INTERNATIONAL FINANCE APPUNTI, Appunti di Economia

Scarica INTERNATIONAL FINANCE APPUNTI e più Appunti in PDF di Economia solo su Docsity! INTERNATIONAL FINANCE 1 Open macroeconomics talks about financial globalisation, integration between countries financial assets and exchange. Current account of BOP (Balance of payment). CURRENT ACCOUNT IMBALANCES: imbalances in the bop, related to financial flows. Int capital mobility, external debt, exchange of financial assets. Euro sustainability, exchange rates as a results of global pandemics. Ability to be fluent in writing short reports that comes from examination of data. TOPICS: - AGGREGATE ACTIVITY (NATIONAL LEVEL) - LEVELS OF EMPLOYMENT - PRIVATE AND PUBLIC ACTIVITY (PRODUCTION) - AGGREGATE DEMAND - EXPENDITURE (consumption, investment, public expenditure) - GROWTH Analysis: 1. Macro integration in terms of their financial resources. 2. International economic policy, help countries to undertake foreign economic policies which concerns relations between two economies in exchange of goods and financial resources, real resources and financial. Real res: goods and services. Financial resources: assets 3. Global macro imbalances, macro disequilibrium. ADJECTIVES FOR A MACROECONOMIC POLICY: DESIRABILITY: how much people or countries, groups, wants to reach an economic result level of integration, exp imp real or financial resources. SUSTAINABILITY: dealt by political economy, many kinds of sust depending on the institutions democratic countries and different in autocracies. Here we refer to democratic regimes. Approval by the majority of the countries, democracies, represented by the majority of the population comes from a voting procedure. It can democratic sustainability, ecological or social. HOW IT FUNCTIONS? Open economy means the exchange of goods, services, financial assets and monetary exchanges  they are all described by INCOME ACCOUNT AND THE BALANCE OF PAYMENT (FOR OPEN ECONOMY) Open macro consider the interactions between countries and their influence on the macrovariables. MAIN INVESTIGATION OBJECTS: - Unemployment - Saving - Trade Balance - Money INCOME ACCOUNTING: aggregate demand and product of a country during a year BALANCE OF PAYMENTS: records the annual levels of imports and exports of goods and services, the annual variation of foreign indebtness, changes in money supply linked to external transactions. Limits of int financial integration, globalization. Associated with the global macro issues. Reduction of sovereignty because of euro. - Balance of payments current account (CA) WHICH IS THE fa FINANCIAL ACCOUNT. Main questions: First part: backgroup in open macro issuesinternational macroeconomics Second part: few questions DEFINITION MACROECONOMICS Economics of nations, concern the level of aggregate (national) activity of a country exchange takes place using money. Includes: levels of aggregate national economic activity using money (provided by institutions, not from heaven) provides mean to exchange financial resources ecc, these money provided by ec institutions which is allowed to produce money (legally). In Italy nobody can but the European central bank legally. Money is the mean to produce exchanges, central bank is usually associated to some elected institutions in democracies. GDP, aggregate income: value of all final goods and services produced within national borders using factors which may not entirely belong to the country in a given period of time (FOREIGN LABOR OR FOREIGN CAPITAL). Intermediate goods are not counted to avoid double checking. aggregate consumption, aggregate investments, exports of goods and of financial resources, the rate of growth of gdp and monetary markets. These are the main activities of macroeconomics and open macroeconomic. Exchange rates exchange money. GNP: is quite the contrary, is the value of all final goods and services produced by a nation’s factors of production even if operating abroad. IT IS: ITALIAN MNL ABROAD – FOREIGN MNL IN ITALY + OUTGOING MIGRANT INCOMES – INCOMING MIGRANT INCOME. NET NATIONAL INCOME: after depreciation allowances = capital consumption, it is relevant to see how capital intensive is a country. WE USE INCOME AND PRODUCT DIFFERENTLY, but there are differences: - 1 euro paid for a barber is both income and product since I receive a product (the cut of my hair) - By the way there are kind of incomes which are not products If Italy donates 1 euro to Egypt then it results like income in Egypt but NOT PRODUCT! THESE ARE UNILATERAL TRANSFERS ITALY INCOME DIMINISHES BUT NOT PRODUCT, ON THE CONTRARY EGYPT INCOME RISES. - IMPORTANT GNP MEASURE FOR COLONIAL GAP FRANCE UK Saving:  In a closed economy: S=Y-C-G=I  In an open economy: S=y-c-g= i+x-m S=Y-C-G=I+CA SAVING doesn’t necessarily equal investment in an open economy S-I=CA NET saving equal to CA balance Excess saving savings more than investments ca surplus living beyond its limits And then lends to foreigners their saving. Germany for example 8% the gdp of Germany Mercantilism: accumulate foreign credit towards other countries adam smith called those countries gold accumulator. THE CURRENT ACCOUNT BALANCE DEFINITION: EXP RECORDED WITH A PLUS SIGN + IMP RECORDED WITH A MINUS SIGN – CA and its Balance relevant because 1. Provides the link between total expenditure on domestic output+ foreign output and total productioncrucial for employment, government revenues investments, welfare levels, international borrowing and lending. 2. Ca balance indicates the extent of the change in a country’s foreign lending or borrowing within one year INTERNATIONAL BORROWING AND LENDING : CA>0 lends/CA<0 Borrows from the ROW.  but we can say that there is a +ca sells to foreigners now and buys in the future. INTERTEMPORAL TRADE a country with a CA surplus has excess saving therefore decides to renounce to present consumption exchanging it with future one. He lends to another country which decided to exchange future consumption with present consumption. CA balance: describes the change over one year of the net international investment position of the entire country towards the row. The sum over time of the current account balance, the external debt of a country is not the debt of a sovereign government, but is the debt or credit of an entire country. One is the private section and one is the public one. EXTERN DEBT: algebraic sum private sector and public sect. for example in Italy the public debt is very high but not the private debt therefore the foreign debt is almost equal to 0. THE CA BALANCE ALSO DESCRIBE THE NET INTERNATIONAL INVESTMENT POSITION OF A COUNTRY TOWARDS THE ROW (NOT THE GOVERNMENT, ENTIRE COUNTRY G+PRIVATE SECTOR) THE BALANCE OF PAYMENTS IN THE EURO AREA 1. EACH EURO member like Italy, has its own national BOP. We have a federal currency or multinational? SINCE WE HAVE ALL DIFFERENT BOP to prof, SHOULD BE federal, like the USA is FEDERAL RESERVE. The BCE is actually a federal central bank The institutional content of the central bank. In the euro area we don’t have just one Balance of Payment, but we have more. Each euro member has its own national balance of payments where all foreign transactions with ROW are recorded (goods, assets, services). Relates to the transactions of each member with the row, where there are also member of the Eurozone are recorded in the national balance of payments. National central banks are the operating tools of the BCE, it does using the facilities of the national central banks. Why we do it? At the very beginning of the euro life sm1 suggested to not record each bop. Recorded and aggregated ecb Eurostat in which you find the euro area balance of payments. Current taxonomy for all balance of payments for all countries around the world. The stat is divided in capital account and current account by the way this taxonomy is old go to the link and go to the current taxonomy. CURRENT ACCOUNT is made by 4 items goods services primary incomes and secondary incomes. Algebraic sum of debit and credit, positive number with surplus. CAPITAL ACCOUNT credit and debit. TRANSFER OF WEALTH NOT PRODUCED (??) NON FINANCIAL AND INTAGIBLE ASSETS. COPYRIGHT TRADE MARKS PATENTE LICENCE DEBT FORGIVENESS AND AIDS TO POOR COUNTRIES. INCLUDING UNILATERAL TRANSFERS, FROM PRIVATE OR PUBLIC INSTITUTIONS OR ORGANIZATIONS. The sum current account and the capital account is the real balance of payments. FINANCIAL ACCOUNT financial assets which can be exchanged by countries: bank deposit, sales and purchases, crossborder exchanges. FINANCIAL ASSETS (BANK DEPOSIT, SHARES LIKE PORTFOLIO INVESTMENTS BONDS FDI LIKE GREENFIELD AND BROWFIELD WITH THE ROW. degree of liquidity (sold and bought without any risk cost), banknotes high degree of liquidity. I can exchange it on the spot. There are assets which are less liquid, I need to go to a structured market, the stock exchange, I which I can exchange less liquid assets than banknotes  These are portfolio investments. Then we have FDI, foreign direct investing, flows which goes through countries greenfield and brownfield (not beneficial as they are the greenfield), italo sold to the american equity fund transferring resources to buy an existing company (this is a brownfield acquisition, the plant already exists). Greenfield is when an American firm decides to build a new plant for production in an another country. Brownfield different in terms of the effects of the employment and on the