International Adjustment and

Interdependence
Session 19 & 20
 Introduction
• Countries are interdependent
– Booms or recessions in one country spill over to other countries
through trade flows
– Changes in interest rates in any major country cause immediate
exchange or interest rate movements in other countries

• Though, we referred to prices in the open economy earlier using

real exchange rate; but for analysis, we took the prices constant
since the focus was on the short-run.

• Now we explore the IS-LM-BP model with flexible prices (medium

and long run)
 Hume’s international trade adjustment mechanism
in the gold standard system
US has a current account deficit

US pays to Britain (in gold)

American money supply declines British money supply increases

American prices declines British prices increases

Decline in Increase in Increase in Decrease in

American imports American Exports British imports British Exports

• The process continues till the time there is parity on the prices.
• If 1 USD is 2 gm and 1 pound is 10 gm, then anything worth 1 pound sterling in Britain should
be sold at $5 in US at the equilibrium
• Why do we need central banks if automatic adjustments can take place
 Some contemporary examples of Hume’s
Theory
• Eurozone
– If Greece has higher inflation, it will import more leading to
outflow of capital.
– Reduction of money supply in Greece would lead to fall in prices
and improvement in the competitiveness.

• Fixed exchange rate

– When there are BoP deficits and the central bank sells foreign
exchange, it reduces domestic high-powered money and the money
stock.
– The reduction in money supply shifts LM curve and the AD leftward,
reducing imports.
 Flexible Exchange Rate,
• Y* = potential
GDP Money, and Prices

• At i=if, BoP are

balanced with
perfect capital
mobility

• Verify the state

of economy in all
4 quadrants

The prices are rising when the economy is above full employment
There are capital inflows and exchange rate appreciation when the i>if
Suppose there is an increase in
the nominal money supply: Recall: Monetary Expansion with
─ The real stock of money, Flexible Exchange Rate and Fixed Prices
M/P, increases since P is
fixed
─ To restore equilibrium, LM
interest rates will have to
fall  LM shifts to the right i LM’
─ At point E’, goods and
domestic money markets are
in equilibrium, but i is E
below the world level  i=if
capital outflows depreciate E’’ BP
the exchange rate Interest rate
─ Import prices increase, E’
domestic goods become
more competitive, and
demand for home goods IS
expands
─ IS shifts right with
equilibrium at E”, where i =
Y* Y
if
But the output at E’’ is higher than the potential output.
 Monetary Expansion with Flexible
• The output at E’’ is higher than Exchange Rate and Flexible Prices
the potential output.
• With rise in the wages, and LM
prices, the SRAS will shift
upward.
i LM’
• Rise in prices will reduce the real E’’’
balances, and the LM curve will
shift backward. E
• Rise in the interest rate will bring i=if BP
capital inflows, leading to E’’
Interest rate
exchange rate appreciation. Rise
in prices also leads to further real
E’
exchange rate appreciation.

IS
• The exports declines and the IS
curve is back to the original
position with output at E. Y* Y
• The outcome of entire process:
Monetary Expansion with Flexible
•
•
Short-run:
The exchange rate depreciated, output Exchange Rate and Flexible Prices
increased, and prices remained
unchanged in the short-run, when the
economy moved from E via E’ to E’’
LM

• Long-run: i LM’
• As the prices increased, the fall in real
balanced and rise in the interest rate
led to capital inflows reversing a part E
of the nominal depreciation i=if BP
• The exchange rate appreciation E’’
Interest rate
reduced exports, and shifted the IS
back
• In the whole process, the prices E’
increased, and the nominal exchange
rate depreciated by the same extent to
keep the real exchange rate IS
unchanged

• The money is entirely neutral Y* Y

• Nominal money, prices, and exchange
rate have all increased in the same   M/P e P ePf/P Y
proportion Short run + ++  0 + +
Long run 0 + + 0 0
 Exchange Rate Overshooting
• The exchange rate overshoots its new
equilibrium level in response to a disturbance
(overreacts).

