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Ch.12 International Linkages (Dornbusch et al., 2008)

Chapter topic: What are the key linkages among open economies?

Some observations:National economies are becoming more closely

interrelatedPolitical and economic events and trends from

abroad affect every open economy.Ex: Econ slowdown in Eurozone hurt TR exports, half

of which is to the EU.Ex: Conflict with Syria Political instability Higher

risk for foreign investors Less FDI inflow to TR

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Economies are linked through two main channels

. Trade in goods and services

. Finance

Commercial link (Foreign trade)

Exports mean higher demand for domestically produced goods

Imports mean higher production in other countries, which is a leakage from the circular flow of income

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Financial link

TR residents can hold TR assets or assets in foreign countries

Portfolio managers shop the world for the most attractive yields

As international investors shift their assets around the world, they link assets markets here and abroad . Incomes, exchange rates, and the ability of monetary policy to affect interest rates are impacted from it.

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Analyzing the trade linkage: Balance of Payments

Balance of payments= The record of the transactions of the residents of a country with the rest of the world

= The fact that current account and capital account always balance out each other.

(Remember: Current account shows all foreign trade and transfer payments, and capital account shows all purchases and sales of assets such as stocks, bonds, and land)

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Current account balance and capital account balance always show the same value, but in different signs (+/-). Because, just like us people, if a country spends more than its income, it has to finance the difference either by borrowing or by selling its domestic assets.

In national income accounting, this borrowing registers as net private capital flows, and sales of domestic assets registers as net official reserve assets.

If net official reserves show a positive figure, it means reserves decreased, which means the country had to sell some of its assets to pay for the deficit. Accordingly, this figure also shows the size of balance of payments deficit.

Balance of Payments

Misbalance of payments

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If current account deficit > net private capital flows, then the country is said to run a balance of payments deficit.

(Vice versa, a balance of payments surplus)

An example

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A major element of the financial link:

Exchange rateExchange rate: Price of one currency in terms of another.

Ex: Today, we can buy one US $ by paying 1.8YTL.

(“Nominal exchange rate between $ and YTL is 1.8”)

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A government can follow one of the two main types of exchange

rate regimes

. Fixed

. Floating (flexible)

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Fixed Exchange Rates

Gov (Central Bank) promises to buy and sell a particular foreign currency at a fixed rate.

It results in the market price being the same as this fixed rate. (Because no seller would sell his currency for less than the fixed rate as he knows that he can sell it to the gov at the fixed rate. Nor he could sell it for more than the fixed rate, because no buyer who knows he can get the same currency at the fixed rate would pay any higher prices for it)

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An outcome of fixed exchange rate regime:

When a central bank adopts the fixed rate regime, it has to keep reserves of the two subject currencies in large amounts. That’s the only way it can keep its promise for a fixed rate. (When demand for a currency exceeds its supply in the marketplace, central bank intervenes and supplies the shortage in order to maintain the fixed rate)

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How is this related to the balance of payments?

Balance of payments determine how much a central bank has to intervene.

Ex: If TR runs a current account deficit in its trade with China, then the demand for Yuan exceeds its supply. TR Central Bank responds by selling Yuan to the market so the demand-supply balance remains unchanged and the exchange rate between YTL and Yuan remains the same.

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That is why current account deficit is considered as a negative development. If a national economy runs current account deficit with a country too much for too long, then the central bank will run out of reserve assets to sell to finance the difference. In that case, devaluing the national currency becomes the only option to remedy the situation.

How is this related to the balance of payments?

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Floating (Flexible) Exchange Rates

= Central bank does not do anything to keep the rate unchanged. (Exchange rates are determined in the market according to the demand and supply of foreign currencies)

What happens in a floating regime?

If YTL/Yuan exchange rate is 0.3 today.An increase in Chinese exports to TR would cause...Turks must pay more yuan to Chinese exportersChinese Central Bank does nothing in response to

this development, and exchange rate changes in the market

Exchange rate increases to 0.4 YTL/Yuan Chinese goods become more expensive for TR

consumersDemand for CH goods in TR declinesExchange rate goes back towards the original

rate.

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