Introductory Macroeconomics Lecture 22: Balance of Payments II PDF

Introductory Macroeconomics Lecture 22: Balance of Payments II Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Balance of Payments II (1) Determinants of net capital inflows (a) General p...

Introductory Macroeconomics Lecture 22: Balance of Payments II Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Balance of Payments II (1) Determinants of net capital inflows (a) General principles (b) Small, open economy setting (2) eurozone sovereign debt crisis BOFAH Chapter 18 2 Determinants of Net Capital Inflows 3  (1)(a) Determinants of Net Capital Inflows Net capital inflows Depends on both foreign demand for domestic assets and domestic demand for foreign assets Demand for domestic assets and foreign assets depends on (i) real return on domestic assets r (ii) real return on foreign assets r∗ (iii) risk premia, both home and abroad Reminder: here ’capital’ refers to financial capital, not physical capital, i.e., trade in stocks, bonds and other financial assets 4  (i) Real Return on Domestic Assets r High real return on domestic assets r makes – domestic assets relatively more attractive to foreign investors (which tends to increase inflow – foreign assets relatively less attractive to domestic investors (which tends to decrease outflow – together, higher r increases net capital inflow In other words, there is net substitution towards domestic assets Net capital inflows are increasing in r 5  (ii) Real Return on Foreign Assets r∗ High real return on foreign assets r∗ makes – foreign assets relatively more attractive to domestic investors (which tends to increase outflow – domestic assets relatively less attractive to foreign investors (which tends to decrease inflow – together, higher r∗ decreases net capital inflow In other words, there is net substitution towards foreign assets Net capital inflows are decreasing in r∗ 6  (iii) International Risk Premia Most investing involves some kind of risk International investing involves additional country-specific risk – exchange rate risk – sovereign risk Risk averse investors need a risk premium as ’compensation’ Changes in risk premia change demand for home & foreign assets – increase in risk premium on domestic assets decreases capital inflows In crises, can be a ’flight to safety’ 7  (1)(b) Small Open Economy Model Consider country like Australia, small relative to rest of world Let rA be the autarky real rate, determined by domestic savings and domestic investment Let r∗ be the world real rate, taken as given Sign and size of net capital flows depend on rA vs r∗ 8  Autarky (No Capital Flows) In autarky, real rate rA determined by domestic saving and domestic investment. 9  Net Capital Inflow If world real rate r∗ < rA , there is excess demand for capital (domestic investment at r∗ exceeds domestic savings at r∗ ) and capital flows in from abroad. 10  Net Capital Outflow If world real rate r∗ > rA , there is excess supply for capital (domestic savings at r∗ exceeds domestic investment at r∗ ) and capital flows out to the rest of the world. 11  Changes in Direction of Capital Flow Shocks to domestic savings or investment can change direction of capital flows. Here the increase in domestic savings is large enough to flip the economy from importing capital in the amount ab to exporting capital in the amount bc. 12 Eurozone Sovereign Debt Crisis 13 (2) Background on Eurozon Sovereign Debt Crisis Euro adopted as single currency in 1999 – common monetary policy, ECB (centralised) – national fiscal policies (decentralised) Stability and Growth Pact to ’coordinate’ fiscal goals inhibit national incentives to over-borrow – government deficits < 3% of GDP – government debt < 60% of GDP – but no eurozone-wide fiscal policy, automatic stabilisers etc Some countries (e.g., Italy, Greece) never satisfied criteria Despite this, remarkable convergence in interest rates on govt debt 14 Interest Rates on Government Debt 15  Lending Boom: 2002-2007 ’Southern Europe’ borrows from ’Northern Europe’ Large current account deficits in Greece, Italy, Portugal, Spain etc Large current account surpluses in Germany, Netherlands, etc 16 Lending Boom: 2002-2007 17 ’South’ Borrows from ’North’ 18 ’South’ Borrows from ’North’ 19  Global Financial Crisis: 2007-2008 Government debt increases in response to crisis, for example – official guarantees of private bank debt – higher deficits as tax collections fall and spending rises Reappraisal of risk, ’flight to safety,’ reduced international lending Large effects on countries most reliant on international lending 20 Global Financial Crisis: 2007-2008 21  Eurozone Sovereign Debt Crisis: 2009-2012 Oct 2009: Greek govt deficit 12% of GDP, historical revisions (context: about same size as Australian govt deficits in 2020) ’Spreads’ on government debt increase and become dispersed Greece (May 2010), Ireland (November 2010) and Portugal (April 2011) ’shut out’ of international bond markets EU/IMF bailout packages conditioned on ’fiscal austerity’ etc 22 Eurozone Sovereign Debt Crisis: 2009-2012 23  Eurozone Sovereign Debt Crisis: 2009-2012 Ongoing speculation about ’Grexit’ and viability of the eurozone July 2012: ECB ’whatever it takes to preserve the euro’ (This proves to the turning point) Sept 2012: ECB ’unlimited support’ for purchasing government debt of crisis countries, normality begins to resume July 2014: Ireland and Portugal complete their bailout programs 24  Learning Outcomes 1 Understand and explain the determinants of net capital flows. 2 Understand and explain how net capital flows using a partial equilibrium (small open economy) model. 3 Understand and explain the Eurozone Sovereign Debt Crisis. 25  New Formula(s) and Notation None! 26  Next Lecture Exam Review I – exam structure – exam review 27