Springer Texts in Business and Economics

Finance and
Open-
Economy
Macroecono
mics
With contributions by Daniela
Federici Second Edition

v) Springer
Springer Texts in Business and
Economics
More information about this series at http://www.springer.com/series/10099
Giancarlo Gandolfo

International Finance
and Open-Economy
Macroeconomics

Second Edition

With Contributions by Daniela Federici

Springer
Giancarlo Gandolfo Classe di Scienze Morali Accademia
Nazionale dei Lincei Rome, Italy
ISSN 2192-4333 ISSN 2192-4341 (electronic)
Springer Texts in Business and Economics
ISBN 978-3-662-49860-6 ISBN978-3-662-49862-0 (eBook)
DOI 10.1007/978-3-662-49862-0

Library of Congress Control Number: 2016945040

Springer-Verlag Berlin Heidelberg 2002, 2016
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To the memory of my father Edgardo
Gandolfo
Preface

Following standard practice in International economics, I have always treated the

theory of international trade separately from international finance, thus writing my
International Economics textbook as a two-volume course (Vol. 1 on the theory of
international trade and Vol. 2 on international monetary theory). This text had two
editions, several reprints, and translations in other languages. However, the
different pace of the revisions of the two volumes suggested to make them self-
contained and independent from each other. The volume covering trade was
published in 1998 (second edition 2014) under the title International Trade Theory
and Policy. This is the second edition of the volume covering international finance
(the first edition was published in 2001). This new edition contains a wealth of
additional material that has been introduced thanks to the suggestions of colleagues
and students and to the comments contained in book reviews. All has been
thoroughly classroom tested in both undergraduate and graduate courses in various
universities in Italy and other countries.
In the Preface to the first edition (1986) of International Economics, I wrote:
There is no lack of good international economics textbooks ranging from the elementary to the
advanced, so that an additional drop in this ocean calls for an explanation. In the present writers
opinion, there seems still to be room for a textbook which can be used in both undergraduate and
graduate courses, and which contains a wide range of topics, including those usually omitted from
other textbooks. These are the intentions behind the present book, which is an outcrop from
undergraduate and graduate courses in international economics that the author has been holding at the
University of Rome La Sapienza since 1974, and from his ongoing research work in this field.
Accordingly, the work is organised as two-books-in-one by distributing the material between text
and appendices.
The treatment in the text is directed to undergraduate students and is mainly confined to graphic
analysis and to some elementary algebra, but it is assumed that the reader will have a basic knowledge
of economics. Each chapter has a mathematical appendix, where (i) the topics treated in the text are
examined at a level suitable for advanced undergraduate or first-year graduate students, and (ii)
generalizations and/or topics not treated in the text (including some at the frontiers of research) are
formally examined.
The text is self-contained, and the appendices can be read independently of the text and can,
therefore, also be used by students who already know graphic international economics and want to
learn something about its mathematical counterpart. Of course the connections between text and
appendices are carefully indicated, so that the latter can be used as mathematical appendices by the
student who has mastered the text, and the text
can be used as graphic and literary exposition of the results derived mathematically in the appendices by
the student who has mastered these. [... ]

7
8 Preface

The present book maintains the same approach, in particular the unique two-tier
feature and the ample coverage of topics, including many at the frontiers of
research, whose often obscure mathematical aspects are fully clarifled in the
second tier. This new edition has been thoroughly revised and enriched thanks to
the numerous contributions by Professor Daniela Federici that bring the book up-
to-date.
I am grateful to the students from all over the world who have written me over
the years to indicate unclear points and misprints and to Guido Ascari, Marianna
Belloc, Andrea Bubula, Nicola Cetorelli, Giuseppe De Arcangelis, Vivek H.
Dehejia, Kieran P. Donaghy, Michele Gambera, the late Carlo Giannini, Bernardo
Maggi, Giovanna Paladino, Luca Ricci, Francesca Sanna Randaccio, the late
Jerome L. Stein, for their advice and comments.
None of the persons mentioned has any responsibility for possible deficiencies
that might remain.

