1. International Leakages (part 3)
By Misha Lee Soriano

2. Highlights of the Report
• Economies are linked internationally through trade in
goods and through financial markets. The exchange
rate is the price of a foreign currency in terms of the
dollar. A high exchange rate (a weak dollar) reduces
imports and increases exports, stimulating aggregate
demand.
• Under fixed exchange rates, central banks buy and
sell foreign currency to peg the exchange rate.
Under floating exchange rates, the market
determines the value of one currency in terms of
another.

3. Highlights of the Report
• If a country wishes to maintain a fixed exchange rate
in the presence of a balance of payments deficit, the
central bank must buy back domestic currency, using
its reserves of foreign currency and gold or borrowing
reserves from abroad. If the balance of payments
deficit persists long enough for the country to run out
of reserves, it must allow the value of its currency to
fall.
• In the very long run, exchange rates adjust so as to
equalize the real cost of goods across countries.

4. Highlights of the Report
• With perfect capital mobility and fixed
exchange rates, fiscal policy is powerful. With
perfect capital mobility and floating
exchange rates, monetary policy is powerful.

5. Exchange Rate Terminologies
NAMES DEFINITION
Balance of The record of transactions of the residents of a
Payments country with the rest of the world
Current Records trade in goods and services, as well as
Account transfer payments
Records purchases and sales of assets, such as
Capital Account
stocks, bonds, and land
Balance-of-
Occurs when more money is leaving the country
Payments
than entering it
Deficit
Balance-of-
Occurs when more money is entering the
Payments
country than leaving it
Surplus

6. Exchange Rate Terminologies
NAMES DEFINITION
A system in which exchange rates are determined by
Fixed Exchange governments and central banks rather than the free
Rate System market, and maintained through foreign exchange
market intervention
Sales or purchases of foreign exchange by the
Intervention
central bank in order to stabilize exchange rates
Flexible/Floating
A system in which exchange rates are allowed to
Exchange Rate
fluctuate with the forces of supply and demand
System
Flexible exchange rate system in which the central
Clean Floating
bank does not intervene in foreign exchange markets
Flexible exchange rate system in which the central
Dirty Floating bank intervenes foreign exchange market in order to
affect the short-run value of its currency

7. Exchange Rate Terminologies
NAMES DEFINITION
Decrease in the value of the domestic currency
Devaluation relative to the currencies of other countries;
used when exchange rates are fixed
Increase in the value of the domestic currency
Revaluation relative to the currencies of other countries;
used when exchange rates are fixed
Decrease in the value of the domestic currency
Depreciation relative to the currencies of other countries;
used when exchange rates are flexible
Increase in the value of the domestic currency
Appreciation relative to the currencies of other countries;
used when exchange rates are flexible

8. Capital Mobility
• One of the striking facts about international
economy is the high degree of integration or
linkage among financial/capital markets –
the markets in which bonds and stocks are
traded.
• If foreign exchange rates are permanently
fixed, taxes are the same everywhere, and
international asset holders never face political
risks (nationalization, restrictions on transfer of
assets, default risk by foreign governments).
There would be strict equality in the world
capital markets.

9. Capital Mobility
• In reality, there are tax differences among
countries. Exchange rates can change,
perhaps significantly, and thus affect the
payoff of a foreign investment.
• Interest rate dissimilarities among major
industrialized countries that are adjusted to
eliminate the risk of exchange rate changes
are partially practiced.
• Henceforth, capital is very highly mobile
across borders.

10. Capital Mobility
Perfect Capital Mobility
• Capital is perfectly mobile internationally when
investors in search of the highest return, can
purchase assets in any country they can choose,
quickly, with low transaction costs, and in
unlimited accounts.
The high degree of capital market integration implies
that any one country’s interest rates cannot get too far
out of line without bringing about capital flows that
tend to restore yields to the world level.

11. Capital Mobility
FIXED FLEXIBLE
When capital POLICY EXCHANGE EXCHANGE
mobility is
perfect, interest RATES RATES
rates in the Output
home country No output
cannot diverge expansion;
change; trade balance
from those Monetary
reserve losses improves;
abroad. This Expansion
has major equal to money exchange
implications for increase depreciation
the effects of
monetary and No output
fiscal policy Output change;
under fixed and Fiscal expansion; reduced net
floating
exchange Expansion trade balance exports;
rates. worsens exchange
appreciation

12. Capital Mobility
The introduction of trade in goods means that some of
the demand for our output comes from abroad and
that some spending by our residents is on foreign
goods. The demand for our goods depends on the
real exchange rata as well as on the levels of income
at home and abroad.
A real depreciation or increase in foreign income
increases net exports and shifts the IS curve out to the
right. There is equilibrium in the goods market when the
demand for domestically produced goods is equal to
the output of those goods.