economy. Financial derivate, derive their existence on other financial assets, insurance policy is a derivate or a future asset is a derivate. Option is right you get to buy in the future at a certain price is a derivate, I can buy a currency in terms of the condition you get on the contract the terms of the contract can take place in the future. So the derivate is a second asset. Many people criticise how they work after 2008. Reserve assets hold by the central bank. Financial account of the Eurozone. Vertically we have the items, dived in portfolio invest, direct investments, net financial (assets liabilities, net) WHAT MATTERS from a macro point of view is the FA balance which may be the result of huge inflows and outflows of assets. BUT THIS IS QUESTIONABLE (OBSTFELD DOES CURRENT ACCOUNT STILL MATTER?) One of the main differences between present and past is that during the last 30 years the dimension of gross flows (mostly liquid assets) has increased many times (10 times with respect to 40 years ago) making them relevant for macroeconomic and financial stability (not just the balance since the financial flows are very mobile) EUROLAND: new bop since 2015. The bop is made of two sessions: the capital account and current account; the financial section (balance). PRIMARY INCOMES: (redditi primari), labour incomes, dividends, interest and rents. SECONDARY INCOMES: migrant remittances, transfers, international aid. Redditi secondary, trasferimenti, rimesse emigrati, cooperazione internazionale. EXAMPLE ITALY 2017 - CA+CC+errors= FA 47850-869+209=47190 FOREIGN EXCHANGE RESERVES OF BANCA ITALIA INCREASED BY 2.6 MILLION IN 2017. Ca imbalances GLOBAL CURRENT ACCOUNT BALANCE: before 2008, many countries went bankrupt the problem is external debt, not public debt. Very efficient financial market can make public debt sustainable. ICELAND: went bankrupt because of the external debt, the public debt were very low 15%. Mishkin said Italy has to frightened about public debt, Iceland no bankrupts because low public debt. Institutions and bank wanted money bank from Iceland and this made Iceland very fragile. British banks lending to English banks these lent to firms for energy product economic crise, English bank became illiquid and they wanted liquidity from the Iceland banks, big American banks and then the Iceland citizens going to atms and they don’t get the money because banks are made illiquid by the other institutions which lent them the money. Gross flows? How much they matter they have a relevant impact over the economy. Depends also on the value added to the goods some items imported could have been imported almost finished and not totally finished. REAL SECTION CAPITAL ACCOUNT, DIFFERENT MATTER. Now is part of the real section of the bop. copyrights, book by camilleri needs copyright from Italian publisher and the payment goes into this capital account. They are actually capital goods, text book is an investiment can give rise to many many other books in the future. FINANCIAL ACCOUNT (FA) exchanges – crossborder, sales and purchases – of financial assets (bank deposits, shares – portfolio investments -, bonds, firms – FDI – greenfield or brownfield) with the ROW. Italian citizen buys a us firm the value paid enters the FA of Italy with a FA BALANCE: during the last 30 years gross products were most in liquid assets which has a high degree of international mobility. Making also gross flows not just the balance but also the balance. Means that a country ahaving a fa equal to 0, the the fa is in equilibrium but if there is a shock in a country this can see international capital mobility capitals to go out of the country SUDDEN ASYMMETRIC SHOCKS. Idiosyncratic shocks in respect to systemic shocks. These days there is a systemic shock which is symmetric because is a shock that hits the entire world. Greece shock was a idiosyncratic shock. Large errors and omissions: hard to find the offsetting entry of a transaction BOP equilibrium  Fundamental BOP identity: CA+CAP ACC=FA since all international exchanges are associated to perfectly balanced credit and debit figures in the BOP. CAP ACC surplus, lending difference to the LESSON 6 RICARDIAN EQUIVALENCE: TOTAL SAVING IN AN OPEN ECONOMY, which are both private and public: S= I+ CA  CA=S-I  PRIVATE SAVINGS: not consumed disposable income Spriv= Y-T-C (Y-T is disposable insome) Y is the GDP and T is the government tax revenue and C is private consumption (all variables are aggregate values at the national level)  PUBLIC SAVING: Sgov= T-G ( PUBLIC DEFICIT OR SURPLUS) where G is total public expenditure therefore total saving S=Spriv+Sgov = Y-T-C+T-G=Y-C-G S=CA+I then we have Spriv+Sgov=CA+I or Spriv=CA+I-Sgov  Government deficit: flow measured over a period of time 1 year and it is the difference between Government expenditure and tax revenue, WHEN EXPENDITURE IS LARGER THAN TAX REVENUE  Government (public) debt: is a STOCK measured at a particular time, for instance DEC 31 and it is cumulated sum over the years of public deficits of a government FINANCING: public deficit must be financed with the issue of government bonds which may be sold to: 1. Private citizens of the country directly or indirectly through the banking system 2. Foreign agents 3. To the CB: bonds (assets) are bought by the CB printing money (TESORO) CREATING A LIABILITY FOR THE cb LEADING TO AN INCREASE IN THE SUPPLY OF MONEY. This is a monetary policy measure (open market operation). SINCE IN AN OPEN ECONOMY S=CA+I Then we have Spriv+Sgov=CA+I or Spriv=CA+I-Sgov RICARDIAN EQUIVALENCE: private savings increases of the same amount of the increase in the government deficit (opposite of Sgov). THIS IS BECAUSE SGOV is proportionally correlated to the taxes to the private sector. Japan is nearer to Ricardian equivalence more than Greece or other countries. PRIVATE SAVING FINANCES 1. If Sgov<0 IT IS PUBLIC DEFICIT  in the equivalence above Sgov BECOMES +SGOV (--  +) 2. CA 3. Investment Spriv= I+ CA – (T-G)= I+CA+(G-T) CA= Spriv – i –(g-t) MORAL if the government deficit grows while Spriv and I stay constant, CA worsens of the same amount of the increase in the public deficit, BUT IT IS ADJUSTED BY TAXED  there could be an increase in taxes in the future to adjust the equivalence.  BUT, if there is ricardian equivalence an increase or decrease in public deficit does not change the CA balance  FOR EXAMPLE ITALY REDUCES GOVERNMENT DEFICIT: was the CA balance affected? If it is yes, then is because there no Ricrdian Equivalence (which states that a variation in the public spending DOES NOT AFFECT the CA of the same amount)  IF IT IS NO, then is because there were ricardian equivalence.  THERE COULD ALSO BE A PARTIAL RICARDIAN EQUIVALENCE: effect smaller on CA than the change in public spending. If the public expenditure are devoted mainly to Investments with positive return equal to r, citizen will not face future increases of taxes equal to the public deficit but lower than that. In that case they may compensate a larger public deficit with a smaller increase in saving since public expenditure gives rise to a return and will require less taxes in the future to be paid. That is the case of public investments in human capital (education) public infrastructures (roads, railways, environment) LESSON 7 FOREIGN EXCHANGE MARKETS: Each nation with national sovereignty on monetary policies has a national currency Each currency has a relative price vis a vis another currency this is the exchange rate and it comes from the transactions of the currency of a country with the currency of another country to trade goods, services and financial assets (saving) The global foreign exchange market shows daily transactions of some 4-5 trillion (thousand of billions) dollars (40% in London, 20 % in NY. More than 3 times of 25 years ago. Main agents are a limited number of international banks (its an highly concentrated monopoly. VOLATILITY AND QUESTIONS: volatility of exchange rates (1. Stock exchange – shares 2. Exchange rates 3. Commodities 4. Goods and services. How are exchange rate determined? Why are so volatile? Do exchange rates affect economies? What exchange rates policies? This is a graph for dollar exchange rate with euro  it is an historical series from 1999 and it actually says that the ER is higher than in 2000. This means that the dollar was devaluated against euro over time. + 0,1725 +14,6% This is the China Yen depreciation rate against the US dollar. In less than 1 year. The country whose currency is reserve currency must be LARGE, to be able to face large financial flows without excessive variations of the exchange rate. Moreover, it must have open, liquid markets with SIMPLE REGULATION. Ecuador (dollarization) and Montenegro (eurization) adopt even more extreme policies than the currency board, because they are not part of the system (dollar or euro) but all the same adopt the currencies of the US and the EU, respectively. SEIGNORAGE= when a country issues its own currency ---loss of wealth by the country because Ecuadorians lend the amount of wealth corresponding to the amount of dollars exchanged in the country to the US at 0 INTEREST RATE, because dollars are an asset for the US but a LIABILITY for the Ecuadorian CB=benefits are given to a foreign institution, not to a State one that then redistributes to the citizens. In this graph we can see the composition of the global reserves 1o dollar claims, 2o