International Finance and Open Economy Macroeconomics

Balance of Payments (BOP)

BOP as a Registry of Transactions

Definition: Tracks trade (goods & services) and capital flows (financial assets for money) between residents and non-residents over a period.

Double-Entry Accounting: Every transaction has a credit (inflow) and debit (outflow) entry, ensuring the BOP balances overall.

Challenges: Detecting transactions can be difficult due to issues like smuggling or capital flight, where only one side may be recorded.

Open Economy: The BOP grows as a country engages in more international trade and finance. For a closed economy, the BOP would have no entries.

BOP as a Macro Tool

Data Analysis: Serves as a comprehensive record of trade and capital flows, useful for tracking economic trends.

Impact on Economy: Links trade and cross-border finance to economic growth, impacting output, employment, and income.

Relation to GDP: The BOP ties into national accounts by reflecting interactions with the rest of the world (ROW) and showing trade patterns.

Early Warning System: Detects unsustainable imbalances, helping to anticipate debt accumulation issues.

BOP and Basic Identity in an Open Economy

Income-Expenditure Identity: Y = C + I + G + (X − M)

Current Account (CA): X – M; if CA = 0, the model mirrors a closed economy. In an open economy: S = I + CA; if CA is in deficit, foreign savings (borrowing) finance excess spending.

Composition of the BOP

Current Account (CA): Tracks trade (goods & services), income (salaries, investment), and transfers.

  • Credits (X): Money received (exports, income inflows).
  • Debits (M): Money spent abroad (imports, income outflows).

Capital & Financial Account (CFA): Tracks the purchase and sale of financial assets, including Direct Foreign Investment (DFI) and changes in foreign-held assets.

Balancing Mechanism: CA and CFA must be equal in magnitude but have opposite signs. A CA deficit requires borrowing in the CFA.

External Imbalances

BOP Balance: It always balances (net 0) due to double-entry bookkeeping. Example: CA = -200 billion (deficit); CFA = +200 billion (surplus).

Internal Imbalances: CA or CFA can show deficits/surpluses individually. Example: A CA deficit signals higher spending on foreign goods/services, funded by CFA.

Macro Tool: Provides a “bottom line” showing whether an economy’s external payments are balanced or if it’s accumulating assets or liabilities.

Exchange Rates, Interest Rates, and Capital Flows

Global Capital Flows

Definition: Money moves internationally, seeking higher returns due to interest rate differentials.

Impact: These flows affect exchange rates, inflation, foreign reserves, and activity levels, sometimes pressuring countries to adjust interest rates to influence capital movement.

Speculators: If interest rates in a country are low, speculators may position to depreciate the currency.

Capital Controls: Some countries impose controls (e.g., Brazil’s deposit tariff) to limit capital inflows and stabilize the economy.

Interest Rate Parity Theory (IRPT)

Definition: The expected rate of currency change should match the interest rate differential. Example: If RUSD = 10% and REUR = 5%, we expect the euro to appreciate by 5%.

Expected % Rate Change: Derived from comparing the spot exchange rate to the expected exchange rate (based on futures market data).

Money and its Functions

Dollar as a Financial Asset: Cash + Demand Deposits (no savings, less liquid).

Functions of Money: Money acts as a means of payment, unit of account, and store of value.

Characteristics of Money:

  1. No Return unless invested in financial assets.
  2. Inflation Risk: Loses purchasing power over time due to inflation.
  3. Liquidity: Most liquid asset.

Supply and Demand for Money

Controlled by Central Banks: Manage money supply, impacting interest rates.

Demand for Money: Based on:

  • Interest Rates: Inverse relationship with money demand—low rates increase demand.
  • Price Level: Direct relationship: higher prices, higher demand.
  • Economic Activity: Positive relationship: higher GDP requires more money.

Real Demand for Money Equation

Md = P ⋅ Lf(R,Y). Lf is the liquidity function, which:

  • is inversely related to interest rates (dL/dR < 0).
  • is directly related to the output level (dL/dY > 0).

Real Money Demand: Nominal money divided by the price level.

Equilibrium: Where money supply intersects with money demand to set the interest rate.

Money Depreciation Effects

  • Cheaper exports, more expensive imports, improved trade balance.
  • Higher prices, increased inflation, and wage increase pressures.

Long-Run Money Supply and Exchange Rates

Adjustment: In the long run, prices adjust proportionally to the money supply, including the exchange rate.

Money Equation: MV = PT, where M is money supply, V is the velocity of money, P is the price level, and T is the volume of transactions.