13. Mundell-Fleming Model
Perfect Capital Mobility Under Fixed Exchange Rates
• The model first proposed by Robert Mundell and
Marcus Fleming that explores economy with flexible
exchange rates and perfect capital mobility.
• Under fixed exchange rates and perfect mobility, a
country cannot pursue an independent monetary
policy. Interest rates cannot move out of line with
those prevailing in the world market. Any attempt at
independent monetary policy leads to capital flows
and need to intervene until interest rates are back
in line with those in the world market.

14. Mundell-Fleming Model
Perfect Capital Mobility Under Fixed Exchange Rates
Monetary Expansion Under Fixed Rates
and Perfect Capital Mobility

15. Mundell-Fleming Model
Perfect Capital Mobility and Flexible Exchange Rates
• Under fully flexible exchange rates the
absence of intervention implies a zero
balance of payments. Any current account
deficit must be financed by private capital
inflows.
• A current account b account surplus is
balanced by capital outflows. Adjustments
in the exchange rate ensure that the sum of
the current and capital account is zero.

16. Mundell-Fleming Model
Perfect Capital Mobility and Flexible Exchange Rates
The Effect of Exchange Rates on Aggregate Demand

17. Mundell-Fleming Model
Perfect Capital Mobility and Flexible Exchange Rates
Effects on An Increase in the Demand for Exports

18. Mundell-Fleming Model
Perfect Capital Mobility and Flexible Exchange Rates
• If an economy with floating rates finds itself
with unemployment, the central bank can
intervene to depreciate the exchange rate
and increase net exports and thus aggregate
demand.
• Such policies are known as beggar-thy-
neighbor policies because the increase in
demand for domestic output comes at the
expense of demand for foreign output.

19. ECONOMIC IMPLICATIONS OF INCREASING
INTEGRATION
• Economic integration is the elimination of tariff
and nontariff barriers to the flow of goods,
services, and factors of production between
a group of nations, or different parts of the
same nation.
• It involves at least two countries to abolish
customs tariffs on inner border between the
states. This causes a number of effects while
the phenomenon itself has specific properties
for its successful development.

20. ECONOMIC IMPLICATIONS OF INCREASING
INTEGRATION
• It requires coherence of the policies (customs, tax,
financial, social policies etc. and entity registration)
applied in integrated states. Economic parameters
(domestic savings rate, tax rates, etc.) are striving to
one single multitude. Coherence policy finally leads
to equal multi-dimensional economic space within
integrated area.
• It needs permanency of economic integration stages
applied to unified states (free trade area, customs
union, economic union, political union). Otherwise
integration process declines, finally leading to
termination of economic unions.

21. ECONOMIC IMPLICATIONS OF INCREASING
INTEGRATION
• Economic integration leads to Pareto-reallocation of
the factors (labor and capital) which move towards
their better exploitation. Labor moves to area of
higher wages, while capital – to area with higher
returns.
• Domestic saving rates in the member states of
economically integrated region strive to the one and
same magnitude, described by the coherence policy
of economic blocks. At the same time, practical
observation shows that this phenomenon is taking
place before formal creation of economic unions.

22. ECONOMIC IMPLICATIONS OF INCREASING
INTEGRATION
• Formulation of economic integration theory has been
initiated by Jacob Viner who described trade
creation and trade diversion effects caused by
economic integration meaning a change in direction
of interregional trade flows respectively caused by
the change of tariffs within and outside economic
union.
• The dynamics of trade creation and diversion effects
was mathematically described by R.T. Dalimov. The
finding shows that trade flow (an output moving from
region to region) may be described with the goods
flow caused by the price difference.

23. ECONOMIC IMPLICATIONS OF INCREASING
INTEGRATION
• Economic integration of states leads to the creation
of the terms of trade. Economic union of states
obtains more privileged position in trade negotiations.
• Economic integration benefits (growth of economy,
specifically the GDP; raise of productivity) depend on
the level of development as well as a scale of
unifying states.
• If there are two states being economically
integrated, then the larger the size of economy the
less it receives from integration and vice versa.

24. ECONOMIC IMPLICATIONS OF INCREASING
INTEGRATION
• The same principle is observed regarding the
level of development of integrating states,
although it is not as clear as the firstly
mentioned principle.
• Productivity in the unified area is increased.
Remarkably, it is increased more in less
developed states, and vice versa (Dalimov,
2008), i.e. according to the principle
observed in practice.

25. ECONOMIC IMPLICATIONS OF INCREASING
INTEGRATION
• Among the main benefits for the countries which
decided to be unified is a free access to markets
of the other member states.
• Since the stage of the common market, or since
supranational bodies of the union are created,
specific regional funds are created to reallocate
revenues from more developed states to less
developed ones.

26. ECONOMIC IMPLICATIONS OF INCREASING
INTEGRATION
• This way, development of the member states
is equalized, with less developed ones
developing faster, leading to an increase of
their earnings per capita and thus purchasing
more from more developed partner states.
• Consequently, economic integration unites
nations, leading them to prosper with each
other.