depreciated while ringgit has
appreciated.
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DD & SS of FOREX
Sfe
Dfe
eo
Forex rate
SS & DD for FOREX
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Contd.
Malaysian imports are DD for FOREX.
DD for FOREX vary with the price of FOREX.
Dfe downward-sloping
as the price of FOREX Dfe
FOREX the cost in terms of ringgit
(import prices become more expensive)
Imports
Less FOREX will be demanded
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Contd.
e.g. Suppose that you are considering the purchase of
an American computer that costs US$1,000.
If the ex.rate US$1 = RM3.50
The computer will cost RM3,500
If the ex.rate US$1 = RM4.00
The computer will cost RM4,000
The higher the exchange rate, the higher the ringgit
cost of imported goods DD for FOREX
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Contd.
The SS schedule for foreign exchange is drawn with a positive
slope.
The SS of FOREX as ex. Rate
As the ex.rate Malaysian goods become less expensive to
Americans.
Holding all other prices, including the ringgit price of Malaysian
exports fixed.
e.g. Malaysian product that sell for RM100 would cost US$28 at an
ex.rate US$1 = RM3.50 or RM1 = $US0.28
But the product would cost US$25 at ex.rate US$ = RM4.00 or RM1
= US$0.25
DD for Malaysian exports as the ex.rate as the ex.rate
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Flexible Exchange Rate (floating rate)
In a flexible exchange rate system, the central banks allow the
exchange rate to adjust to equate the SS and DD for foreign
currency.
If the ex.rate were US$1 = RM3.50 and American exports to
Malaysia
DD for dollars by Malaysians.
Central banks stand aside completely and allow ex.rates to be freely
determined in the FOREX markets.
In the above example, the ex.rate could move from RM3.50 per
dollar to RM3.55 per dollar
Making American goods more expensive in terms of ringgit.
DD for American goods by Malaysians.
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Effect in the FOREX market of an
increase in the DD for imports
Sfe
Dfe
eo
ex
rate
SS & DD for FOREX
Dfe
e
An autonomous increase in
import DD shifts the DD for
FOREX from Dfe to Dfe.
At the initial equilibrium
exchange rate (eo)
excess DD FOREX.
The exchange rate to e to
re-equilibrate SS and DD in
the FOREX.
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Fixed exchange rates/ pegging the
exchange rate
In a fixed exchange rate system, foreign central banks
stand ready to buy and sell their currencies at a
fixed price in terms of other currency.
Assume that the central bank of Malaysia (Bank
Negara) wishes the exchange rate for the ringgit:
US$1 = RM3.50 (RM1= US$0.28)
The official fixed exchange rate US$1 = RM3.50 is
below the equilibrium exchange rate.
(see next slide)

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DD & SS of FOREX
Sfe
Dfe
3.60
ex
rate
SS & DD for FOREX
3.50
XDfe
At US$1 = RM3.50
Ringgit overvalued
Dollar undervalued
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Contd.
The fixed exchange rate US$1 = RM3.50 is below the
market equilibrium rate US$1 = RM3.60 excess
DD (XD) for FOREX.
To keep the exchange rate at US1 = RM3.50 Bank
Negara will buy dollars for RM3.50, the exchange
rate cannot fall below that point.
To keep the exchange rate from rising, Bank Negara
must supply FOREX it must exchange dollars for
ringgit.
Alternatively, the CB of the USA i.e the Federal
Reserve would SS dollars (sell dollars and buy
ringgit) to satisfy the excess demand.
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Real exchange rate
The price of the foreign currency in terms of the ringgit e.g. US$1 =
RM3.50
Bilateral nominal exchange rate
Multilateral or effective exchange rate
- The price of a representative basket of foreign currencies, each
weighted by its importance to Malaysia in international trade.
Real exchange rate R = ePf/P
e = nominal exchange rate
Pf = foreign prices
P = domestic prices
R or real depreciation goods abroad more expensive relative to
goods at home.
R or real appreciation our goods relatively more expensive.
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Domestic spending and spending on
domestic goods
Spending by domestic residents
A = C + I + G
Spending on domestic goods
= A + NX
= C + I + G + NX
Domestic spending depends on i and Y
A = A(Y,i)
Net exports
Net exports depend on income (Y) which affects import;
Foreign income (Yf) which affects our exports; also depend on R.