euro claims. China policy not orthodox they follow the proper way, from a structural point of view is different, flexible but not entirely flexible. They have their proper politics in economics. Large countries tend to choose this sort of regime. EICHENGREEN number one NOTES: TOPIC role of central banks in shaping financial structures and building financial markets (how their actions can have implications for the place of those markets in the world). Making of market in dollar- denominated trade credits bankers acceptances in the early 20th century. SECOND international currency competition. Is there room only for one currency in the global system? Increasing returns to using the national currency in international transactions are strong, network externalities are pronounced. Therefore, the pound dominated the first half of the 20 th century while the dollar the second half. By the way, this last assertion is not adequate for foreign-exchange reserves. Network effect are in fact weak for international reserves. Central Bank, opposite to importers and exportes, have no incentives into holding one currency-denominated reserves. Instead, they prefer a diversified portfolio of reserves. By the way, what was true for international reserves before 1914, was also true for trade credit of private use. Today, there is no reason for euro and the dollar for not being both international currencies. Also true for China, because if we see the world through the eyes of this model, we should expect the Yuan being an international currency soon. In fact, if network effects (kind of lock in effect in international markets) are less powerful than commonly asserted, the renmimbi’s emergence may be quicker than widely presumed. Finally, there is concern that central banks’ extraordinary actions in 2007-9 taken to provide liquidity to distressed financial markets by purchasing commercial paper, mortgage-backed securities and other financial assets outright, created a reservoir of inflationary pressure that will burst when bank lending picks up (central banks’ market making and market supporting actions will create a conflict with their price stability mandate). This policies create now a lot of concern, because, in few words, their intervention in markets can actually have repercussions on issuance of financial instruments of dubious quality, last resort policy of banks may discourage others buyier from entering in the market; therefore setting the stage for another round of financial excess problems. We find all these criticism in the parallelism with the interwar period in the XX cent. Rise of the dollar as an international currency  1914-1939 In 1920: growing importance of the dollar. BACKGROUND: exporters need credit to purchase materials and pay their bills to for furniture. Possible while their merchandise is in transit the payment may not yet take place (no settlement). Financial intermediaries are needed. In the international markets at that time: 1. London has a lock-in advantage: By 1912, US exporters dominated, but no credit were supported by US banks, instead they asked for it in London (acceptances denominated in pounds) 2. In US there were regulatory prohibitions and not increasing returns preventing US banks from entering in the credit market (under the National Banking Act) 3. In 1920 the Federal Reserve Act of 1913 created a Us central bank authorized to discount and purchase trade acceptances as a mechanism for smoothing interest rates and managing credit conditions. It eventually removed the prohibition. 4. WW1 disrupted London Trade credit and other European financial centre, giving New York the opportunity to run up. 5. Example that there were room for other currencies since Sterling did not monopolies foreign exchange market and reserves. Therefore, sterling was not the only one currency in international markets. 6. Market forces and policy intervention of the FED has rose the importance of the dollar as an international currency (vehicle currency) 7. EVENTUALLY the sterling monopoly became a duopoly 8. THIS MEANS THAT WHILE NETWORK EFFECTS AND INCREASING RETURNS WERE STRONG, central banks as architects could shift the system between equilibria (even though New york lacked of a secondary market). CONCLUSION: the paper analyses policy factor (of the CB) behind the emergency of vehicle currency the idea is that they depict the economic power of hegemonic countries, but not in a naturally oriented way, behind there were also policy choices (along with external casualities). Also, not true that politics and monetary policy and CB doesn’t matter. The FED was fundamental into support opening of new US market and sponsor dollar driven markets and exchanges. THE RISE OF NEW YORK: IT OCCURRED BEFORE THAN CONVENTIONALLY SUPPOSED during and immediately after the IWW (Fed role as market maker) this experience challenges the popular notion of international currency status as being determined mainly by market size. UNTIL WWI US commercial paper was continually above the open market rate in London, as much as 200points. Then the creation of the FED was allowed by sharp reduction in differential. In 1917 when dollar acceptances rate become available, they are even lower than commercial paper rates. 1915 REVOLUTION IN THE RELATIVE POSITION OF LONDON AND NEW YORK: TOTAL AUTSTANDING ACCEPTANCES OF us BANKS BEGAN RISING THAT SAME YEAR. FED POLICY: 1. keeping rate of dollar near to the market value. 2. Push the dollar into trade exchanges, fostering new markets in dollar denominated trade credit. We see here two boon and bust cycles. There was a sharp increase toward the end of WWI (increase in US trade toward ww1, coincident in increase US trade associated with direct American military involvement). The peak reached in 1919-1920 was then followed by a sharp decline. Then new expansion in 1922-30 and the subsequent decline in 1930s. The withdrawal of the FED from the market coincides with the decline of the industry in 1930s. Figure 3. two indicators of official support of the market. Fed’s holding as a share of outstanding acceptances. Second is the spread between federal reserve and market rates for acceptances. The narrower the spread the stronger the support. WINNER JAPAN UK AND SINGAPORE (even though their currencies are not traded as much as euro and dollar) EICHENGREEN PAPAR 3: When did the dollar overtake sterling as the leading currency? Evidence from the bond markets At the Cannes Summit G20 leaders committed to taking “concrete steps” to ensure that the international monetary system reflects “the changing equilibrium and the emergence of new international currencies”. It is a natural result or not? SHIFT UNLIKELY lock in view and network externalities, benefiting the incumbent. These models rest on conventional historical narrative: it took a lot of time for US dollar to overcome the sterling. NEW VIEW Frankel and Eichengreen and Flandreau, relying on data on the currency composition of global foreign exchange reserves.--> dollar overtook the sterling already in the mid-20s. IMPLICATIONS: not true inertia and the advantages of the incumbency have not the importance that narrative believes; secondly, there is space for more vehicle currencies. 3. Predominance once lost can return (happened in 1930s). True both for trade and exchange of reserves. Both market forces and policy support were instrumental in helping the dollar rival and overtake sterling. There is no such thing as a winner-take-all game in currency competition. CRITICS difficult to make inferences relying on past experiences since nowadays currency system is totally different from that during the 20s. 1. There is no gold standard anymore. 2. In the 20s the dominant asset and main international reserve were the dollar. Compared to the past financial transactions today play a much larger role. This paper new evidences that in the interwar period there were usage of international currencies in financial transactions (second objection doesn’t yield). Provide a systematic empirical analysis of the determinants of currency choice in international bond markets during the interwar period. Data in the currency denomination of foreign public debt for 33 countries in the period 1914-1946. Why interwar period? Only period since industrial revolution in which one incumbent reached another one. This means that a shift toward a monetary multipolar system is not impossible. Contemporary data on the currency of denomination of international bonds are consistent with the existence of this kind of shift.) The share of the euro in the stock of international debt securities increased some 30% in the 2000s from approximately 20% in the 1990s. Inconsistent with the presumption there is space for only one currency. In order to understand the evolution of currency shares, it is important to consider medium-term evolutions findings says thet the share of a currency in global bond markets can be halved in less then a decade which is what happened to the sterling in the 1914 1920 period. Lower inflation significantly raises the share of the dollar or sterling in counties’ foreign public debt although impact is small. In the short effect of reducing inflation is associated with increases in the share of US dollar. COUNTRY SIZE IS ALSO IMPORTANT: IN THE SHORT RUN increase in the share of the US uk ECONOMY IN GLOBAL OUTPUT, corresponds to an increase in the share of the US dollar (STERLING) by roughly four percentage points. FINANCIAL DEEPENING, the persistence and credibility effects change somewhat with the size being larger than before. Financial deepening exerts a significantly effect on the US dollar sterling in global foreign public debt market. An increase in the ratio of banking assets to GDP by 10% is associated with an increase in the share of the US dollar (STERLING) of about three %. COMPARISON contribution of size credibility and financial deepening to the change in the average share of US dollar in foreign public debt between 1918 and 1932. Calculated using the estimated parameters of the benchmark model. financial deepening is by far the most important contributor to the increase in the share of the dollar as a currency of denomination for international bonds between 1918 and 1932. Credibility because of lower US inflation. Different with country side less relevant here. Slow growth and high unemployment handicapped Britain’s efforts to maintain its financial pre-eminence and undermined the role of sterling in the 1920s. 1932 1939 financial depth and retrenchment contributed most in fell (crisis of the banking system in US after Great Depression). CONCLUSIONS AND IMPLICATIONS: New evidences on the emergence of the US dollar as the leading international currency, focusing in its role as a financing currency in the global debt market. 