ECON 671 – International Economics

1. ECON 671 – International Economics Portfolio Balance Models

2. Asset Market Approach to Exchange Rates

3. Asset Markets Approach • Asset Markets or Portfolio Balance approach focuses on capital flows due to changes in assets held by residents • assumes that financial markets to keep international demand for stocks of national assets equal to their supply. • Foreign & domestic bonds are imperfect substitutes. • Characterize asset-holdings of residents as: • Domestic money, implicit cost of interest rate i. • Domestic government bonds yielding interest rate i. • Foreign government bonds yielding i* + xa where xa is the expected % change in the exchange rate (UIPC).

4. Domestic Money Market 1. Domestic Money Market • Money Demand- - + + L = m( i, i*+xa, Y, P)W • m( ) is the percent of Wealth, W, held as domestic money. • Signs of i and i*+xa reflect opp. cost of holding money. • Money Supply Ms = M0 • Assuming money stock set by domestic central bank. • Equilibrium M0= m(i, i*+xa, Y, P)W= L • Assuming only domestic residents hold domestic money.

5. Domestic Bond Market 2. Domestic Bond Market • Bond Demand+ - - - Bd = b( i, i*+xa, Y, P)W • b( ) is the percent of Wealth, W, held as domestic bonds. • Signs of Y and P reflect transaction demand for money. • Bond Supply Bs = B0 • Assuming bond stock set by domestic government. • Equilibrium B0= b(i, i*+xa, Y, P)W= Bd

6. Foreign Bond Market 3. Foreign Bond Market • Bond Demand- + - - B*d = b*( i, i*+xa, Y, P)W • b*( ) is the percent of Wealth, W, held as foreign bonds. • Bond Supply B*s = eB*0 • Assuming bond stock set by foreign government. • Must multiply B* by e to convert into domestic currency. • Equilibrium eB*0= b*(i, i*+xa, Y, P)W= B*d • Assuming domestic residents do not hold foreign money.

7. Overall Asset Markets Model • Domestic Money, (MM Curve) M0= m(i, i*+xa, Y, P)W • Domestic Bonds, (BB Curve) B0= b(i, i*+xa, Y, P)W • Foreign Bonds, (FF Curve) eB*0= b*(i, i*+xa, Y, P)W • Wealth Identities W = M + B + eB*0 and m() + b() + b*() = 1

8. Asset Markets Approach • Features of the Model • Wealth identity ensures that equilibrium in two of the markets implies third market is also in equilibrium. • Wealth share identity means that changes in desire to hold one asset imply adjustments in one or both of the others. • Asset Markets Approach Diagrams • Begin by looking at interactions between the three markets induced by policy events. • Then derive single diagram that summarizes the three markets equilibrium. Relate shifts in individual markets to shifts in market curves (MM, BB, FF) on this single diagram.

9. Increase in Domestic Bond Supply

10. B s1 i1 Md1 Direct Effects (Curve Shifts) 1. Supply of Domestic Bonds rises, PB falls. Wealth increases by amount of new bonds Indirect Effects (Adjustments) ? 2. Rise in W raises Md. Domestic i rises. 3. Rise in W raises B*d, capital outflows but rise in i lowers B*d. Effect on e uncertain. 4. Rise in W raises Bd partly offsets 1. Increase in Domestic Bonds B s0 i PB = 1/i Ms0 i0 Md0 Bd Domestic Money Market M Domestic Bond Market B P*B = 1/(i*+xa) Increase in Domestic Bonds B*s B*d0 Foreign Bond Market B*

11. Deriving Portfolio Balance Diagram • Working with the three markets directly is cumbersome and hides the dependence of the markets through the Wealth identity. • Portfolio Balance Diagram (Axes are e and i) • Derive relationship between e and i in each market. • Note that as e rises, eB* rises, and so wealth, W, rises. • Money Market, MM Curve M0= m(i, i*+xa, Y, P)W • Rise in e, leads to rise in W, which raises Md. To keep Ms = Md requires rise in i. MM curve is upward-sloping in e-i diagram. • Domestic Bond Market, BB Curve B0= b(i, i*+xa, Y, P)W • Rise in e, leads to rise in W, which raises Bd. To keep Bs = Bd requires rise in PB i.e. i falls. BB curve is downward-sloping in e-i diagram. • Foreign Bond Market, FF Curve eB*0= b*(i, i*+xa, Y, P)W • Fall in i, leads to rise in B*d. To keep B*s = B*d requires rise e. FF curve is downward-sloping in e-i diagram. • We are assuming expected future spot exchange rate is constant throughout.