NX = X(Yf,R) M(Y,R)
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Contd.
Yf improves the home countrys trade
balance AD
R real depreciation improves the trade
balance AD
Y M worsen the trade balance
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Contd.
IS curve: Y = A(Y,i) + NX(Y,Yf,R)
X IS shifts to the right
X IS shifts to the left
R or real depreciation
IS shifts to the right and raises net exports
Y

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Effects of disturbance on Y and NX
________________________________________
Home spending Yf Real depreciation
________________________________________
Y + + +
NX - + +
________________________________________

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Capital mobility
One element in the international economy
High degree of linkage among financial or capital
markets.
In most industrial countries there are no restrictions
on holding assets abroad.
Malaysians or residents in other countries can hold
their wealth either at home or abroad.
They search around for the highest return.
In reality tax differences among countries; exchange
rate can change; restrictions on capital outflows
differences in interest rates among countries.
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Perfect capital mobility
Capital is perfectly mobile internationally when
investors can purchase assets in any country,
quickly, with low transaction costs, and in unlimited
accounts
- One countrys interest rates cannot get too far from
the world level.
- E.g. if Malaysian yields less than Singaporean yields
capital outflow from Malaysia
Interest rates affect capital flows & the BP
Monetary & fiscal policies affect interest rates
The policies affect capital account & BP
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The Balance of Payments and Capital Flows

Balance of payments surplus, BP:
BP = NX(Y,Yf,R) + CF(i if)
CF: capital flow; if: world interest rate; i = domestic interest rate
Y worsen the trade balance
i where i > if capital inflow improves the capital account
The trade deficit would be financed by a capital inflow
BP in equilibrium (BP = 0)
When BP = 0 a flat line i = if
Points above BP = 0 surplus BP
Points below BP = 0 deficit BP
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Fiscal policy with a fixed exchange rate
(Contd.)
BP
LM
LM
IS
IS
Yo Y Y
1
i = if
i
1
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Policy effects under fixed exchange rates
Fiscal policy with a fixed exchange rate
F shifts IS to the right from IS to IS
Domestic interest rate, i > if
Resulting in a massive capital inflow
Central bank intervention to maintain the fixed
exchange rate causes Ms
LM shifts to the right from LM to LM
Domestic interest rate is brought back into equality
with if
Y from Yo to Y1
(see next slide)
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Monetary policy with a fixed exchange rate
Ms shifts the LM curve to the right from LM to LM.
Domestic interest rate below if
BP deficit
Massive capital outflow
Central bank intervention to maintain the fixed exchange rate by
selling foreign reserve assets & buys domestic currencies
domestic Ms
Domestic interest rate is restored to equality with if
Y is back at its initial level
Monetary policy is completely ineffective
(see next slide)

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Monetary policy with a fixed exchange rate
(Contd.)
BP
LM
LM
IS
Yo

i = if
i
1
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Policy effects under flexible exchange rate
monetary policy with a flexible exchange rate
BP
LM
LM
IS
IS
Yo Y
1
i = if
i
1
Ms causes the LM shifts to the right
from Lm to LM
donestic interest rate, i fall below if
massive outflow of capital
BP deficit
the exchange rate
NX IS shifts to the right from IS to
IS
domestic interest rate = if
Y from Yo to Y1
monetary policy is highly effective
with perfect capital mobility and
flexible exchange rates.
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Fiscal policy with a flexible exchange rate
BP
LM
IS
IS
Yo

i = if
i
1
G causes the IS shifts to the right
from IS to IS
donestic interest rate, i above if
massive capital inflow
BP surplus
the exchange rate
NX IS shifts back to the left from
IS to IS
domestic interest rate = if
Y to its initial level (Yo)
fiscal policy is completely
ineffective under flexible exchange rate