1. Network externalities and inertia matter but no indefinetly delay the transfer of leadership in the international monetary sphere relative to that in the economic commercial and financial sphere. Abstracting from common wealth countries the dollar took over sterling 15 years before what the narrative says. 2. In 1920 and 1930 the system was a bipolar currency system not a unipolar one this is true also taking into account the commonwealth 3. Financial deepening was the most important contributor to the increase in the shareof the US dollar in global foreign public debt between 1918 and 1932. Uk stagnation most important factor for decline. 4. The international status of a country will rest on solid foundations only if financial deepening in the issuing country is sustainable and not if financial liberalization simply causes a boom that eventually goes bust. The collapse in US UK system was due to the collapse of the banking system and sub sequential financial retrenchment. 5. IMPORTANCE OF MACROPRUDENTIAL POLICIES. LESSON 9 R3 History Central banks had the right to issue banknotes---the Bank of England started as a private bank and started its activity in 1694. 1926 Quota 90= the Bank of Italy starts to print money 1880-1913 Gold Standard GOLD IS THE MAIN RESERVE, currencies are pegged to gold price = fixed exchange rate with gold. British pound sterling at the centre of the system. Main reserve currency British empire global prevailing economic and military power. Exchange rate were pegged in terms of dollars (and pound). Many countries joined the gold standard but not all the countries. Money supply determined (monetary base) by the quantity of gold owned by the system of private chartered banks (with the right to issue bills) (central banks were not there yet). CENTRAL BANKS  only few central canks, FED was born in 1913. Bank of England founded in 1694 as a private bank to provide banking services to the crown WERE NATIONALIZED IN 1946  pivot of convertibility of currencies into gold. In 1997 it becomes operationally independent = monetary policy is not under Government control (even though the decision to not join the euro or to sell gold were taken by the government) Banca d’Italia founded in 1893, merger of 3 large Italian banks (scandal of Banca Romana-gold standard) issues banknotes from 1926. FROM 1918 to 1945  British empire demise and rising of the USA as a global power. Impossible to go back to the gold standard after WW1 inflationary monetary policies (printing money without complying with Gold standard tenet to finance military expenses) Fierce discussions on the gold parity of pound (prewar or new devalued exchange rate with gold?) (Chruchill – Keynes UK, quota novanta Italia) They decided to go with a semi-gold standard with two reserve currencies £ and $. In 1933 Roosvelt quits the gold standard and other countries followed. 1930: competitive devaluations  trade restrictions tariffs  spreading of depression Gold standard suspended during WWI because banks need to finance wars and start printing money without following rules---at the end some countries wanted to go back according to the parities before the war, but it would have not had sense. Between the 2 wars SEMI GOLD STANDARD with 2 RESERVE CURRENCIES, until 1933 when Roosevelt decides to leave because of the Great Depression= BEGGER THY NEIGHBOUR POLICIES, because they did not take into account the problems of other economies, by simply making COMPETITIVE DEVALUATIONS FROM 1945 TO 1971: Bretton Woods (1944) DOLLAR-GOLD-EXCHANGE STANDARD. Fixed exchange rate between gold and dollar but restricted to official transactions (only CB). Agents wishing to buy and sell gold should go to the private gold market where the price is set by demand and supply. International mobility of financial assets (capitals) is absent or very low. WESTERN CURRENCIES PEGGED TO DOLLAR WITH SMALL RANGES OF VARIATION. NEW GLOBAL ECONOMIC AND MONETARY INSTITUTIONS IMF, BIS, WB (GATT AND WTO) Bretton Woods system---confined to official authorities, so that another MARKET FOR PRIVATES rublo was not a convertible currency, so not traded in foreign countries---BLACK AND OFFICAL MARKETS, the former with totally different exchange rates interest rate varies.  to tackle the weaknesses of this model we consider that demand for money may vary when there are different rate of interests. The WEAKNESS HERE IS V WHICH IS CONSIDERED CONSTANT it is not because it depends on the price of holding money, which is eventually the interest rate. A GENERAL MODEL FOR MONEY DEMAND: Money demand for transactions (money used for payments for goods and services) depends on income. Yet holding money is costly since the holder gives up an interest that may be obtained by putting money in a time deposit. If I keep it in my wallet nothing happens by the way today keeping money in the wallet is even better than investing them in german bonds because their interest rate is negative. V (speed of the circulation of money) is no longer constant because it depends on the cost of money With deflation? If cash (liquidity) has a return higher than a deposit demand for money may become infinite or quite unstable  there is an infinite demand for liquidity because those who have liquidity doesn’t want to share it  deflation is the result of a lower rate of liquidity Md=L(i) P Y WHERE L(I)=1/v (I) WAY we model circulation, extent of the liquidity preferences of people and the liq preferences the desire for liquidity is something that depends on the interest rate. People not the same in terms of liquidity preferences they change over time and spaces, also over cultures or external variables IN THE QUANTITY THEORY OF MONEY L which is the inverse of speed is constant (as the v) L is an inverse function of the rate of interest (quasi Keynesian assumption). L is the liquidity ratio: the quantity of money to finance the activity level = nominal income PY Since 2008 L has increased due to a flisht to liquidity of households and financial intermediaries such as banks, in March 2020 has increased even more. Liquidity is the inverse of the speed of circulation times the interest. So the higher the speed of circulation the lower the liquidity preference. When everything is working properly there is less demand for liquidity Liquidity is costly for society when there is a high demand of liquidity economy is in strain. HENCE Md/p=L(i)Y INCOME : if Y increases the demand for Money increases too. INTEREST RATE: in the quantity theory of money is irrelevant. HERE WE NEED IT In this graph we can see how the REAL money demand changes as a function of the interest rate the higher the interest rate, the lower the money demand. Also, we can see how the variable Y changes the frame: we consider it as an exogenous variable it the Y rises then, for each level of Md/p we have an higher interest rate. THEREFORE, THE HIGHER THE Y THE HIGHER THE I. INVERSE RELATIONSHIP BETWEEN THE RATE OF INTEREST AND MONEY DEMAND: GIVEN THE LEVEL OF INCOME THE DEMAND FOR MONEY FOR TRANSACTIONS GOES DOWN AS THE INTEREST RATE GOES UP. EQUILIBRIUM IN THE MONEY MARKET Now let’s talk about equilibrium: we need to introduce the MS, money supply. It is fixed since it is decided by the CB and doesn’t vary. IN THIS GRAPH TWO DIFFERENT RATE OF INTEREST CORRESPOND TO TWO DIFFERENT INCOME LEVELS, which both correspond to a certain level of money demand, facing a fixed money supply Ms. UIP – uncovered interest parityinternational financial equilibrium relation between THE INTEREST RATE AND THE EXCHANGE RATE UNCOVERED: NO PROTECTION USING FORWARD OR FUTURE CONTRACTS FOR FINANCIAL INVESTORS. UIP: fin invest indifferent between holding one of two currencies (doll euro). Currency that is expected to devalue is compensated with a higher interest rate (no arbitrage condition) D Ee/E $ EU= I$-IEU DEe is the variation of the expected ER If for example the Ex change rate devaluate by 5%, the difference between interests needs to be equal that devaluation. Inflation and the interest rate in the long run: