Harvard University Professor Andrés Velasco
John F Kennedy School of Government Spring 2004 (updated April 29, 2004)
International Finance: Issues and Analysis
ITF-346
OVERVIEW
This is an advanced course on international finance and macroeconomics for students who have a good background in micro and macroeconomic theory, econometrics, and mathematical techniques for economic analysis (in particular multivariate calculus and static and dynamic optimization). The objective of the course is to develop expertise with economic models used for the analysis of policy issues in international finance and macroeconomics. The course relies on economic research to develop a substantive understanding of policy issues as well as a facility with the models themselves. Issues of interest to developing countries receive special attention.
The course is designed to appeal to two groups of students: MPAID and other Kennedy School students with excellent backgrounds in micro and macroeconomics and quantitative methods, and Ph.D. students (in economics, public policy, and PEG) with substantive interests in international finance and macroeconomics.
READINGS
Readings are drawn from the current economics literature. They will be technical and mathematically sophisticated, requiring close attention. Starred articles indicate required reading. No single text is required for the course, but useful treatments of almost all the topics can be found in M. Obstfeld and K. Rogoff (OR), Foundations of International Macroeconomics, 1996, the Handbook of International Economics (GO), Vol. 3, G. Grossman and K. Rogoff (eds.), June 1995, and Development Macroeconomics by Pierre Richard Agenor and Peter Montiel (AM), 2nd edition, 1999. Classic if outdated general references are R. Dornbusch, Open Economy Macroeconomics (OEM), Basic Books, 1980, and Handbook of International Economics (HIE) Vol. 2, R. Jones and P. Kenen (eds), 1985. In addition to the readings, we will use handouts which lay out the basic theoretical model for each section. These handouts will be at the center of class discussions, but they should not be viewed as a substitute for reading the original articles.
PREREQUISITES
Macroeconomic theory at the intermediate level and multivariate calculus and dynamic optimization (rudiments of control theory and dynamic programming) are necessary. Previous exposure to upper level international finance is useful but not required. The course freely uses the techniques of dynamic optimization in continues time. Some tips will be provided at the start. As background reading I highly recommend a close reading of the math appendix of OR and of “Dynamic Optimization in Continuous-Time Economic Models (A Guide for the Perplexed),” by Maurice Obstfeld of Berkeley, at http://emlab.Berkeley.EDU/users/obstfeld/e202b/e202b.html.
GRADING
Grading will be based on a midterm to be administered in class (30%), 4 problem sets (30%), and a final (40%). The midterm will take place early in March.
COURSE CONTENTS
I. Basic Relationships (this section will not be discussed in class; you should review the materials on your own)
Dornbusch, R. (1980) Open-Economy Macroeconomics, Ch. 1
Dornbusch, R. (1988) "Balance of Payments Issues" in Helmers, F.L. and R. Dornbusch (eds.) The Open Economy: Tools for Policymakers in Developing Countries The World Band and Oxford University Press, 1988.
II. Optimizing Models of the Current Account
1. The Open-Economy Ramsey Model
*Blanchard, O. and Fischer, S. (1989) Lectures in Macroeconomics, Chapter 2.
*Sachs, J. (1982) "The Curent Account in the Macroeconomic Adjustment Process" Scandinavian Journal of Economics, Vol. 84, pp. 147-159.
OR, Chs. 1 and 2
Svensson, L. and A. Razin (1983) The Terms of Trade and the Current Account: The Harberger-Laursen-Metzler Effect" Journal of Political Economy, Vol 91, pp. 97-125.
Obstfeld, M. (1982) "Transitory Terms of Trade Shocks and the Current Account: The Case of Constant Time Preference" NBER Working Paper No. 833.
_____________________ (1982) "Aggregate Spending and the Terms of Trade: Is there a Laursen-Metzler Effect?" Quarterly Journal of Economics, Vol. 97.
_____________________ (1990) "Intertemporal Dependence, Impatience and Dynamics"
Journal of Monetary Economics, Vol 26.
2. Application: Temporary Policies and Intertemporal Distortions
*Calvo, G.A., "Costly Liberalizations," International Monetary Fund Staff Papers, Vol. 35 (September 1988), pp. 461‑473..
Engel, C., and K.M. Kletzer, "Trade Policy under Endogenous Credibility," Journal of Development Economics, Vol. 36 (1991), pp.213‑228.
van Wijnbergen, S. "Trade Reform, Policy Uncertainty, and the Current Account: A Non‑Expected‑Utility Approach" American Economic Review, Vol. 82 (1992), pp. 626‑633.
