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Lecture 19Interdependence & 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
Interdependence under floating exchange ratesRevisited
Two of the results derived previously were too strong to be literally true:
When we first looked at the question, floating rates insulated countries from each other’s economies. But that was when KA=0 (+ORT=0 => CA =0).o Since then, capital mobility has changed things.o US, euroland, Japan, UK, etc., are still visibly correlated.
Under κ=, we found G leaked abroad 100%, through offsetting TD. No effect remained at home.o This overly strong result was a consequence
of the assumption i = .ITF-220 Prof.J.Frankel
Why don’t floating rates insulate? Capital flows => CA is not necessarily = 0.
But the restriction i = is in reality too strong, even for modern conditions of low international capital flow barriers.
Why? 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.
ITF-220 Prof.J.Frankel
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, o thereby appreciating $ and worsening TB,o now also depreciates € and raises TB*.o So Y rises (crowding out < 100% ), despite κ=∞,o Y* rises (international transmission), despite floating,o as i and i* rise in tandem.
ITF-220 Prof.J.Frankel
ITF-220 Prof.J.Frankel
US expansionbecause US is large in world financial markets.
drives up interest rates worldwide,
$↑
€↓
=> Expansion is transmitted from US to Europe.
• •
G↑
Transmission in practicein 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 2009-15).Multiplier is lower in normal times, esp. under full employment (or under default risk, or in small open economies).
ITF-220 Prof.J.Frankel
ITF-220 Prof.J.Frankel
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
Similarly, a fiscal expansion in the rest of the OECD countries via TBRoW <0 and TBUS >0, is transmitted positively to the US.
G↑
ITF-220 Prof.J.Frankel
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, TBRoW and YRoW.
Reason: two effects go opposite directions. Y ↑ => TB ↓, but $↓ => TB ↑
M↑
ITF-220 Prof.J.Frankel
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↑
International macroeconomic policy coordination, continued
Institutions of coordination: G7 Leaders Summit & 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
ITF-220 Prof.J.Frankel
International policy coordination is an application of game theory.
In another game, the players choose the monetary/fiscal mix.
In one game, the players choose their level of spending.
Cooperation here means joint expansion.
Dilemma: Each is afraid to expand alone.
ITF-220 Prof.J.Frankel
THE GAME OF “COMPETITIVE DEPRECIATION”
U.S. lowers iJapan lowers i* Global i too low =>
Excessive flows (to EMs)¥ depreciates, Japan’s TB rises
$ depreciates, US TB rises
A third game is what Brazilian Minister Guido Mantega had in mind in 2010 when he warned of “Currency Wars.”
ITF-220 Prof.J.Frankel
Applications of the theory of coordination
Name of the game:
Nash equilibrium:
Non-cooperative
Cooperative
Exporting unemployment
Everyone contracts
Everyone expands (locomotive)
Competitive appreciation
Everyone raises i
Everyone refrains from changing the exchange rate.Competitive
depreciationEveryone lowers i
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