PPP+UIP From relative PPP we get the expected devaluation rate of the dollar in one year D Ee/E $/€= PGRECOeUS-PGRECOeEU PGRECOEXP is the annual expected inflation rate FROM THE UIP WE GET THAT The variation of the exp exchange rate over the exchange rate of the $ compared to € need to be equal to the difference between the i$ and i€ DEe/E$/€= i$-i€ Since in both equations the left parts are equal (Dee/E) we can actually put the RELATIVE PPP and the UIP together saying that there is a relation in the difference expected variation of the inflation in both countries and the difference between the interest rate in the two countries we are considering. THEY NEED TO BE EQUAL, THEY ARE EQUAL the expected inflation rate variation has an impact in the nominal interest rate  THIS IS THE FISHER EQUATION: AN INCREASE IN THE EXPECTED INFLATION RATE IN A COUNTRY CORRESPOND IN AN INCREASE OF THE NOMINAL INTEREST RATE. THIS RESULTS HOLDS ONLY IN THE LONG RUN. FISHER EQUATION (in the long run equation)  i$-i€=pgr$-pgre€ Increase in the expected inflation generates increase in the nominal interest rates From the Fisher equation we get the Real Interest rate parity I$-pgre$=i€-pgreco€  (another way to write the fisher equation) Do central banks actually control the interest rate as assumed above? Not clear, it depends not in all cases. Cross country spreads in the Eurozone are the first proof. To eliminate spreads the ECB should buy sovereign bonds in a targeted manner buy more Italian bonds and less german bonds. But this is forbidden in euroland proportionality rule relaxed march 2020 Usa FED, the instrument (control) is overnight rate paid by the FED to banks demanding liquidity to the fed and this intervenes in a discretionary manner on federal bonds (increased share of the FED balance sheet and other securities and uses generous quantitative easing increasing money supply. In normal time this rate (overnight rate) this rate determines chain of reactions the remaining market rates on banking loans to households, firms and banks  TRANSMISSION MECHANISM OF THE MONETARY POLICY MONETARY POLICY HAS AN IMPACT ON GENERAL ECONOMIC CONDITION AND ON PRICES However, since 2008 the majority of banks sees other banks and customers as very risky and they lend much less than in normal times while they prefer to deposit liquidity at the central bank even though the returns are very low (negative) LARGE SPREAD BETWEEN THE OVERNIGHT RATE (VERY HIGH) AND CUSTOMERS RATE WHICH IS REALLY LOW. When the interest rate was at zero, the FED could not push it in negative territory, in the USA there a zero lower bound policy. That is the main reason the FED decided to adopt quantitative easing increasing ms and expanding the monetary base MO lending the banks or by direct interventions) open market operations) in Tbills auction- primary and secondary markets or in other operations financing directly the economic activity enlarging the set of collaterals to junk paper. With the QE the FED doubled Mo after 2008 reaching 1 trillion without moving M1 and M2 showing that banks did not want to transfer liquidity to the market (their customers) The transmission mechanism of the monetary policy to the market via the banking system collapsed and the fed took over the banks lending money directly to firms and financial intermediaries (insurance hedge funds) THE SHORT RUN THE ASSET APPROACH TO THE EXCHANGE RATE Short run international financial flows are very large and volatile, but they are the main determinants of ER fluctuations in the short run Goods and services international flows are less volatile in the SR and are more relevant for LR ER fluctuations ASSET APPROACH: THE SHORT RUN The first remark: Currencies are liquid financial assets a) The monetary approach for the LR b) THE ASSET APPROACH FOR THE SR: is able to explain the SR fluctuations of the ER In the SR (weeks months) there are relevant deviations from the PPP goods and services prices are rigid in the short while they are flexible in the long run UIP : the fundamental equation of the asset approach is the UIP (uncovered interest parity) links LR and SR I$=ieu+(Ee $/eu-Es/eu)/E$/eu We use it to determine the spot exchange rate E$/eu Spot exchange rate is determined by expected exchange rate, which we gain from the monetary approach. How is the interest rate determined? HOW DO WE PROCEED? We upend the UIP derivation forecast the spot ER while knowing the EXPECTED ER and the interest rate EXAMPLE of equilibrium in the currency market Ee$/eu=1.22 the spot ER expected to prevail in 12 months I=3%=o.o3 I$=o.o5 In order to have equilibrium 1.22- E/E=o.o2 1.22-e=0.02e E=1.22/1.02 E=1.20 If the FED increases the interest rate from 5 to 7 % spot $ appreciates in the SR  everyone wants to buy asset denominated in that currency, therefore pushing down the price of that currency. Sr INTEREST RATE DETERMINATION: MONEY MARKET EQUILIBRIUM At the basis of the asset approach there is the uncovered interest parity E$/eu EXOGENOUS variable, with the two interest rateswe take it from the outside E SPOT EXCHANGE RATE IS THE ENDOGENOUS VARIABLE  By the way Ee comes from the LR monetary approach, where do the interest rate come from? From Fisher equation : LR: A) P FLEXIBLE B)I=RINT+PGREC (DEFINITION OF THE REAL INTEREST PARITY) In the short run: P=p are rigid c) I nominal (NO REAL INTEREST PARITY) In the LR p is Flexible and varies to equilibrate the money market in the short run I is a pivot a variable to which the responsibility is totally charged. In the short run there are rigidities (labour contracts or whatever), therefore the PPP doesn’t hold in fact the Ppp says that prices adjusts naturally to a change in the MS. In the long run the definition of I can be r+pgreco(because there is inflation). In the SR there is no change in prices therefore the definition of I changes and I is nominal always. In the short run the I is not the Fisher value but it goes around it, it fluctuates around it. LR: P ADJUSTS TO THE MS TO EQUILIBRATE THE MONEY MARKET SR: I ADJUSTS TO THE SHORT RUN TO EQUILIBRATE THE MONEY MARKET  Msus/prigus=L(i$)Yus IF THERE IS A DISEQUILIBRIUM IN THE MARKET IN THE SR, FOR EXAMPLE AGENTS HOLD TOO MUCH PAPER At the point i$ agents hold excessive money with respect to the demand (S>d). Therefore they decide to sell money to Treasury of US and buy Bills from it. This will push down I (price of the asset, increased demand for asset) towards point 1. Nominal interest is determined by Ms and Y (via money demand) in the SR. If US Ms increases i$ decreases; If Md increases i$ increases. EFFECT ON THE SPOT EXCHANGE RATE we plug Ee and the nominal interest of US and UE in the UIP AND WE GET E. In the short run the market will be adjusted by a change in interest rate: in particular if the money supply rises (go to the left) we have that (without an adjustment in Md and Y, which are more rigid in the sr) the interest rate goes down and the currency is devaluated. SR vs LR: TEMPORARY OR PERMANENT? Suppose the FED increases Ms from 0% to 5% in 2020: Fundamental is the role of expectations on Ee $|eu  if the increase in money is deemed as permanent then we have that the expectations over the devaluation are adjusted with prices, therefore we should end up in an increase of the interest rate. In both cases by the way the currency is devaluated. LESSON 21/04 The crucial point: LR devaluation is associated to an increasing interest rate In the short run devaluation is associated to a decreasing interest rate RECENT HISTORY: 1990 2000: ECB adopts nominal control the interest rate for inflation targeting The FED is more fuzzy, ambiguous. Different controls in the Usa vis a vis the EU should generate different interest rates fed policy was to have interest rate higher than interest rate in Europe. CENTRAL BANKS MORE FOCUSING ON SHORT RUN INTEREST RATES (because long run are different to control) Fed policy 1990s dollar appreciates on euro with i$>i€ FED policy 2000s i$<ieu dollar depreciated  devastating against euro policy by jean claude trichet difference between the two interest rates was never justified. SINCE 2015 each time FED hint the possibility of an end of increase overnight interest rate the rate of dollar appreciates. Ms and I For a given money demand in the SR we have that both Ms and I may be used as controls  anchors by the CB for the main purpose of the monetary policy (price stabilization) Usually central banks prefer to control the short term interest rate since money demand is not stable in the SR Should the CB control the Ms it would make I unstable, volatile In the sr an increase in Y increases I if Ms does not change and does not accommodate change in income. WITH DEFLATION: in deflation the interest rate becomes almost useless as an anchor, unless negative interest rate are used (happened in 2014 in Germany). With negative interest rate the monetary policy is hard to manage and risky. There are capital losses for bond holders while cash holders do not face losses. Infinite demand for hot money (cash and liquidity) the most liquid asset. There were also the idea of taxing liquidity to correct this financial market problem. NEW GOALS OF CENTRAL BANKS IN EMERGENCY TIMES: 2008 cbS ARE REQUIRED TO PROVIDE LIQUIDITY to banks private agents short of liquidity because of sudden: 1. Demand drop 2. Unemployment increase 3. Decreased confidence The objective of price control becomes secondary 2020 CBs to