Principles of International Finance and Open Economy Macroeconomics: Theories, Applications, and Policies

341 Pages·2015·6.19 MB·English

by  Cristina Terra

Principles of International
Finance and Open Economy
Macroeconomics
Principles of International
Finance and Open Economy
Macroeconomics
Theories, Applications, and Policies
Cristina Terra
THEMA, Université de Cergy-Pontoise
AMSTERDAM(cid:129)BOSTON(cid:129)HEIDELBERG(cid:129)LONDON
NEWYORK(cid:129)OXFORD(cid:129)PARIS(cid:129)SANDIEGO
SANFRANCISCO(cid:129)SINGAPORE(cid:129)SYDNEY(cid:129)TOKYO
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Foreword
Thisiswhatinternational economystudentsandpractitionersneeded:AbookonOpenEconomy
MacroeconomicsandInternationalFinancewithactualworldexamples.Andtherealworldexam-
ples are from the developing world! What a treat. The book is well written. The analytical rigor is
first rate, the reader can rest assure the mathematical models are consistent and can provide a
solid basis to think about very important issues. The book covers countries balance of payments,
theirindebtedness,anditsrelationshipwithitscurrent-accountdeficits,andalsoexchangerates—
how they are determined and their fundamental role in economics. Having myself worked in this
area for the past 20 years, I am happy to see that we are constantly evolving in our learning
andunderstandingofthefield.Thisbookisanimportantcontributionforthat.
IlanGoldfajn
PontifíciaUniversidadeCatólica,RiodeJaneiro
ix
Preface
Principles of International Finance and Open Economy Macroeconomics grew out of international
finance courses I taught in undergraduate and master programs over the past 20 years. It pre-
sents a macroeconomic framework for understanding and analyzing the global economy, empha-
sizing the perspectives of emerging economies and developing countries. It discusses the main
theories of open economy macroeconomics and international finance, illustrating them with
examples and actual cases, mostly related to developing countries.
The theories are built through a unified mathematical framework accessible to those with
basicmathematicalskills (basiccalculus).Withthefocusonrealworldpracticalissues,themath-
ematical models serve as an analytical tool to help in organizing ideas and clarifying arguments.
They make clear the assumptions and simplifications used to describe real economic situations.
Moreover,mathematicsensuresthelogicalprecisionoftheargumentandhelpsinunderstanding
theconnectionsamongeconomicvariables.
The book is aimed at upper division undergraduate and graduate level students. The format
appeals to those who want to read single chapters as well as those who want to read the whole
book. To this end, explanations are made step by step, focusing on economic intuition. More
complicatedmathematicalpassagesaredevelopedinappendicesattheendofeachchapter.
How to Use This Book
As a guideline, the main material for a course can be found in Chapters 1, 2, 3, 4 (excluding
Sections 4.3 and 4.4), 6, 7 (excluding Section 7.2), and 8 (excluding Section 8.4). These chapters
contain the main models and issues concerning international macroeconomics and finance.
Sections 4.3, 4.4, and 7.2 develop extensions to the basic model developed in the first sections of
the respective chapters. Section 8.4 and Chapters 9(cid:1)11 are more specialized or somewhat more
advanced,andnotessentialforabasiccourse.
xi
Acknowledgments
Although academic work appears to be a solitary activity, it cannot be accomplished without
the intellectual stimulation of interpersonal interactions. The lonely mind tends to always
followthesamepaths,whileotherstakeusoutofourcomfortzone,bringinglighttonewwaysof
reasoning. I am thankful for my students at Fundação Getulio Vargas, PUC-Rio, Université de
Cergy-Pontoise,andESSECBusinessSchool,duringthese20yearsofteachinginternationalmacro-
economics.Theirquestionsandcommentswerefundamentaltotheelaborationofthisbook.Ialso
thank my colleagues of these institutions by the rich intellectual environment that taught me so
much.Iamsurethatyou,studentsandcolleagues,willrecognizeyourcontributioninthisbook.
I thank FGV Projetos for financial support and Cesar Campos, its executive director, for his
incentive,withoutwhichtheprojectwouldnothavematerialized.