Implication: Long-term increases in money supply lead to proportional increases in prices, causing no real economic changes.

Purchasing Power Parity (PPP)

Definition: Exchange rates adjust so that money has equal purchasing power across countries.

Example: If prices rise by 30% abroad but remain the same at home, the home currency should appreciate by 30%.

PPP Equation: ERPPP = Domestic Price Level / Foreign Price Level

Global Financial Architecture

Definition and Importance

Definition: The set of rules that govern financial markets and international capital flows.

Importance: Essential to reduce the risk of financial crises: more rules mean lower crisis probability.

Evolution of Rules

Progress is slow and cyclical; new rules often arise after crises but are later tested by new financial challenges.

Key Institutions

  • UN: Facilitated a framework for non-aggressive conflict resolution, with specialized economic agencies:
    • IMF: Manages external imbalances and financial adjustments.
    • World Bank: Focuses on reconstruction and development.
    • WTO: Promotes global trade liberalization.
  • Architecture Definition: The structure of rules, institutions, and power dynamics governing international trade and finance.
  • Key Aspects:
  1. Economic & Legal Framework: Rules for global trade and finance interaction.
  2. Institutions & Compliance Bodies: Organizations and agreements enforcing these rules.
  3. Power Distribution: Decision-making power shared among countries.

Political Nature of Capital Flows

Impact Beyond Markets: Capital flows affect economic activity broadly, influencing interest rates, exchange rates, employment, and demand.

Influence of Wealthy Entities: With a few controlling most of the capital, they can manipulate the system through policies that favor them, often at the public’s expense.

Challenges in Emerging vs. Developed Economies:

  • Developed economies may face declining returns when capital is abundant but investment opportunity is limited.
  • Emerging economies often have abundant labor but limited capital, restricting job creation.

Key Trends

  1. Central Banks’ Growing Role:
  • Increased Influence: Free markets replace some official decision-making in resource allocation.
  • Need for Regulation: Increased capital movement requires oversight.
  • Financial Stability Concept: Ensuring stability by avoiding crises became a focus, leading to strong regulatory frameworks.
a. Financial Stability Board: Promotes global financial stability, coordinating financial authorities and standard-setting bodies.b. Basel Organizations:
  • Bank for International Settlements: Provides support for central banks, offers reserve management, research, and regulatory frameworks.
  • Basel Committee: Sets standards for bank regulation; Basel III is the latest iteration aiming to prevent crises like 2008.
c. Bretton Woods Institutions:
  • IMF: Focuses on financial stability and managing global imbalances.
  • World Bank: Supports reconstruction and development.
  • WTO: Promotes trade liberalization and settles trade disputes.
d. Power Groups:
  • G7/8: Includes the US, Japan, and the EU (observer).
  • G20: G8 + major emerging markets (e.g., China, Brazil).
Emerging Markets’ Rising Influence:
  • Economic Growth: Emerging markets increased their global trade, output, and reserves since the 1990s.

GATT and the WTO

GATT (General Agreement on Tariffs and Trade)

Made significant progress in liberalizing trade practices in the postwar years through successive rounds of multilateral negotiation in areas such as:

  • Tariffs
  • Anti-dumping and non-tariff barriers

But GATT was not an institution. It was more like a succession of multilateral treaties in which countries decided whether or not to participate. Finally, the Uruguay Round was launched. It dealt with:

  • Trade in services and intellectual property
  • Sensitive areas such as agriculture and textiles
  • Dispute settlement mechanisms

WTO (World Trade Organization)

The only global international organization dealing with the rules of trade between nations. At its heart are the WTO agreements, negotiated and signed by the bulk of the world’s trading nations and ratified in their parliaments. The goal is to ensure that trade flows as smoothly, predictably, and freely as possible. The WTO has over 160 members representing 98% of world trade.

Dispute Settlement: Under the Dispute Settlement Understanding, vital for enforcing the rules and therefore for ensuring that countries bring disputes to the WTO if they think their rights under the agreements are being infringed. Judgments by specially appointed independent experts are based on interpretations of the agreements and individual countries’ commitments.

Two Ways to Settle Disputes:

  1. Parties find a mutually agreed solution, particularly during the phase of bilateral consultations.
  2. Through adjudication, including the subsequent implementation of the panel and Appellate Body reports, which are binding upon the parties once adopted by the Dispute Settlement Body.