• It first moves beyond the equilibrium it

ultimately will reach, and then gradually
returns to the long-run equilibrium position.

• Process (already discussed)

• The monetary expansion brings down the
interest rate.

• The fall in interest rate leads to capital

outflows leading to sharp depreciation

• The exchange rate adjusts immediately, but

the prices adjust gradually.

• The rise in prices reduces the money

balances leading to rise in interest rate,
capital inflows and exchange rate
appreciation.

• This nominal appreciation coupled with

inflation leads to even sharper real
appreciation, resorting the economy at a new
level with higher nominal variables, but no
change in the real variables.
 Purchasing Power Parity
• In theory, the nominal exchange rates move to keep the real exchange rate
constant

• The purchasing power parity theory of the exchange rate argues that
exchange rate movements primarily reflect differences in inflation rates
between countries.

• the real exchange rate

• When Pf or P changes, e changes in such a way as to maintain constant

• The PPP hypothesis holds relatively more reliably when the inflation
differentials between the countries are quite large.
 Exchange Rate Overshooting and Hysteresis

• The sharp movement of the exchange rate (appreciation/depreciation) in the

medium run might hurt certain segments on the economy irreparably.

• If some industries moves out of the economy in response to the exchange rate
movements, getting them back might become tougher even when the
exchange rates returns to normal

• E.g. appreciation of the US dollar in the early 1980s led to permanent shift of
many industries from the US and led to persistent trade deficit, despite the
deprecation in the 1985-88 bringing the real exchange rate close to the levels
in 1980.
 Interest Differentials and Exchange Rate
Expectations
• In the model of exchange rate determination, perfect international capital mobility
was assumed.
– It says that when capital markets are sufficiently integrated, we expect interest rates to
be equated across countries
– The rates in the US and Germany have moved together but are not equal: How do we
square this fact with the theory?
 Exchange Rate Expectations
• Total return on foreign bonds measured in our currency is the interest rate
on the foreign currency plus whatever earned from the appreciation of
the foreign currency𝑜𝑟 𝑖 + Δ 𝑒
𝑓
𝑒

• Investor does not know at the time of investment how much the exchange
rate will change
– The term should be interpreted as the expected change in the exchange
rate

• The balance of payments equation needs to be modified

– Net capital flows are governed by the difference between our interest rate and
the foreign rate adjusted for expected depreciation:
– The balance of payments equation is:
 ‘Uncovered’ Interest Rate Parity
• The exchange rate today—let’s in 2020—is e2021 = Rs 50 /USD
• Rupee is expected to depreciate/devalue by 10 percent next year.
• The interest rate on the US treasury is 2 percent
• What should be the interest rate on the Indian treasury bills

• Consider alternative of investing in 1-year treasury bills in the United States and the
alternative of investing in 1-year Indian treasury bills.
• US treasury bill investment this year will become = $ 1.02 next year
• Indian interest rate should be attractive enough to make Rs 50 into 55*1.02 = 56.1 next
year i.e., give you an interest rate of 12.2 %

e e 202 2 ∗ (1+ 𝑖𝑈𝑆 )

𝑖𝑖𝑛𝑑𝑖𝑎 = − 1 = expected exchange rate
e 202 1
e e 202 2 e e 2022 − e 2021
𝑖𝑖𝑛𝑑𝑖𝑎 =𝑖𝑈𝑆 +
e 2021 e 202 1
e e 202 2− e 202 1
𝑖𝑖𝑛𝑑𝑖𝑎 ≈  𝑖𝑈𝑆 +
e 2021
 Exchange Rate Expectations
• The adjustment for exchange rate expectations thus accounts for
international differences in interest rates that persist even when capital is
freely mobile among countries
– When capital is completely mobile, we expect interest rates to be equalized,
after adjusting for expected depreciation:

• Expected depreciation helps to account for differences in interest rates

among low and high-inflation countries
– When inflation in a country is high, its exchange rate is expected to depreciate,
and nominal interest rates will be high