First problem set
III. Non-Traded Goods and the Real Exchange Rate
1. Traditional Models
Corden, M. (1960) "The Geometric Representation of Policies to Attain Internal and External Balance" Review of Economic Studies, VOl. 28, pp. 1-22.
Salter, W. (1959) "Internal and External Balance: The Role of Price and Expenditure Effects" Economic Record, Vol. 35, pp. 226-238.
Swan, T. (1960) "Economic Control in a Dependent Economy" Economic Record, Vol. 36, pp. 51-66.
Dornbusch, R. (1980) Open-Economy Macroeconomics, Ch. 6.
____________ (1975) "Exchange Rates and Fiscal Policy in a Popular Model of International Trade" American Economic Review, Vol. 65, pp. 859-871.
2. Dynamic Behavior
*AM, Ch. 7.
*Dornbusch, R. (1983) "Real Interest Rates, Home Goods and Optimal External Borrowing" Journal of Political Economy Vol. Vol. 91.
*OR, Ch. 4.
Obstfeld, M. (1983) "Intertemporal Price Speculation and the Optimal Current Account Deficit" Journal of International Money and Finance, Vol. 2.
Edwards, S. (1991) Real Exchange Rates, Devaluation and Adjustment The MIT Press, Chs. 1-3.
IV. Exchange Rate Determination and Macroeconomic Balance under Flexible Prices
1. The Monetary and Asset Market Approaches
*Obstfeld, M. (1981) "Imperfect Asset Substitutability and Monetary Policy under Fixed Exchange Rates" Journal of International Economics.
__________ (1982) "The Capitalization of Income Streams and the Effects of Open Market Operations under Fixed Exchange Rates" Journal of Monetary Economics, Vol. 9.
OR, Ch. 8.
Calvo, G. and C. Rodriguez (1977) "A Model of Exchange Determination under Currency Substitution and Rational Expectations" Journal of Political Economy, Vol. 85, pp. 617-625.
Kouri, P. (1976) "The Exchange Rate and the Balance of Payments in the Long Run and the Short Run: A Monetary Approach" Scandinavian Journal of Economics, Vol. 78, pp. 280-304.
Frenkel. J. and C. Rodriguez (1975) "Portfolio Equilibrium and the Balance of Payments: A Monetary Approach" American Economic Review, Vol. 65, 674-688.
Dornbusch, R. (1975) "A Portfolio Balance Model of the Open Economy" Journal of Monetary Economics, Vol. 1, pp. 3-20.
Mussa, M. (1974) "A Monetary Approach to Balance of Payments Analysis" Journal of Money, Credit and Banking, Vol. 6, pp. 333-351.
2. Optimizing Models with Money
*Calvo, G. (1981) "Devaluation: Levels versus Rates" Journal of International Economics, Vol. 11, pp. 165-172.
*Obstfeld, M. (1981) "Macroeconomic Policy, Exchange Rate Dynamics and Optimal Asset Accumulation" Journal of Political Economy, Vol. 89, pp. 1142-1161.
OR, Ch. 8.
____________ and A. Stockman "Exchange Rate Dynamics" in Handbook of International Economics, Vol. 2, Section 5.
Second problem set
V. Exchange Rate Determination and Macroeconomic Balance under Sticky Prices
1. The Classics
Mundell. R. (1963) "Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates" Quarterly Journal of Economics, Vol. 74, pp. 227-257.
Fleming, M. (1969) "Domestic Financial Policies under Fixed and under Floating Exchange Rates" IMF Staff Papers, Vol. 9, pp. 379-390.
Frenkel, J. and A. Razin (1987) "The Mundell-Fleming Model a Quarter Century Later: A Unified Exposition" IMF Staff Papers, Vol. 27.
*Dornbusch, R. (1976) "Expectations and Exchange Rate Dynamics" Journal of Political Economy, Vol. 24, pp.1161-1176.
2. More Modern Classics
*Calvo, G. (1983) "Staggered Prices in a Utility-Maximizing Framework" Journal of Monetary Economics, Vol. 12, No. 3.
*Calvo, G.A., and C.A. Végh, "Credibility and the Dynamics of Stabilization Policy: A Basic Framework," in C. Sims, ed., Advances in Econometrics: Sixth World Congress, Vol. II (Cambridge: Cambridge University Press, 1994), pp. 377-420..
Obstfeld, M. and K. Rogoff "Exchange Rate Dynamics with Sluggish Prices under Alternative Price Adjustment Rules" International Economic Review, Vol. 25, No.1, February 1984.