provide liquidity to the entire economy because of sudden 1. Demand and supply drop 2. Unemployment increase 3. Bleak expectations and lost confidence Present deflation (goal is price increase rather than decrease) Whereas liquidity in 2008 was needed to some sectors, today liquidity now is due to everyone. DEFLATION (2012-2020) In this case interest rate is almost useless as an anchor (zero lower bound ZLB in the Usa) inless negative nominal rates are used (in 2014 Draghi introduced a negative rate for deposits of banks at the ECB, August 2019 Germany issued a 30 years bond with negative rates) in euroland negative yields bonds (in Italy up to 3 years fbre 2020) With negative interest rates monetary policy different capital losses while cash holders don not face losses. Why so countries so keen about reducing the use of cash, RESTRICTING THE AMOUNT OF CASH. Interpretations: If we know the future (or there is an expectation of) Ms Y and future interest rate ie we have three endogenous variables. Arbitrage and expectations WE JOIN SR ASSET APPROACH AND THE LR MONETARY APPROACH: TWO SYSTEMS SYSTEM 1 ASSET SR 3 equations 3 unknown: i$, ieu, E$/eu SYSTEM 2 LR 3 EQUATIONS 3 UNKNOWNS PeUS PeEU Ee$/eu To solve the system we need expectations FLEXIBLE ER THE GENERAL SOLUTION For dynamic consistency we proceed backwards  we take a decision on the base of future to not regret tomorrow what we do today, since what we do now is consistent with the future (DYNAMIC CONSISTENCY) (HARD IN REAL LIFE) STEP 1 Solve the LR system and get the exogenous variables to plug in the short run system and solve it. Backward induction procedure solution Beyond technicalities application of a specific case, how the interactions of short and long run work together. To explain overshooting, volatility of exchange rates, sort of disease that plagued most of systemic crises up to now, recent times. LESSON 22/04 Time inconsistency Overshooting We link the SR and the LR and consider them in a single model THE STARTING POINT: a permanent unexpected increase in the US Ms THE DIFFERENCE BETWEEN WHAT HAPPENS IN THE REAL MARKET AND IN THE FINANCIAL MARKET causes the overshooting, this is because prices reacts in the long run. We consider time from the beginning time t and then time after t No room for discretionary policies because the interest rates should be equal in order to not have a devaluation of their currency EXPLANATION: Denmark cannot change the interest rate in a discretionary manner but it must adopt the same interest rate of euroland Once the country pegs the ER to the euro there is only one level of the MS consistent with the fixed ER: I€=IKR P rigid is exogenous and determined by the fixed ER through the PPP pDK=Ehat/peu Y IS EXOGENOUS AND THEREFORE dk DOES NOT CONTROL ANY VARIABLE SINCE IT HAS USED THE er AS THE ANCHOR-CONTROL. the SR model is similar to the case of flexible ER but with an inverted sequence Flexible ER: the CB chooses MS that in the SR determines I and with the UIP determines E. Ms exogeneous E endogeneous Fixed ER: the CB chooses E that in the SR determines I via UIP and I determines the necessary level of MS_ E exogenous, Ms endogenous. IMPLICATIONS: endogenous MS and the BOP.  currency board, WITH CURRENT ACCOUNT SURPLUS BY 10 EUROS and FA DEFICIT 5 euro WE CALL IT A DEFICIT OF THE BOP. HOW CAN WE COMPENSATE IT? THERE ARE PEOPLE GOING TO THE CB 10 DOLLARS BECAUSE THEY HAVE SOLD ABROAD MORE THAN WHAT THEY IMPORT. 10 DOLLARS IN THE HAND OF ARGENTINIAN EXPORTERSthey have also to pay employee and managers and cost, but no way to get pesos to pay employees and they have to go to the CB with 10 dollars to get 10 pesos. Simultaneously at the cb there are people going for the deficit of the FA (the 5 dollars) people asking for 5 dollars, they give them 10 pesos, no possibility to get them 10 dollars (therefore they give 5 doll, 10 pesos).Argentinian CB is now owing 5 dollars, the Argentinian CB was issuing pesos for compensating  the pesos they receive have an impact on money supply foreign exchange reserve res increase due to bop surplus translate automatically into an increase of the money supply of the same amount. Variations in the money supply are determined by the BOP deficit (not decided by the CB), result of adopting a fixed rule so there is a fixed rule to accommodate a change in income Official reserves variation which is out of the BOP and may show either a surplus or a deficit Balance of Payments surplus of Argentina, would mean current account surplus of ten pesos and a financial account deficit  EUROLAND Ms changes in a euroland member (independently of what does the ECB) if: 1. Foreign exchange reserves of a country change (foreign exchange reserves are partly at the ECB and partly at each euro member) 2. If the (TARGET) position of a country at the ECB changes (“the reserves”in euro) If the ECB doesn’t balance these positions a BOP deficit of a euromember may generate a liquidity shortage with interest spikes (Greece 2011-2015, Spain and Ireland) independently of the condition of government debt. Dollars the bank of Italy deposit get from a Italian firm in the usa. The bank of Italy pays this dollars paying in euro increasing the money supply of euros. The euro is for us at the same time our domestic currency and the foreign currency. this sort of double nature of the euro is not simple to understand. You spend 100 euro in Germany for a trip, you brought it from Italy it means that the circulation of euros in Italy has decreased by 100 euros. So disappearance in Italy and go in the circulation in Germany. Would effect the liquidity of Italy and increase the one in Germany. The cb could intervene, balancing this thing, introducing a compensation giving to the circulation of Italy 100 euros of Germany. EXAMPLE: Italy shows a CA deficit with Germany of 10 eu and a FA surplus of 8 euro in 2019 The BOP deficit with Germany is 2 euro It is paid with 2 eu coming from euros of Italy In that case the monetary base in Italy decreases by 2 eu unless the ECB increases of 2 eu the cash in Italy If the ECB does it Italy will see its debt position at the The monetary base in Italy decreases by 2 eu unless the ECB increases of 2 eu the cash in Italy if the monetary base decrease the interest rate goes up If the ECB does it Italy will see its debt position at the ECB (Target system) increase by 2 euro BOP and the Ms the variation of official foreign exchange reserves is a source of endogenous variation of Ms (China answer to US President 2010) Our current account surplus (but FA in equilibrium) translates into an increase of the money supply in china expanding the economy The Currency Board: Ms (Monetary base) entirely backed by foreign exchange reserves. Argentina 1990s. Hong Kong. Political economy question behind: the seignorage hot issues in developing or transition countries. Because THE VARIATION OF OFFICIAL FOREIGN EXCHANGE RESERVES IS A SOURCE OF ENDOGENOUS VARIATION OF THE MS (CHINA ANSWER TO US PRESIDENT) WHY DID HK HOLD EXESSIVE RESERVES WHILE ARGENTINA INSUFFICIENT? May come also from the banking money system not just banknotes in circulation. It is a prudential policy to protect the banking system from speculative attacks. Prudential policy to protect the banking system, hong kong able to defeat the international speculation against the currency board and the stock exchange. HK taught China how to react to Shanghai stock exchange fall 2015 china able to defeat thanks to amount of international foreign exchange reserves (which can be considered as weapons in the international economic battles) On the contrary Argentina had less reserves since it relied on the US FED to tap draw dollars …FOREIGN EXCHANGE RESERVES SINCE THEY ARE WEAPONS THEY CAN BE USED TO DEFEND OR ALSO TO ATTACK. In 2015 international foreign exchange reserves have started to decrease after two decades of growth. This is because There is a higher degree of cooperation with many swap contracts among main CBs. If the FED needs euros it may get them from the ECB thanks to a swap contract without accumulating reserves of euros Cooperation with the IMF and a suitable shooting power of the IMF via a vis international capital flows could lead to similar results A reduction of global imbalances has contributed to a lower demand for foreign exchange reserves Reserves are weapons to protect a country from speculative attacks in the foreign exchange markets DEFINITION OF SEIGNORAGE: in today monetary system, in which CBs sell assets and acquire liabilities the seignorage is the profit of the CB. In france and Germany the seignorage goes to the state since the there is no private system. In Italy bank of Italy is property of private banks the seignorage is not public revenue. In the Us the system is private but the 94% of seignorage goes to the government. Sj= ij Mj Where M stands for the monetary base yielding seigniorage (banknotes in circulation) I is the interest rate In the euro area each country j obtains a share of the seigniorage (profits of the ECB) given by its capital share in the ECBS If the BC finances DIRECTLY the Government at zero interest rate issuing notes, which are not redeemable, the seignorage is the entire value of cash plus interest Si=(1+r)Mi EULER 1: CA imbalances as an inter-temporal consumption choice INTERTEMPORAL TRADE: Basic notions: balance of payments, national accounting Open economy and closed economy differ owing to