Inflation differential = interest rate differential = execrated depreciation

• A country is initially in the
equilibrium Expectations and Speculative
• Let’s say exchange rate of a
country is expected to appreciate Flows
• The BP curve shifts downward, as
investors are willing to hold this
currency at a lower interest rate
than foreign interest rate i LM
• Given the higher domestic interest
rates (at BP =0) than implied by
BP’=0, there is inflow of the BP
foreign capital E
Interest rate
• This leads to exchange rate
appreciation BP’ IS
• Given that the prices are sticky in
the short-run, the nominal
IS’
exchange rate appreciation
translates into real appreciation
• The decline in exports lead to Y* Y
leftward shift of the IS Curve, and
the AD
• The BoP are balanced, but the The expectations can be self-fulfilling prophecy
economy is below Y*
 Interdependence
• Consider that the EU and
the US expands money
supply
• What would be the impact on a
small economy like Vietnam or
Switzerland
 Three Criteria for used by the US for ‘awarding’
the ‘title’ of ‘currency manipulator’

• A country has to persistently intervene in its currency market

with an aim to keep the currency relatively weaker;

• the country should be running significant trade surplus vis-a-

vis the US;

• and the country has to have a current account surplus.

• Monetary expansion in rest of
Monetary Expansion in Rest of the World
the world leads to reduction
in the foreign interest rates (foreign) and its impact on the home
(foreign LM curve shift economy (Vietnam): Short-Run
rightward)
• The BP curve shifts downward
• Given the higher domestic i LM
interest rates, there is inflow
of the foreign capital
• This leads to exchange rate i=if BP
appreciation E
• Given that the prices are Interest rate
BP’ E’ IS
sticky in the short-run, the
nominal exchange rate
appreciation translates into IS’
real appreciation
• The decline in exports lead to Y* Y
leftward shift of the IS Curve, Notice, that the monetary expansion by the US and the
and the AD EU in flexible exchange rate is similar to currency
• The BoP are balanced, but the devaluation against Vietnam and Switzerland in a fixed
economy is below Y* exchange rate regime: The beginning of currency war
 Monetary Expansion in Rest of the World (foreign) and its impact
on the home economy (Vietnam): Short-Run

i LM

i=if BP
E
Interest rate

BP’ IS

IS’

Y* Y Y* Y

The BoP are balanced, but the economy is below

Y*
• Since the output is below the Y*,
there will be unemployment Monetary Expansion in Rest of the World
• The wage cuts will leads to price (foreign) and its impact on the home
cuts, and the AS will shift economy (Vietnam): Long Run
downward and rightward
• The reduction in prices will increase
the real balances and lead to a
rightward shift of the LM curve i LM
• The rightward shift of the LM curve
will reduce the interest rate, lead to E
capital outflows, and exchange rate BP
depreciation i=if
• Nominal depreciation coupled with
Interest rate
decline in price will lead to a real BP’ E’ E’’ IS
depreciation leading to rightward
IS’’
shit of the IS curve
• You may see the exchange rate IS’
overshooting here.
• The initial appreciation shifts the IS Y* Y
curve such that economy reaches E’ The overall appreciation will be such that it
but some of the appreciation is counters the fall in domestic prices, leaving the
reversed when the exchange rate real exchange rate unchanged.
depreciate leading to equilibrium at
E’’. Will Vietnam wait for this long run ??
• Monetary expansion in rest of the world
leads to reduction in the foreign interest Monetary Expansion in Rest of the World
rates (foreign) and its impact on the home
• The BP curve shifts downward
• Given the higher domestic interest
economy (Vietnam): Intervention
rates, there is inflow of the foreign
capital
• The central bank absorbs the foreign
currency, thus abandoning flexible i LM
exchange rate and acting as if there is a
fixed exchange rate
• Or in the language of fixed exchange LM’
rate regime, after devaluation by the US i=if BP = 0
and EU, Vietnam has retaliated by a E
Interest rate
counter devaluation to bring back the
exchange rate to initial level BP’ = 0
• The buying of foreign currency by the IS
central bank leads to conversion of BoP
surpluses into high powered money IS’
• The money supply expands and the LM
curve shift rightward.
• The output expands Y* Y
– Not because of rise in the net exports but
because of the rise in the investment at
lower interest rate
• The BoP are balanced, but the economy
is above Y*
 Monetary Expansion in Rest of the World (foreign) and its
impact on the home economy (Vietnam): Intervention