3. The “New” Open-Economy Macroeconomics
OR, Chs. 9 and 10.
*Obstfeld, M. and K. Rogoff "Exchange Rate Dynamics Redux" Journal of Political Economy, Vol. 102, June 1995.
Corsetti, G. and P. Pesenti, “Welfare and Interdependence,” Quarterly Journal of Economics, 2001.
Lane, P. “The New Open-Economy Macroeconomics: A Survey,” Journal of International Economics, 2002.
Chari, V.V., Patrick K. Kehoe, and Ellen R. McGratten, "Monetary Shocks and Real Exchange Rates in Sticky Price Models of International Real Business Cycles," mimeo, Federal Reserve Bank of Minneapolis, 1996.
VI. Stabilization Policies
1. Background
*Vegh, C. "Stopping High Inflation: An Analytical Overview" IMF Staff Papers, 1992.
*AM, Ch. 10, 12.
Rebelo, S., and C.A. Végh, "Real Effects of Exchange Rate-Based Stabilization: An Analysis of Competing Theories," NBER Macroeconomics Annual 1995, pp. 125-174.
Sargent, T. "The Ends of Four Big Inflations" in Rational Expectations and Inflation, 1986.
___________ "Stopping Moderate Inflations: The Methods of Poincare and Thatcher" in R. Dornbusch and M.H. Simonsen (eds.) Inflation, Debt and Indexation, Cambridge: The MIT Press, 1986.
Dornbusch, R. (1988) "Inflation Stabilization and Capital Mobility" in Exchange Rates and Inflation. The MIT Press.
2. Credibility
*Calvo, Guillermo A. and Carlos A. Végh, "Exchange Rate-Based Stabilisation under Imperfect Credibility" in Open-Economy Macroeconomics, by Helmut Frisch and Andreas Worgotter (London:MacMillan Press, 1993), pp. 3-28. Reprinted as Chapter 18- in Calvo’s colleteted essays volume.
*Dornbusch, R. “Credibility and Stabilization,” Quarterly Journal of Economics Vol. 106, 1991.
Calvo, G. "Temporary Stabilization: The Case of Predetermined Exchange Rates" Journal of Political Economy, 1986b.
3. Sticky Inflation and Real Exchange Rate Overshooting
*OR, Ch. 9.
*Calvo, G.A., y C.A. Végh, "Stabilization Dynamics and Backward-Looking Contracts," Journal of Development Economics, Vol. 43 (February 1994), pp. 59-84.
*Ghezzi, P. “Bacward-looking Indexation, Credibility and Inflation Persistence,” Journal of International Economics, Vol. 53, No. 1, 2001.
Celasun, O. “Sticky Inflation and the Real Effects of Exchange-Rate Based Stabilization,” IMF Working Paper 03/151, 2003.
Galí, J. and M. Gertler, “Inflation Dynamics: A Structural Econometric Analysis,” Journal of Monetary Economics, No. 44, 1999.
Buiter, W. and M. Miller (1981) "Real Exchange Rate Overshooting and the Output Costs of Bringing Down Inflation" in International Macroeconomics J. Frenkel (ed.).
VII. Exchange Rate Regimes
1. Regime Characteristics
*Rogoff, Ken, Aasim M. Husain, Ashoka Mody, Robin J. Brooks, and Nienke Oomes, “Evolution and Performance of Exchange Rates Regimes,” forthcoming as an International Monetary Fund Occasional Paper, 2004. Earlier version IMF Working Paper WP03/243, December 2003. Paper is posted in course website.
*Obstfeld, M. and K. Rogoff, “The Mirage of Fixed Exchange Rates,” Journal of Economic Perspectives, 1995.
*Reinhart, C. “The Mirage of Flexible Exchange Rates,” American Economic Review, May 2000.
Velasco, A. and F. Larraín, “Exchange Rate Policy in Emerging-Market Economies: The Case for Floating,” Princeton Essays in International Finance, No. 224, December 2001.
Obstfeld, M, “International Currency Experience: New Lessons and Lessons Re-Learned,” Brookings Papers in Economic Activity, 1: 1995.
Friedman, M. "The Case for Flexible Exchange Rates" in Essays in Positive Economics. University of Chicago Press, 1953.
Johnson, H. "The Case for Flexible Exchange Rates, 1969" Federal Reserve Bank of St. Louis Review, Vol. 51, June 1969.
Obstfeld, M. "Floating Exchange Rates: Experience and Prospects" Brookings Papers on Economic Activity, 1985.