12. 1. Increase in relative Ms shifts MM back as i falls to raise Md. MM 2. Increase in relative Bs shifts BB out as i rises to raise Bd. 3. Increase in relative B*s shifts FF down as e falls to raise xa, and so B*d. e0 FF BB i0 Portfolio Balance Diagram Exchange Rate, e Domestic Interest Rate, i

13. 1. Increase in domestic Bs shifts BB out.. 2. Rise in Wealth shifts MMout & i up to keep MD equal to unchanged MS. 3. FF shifts out as wealth up but i up may bring offsetting shift back. MM1 5.Results? Domestic i rises with certainty but effect on spot enot certain depends on shifts in FF. Likely FF shift is small so e falls FF1 BB1 i1 Increase in Domestic Bonds Exchange Rate, e MM0 4. Rise in wealth also partially offsets original shift in BB (not shown). e0 FF0 BB0 i0 Domestic Interest Rate, i

14. Open Market Operations

15. Ms1 B s1 i1 Direct Effects (Curve Shifts) 1. Supply of Domestic Bonds rises, PB falls. 2. Domestic Money Supply falls, i rises. Indirect Effects (Adjustments) 3. Rise in i lowers B*d. Capital inflows. B*d(i1) 4. Domestic currency appreciates, spot e falls, raising xa and return on foreign bonds. Open Market Operations Ms0 B s0 i PB = 1/i i0 Md Bd Domestic Money Market M Domestic Bond Market B P*B = 1/(i*+xa) Open Market Sale of Gov’t Bonds B*s B*d(i0) Foreign Bond Market B*

16. 2. MM shifts out as i rises to keep MD equal to lower MS. MM0 3. BB shifts out as bonds supply increases, bond price (1/i) falls. MM1 5. Lower i leads to capital outflows. Result: e down, (foreign currency depreciates). Assumed i* fixed but outflows may cause i* to fall also. FF e1 BB1 i1 Open Market Operations 1. Central bank does Open Market Sale of government bonds. Reduces MS. Exchange Rate, e 4. No change in foreign BS or FF. e0 BB0 i0 Domestic Interest Rate, i

17. Short Run vs. Long Run -Exchange Rate Overshooting

18. Exchange Rate Overshooting • Feature of FX markets is that exchange rates “overshoot” new equilibrium positions during adjustment to a market shock. • Assume Home country is “small” relative to Rest of World and that capital is perfectly mobile. • UIPC holds, foreign & domestic assets are perfect substitutes. • Asset markets adjust more rapidly to external shocks than goods markets. • Equilibrium involves both Asset market equilibrium and Goods market equilibrium simultaneously. • Goods Market Equilibrium(e = P/P* i.e. Relative PPP holds) • Higher P implies rise in e (depreciation) to keep Absolute PPP. • Asset Market Equilibrium (i = i* + xa i.e. UIPC holds) • Higher P, implies higher Md, which implies higher i, so i > i* + xa. • Capital flows in, strengthens e which raises xa leads to i = i* + xa.

19. M/PLR M/PSR RF1 Rise in future price level, leads to expected future dep’n of currency. Shifts RF outwards in SR & LR. RD1 i1 eSR eLR Overshooting in Monetary Model Perfect Capital Mobility Domestic Money Market Interest rates M/P0 RF0 RD0 i0 L( i, Y0) e0 Domestic MS Spot Rate, e

20. Absolute PPP e = P/P* Higher P leads to higher Md which raises i > i* + xa. Must have fall in e (xa up) for UIPC. P0 UIPC i = i* + xa e0 Dornbusch Overshooting Model Domestic Price level, P Spot EXR, e

21. 1. Increase in Domestic Ms, lowers i, shifts out UIPC. (xa falls for UIPC) 2. Asset markets adjust quickly, P sticky. In SR, EXR rises to eSR. Absolute PPP e = P/P* 3. Goods markets adjust slowly, P rises. Real Ms falls, i rises in LR, EXR falls back to eLR. LR P1 SR P0 UIPC1 e0 eLR eSR Exchange Rate Overshooting!!! SR Overshooting of EXR Domestic Price level, P UIPC0 Spot EXR, e