i LM

LM’
i=if BP
E
Interest rate

BP’
IS

Y* Y
Y*

The BoP are balanced, but the economy is above Y*

• Monetary expansion in rest of the
world leads to reduction in the foreign
interest rates Are There Any Other Alternatives?
• The BP curve shifts downward
• Given the higher domestic interest
rates, there is inflow of the foreign
capital
• The central bank absorbs the foreign
currency, thus abandoning flexible i LM
exchange rate and acting as if there is
a fixed exchange rate
• Or in the language of fixed exchange BP
rate regime, after devaluation by the
i=if
E
US and EU, Vietnam has retaliated by
a counter devaluation to bring back Interest rate BP’
the exchange rate to initial level IS
• The buying of foreign currency by the
central bank leads to conversion of
BoP surpluses into high powered
money
• The money supply expands and the Y* Y
LM curve tends to shift rightward.
• But the central bank simultaneously
The Process is termed as sterilization
sell the government securities and
absorbs an equivalent amount of the
monetary base.
 Sterilization

• Domestic credit can be to government or private sector

• ∆H=∆DC +∆NFA
 Sterilization
• Central bank sterilizes the monetary impact of the BoP

• BoP surpluses
– The monetary base is created against the foreign currency purchases
by the central bank.
– The central bank sell the government bonds to absorb the liquidity
created

• BoP deficits
– The monetary base is reduced when the central bank sells the foreign
currency
– The central bank buy government bonds to replenish the liquidity
 Why to intervene in a flexible regime
• Belief that capital flows are due to unstable expectations, but
such volatile flows can cause damage to domestic economy

• Attempts to impact trade flows

• Attempt to control domestic inflation

 Fiscal Expansion in Rest of the World
(foreign) and its impact on the home
• A fiscal expansion in the US economy (Vietnam)
shifts the IS curve in the US LM
rightward, and raises the
interest rate
• The world interest rate i E’
increases, and capital BP’
outflows from Vietnam (a E
small open economy) will i=if
depreciate the currency BP
• Rise in export will shift the
IS curve rightward, and Interest rate IS’
raise the output in the short-
run
IS

Y
 Interdependence:
Monetary Contraction
• U.S. interest rates rise
• •
Attracts capital flows from abroad
• •
Dollar appreciates (IS curve shift left)
• Foreign currencies depreciates
• World demand shifts from U.S. goods
to those produced by competitors
• In U.S. output and employment decline
• Abroad, competitors benefit from the
appreciation of the US currency 
become more competitive
• Output and employment abroad
expand
Interdependence: Fiscal
Expansion
• US IS curve shift rightward
U.S. interest rates rise
Attracts capital flows from abroad
• Dollar appreciates (IS curve partially shift
back to left)
• Foreign currencies depreciates
• World demand shifts from U.S. goods to
those produced by competitors
• In U.S. output and employment decline
• Abroad, competitors benefit from the
appreciation of the US currency 
become more competitive
• Output and employment abroad expand
 Fixed vs Flexible Exchange Rate
• Floating exchange frees monetary policy for other purposes such as
interest rate, inflation targeting etc. rather than solely being occupied
with exchange rate ‘maintenance’

• Fixed exchange rates makes international trade simpler and convenient

• Fixed exchange rate requires a nation to have disciplined fiscal and

monetary policies

• In case the monetary authority is not disciplined, (ir)rational and

destabilizing speculation hurt the exchange rate and credibility of the
nation
Using the Newly Learned Tools in
the Context of 2008-13 Episode
 Macroeconomic Indicators
Annual Parentage Change in Key Economic indicators