Aschauer, D. and J. Greenwood "A Further Exploration in the Theory of Exchange Rate Regimes" Journal of Political Economy, Vol. 91, No. 5, 1983.
Helpman, E. and A. Razin "Toward a Consistent Comparison of Alternative Exchange Rate Regimes" Canadian Journal of Economics, 1979.
Svensson, L. E. O. "Fixed Exchange Rates as a Means to Price Stability: What Have We Learned?" NBER Working Paper No. 4504, October 1993.
2. Shocks and the Insulating Properties of Alternative Regimes
*Calvo, G. “Fixed vs. Flexible Exchange Rates: Preliminaries of a Turn-of-Millennium Rematch,” May 1999. In http://www.bsos.umd.edu/econ/.
*HIE, Chapter 17, especially sections 5 and 6.
Flood, Robert, “Capital Mobility and the Choice of Exchange Rate System,” International Economic Review, Vol. 2, June 1979.
Fischer, Stanley, “Stability and Exchange Rate Systems in a Monetarist Model of the Balance of Payments,” in The Political Economy of Monetary Reform, Robert Aliber (ed.), 1977.
Flood, Robert P., and Nancy P. Marion, “The Transmission of Disturbances under Alternative Exchange-Rate Regimes with Optimal Indexing,” Quarterly Journal of Economics 97, 1, February 1982: 43-66.
Aizenman, Joshua, and Jacob A. Frenkel, “Optimal Wage Indexation, Foreign Exchange Intervention, and Monetary Policy,” American Economic Review, 73, 3, June 1985: 402-423.
3. Credibility, Flexibility and Discipline
*Velasco, A. “Fixed Exchange Rates: Credibility, Flexibility and Multiplicity,” European Economic Review, May 1996.
*Rogoff, K. “The Optimal Degree of Commitment to an Intermediate Monetary Target'' Quarterly Journal of Economics Vol. 100, pp. 1169‑90, 1985.
OR, Ch. 9, sections 9.4 and 9.5.
Drazen, A. and P. Masson “Credibility of Policies versus Credibility of Policymakers'' NBER Working Paper No. 4488, September 1993.
Cukierman, A., M. Kiguel and N. Liviatan "How Much to Commit to and Exchange Rate Rule? Balancing Credibility and Flexibility" World Bank Working Paper WPS 931, July 1992.
Tornell, A. and A. Velasco “Fixed versus Flexible Exchange Rates: Which Provides More Fiscal Discipline?” Journal of Monetary Economics, 2000.
De Kock, G. and V. Grilli "Fiscal Policies and the Choice of Exchange Rate Regime" The Economic Journal, Vol 103, March 1993.
4. Imperfect Financial Markets and Monetary Policy
*Krugman, P. Analytical Afterthoughts on the Asian Crisis.'' in http://www.wws.princeton.edu/~pkrugman/.
*Céspedes, L. F., R. Chang and A. Velasco, “IS-LM-BP in the Pampas.” IMF Staff Papers, Vol. 50, 2003, pp. 143-156.
Céspedes, L. F., R. Chang and A. Velasco, “Balance Sheets and Exchange Rate Policy,” Forthcoming, American Economic Review, 2004.
Aghion, P., P. Bachetta and A. Banerjee, “Currency Crises and Monetary Policy in an Economy with Credit Constraints,” European Economic Review, 2001.
Midterm
VIII. Monetary and Fiscal Policy in the Open Economy
1. Basic Relations
*Obstfeld, M. “Notes on Seigniorage and Budget Constraints” at http://emlab.Berkeley.EDU/users/obstfeld/e202b/e202b.html
*AM, Ch. 5
2. Fiscal Policy in the Open Economy Ramsey Model
*Blanchard, O. and Fischer, S. (1989) Lectures in Macroeconomics, Chapter 2.3.
3. Fiscal Policy and Monetarist Arithmetic
*Drazen, A. "Tight Money and Inflation: Further Results" Journal of Monetary Economics, Vol. 15, 1984.
* AM, Ch. 5.3.2
OR, Ch. 8, section 2.
Drazen, A. and E. Helpman, “Inflationary Consequences of Anticipated Macroeconomic Policies,” Review of Economic Studies, Vol. 57, 1990.
Drazen, A. and E. Helpman, "Stabilization with Exchange Rate Management" Quarterly Journal of Economics, 1987, pp. 835-855.
Velasco, A. “Real Interest Rates and Government Debt During Stabilization,” Journal of Money, Credit and Banking, April 1993.
IX. Speculative Attacks and Currency Crises