22. Short Run vs. Long Run -Asset Market Model

23. Real Side of the Economy • So far have examined only asset market conditions. • All these quantities are in nominal terms, i.e. W = M + BD + eBF • Focus now on real side of the economy, i.e. production and demand of goods & services in the economy. • Assume full domestic employment in prod’n of two types of goods. • Non-traded Goods, YN(q): produced & consumed in domestic economy. • Traded Goods, YT(q): produced domestically but consumed both domestically and abroad. YTq > 0, YNq < 0 • Relative Price of Traded vs. Non-traded goods: q = e/PN • Price of Non-tradables = PN Price of tradables = PT = e • Overall Price Level: P = PNae1-a • Demand for goods by consumers • Non-traded goods, CN = CN(q, w) with CNq > 0, CNw > 0 • Traded goods, CT = CT(q, w) with CTq > 0, CTw > 0 • Real Wealth = W/P = (M + B + eB*)/P • Macro Identities • C = CN + CT YD = YN + YT + (i*+ xa)eB*

24. Deriving Real Side Diagram • Real side of model has two equilibrium conditions: • Equilibrium in Production: How much of total prod’n goes to tradable good? • Equilibrium in Consumption: How much of total consump. is tradable good? • Real Side Diagram (Axes are e and YT, CT) • Derive relationship between e and YT or CT. • Production Equilibrium, YY Curve • Rise in e (currency depreciates), leads to rise in value of Tradable good, prod’n switches to YT. YY curve slopes up. • YY curve shifts with changes in full employment GDP and PN • Consumption Equilibrium, CC Curve • Rise in e (currency depreciates), leads to rise in value of Tradable good, consumption switches away from YT. CC curve slopes down. • CC curve shifts with changes in real wealth, w = W/P • Increase in real wealth shifts CC curve away from origin

25. YY 1. 1. Increase in PN, price of Non-traded good shifts both curves. 2. 2. Increase in real wealth, shifts CC curve outwards. e0 1. CC Y T CT Real Side Diagram Exchange Rate, e YT, CT

26. Linking Real & Asset Sides • Asset markets and real economy are linked in two ways. • Exchange rate is determined/affects both parts of the economy • Level of real wealth is determined/affected by both parts also. • Interaction on exchange rate is captured by placing Asset market and real-side diagrams back-to-back. • Interaction with real wealth is more complicated. • Clearly asset market nominal supplies affect nominal & real wealth. • Less obvious is that real-side equilibrium affects real wealth • Assume consumers have a target level of real wealth, w*. • Their savings behavior is based on comparison of desired level with actual level of real wealth, S = b(w* - w), b > 0 • By definition Savings equals difference between total income YD and total consumption C. Can show using identities that: S = (YT – CT ) + (i* + xa)eB* • i.e national savings equals net exports plus income on foreign investments. Thus change in real wealth over time is related to current account position, which affects Asset market equilibrium.

27. MM YY e0 FF BB CC i0 Y T CT Linking Real & Asset Sides I Exchange Rate, e Domestic Interest Rate, i YT, CT

28. Linking Real & Asset Sides • Important to be clear about time frames in within which interactions occur between markets in the economy. • Impact Period (Shifts in MM-BB-FF curves): • Instantaneous adjustment of Asset markets to shock in one or more of the Asset markets of the economy. • Short Run (Price Changes through e affect YY-CC curves): • Prices change as a result of the asset market shock(s) and have effects on real quantities in the the model. Will cause a divergence between actual real wealth and desired real wealth, which in turn causes changes in savings behavior and current account. • Long Run (Current account imbalance affects w & W): • Changes in flow of real savings cause accumulated changes in level of real & nominal wealth in the economy over longer periods. These flow accumulations lead the economy to new long run equilibrium in both Asset and real markets of the economy.

29. Open Market Operation:Impact, Short Run & Long Run

30. BBI MMI Impact Current Account Surplus eI iI Open Market Operations: Impact Effects Exchange Rate, e BB0 YY0 CC0 MM0 FF0 e0 Y0T C0T i0 Domestic Interest Rate, i YT, CT

31. Short Run Current Account Surplus CCSR Y T SR CTSR Open Market Operations: SR Effects Exchange Rate, e BB0 BB1 MM1 YY0 CC0 MM0 FF0 e1 e0 Y0T C0T i1 i0 Domestic Interest Rate, i YT, CT

32. LR Current Account Deficit CCLR YYLR eLR Open Market Operations: LR Effects Exchange Rate, e BB0 BB1 MM1 CC0 CCSR YY0 MM0 FF0 eSR e0 Y T SR Y0T C0T CTSR i1 i0 Domestic Interest Rate, i YT, CT