My special thanks to Rodrigo Soares de Abreu, doctoral student at EPGE/FGV, for his meticu-
lous work in the construction of graphs, the preparation of the proposed exercises, as well as for
his careful reading of the manuscript, which greatly contributed to eliminate inaccuracies and to
enrichthetext.
I am grateful to Mark Evans for the careful and competent translation of the book from its
originalversioninPortuguese.
To be free to produce, the mind needs a quiet heart. I thank my parents, Hélio and Ineˆs, for
thelove,support,andlifeexample;mydaughter,Tatiana,forenrichingmylifeinsomanydimen-
sions;mystepchildren,EdmondandLudmilla,forthejoy;mysisters,MariaIneˆs,Carol,Bel,Elisa,
Lis, Marisa, and Lulus; and my brothers, Bonomo, Gustavo, and Marco, for the safety net; my
friends,forthesupport.Ithankmyhusband,Thierry,fortheaffectionandthecomplicity.
xiii
1
Introduction
CHAPTER OUTLINE
1.1 MathematicalModeling..................................................................................................................2
1.2 BookStructure.................................................................................................................................4
Reportsoninternationalfinancealwaysmaketheheadlines.Industriescomplainthatexchange
rates are too appreciated. The American governmentaccuses the Chineseofmaintaining their
exchangeratesartificiallydepreciatedwhiletheChinesedenyitistheresultofanactivegovern-
ment policy. The debt crisis of the 1980s took Latin American countries into a decade-long
struggleagainstastronomicalinflationratesandgovernmentfiscaldifficulties.Itisevenknown
astheregion’slostdecade.NowitisEuropethatappearstobelivingitslostdecade.
Whenisexternaldebtexcessive?Howdoesoneknowifanexchangerateisoverappreciated?
Whatleadstoanexchangeratecrisis?Dovariationsingovernmentspendingaffecttheexchange
rate?Whatistherelationshipbetweenfiscaldeficitandcurrent-accountdeficit?Whichisbetter,
afloatingorfixedexchangerateregime?ShouldGreeceabandontheEuro?Thisbookintendsto
provide an analytical framework that allows the reader to understand how to deal with these
and other important questions related to international economics from the macroeconomic
pointofview.
Macroeconomics and international finance are vast fields1 and covering all questions,
models, and applications pertinent to these two fields would be a “mission impossible.” The
objective forthe choiceof topicscovered inthis book istoprovidea logical structure to aidin
understanding and analyzing questions concerning exchange rates and balance of payments.
Each chapter describes a facet of international finance, like pieces of a puzzle that, once put
together, form a picture of international finance that allows one to appreciate the individual
elementsandtheirinteractions.Theideaistohelpthereaderinbuildingtheirownconceptual
framework, allowing them to form their own analysis and conclusions regarding issues related
to macroeconomics and international finance. More important than understanding the crises
in exchange rate that have already occurred, for example, is understanding how they function
and what causes them, allowing one to analyze new international finance contexts that may
comeaboutinthefuture.
Each chapter presents economic situations that provide for the development of mathe-
matical models to highlight the essence of the problem, understand how the economic
variables interact, and illustrate the forces in play. These models are simple, presented in an
1Internationalmacroeconomicsseekstoexplaintheinteractionbetweenmacroeconomicvariables,suchaslevel
ofincome,interestrates,andprices,whileinternationalfinancefocusesontheexchangeofassetsandcurrency
betweencountries,thatis,themonetarysideofinternationaleconomics.
PrinciplesofInternationalFinanceandOpenEconomyMacroeconomics.
Englishtranslation©2015ElsevierInc. 1
2 PRINCIPLESOFINTERNATIONALFINANCEANDOPENECONOMYMACROECONOMICS
intuitive manner, and have mathematical appendices that provide step-by-step explanations
of how they work. Concrete examples show how the theory can be applied to real-world
situations. The book presents graphs, using data easily found on the Internet, so that the
reader can reproduce them for different countries or periods in order to perform their own
analysis of situations of interest to them and which have not been covered in the book. The
AnnexesattheendofthebookprovideInternetaddresseswherethedatausedinthegraphs
can be found. The intent is to offer instruments for analysis and tools that can be used in
concrete cases. Finally, exercises are given at the end of each chapter. Some are designed to
consolidate the material presented while others propose questions that will require addi-
tionalanalysis.
