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Lecture 19 Interdependence & Coordination

Lecture 19 Interdependence & Coordination. International Interdependence Theory: Interdependence results from capital mobility , even with floating rates. Empirical estimates of cross-country effects. International Coordination The institutions of international cooperation

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Lecture 19 Interdependence & Coordination

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  1. Lecture 19 • Interdependence & Coordination • International Interdependence • Theory:Interdependence results from capital mobility, even with floating rates. • Empirical estimates of cross-country effects. • International Coordination • The institutions of international cooperation • Theory: Prisoners’ dilemma ITF-220 Prof.J.Frankel

  2. Interdependence under floating exchange rates • (Revisited) • Two of the results derived previously • were too strong to be literally true: • When we first looked at the question, floating rates completely insulated countries from each other’s economies. But that was when KA=0 (=> CA =0). • Since then, capital mobility has changed things. • Indeed, US, euroland, Japan, UK, etc., are still correlated. • Under κ=, we found G leaked abroad 100%, through offsetting TD. No effect remained at home. • This overly strong result was a consequence of the assumption i= . ITF-220 Prof.J.Frankel

  3. The restriction i = is in reality too strong, even for modern conditions of low barriers to international capital flows. • Reasons: • (1) i  i*, when investors are aware of likelihood of future exchange rate changes, • and • (2) i* is not exogenous, if domestic country is large in world financial markets (as are US & EU). • => Two-country model. • Implication: Effects of AD expansion are partly felt in domestic country, partly transmitted abroad through TD. • Why don’t floating rates insulate? Capital flows. ITF-220 Prof.J.Frankel

  4. Two-country model with perfect capital mobility • For now, retain i=i*, but drop i* =<= domestic country is big enough to affect i*. • Fiscal expansion, shifting ISUS out, • thereby appreciating $ and worsening TB, • now also depreciates € and raises TB*. • So Y rises (crowding out < than 100% ), despite κ=∞, • Y* rises (international transmission), despite floating, • as i and i* rise in tandem. ITF-220 Prof.J.Frankel

  5. US expansion drives up interest rates worldwide, because US is large in world financial markets. G↑ • €↓ • $↑ => Expansion is transmitted from US to Europe. ITF-220 Prof.J.Frankel

  6. Transmission in practice. • In 12 large econometric models, on average: • US fiscal expansion -> • Multiplier  1.5 in US 1/ • and  ½ in EU & Japan. • US 4% monetary expansion -> • Effect on GDP  1% in US • and  0 in EU & Japan. • 1/Most relevant in recession with liquidity trap(US 2009-14).Multiplier islower under full employment (or under default risk, or in small open economies). ITF-220 Prof.J.Frankel

  7. The econometric models agree that US fiscal expansion,via TBUS<0 and TB* >0, is transmitted positively to the rest of the world. G↑ ITF-220 Prof.J.Frankel

  8. Similarly, a fiscal expansion in the rest of the OECD countriesvia TBRoW<0 and TBUS>0,is transmitted positively to the US. G↑ ITF-220 Prof.J.Frankel

  9. More disagreement regarding international effects of monetary policy. A US monetary expansion, domestically, raises output & inflation. But the models divide regarding the effects on TB, TBRoWand YRoW. Reason: two effects go opposite directions. Y ↑ => TB↓, but $↓ => TB ↑ M↑ ITF-220 Prof.J.Frankel

  10. Disagreement regarding international effects of monetary policy. A foreign monetary expansion raises output & inflation there. But the models divide regarding cross-border transmission. Reason: 2 effects go opposite directions.YRoW↑=>TBRoW↓, but €↓=> TBRoW↑ M↑ ITF-220 Prof.J.Frankel

  11. International macroeconomic policy coordination • Institutions of coordination: • G8 Leaders Summit & G7 Finance Ministers • 1975 Rambouillet: ratified floating • 1978 Bonn: locomotive theory • 1985 Plaza: concerted intervention to depreciate $ • 2013 No currency war: Members agree won’t intervene. • BIS & Basel Committee on Banking Supervision • 1988 Basel Accord: set capital adequacy rules for intl. banks • 2007 Basel II: Gov.t bonds should not necessarily get 0 risk weight. • 2011 Basel III: Higher capital requirements. • G20 includes big emerging markets; • 2009 London: G20 replaced G7/G8, responded to global recession with simultaneous stimulus. • OECD for industrialized countries . • IMF for everyone (“Surveillance”). ITF-220 Prof.J.Frankel

  12. Internationalpolicycoordination is an application of gametheory. In one game, the players choose their level of spending. Dilemma: Each is afraid to expand alone. Cooperation here means joint expansion. In another game, the players choose the monetary/fiscal mix. ITF-220 Prof.J.Frankel

  13. A third game is what Brazilian Minister Guido Mantegahad in mind in 2010 when he warned of “Currency Wars.” ITF-220 Prof.J.Frankel

  14. Theories of Coordination ITF-220 Prof.J.Frankel

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