Indicator 2007-8 2008-9 2009-10 2010-11

Real GDP growth 9.3 6.7 8.6 9.3
Inflation (CPI based) 6.2 9.1 12.4 10.4
Growth of Imports
35.5 20.7 -5 28.2
(in US$)
Growth of Exports
29 13.6 -3.5 40.5
(in US$)
Monthly Average of Daily Closing Stock Index
(Sensex)
Index of Industrial Production
Changes in Repo Rate
Changes in CRR
Central Govt. Fiscal Deficit (% of GDP)
S. No. Item
A Current account balance
2006-07 2007-08 2008-09 2009-10 2010-11
-10 -16 -28 -38 -48
External
1 Exports 129 166 189 182 256 Accounts of
2Imports
3Trade balance (1-2)
191
-62
258
-91
309
-120
301
-118
383
-127
India
4 Invisibles (net) 52 76 92 80 79
4a Non-factor services 29 39 54 36 44 • On 11 July
4bnet factor Income -7 -5 -7 -8 -18 2008, oil hit $
4cTransfers 30 42 45 52 53 147 per barrel
Capital account balance (sum 1
B to 6) 45 107 7 52 64
1
External assistance (net) • On 15
2 2 2 3 5
External commercial
September
2
borrowings (net) 16 23 8 2 12 2008, Lehman
3Short-term debt 7 16 -2 8 12 Brothers filed
Banking capital (net): :of which
4
2 12 -3 2 5
for bankruptcy
4a Non-resident deposits (net) 4 0 4 3 3
5Foreign investment (net) 15 43 8 50 42
5a FDI (net) 8 16 22 18 12
5b Portfolio (net) 7 27 -14 32 30
6Other flows (net) 4 11 -6 -13 -12
C Errors and omissions 1 1 0 0 -3
D BoP/Reserves change (A+B+C) 37 92 -20 13 13
 Exchange Rate
55

53

51

49

47

45

43

41

39

37

35
- 06 r-06 -06 l-06 -06 -06 -07 r-07 -07 l-07 -07 -07 -08 r-08 -08 l-08 -08 -08 -09 r-09 -09 l-09 -09 -09 -10 r-10 -10 l-10
n y p v n y p v n y p v n y p v n y
Ja Ma Ma Ju Se No Ja Ma Ma Ju Se No Ja Ma Ma Ju Se No Ja Ma Ma Ju Se No Ja Ma Ma Ju
 High Inflation during 2009-2013

Indicator 2007-8 2008-9 2009-10 2010-11 2011-12 2012-13

Real GDP
9.3 6.7 8.6 9.3 6.2 5.0
growth
Inflation (CPI
6.2 9.1 12.4 10.4 8.4 10.21
based)

Fiscal Deficit
2.6 6.0 6.4 4.9 5.7 4.8
(% of GDP)