Three Stages to the WTO Dispute Settlement Process:

  1. Consultations between the parties.
  2. Adjudication by panels and the Appellate Body.
  3. Implementation of the ruling, which includes the possibility of countermeasures in the event of failure by the losing party to implement the ruling.

G8 and G20

G8: US, Canada, France, Germany, Italy, Japan, UK, EU.

G20: All G8 + Argentina, Australia, Brazil, China, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa, South Korea, and Turkey. These countries represent the world’s largest economies and play key roles in global political and economic affairs.

WTO as Corporate-Backed

Large Corporations’ Influence: Large corporations have lobbying power, shaping trade negotiations and policies. Corporations push for reduced tariffs and barriers to enhance global trade.

Trade Liberalization Focus: The WTO’s goal to promote free trade often benefits multinational companies. Critics argue this focus can harm local industries and labor rights.

Civil Society Critics: The WTO lacks transparency, favors corporate interests over smaller businesses, labor, and environmental concerns.

International Monetary Fund (IMF)

Role Under Bretton Woods

Served as the “lender of last resort” for countries in payment crises. Provided emergency loans to support reserves and maintain import ability. Required adjustment measures (spending cuts, tax increases, devaluation), known as “IMF conditionality.”

Reputation

Tarnished Image: Involvement in crises (e.g., Asian debt crisis, Argentina’s collapse) harmed its reputation.

Self-Insurance Trend: Many countries, especially middle-income nations, now maintain large foreign reserves to avoid IMF dependency.

US-China Trade Wars

Trump’s Tariffs

Trump aimed to reduce the US-China trade deficit, citing unfair practices such as intellectual property theft and limited access to Chinese markets. The deficit is partly attributed to differing savings rates: 7% in the US vs. 30% in China.

Trade Deficit Overview

The US deficit with China remained significant in 2022, nearing $1 billion.

COVID-19 Impact

China experienced a larger economic hit from COVID-19 but began recovering gradually.

Biden’s Policy Continuation

Biden retained and expanded Trump’s tariffs, emphasizing national security, particularly in tech sectors. The trade deficit remained largely unaffected, as other suppliers replaced Chinese imports.

Recent Escalations

New Export Controls: The US Department of Commerce restricted exports of advanced computing and semiconductor products to China, citing national security. US companies now need licenses to export high-end chips and equipment to China. US citizens and companies are also restricted from supporting certain Chinese semiconductor fabrication without a license.

China’s Response: China condemned the restrictions as damaging to Chinese and US business interests, urging fair treatment.

Hyperglobalization and its Discontents

Dani Rodrik’s Theory

Argues that globalization, national sovereignty, and democracy cannot coexist. For more globalization, countries must sacrifice either:

  • Sovereignty: To allow global governance.
  • Democracy: To align with global economic demands.

This creates a trilemma where countries must choose between these three options.

Waves of Globalization

  1. 1st Wave (Late 19th Century – WWI): Based on the Gold Standard under British and US influence, creating an early “institutionality” for trade and capital flow.
  2. Post-WWII/Bretton Woods System:
  • Controlled Capital Flows: Strict rules limited money movement across borders, supporting national sovereignty in Western democracies.
Second Wave (1970s – Present): Triggered by the end of Bretton Woods, leading to floating exchange rates and deregulated financial markets. Marked by rapid capital flow liberalization and deregulation, especially in the financial sector.

Global Discontents

Financial liberalization promoted by institutions led to a “race to the bottom” where countries offered low wages, tax breaks, and deregulation to attract foreign investments.

Downsides:

  • Workers in developing countries faced job losses due to production moving overseas.
  • Benefits favored corporations and investors, fueling economic inequality.

Examples of Resistance:

  • Brexit: Reflects rejection of EU rules perceived as eroding UK sovereignty and democracy.
  • COVID-19 Impact: Exposed the fragility of supply chains, encouraging vertical integration and domestic production. Led to congestion in ports, supply shortages, and higher logistics costs.

Future: Major economies struggle with inflation management vs. economic stimulation. Growing preference for policies that prioritize national interests over hyperglobalization.

Law of One Price and Debt

Law of One Price

Definition: In a commercially integrated economy, the domestic price of a tradable good equals its world price multiplied by the exchange rate, assuming no barriers to trade.

Conditions: Applies only to tradable goods—those with characteristics that allow them to be easily traded internationally.

Price Equalization: Without barriers like high tariffs, trade exploits price differences, leading to price equalization globally for these goods.

Non-Tradable Goods: Items that cannot be traded due to factors like perishability or high transportation costs are exempt from the law of one price, as they’re not exposed to global price arbitrage.