1.1 Mathematical Modeling
Economic analysis is usually performed using mathematical models. It is important to
emphasize that these are used as analytical instruments and not as an end in themselves.
Mathematics can be considered a type of language where the mathematical model tells a
story. But, why tell a story using mathematics and not English? Mathematics is a specific
type of language with four characteristics that make it more attractive to use when dealing
witheconomics.
First, each mathematical symbol, which corresponds to words, has a unique and precise
definition. The same is not true for English. For example, the dictionary offers at least five
different definitions for the word symbol.2 Second, mathematics is a concise language. Once a
termhasbeenpreciselydefined,itcanberepresentedbyasymbol.Amathematicalexpression
can represent an idea that would take an entire page to explain were it transcribed into
English.Givenitsdueproportion,theexpression“apictureisworthathousandwords”canbe
applied in this case. Third, mathematical grammar is also very precise. In mathematics, there
are strict rules regarding the relationships that can be made, or rather, about what can be
expressed based on the initial definitions. There is no room for reading between the lines or
for metaphors. It is really less charming than a discourse in English (there are those who may
disagree)butwhenonedesiresapreciseunderstandingofaconcreteelement,mathematicsis
best. Finally, mathematics is a universal language. Not everyone speaks English, but anyone
whohasbeentoschoolhasstudiedmath.
Due to thesecharacteristics,when one tells a story in mathematics, it is told in such a way
that each of its elements is precisely defined and the logical structure is strictly obeyed.
Mathematics obliges the author of the story to express all the hypotheses used and the
2Definitions for “symbol,” according to the Merriam-Webster online dictionary (http://www.merriam-webster
.com/dictionary/symbol)are:1.Anauthoritativesummaryoffaithordoctrine;2.Somethingthatstandsforor
suggestssomethingelsebyreasonofrelationship,association,convention,oraccidentalresemblance;especially:a
visiblesignofsomethinginvisible;3.Anarbitraryorconventionalsignusedinwritingorprintingrelatingtoa
particularfieldtorepresentoperations,quantities,elements,relations,orqualities;4.Anobjectoractrepresenting
somethingintheunconsciousmindthathasbeenrepressed;5.Anact,sound,orobjecthavingculturalsignificance
andthecapacitytoexciteorobjectifyaresponse.
Chapter1(cid:129)Introduction 3
grammarguaranteesthattherearenoerrorsinlogic.Whileitistruethatthesamestorycould
be told in English, it is much more difficult to express with the same precision, and errors in
logicaremoreeasilymade.Mathematicsserves,therefore,asatooltohelpmeremortals,such
asmyself,tomakefewermistakes.
Up to this point, I have only spoken regarding the advantages of using mathematics.
After all, I must convince you that the analytical method presented in this book is the one
best suited for its purpose: offer an analytical framework you can use to understand situa-
tions not covered in the book. I do not want to sell a pig in a poke: mathematics also has
its limits. As is almost always true, its best quality is also is greatest liability. Given that it is
very precise, mathematics does not capture all the nuances inherent to socioeconomic
relations. Simplification is necessary to express the world in a mathematical model. This is
where it becomes an art: how does one simplify in such a way as to make the model
understandable while at the same time maintain the elements necessary to understand the
problem?
If I throw a stone into the waters of Copacabana Beach in Rio de Janeiro, waves are
created that, in principle, would reach Walvis Bay in Namibia. However, there is an ocean
between Copacabana and Walvis Bay (both literally and figuratively) with currents and
waves caused by other factors that make those waves created by my stone to be impercep-
tible in Africa (actually, well before reaching Africa). If, instead of my small stone, a large
meteorite fell into the watersof Copacabana Beach, the impact would be felt in Walvis Bay.
Just like waves in the ocean, markets and economies are interconnected. Buying grapes at
the supermarket, in principle, could stimulate an increase in grape prices, which could
lead people to eat more apples, given that grapes are more expensive. This could lead to
greater apple imports, which could lead to a deficit in current account...and a crisis in
balance of payments. Well, just as my small stone in the waters of Copacabana Beach will
not cause a tsunami in Walvis Bay, I can buy grapes without worrying about causing an
international crisis.