Year 2011-2012 2012-2013 2013-2014 2014-2015 2015-16 2016-17

Fiscal Deficit 5.91 4.93 4.48 4.1 3.87 3.51

RBI’s Response
Date CRR
17-Jan-09 5.00 (–0.50)
04-Mar-09 5
21-Apr-09 5
13-Feb-10 5.50 (+0.50)
27-Feb-10 5.75 (+0.25)
19-Mar-10 5.75
20-Apr-10 5.75
24-Apr-10 6.00 (+0.25)
02-Jul-10 6
27-Jul-10 6
24-Jan-12 5.5(-0.5)
09-Mar-12 4.75 (-0.25)
17-Sep-12 4.5 (-0.25)
S. No. Item 2011-12 2012-13 2014-15 2015-16 2016-17 External
A Current account balance -78.2 -88.2 -26.9 -22.2 -15.3
1 Exports 309.8 306.6 316.5 266.4 280.1 Accounts of
2 Imports 499.5 502.2 461.5 396.4 392.6
India
3 Trade balance (1-2) -189.8 -195.7 -144.9 -130.1 -112.4
4 Invisibles (net) 111.6 107.5 118.1 107.9 97.1
4a Non-factor services 64.1 64.9 76.5 69.7 67.5
4b net factor Income -16 -21.5 -24.1 -24.4 -26.3
4c Transfers 63.5 64.0 65.7 62.6 56.0
Capital account balance (sum 1 • Outflows started
B to 6) 67.8 89.3 89.3 41.1 36.5
External assistance (net) in 2011-12
1
2.3 1.0 1.7 1.5 2.0
External commercial
2
borrowings (net) 10.3 8.5 1.6 -4.5 -6.1
3 Short-term debt 6.7 21.7 -0.1 -1.6 6.5
4 Banking capital (net) 16.2 16.6 11.6 10.6 -16.6
4a Non-resident deposits (net) 11.9 14.8 14.1 16.1 -12.4
Foreign investment (net)
5
39.2 46.7 73.5 31.9 43.2
5a FDI (net) 22.1 19.8 31.3 36.0 35.6
5b Portfolio (net) 17.2 26.9 42.2 -4.1 7.6
6 Other flows (net) -7 -5.1 1.0 3.2 7.5
C Errors and omissions -2.4 2.7 -1.0 -1.1 0.4
D BoP/Reserves change (A+B+C) -12.8 3.8 61.4 17.9 21.6
Aggregating Macroeconomics Concepts
 Measuring Economic Activity
• Focused on understanding various terms such as consumption,
investment, trade balance, GDP, NDP, and growth rate

• Looked at three approaches to measure GDP (income,

expenditure, and output approach): Circular flow of income

• Differentiated between real and nominal output

• Looked at some of the major macroeconomic relationship,

such as national income identity (C + I +G + X – M), saving
investment identity, etc.
 Goods Market

• Looked at the booms and recessions due to lack of aggregate

demand

• Looked at the role of investment and government expenditure

on aggregate demand: Inventory adjustments by firms

• Built a multiplier model and derived IS curve

 Money and Economy

• Introduced the concept of money

• Looked at the money multiplier and tools of monetary policy

to influence interest rate

• Monetary transmission mechanism: How does it influence the

most volatile component of aggregate demand (Investment)

• Derived LM Curve
 AS-AD, Unemployment and Inflation

• Derived aggregate demand from IS-LM framework with

flexible prices

• Studied inflation-unemployment trade-off in short and

long run using Phillips curve

• Derived the aggregate supply curve using relationship

between Phillips curve, output, and employment
International Linkages: Fixed Prices
• Introduced concept of nominal and real exchange rates

• Looked at the multiplier model again by taking exports and

imports in account

• Looked at the role and monetary and fiscal policy in

influencing aggregate demand
– Under fixed and flexible exchange rates using IS-LM and BP
model
 International Linkages: Flexible Prices
• Differentiated between short-run and long-run implications of
external macroenvironment on domestic economy

• Discussed some costs and benefits of fixed and flexible

exchange rates

• Discussed different policy interventions that the countries can

attempt to address short-run challenged arising out of fixed
and flexible exchange rates
 Output (GDP)

Aggregate Demand Aggregate Supply

(Short term) (Medium and Long
term)

International Inflation and

Fiscal policy Trade Unemployment
Tradeoffs

Monetary Policy,
interest rate, and
Investment demand
 Lessons of Macroeconomics
• Lesson 1: In the long run, a country’s capacity to produce goods
and services (Aggregate Supply) determines the standard of
living of its citizens

• Lesson 2: In the short run, aggregate demand influences the

amount of goods and services that a country produces.

• Lesson 3: In the short run, policymakers who control monetary

and fiscal policy face a tradeoff between inflation and
unemployment.

• Lesson 4: In the long run, money growth shifts the AD and leads
to inflation but does not affect the output.
Questions ??