Rome, Italy Giancarlo Gandolfo

January 2016
Contents

Part I Introduction
1 International Finance and International Macroeconomics: 39
An Overview...................................................................................................393
1.1 Globalization...................................................................................................435
1.2 Old and New Approaches to International Finance........................................446
1.3 Structure of the Book......................................................................................467
47
1.4 Small and Large Open Economies.................................................................. 8
47
References....................................................................................................... 9
50
Part II The Basics 51
2 The Foreign Exchange Market ............................................................... 53 13
2.1 Introduction................................................................................................... 13
53
2.2 The Spot Exchange Market........................................................................... 15
56
2.3 The Real Exchange Rate............................................................................... 18
57
2.4 The Effective Exchange Rate........................................................................ 21
58
2.5 The Forward Exchange Market..................................................................... 22
59
2.5.1 Introduction........................................................................ 22
2.5.2 Various Covering Alternatives: Forward 60
Premium and Discount....................................................... 62 23
2.6 The Transactors in the Foreign Exchange Market........................................ 27
2.6.1 Speculators.......................................................................... 62 27
2.6.2 Non-Speculators................................................................. 63 28
2.6.3 Monetary Authorities.......................................................... 64 29
2.7 Derivatives ................................................................................................... 65
29
2.7.1 Futures................................................................................ 67 29
2.7.2 Options ............................................................................... 67 30
2.7.3 Swap Transactions.............................................................. 67 31
2.7.4 Credit Derivatives .............................................................. 70 33
2.8 Eurodollars and Xeno-Currencies................................................................. 73 34
2.9 Appendix ...................................................................................................... 76
35
2.9.1 N-Point Arbitrage .............................................................. 76 35
References .................................................................................................... 37
Exchange-Rate Regimes.................................................... 80
83
85 I
85 X
87
89
91
93
3.1 The Two Extremes, and Intermediate Regimes...................
3.2 The Bretton Woods System ................................................
3.2.1 The Monetary Authorities Intervention ..
3.3 The Current Nonsystem.......................................................
3.4 International Organisations..................................................
3.4.1 The IMF....................................................
3.4.2 The World Bank........................................
References...........................................................................
International Interest-Rate Parity Conditions................
4.1 Covered Interest Arbitrage, and Covered Interest
Parity (CIP).............................................................
4.2 Uncovered Interest Parity (UIP)..........................................
4.3 Uncovered Interest Parity with Risk Premium....................
4.4 Real Interest Parity..............................................................
4.5 Efficiency of the Foreign Exchange Market........................
4.6 Perfect Capital Mobility, Perfect Asset
Substitutability, and Interest Parity Conditions......
4.7 Appendix.............................................................................
4.7.1 Rational Expectations and Efficiency
of the Foreign Exchange Market .............
4.7.2 The Peso Problem.....................................
4.7.3 The Siegel Paradox...................................
References ..........................................................................
The Balance of Payments .................................................
5.1 Balance-of-Payments Accounting and Presentation
5.1.1 Introduction..............................................
5.1.2 Accounting Principles..............................
5.1.3 Standard Components...............................
5.1.4 Capital Account........................................
5.1.5 Financial Account.....................................
5.2 The Meaning of Surplus, Deficit, and Equilibrium
in the Balance of Payments ...................................
References ..........................................................................
Real and Financial Flows in an Open Economy ............
6.1 Introduction.........................................................................
6.2 The Row Identities...............................................................
6.3 The Column Identities.........................................................
6.4 Derived Identities................................................................
6.5 Identities Are Only Identities...............................................
 References................................................................................................... 158
An Integrated Approach ................................................................
9.1 Interaction Between Exchange Rate and Income
in the Adjustment Process.....................................................
9.1.1 A Graphic Representation.......................................
9.1.2 Stability...................................................................
9.1.3 Comparative Statics and the Transfer Problem.......
9.2 The J-Curve.......................................................................................
9.3 The S-Curve.......................................................................................
9.4 The Alleged InsulatingPower of Flexible Exchange
Rates, and the International Propagation of Disturbances ...
9.5 Appendix............................................................................................
9.5.1 A Simplified Version of the Laursen
and Metzler Model .................................................
9.5.2 The BB and RR Schedules.......................................
9.5.3 The J-Curve............................................................. 161
9.5.4 The Original Two-Country Version
of the Laursen and Metzler Model ......................... 161
References ......................................................................................... 163
The Mundell-Fleming Model ......................................................... 166
10.1Introductory Remarks........................................................................ 168
10.2Fixed Exchange Rates........................................................................ 169
10.2.1 Graphic Representation of the Equilibrium 171
Conditions ..............................................................
10.2.2 Simultaneous Real, Monetary and External 172
174
Equilibrium: Stability..............................................
10.2.3 Comparative Statics................................................. 174
10.3Flexible Exchange Rates ................................................................... 174
10.4Appendix............................................................................................ 178
10.4.1 The Mundell-Fleming Model Under Fixed
Exchange Rates....................................................... 182
10.4.2 The Mundell-Fleming Model Under Flexible 190
Exchange Rates....................................................... 191
References ......................................................................................... 191
Policy Implications of the Mundell-Fleming Model, 192
and the Assignment Problem..........................................................
11.1Introduction........................................................................................ 193
11.2Internal and External Balance, and the Assignment Problem
197
11.2.1 The Assignment Problem........................................
204
11.2.2 Observations and Qualifications.............................
208
11.3Flexible Exchange Rates ................................................................... 211
11.4Perfect Capital Mobility ...................................................................
11.5Appendix ........................................................................................... 211

1
11.5.1 Monetary and Fiscal Policy Under Fixed
Exchange Rates....................................................... 216
11.5.2 Monetary and Fiscal Policy Under Flexible 220
Part III Flow Approaches
667
7 The Elasticity Approach.......................................................................... 97
221
7.1 Introduction................................................................................................... 97
221
7.2 Critical Elasticities and the So-Called
223
Marshall-Lerner Condition............................................................... 98
224
7.2.1 The Balance of Payments in Domestic Currency...........
226
99
229
7.2.2 The Balance of Payments in Foreign Currency................ 101
231
7.2.3 Elasticity Optimism vs Pessimism................................... 102
233
7.3 Foreign Exchange Market Equilibrium and Stability.................................. 102
7.3.1 Derivation of the Demand and Supply 233
Schedules: Multiple Equilibria and Stability .................. 103