Of course, decisions in economic modeling are more subtle than the simple example
given above. It is not always clear which variables are relevant. Actually, relevant variables
can change over time, as will be seen in Chapter 9. Each new wave of exchange rate crises
generates more literature, adding previously absent variables to the models. The first models
developed in the 1980s did not consider foreign corporate debt, for example, which was
essentialtothedevelopmentofthecrisesofthe1990s.
As George E.P. Box said, “essentially, all models are wrong, but some are useful.” If on
the one hand simplifications to an economic model make it unrealistic, on the other, not
simplifying makes it impossible to understand what is occurring. Useful models are those
that are able to discard what is really unimportant, but keep those elements essential for
comprehension. A good model should be like a good map: it shows the trajectory from one
point to another, identifies obstructions, topography, vegetation, and any other element
important in reaching the destination. I present models that are useful, pointing out their
limitations. The notations are uniform throughout the book and, whenever possible, the
samemodelstructureisused.
4 PRINCIPLESOFINTERNATIONALFINANCEANDOPENECONOMYMACROECONOMICS
1.2 Book Structure
The first part of the book defines the object of our analysis. Given that macroeconomics and
international finance deal with economic relations between countries, Chapter 2 begins by
describingthetaxonomyoftheinternationalflowofgoodsandfinancialassets.Thebalanceof
paymentregisterstheinternationaltransactionofgoods,services,andfinancialassetsbetween
countries. In national accounts, we will see how the results of these transactions relate to the
main macroeconomic aggregates. The main objective is to understand the relation between
current-account balance and the evolution of the external debt of a country, and how private
consumptionandgovernmentexpensesareassociatedtothecurrentaccount.
The rate is a fundamental variable in international economics for it converts prices set in
different currencies into a common currency. Chapter 3 defines what an exchange rate is and
howtoassessitslevel,thatis,whatvariablesarerelevantindeterminingifanexchangerateis
appreciatedordepreciated.Animporter,forexample,isinterestedincomparingthepriceofa
product in their country with its price in another country. The exchange rate converts the two
prices into a single currency, allowing comparison. Assessing the exchange rate depends,
therefore, on the role of the exchange rate in comparing the purchasing power of the two
currencies. However, for an individual who goes into debt in Chinese yuans, what matters is
how much the exchange rate will change from the time they went into debt to when they pay
it off. If the price of the Yuan goes up, the debt becomes more expensive. For the financial
investor,whatmattersistheexpectationofexchangeratevariations.
Part I of the book describes and defines the variables and discusses the relationship
betweenthem.However,thereisnodiscussionofcausality.Itislikeapictureoftheeconomic
world but without defining if the horse is before the cart or the cart before the horse. The
remainderofthebookisdedicatedtodiscussionsofhowtheeconomyworks.
Part II is dedicated to understanding how the main macroeconomic aggregates relate to
foreign debt and the real exchange rate. Chapter 4 shows how the current-account balance,
which corresponds to the change in the country’s net foreign liabilities, is the result of
economic decisions regarding savings and investment. By means of the model presented in
thechapter,itispossibletounderstandthesourceofbenefitsforacountryinopeningitselfto
the international financial market and what variables are relevant to assess if a given current-
accountlevelisdesirableand/orsustainable.
Each current-account level is associated with a real exchange rate level, which, in turn,
reflectstherelativepriceoftradableandnontradablegoodsintheeconomy.Assuch,thetrade
balance is associated with level of the real exchange rate, which is covered in Chapter 5. We
will see how economic variables, such as interest rates, fiscal policy, and terms of trade, affect
the equilibrium real exchange rate. The analysis will show how an increase in international
commoditypricesinthelastyearscausedanincreaseinservicesinBrazil,forexample.
The notion of a real exchange rate is associated with the comparison of prices among
countries by using the same currency. However, the variable published daily in the news-
papers is the nominal exchange rate, or rather, how many Dollars are needed to buy one
Euro, for example. Its interaction with the level of prices is what results in the real exchange