the opportunity of borrowing and lending from to another country impossible in a closed one. An economy may face a temporary income decrease (or an increase). It will cope with it by borrowing (lending) from (to) the ROW. Intertemporal trade is measured by the Current Account (CA) balance of the Bop. SINCE ECONOMIES ARE OPEN may face temporary increase or decrease. APPLY FOR  SHOCK WHICH IS NOT SYMMETRIC, BUT ASYMMETRIC. WHICH TOUCH ONE COUNTRY AND NOT THE OTHER. BIBLE, Egypt, shocks many can come from nature, can reduce the income of that country. This is actually a tale on the bible but it can happen, income decrease or even an increase. Then the country may cope with it by borrowing or lending from the ROW this is consequence or a possibility of financial openness. If financial openness is not there this is not possible. WHY SAVING DIFFERENCES ACROSS COUNTRIES? Countries have different saving behaviour this is what happens after a shock. But there are other reasons for different saving behaviours because different saving behaviours affect financial markets and affect also other countries, their effect is not constraint to the country having that behaviour but it actually have repercussion on the other countries. So this behaviour affect the global economy. a) Countries may have different saving behaviour because they have different demographic structure (EU) consumption time profile over the life cycle, Ando Modigliani, Friedman (long term) mostly young people don’t save, until 20 or 30, until they are in the labour market (but there are countries in which they start working early). Young people don’t save, they dissave (I am spending my family money, investing on human capital formation). If we have a very young population low save rate, instead if we have a old population they save more. b) Different cultures (Japan and Germany) culture for saving, people saving are better than people don’t saving too much. Debt in Germany is like blame then is considered something which is not good, not good for economics because debt and credit are too side of economy. c) Different policies (exchange rate + demand policies) China and short term  lack of freedom from trade union, lower wages, no democracy quite a relevant point for saving behaviour d) Different pension systems (Eugeni 2015) short-long term different accumulation systems people anticipate by saving more or less what they will get during retirement important the way through finance it. Eugeni pension system in different countries determinant of different current account disequilibria EXCESS SAVINGS CANNOT OCCUR IN EQUILIBRIUM IN A CLOSED ECONOMY, since the excess is actually the CA S-I=CA SLIDE 6 INTERTEMPORAL TRADE DEF: exchange of resources over time – saving – among countries = inter-temporal trade  waiting for return of what you have done. S-I>0 in a closed economy (japan 1990) not perfectly flexible exchange rate and the sterilization of the increase in foreign exchange reserves produced deflation (not just CA surplus),the private sector doesn’t invest abroad therefore there is increase in money supply with fixed exchange rate and then sells bond to absorb the money supply. Selling too many bonds may push interest rates too high encouraging further saving (excess of demand) DEFLATION AND LIQUIDITY TRAP Saving can take place only if you introduce time way to do inter-temporal trade. Here (slide 8) link to a table reported just partially, interactive table, scroll by countries and by time, extent of the current account imbalances. Goes on from 2020 about global current account imbalances. A model of inter-temporal trade theoretical model providing us list of opportunities that intertemporal trade could provide us. Is there is financial openness and some specific condition specified are met. We focus on interest rates  crucial variable is time and then interest rates as to follow because is the price of time, interest rate is mostly the price of time (lend into the picture too). We neglect intra-period price changes and home vis a vis foreign prices. MODEL OF INTERTEMPORAL MACRO ECONOMIC CHOICES which could apply to different economics systems. An economy where markets are side steps and the government wants to decide for the people as well, but it must be an economic system which is open to foreign financial exchange. GENERAL ASSUMPTIONS: 1. Assumption, only one good (elimination of macro and micro economic approach, sort of bridge between the two) we don’t take into account international relative prices something which from macro economic feature. Across time good 1 available now, good 2 available next year, good 4 available in 3 yearsgoods differ only for their time availability in time. 2. Financially open small economies over two periods no production__ only exchange of existing goods and saving only international exchange of existing goods and saving saving is given by the goods which are not consumed and cannot be stored because storage is very costly (goods which deteriorates) LESSON 6/05 Less general assumptions: I3. All individuals are equal I4. Population normalized to 1 I5. U’(C1,2)>0 I6.u”(C1,2)<0 MODEL: max collective utility over the life cycle (social planner or representative individual) U=u(c1)+Bu(c2) Where B(beta) is the subjective discount rate or intertemporal preference rate or impatience (lower if we are more impatient, we want to consume ASAP)  DEPENDS ON δ which is the subjective time preference rate u welfare, the benefit comes to the population, community. As a result of consumption in two periods c1 consumption in period 1 and consumption in period 2. Small u’ larger than 0. Depends on the consumption in period 1 and 2, time horizon two periods so this is utility function with a prime, which is the change of utility if for instance c’ changes or increases (is the derivative, reaction) how much population increases or how much consumption increase. If I make a small action, how much can car speed increase (example of pression or depression on consumption) The u’ is the first derivative the reaction of c going up is increase in welfare. I increase the variable (control variable, which is consumption) by small amount and welfare increases. The reaction move in the same direction. The first derivative is positive There are two primes- variation of the derivative which is the variation of the two prime we have about u”: is the variation of the variation: when consumption increases is always positive, you always want more. You prefer to have more than less, with first derivative u’. In I6 you simply say you want more and the additional welfare you get is decreasing as you become more affluent your increment your additional welfare is lower and stay positive as you become richer. What you get in addition is an increase in welfare which in turn gets gradually smaller and smaller. THIS IS WHY THE SECOND DERIVATIVE IS NEGATIVE. THE CHANGE OF THE INCREMENT IS NEGATIVE. I6 DECREASING MARGINAL UTILITY I5 INCREASING MARGINAL UTILITY we plug c2 (previous equation) and we substitute it to the c2 which where in the original equation. (bu(c2) with respect to c1 control variable  this community chooses c1 so as to maximize the aggregate utility which is U max problem is solved and performed with respect to C1 which is the control variable. This one would change so now the problem is to maximize capital U with respect to C1 this one is written taking into account the constraint. INTUITION ON THE MATH SOLUTION: equilibrium is where we stop moving consumption from period 1 to 2  redistributing consumption to period one to 2 at a point we get addition utility consumption in period 1 is equal to utility we lose by decreasing consumption in period 2 . if we increase consumption in period one we shall decrease consumption in period 2. Perfectly balance so at that point we don’t move anymore. We should go on by increasing consumption until increase consumption as we have the loss in period 2. EQUILIBRIUM RELATIONSHIP. Skip 19 slide  MAXIMISE UTILITY USING AS A CONTROL CONSUMPTION IN TIME 1, in order to obtain the best result maximum point if the first derivative when it is equal to 0 1st Euler equation: from which u’(c1)=(1+r)Bu’(c2)  THIS IS THE RESULT OF THE MAXIMIZATION Best consumption profile over time in an open economy. This is the first euler equation Lesson 12/05 1st Euler equation: U’(C1)=(1+R)BU’(C2) Best consumption profile over time in an open economy : The utility of the derivative (the path) of C1 is equal to the interest rate times the preference of the population over consumption in tie 1 (the discount rate) time the utility as a first derivative of the consumption in time two. Meaning and more intuition: In equilibrium, if we decrease by one small unit C1, utility goes down by u’(c1) . The saved unity will give 1+r units to be consumed in period 2. This increases utility U by (1+r)Bu’(c2). In equilibrium the two parts are equal. OFF EQUILIBRIUM SKIP IT REWRITEING EULER 1: Bu’(c2)/u’(c1)=1/(1+r) Bu’(c2)/u’(c1) is the marginal rate of substitution of the consumer (or the country) between c1 and c2 1/(1+r)  this is the price of future consumption in terms of the present consumption: how many units of c1 we must give for an additional unit of c2? The left side is the marginal rate of substitution of the consumer of this community between C1 and C2. The marginal willingness of one community to substitute consumption in one period in