Debt

Definition: The result of spending exceeding income, covered by borrowing. Accumulates financial liabilities over time. At the macro level, it often stems from persistent BOP current account deficits.

Debt and Globalization: In a global economy, countries can borrow globally, accelerating debt accumulation.

Levels of Debt:

  • Public Debt: Government borrowing.
  • Corporate & Household Debt: Corporate projects or household expenses through bank loans or credit.

Debt Purpose:

  • Investment: Promotes growth and better living standards.
  • Consumption: Covers overspending but doesn’t contribute to economic growth.

Debt Instruments:

  • Bonds: Common for governments and corporations.
  • Loans & Credit: Common for households.

Debt Limit: No strict limit exists, but a common guideline suggests interest payments shouldn’t exceed 30% of income.

Debt Sustainability: Ability to meet financial obligations on time, maintaining creditworthiness. Non-payment leads to default, impacting access to financial markets.

Roll-Over: Renewing debt to cover repayments, dependent on favorable market conditions. In times of market stress, roll-overs may become costly or unavailable.

Types of Debt:

  1. Public vs. Private:
  • Public Debt: Owed by the State.
  • Private Debt: Owed by individuals or corporations.
Gross vs. Net Debt:
  • Gross Debt: Total debt amount.
  • Net Debt: Gross debt minus external assets (e.g., reserves).
Total vs. External Debt:
  • Total Debt: All debt, domestic and foreign.
  • External Debt: Debt issued in foreign jurisdictions.

Debt Challenges:

  • Default Consequences: Loss of market access and seizure of assets abroad.
  • Global Market Influence: Investors may chase higher returns, impacting debt sustainability and market conditions.

Purchasing Power Parity (PPP) and Balanced Trade

Absolute vs. Relative PPP

Absolute PPP (APPP): Directly compares the price of a standard bundle of goods across countries.

Relative PPP (RPPP): Compares the price change of the bundle over time to determine currency adjustments based on inflation differences.

Example: If US prices increase by 2% and Mexico’s by 10%, the dollar should appreciate by 8% relative to the peso.

Importance in Developing Economies: Developing countries often show stronger PPP for international currencies due to low labor productivity and prices of non-tradable goods.

GDP Comparisons: Converting GDP solely by market exchange rates can undervalue real productivity; adjusting exchange rates by PPP provides a more accurate economic comparison.

Balanced Trade

Definition: Balanced trade occurs when a country’s imports and exports of goods and services are roughly equal.

Two-Country Model: Trade is balanced by definition; opposite sides of the trade triangle represent equal values.

Multi-Country Reality: In the real world, trade is rarely balanced with all countries. Selling exports and buying imports are separate transactions, often involving money in both directions.

Trade Balance: Refers to a country’s net trade outcome with the world unless specifically referring to a bilateral balance with another country. A country can have an overall trade surplus while also having deficits with some countries.

Imbalanced Trade: These imbalances can redistribute wealth among nations and are a common source of discord. Imbalances are only possible with foreign lending or reserves. In a barter economy, trade would always be balanced; money enables imbalances.

International Finance and the Big Mac Index

International Finance

Goes beyond trade payments, involving cross-border transactions in financial assets like loans, deposits, bonds, and shares.

Financial Assets: Non-physical assets that derive value from legal claims. Money, the most liquid and risk-free financial asset, is used as payment in all international transactions, whether trade or financial.

Transactions: In financial transactions, one party lends (money for a promise of repayment with interest) or invests in a financial asset. Cross-border capital flows support both direct and speculative investments.

Financial Assets as Legal Claims: Financial assets represent legal claims. For creditors, they are assets; for debtors, they are liabilities.

Example: A loan is a financial asset for the bank (creditor) but a liability for the borrower (debtor). Bonds are standardized financial assets issued by governments or corporations and are tradable in markets, unlike most personal loans.

Big Mac Index

Definition: A price index that uses the price of a Big Mac to measure PPP between two currencies.

Example:

  • Price in US: $5.69
  • Price in Uruguay: $285
  • Current Exchange Rate (USD/Peso): 41.18/USD1
  • Dollar Cost of Big Mac in Uruguay: 285/41.18 = 6.92

Conclusion: The peso appears overvalued by: (6.92/5.69) − 1 = 21.6%. To align prices, the exchange rate needs to be 50.09/USD1, implying a 21.6% appreciation of the dollar or a 17.8% depreciation of the peso.