respect to consumption in the other period. This is given by the ratio , marginal utility of the consumption times to the This should be equal to 1/1+r this can be seen also as price of future consumption in terms of present consumption is determined by the market interest rate. How many units of C1 we need to get additional units of C2 this is the price of future consumption or also called the market discount rate. Whenever is larger than 0 the market discount rate lower than 1, means that the interest rate is equal or lower than 0, therefore the price of future consumption in terms of present consumption is 0. This means of course that preference of the community is fundamental. Preferences must be compared to international interest rate. 1/1+R MARKET DISCOUNT RATE  price of future consumption in terms of present consumption while the price of present consumption in terms of future consumption is pc1/pc2= 1+r Is also an implicit price: not a market price (interest rate on commodities) Pc2/Pc1=1/1+r Larger than one to consume now than in the future is more expensive because postpone consumption I receive a premium which is the interest rate. THE OPTIMAL CONSUMPTION PROGRAM: If B=1/1+r u’(c1)=u’(c2) Or c1=c2 B is the discount rate, which is the preference for people to consume tomorrow (rate of impatience, the higher it is the less people want to consume tomorrow)  therefore in equilibrium if this preference meets the price (the interest rate) we should have that the marginal utility of consumption in period one is equal to the marginal utility of consumption in period 2. Therefore consumption in period 1 should be equal to consumption in period 2. IN A SMALL OPEN ECONOMY R IS GIVEN BY INTERNATIONAL FINANCIAL MARKETS: If B=1/(1+L) > 1/(1+r) means that the international market offer a return r higher than L and the country is willing to decrease present consumption: we are less impatient than the rest of the world financial market and EULER 1 STATES THAT: U’(c1) > u’(c2)  c1<c2 INTERNATIONAL FINANCIAL FLOWS: lending and borrowing allow welfare gains from inter-temporal trade. Open economies are not constrained to match each period exactly Y and C. CASES: consumption is flat over time if B=1/(1+r) in this case y1<y2, the country borrows c-y1 in period 1 and pays back (1+r)(c-y1) in period 2. May happen that B is equal the discount rate 1/1+r In euler 1 equation marginal utility of c1 is equal to marginal utility of c2 PERFECT CONSUMPTION SMOOTHING FLAT VIEW C1=C2= INTERTEMPORAL BUDGET CONSTRINT= Chat IN A SMALL OPEN ECONOMY R IS GIVEN FROM INTERNATIONAL FINANCIAL MARKETS International markets offer a return r higher than L (our discount rate) therefore we prefer to consume less now to consume more in the future. less impatience than the row this case the euler 1 says the market discount rate is lower from our discount rate we shall have that c1 is lower than c2. Marginal utility of c1 is larger than marginal utility of c2. In this graph we see that point is the equilibrium point in which C1=C2 and also y1different from y2. Instead in point A, which is the anarchy point, no openness, we have that y2>y1 and c2>c1. The two curves are the slope of the international budget constraints, which is eventually the marginal rate of substitution between the two inter-temporal choices. The first one is the IBC for autarchy and the other is in equilibrium. This also means that rA (the interest in autarchy) is higher than with open financial markets. IBC=PV= y1+y2/(1+r)  THE HIGHER IS THE R THE STEEPER IS THE IBC. In E we have: B= 1/(1+r) and c1=c2 if y1<y2 we can reach E thanks to inter-temporal trade C1 is more expensive in our country than abroad. The gain here is evident and stands on the possibility to consume more now, balancing consumption over time (smoothing). IT IS GOING FROM A TO E, in E we can consume more with respect to A, which is the autarky consumption point (where consumption=production in each period) AUTARKY INTEREST RATE: before opening up, a country has an interest rate which is given by substituting C1 and C2 with Y1 and Y2. Therefore we get Bu’(Y2/u’(Y1)= 1/1+ra KT+1=KT+IT where Kt is the existing capital endowment (exogenous) Net wealth of Italy is given by capital endowments our infrastructures and our lands and net position at the international tier. For instance has an aggregate net wealth, which is K in Italy . B is the sum of private and public net foreign assets. In the net wealth of a country you don’t see bonds, they don’t belong to the net wealth of the country. Still consider the inter-temporal utility function but we have more constraints, the intertemporal profile, the investment is equal to the difference between capital in the first period and capital in the second period. Capital cannot be stored, which means we have to consume accumulate capital for the sake of production but at the end of period 2 there is nothing and therefore we have to eat capital. K3 must be equal to 0 Investment may be negative and capital is consumed. DOMESTIC SAVING EXCEEDING INVESTMENT IS EQUAL TO THE ACCUMULATION OF NET FOEREIGN ASSETS Control variable is no longer consumption is investment this community now can use investment in an optimal way to get the best consumption profile. I decided to the central planner in a way to optimise consumption over time. So planning would give rise to the best choice of investments in order to give people the best consumption profile. Maximization process with respect to In order to make the equation equal to 0 means we translate the fisrt euler condition into F’(K2)= r which is the second euler equation. If a country is open financially what matters for the country in order to get inter profile are not intertemporal preference is only the international interest rate and the marginal productivity of a country and the country will be obliged to invest meeting this rule if the country is open. If a country wants to invest in aventure which is not profitable for the interest rate providing lower return (return must be equal or higher than r), if it is completely open cannot do it because people would not invest, this is why schools have not returns. Question mark on international financial openness? Financial openness provides opportunities because condition of investment are given by the return on that investments which are linked to market. One of the main problem for countries wanting to invest in social welfare were the returns are very low, but they are not able to do that. QUESTIONS: will an impatient country with a lower B invest less? Not necessarily, if it has access to international open market It can borrow at rate r it will not reject investment opportunities with a net return larger than r. SMALL ECONOMY ASS: our saving does not affect r. Investments are independent from consumption depends on r Investment in period 1 continues up to the point where the marginal return equals the return on foreign assets or (in case of differences between interest rates across countries due to specific country differences) Will an impatient country with a lower B invest less? Not necessarily if it has access to international open financial markets. If it can borrow at the rate r will not reject investment opportunities with a net return larger than r. Ages differences Will a country populated by elderly people invest more? Not necesseraly, it depends on investment. UNIQUE R? Hyp very strong. May be it is not for china Malaysia or other whose financial markets are not completely open making for non-unique r assumption. SMALL ECONOMY: our saving doesn’t affect r Perfect capital markets no limits for borrowing and lending NO DEFAULTS RISK. STABLE INTERTEMPORAL CONSUMPTION PROFILE AGGREGATE UTILITY FUCTION, CAPITAL U WE COMPARE CONSUMPTION IN THE TWO PERIODS WITH INVESTMENTS max our welfare over time in terms of consumption. Now income is produced, by using one factor of production which I: it comes from our investment production. It makes a difference in our investment production. We consume a lot of widt this year we don’t have widt for tomorrow. THIS IS POSSIBILITY FOR BORROWING AND LENDING. This decision is not made by our consumption, but by the return on investment. If we invest in seeds, technology is bad and our seeds goes off means our productivity is very low. For us better not no invest there but in a foreign asset better technology for storing seeds in another country, we invest less. Our preferences will be irrelevant because the amount of our investment is independent from our investment. F’(k2) is the productivity of our investment. What is relevant is the productivity of the new system. This given assumption of perfect capital mobility. The process of the second euler equation as the same starting point of euler one. In euler one is sympli consumption in the second is investment. Which means to produce. All the assumption for euler 1 hold also in this case. But there is this is sort of severe disciple that makes some of them irrelevant if we have perfect capital mobility. THIS IS WHAT HAPPENS IN A SMALL COUNTRY WHERE R IS EXTERNAL. Large countries are able to affect the international interest rate. 1+r  if we borrow 1 euro, you have to pay 1 euro +r you have to pay back the same amount with the r. THE PRINCIPLE. BOOK VALUE day of the liquidation of the settlement. Then you keep the asset and this can have a higher or lower value on the base of market fluctuations.