International Macroeconomic Development

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Macroeconomic Modelling

Here the macroeconomic models most important to understand the development in the Baltic and Nordic region are presented:

National Accounting and Equilibrium

We know by definition that the total domestic demand for output, income (Y) is made up from consumption (C), investment (I), government spending (G) and net exports (NX). This will take the following form:
The national income accounting identity is an accounting standard, simply put: the proce-dure to calculate for total output or GDP in a country (or region). But this definition can also be used to show the national income equilibrium. By definition, no inputs or outputs can come out of nowhere and there must always be a balance in the identity. With help of mathematical manipulation we can look at this accounting identity and gain several helpful insights about the links between savings, income, investment, government spending and net exports and why they have to be in an equilibrium situation. There can be no black holes in an economy; it is by law of physics impossible to make something out of nothing. The value of production equals income equals expenditure (plus net exports) (Bade & Parkin, 2004).
We know by definition that the disposable income (YD) is equal to output/income minus the money spent on taxes (TA) plus the net transfers (TR) received by the private sector:
Equation (7) is very important because it shows us that investment (I) must equal saving (S) minus the budget deficit (G + TR – TA) minus the net exports (NX). All money being saved in an economy is considered to be invested. If a country has too much investment compared to the levels of saving (Too high level of consumption and too little saving), this implies that there also will be a budget deficit or a negative in the net exports. A negative net export means that a country is borrowing from the rest of the world to finance their in-vestments due to lack of savings. This is something that has perhaps taken place in both Estonia and Latvia since they have aimed at getting attention from foreign investors more actively than trying to keep their budget stable (Dornbusch, Fischer & Startz, 2008).
A country in an open world market works a lot like a person on the credit market in a closed economy. Assume that the country in question experiences a supply shock such as a bad harvest. This will make people in the country wanting to borrow from the outside world. As long as the country is small and the crisis is not worldwide this borrowing can take place on the world credit market without a notable change in the world’s interest rate. If we instead assume that the supply shock is worldwide, then the possibility to borrow at the interest rate, that was set before the shock, would not be possible. Instead the real in-terest rate on the world credit market would rise so that the world aggregate borrowing would equal the desired lending (Barro, 1990).
If instead a country experiences an increase in the demand for goods, this can also be fi-nanced by borrowing abroad. A small country that for some reason has this increased de-mand will find that their domestic expenditure is higher than their GNP, is this case they will have to borrow from abroad to finance their investments and by doing this they will run a current account deficit. Small countries with favourable investment opportunities can borrow from abroad during an investment boom without having to raise their production or to slow down their consumption or cut back on government spending; this is something that can pose a risk when the investment boom slows down and world interest rates in-crease. According to the national income accounting identity, borrowing from abroad represents too little domestic saving compared to the amount of domestic investment (consider equation 7) (Barro, 1990).
An example of this is Mexico where they found oil during the 1970s, and saw the possibil-ity of large future incomes. These expectations increased the aggregate demand for goods in Mexico. To finance their increased demand and the costs for exploiting the oil reserves, they borrowed heavily and Mexico’s external debt increased from 9% of GDP in 1971 to 26% in 1981. Of course this kind of behaviour can pose problems, when the oil prices dropped in the first half of 1980s the future expected earning of Mexico decreased and caused trouble both for Mexico and its creditors (Barro, 1990).
According to Barro, (1990) the discussions about current account deficits have often been accompanied with discussions about the exchange rate. A common argument was that for the U.S to stop their deficits the dollar would have to depreciate against other major cur-rencies to decrease the imports and increase exports. A problem with this is that people making this kind of statements think too much in terms of dollars instead of goods. Con-sider that the amount of exports or imports did not change, then exporters would receive the same amount of dollars for their exports while importers would have to pay more for their imports which would result in an even larger current account deficit. Barro also points out that there is no clear empirical pattern between the U.S exchange rate and their current account.

The IS-LM Model

The Mundell-Flemming is a model based on the Keynesian idea that aggregate supply holds a passive role of fixing the price level while the aggregate demand level decides the amount of economic activity. The M-F approach puts its focus on the different conditions deciding the current balance on one side and the new capital inflow on the other side.
The Mundell-Flemming model is based on the IS-LM model which below is explained and then expanded to the full M-F model. Not only does the IS-LM model serve as a founda-tion for the M-F model, it is also needed to understand the macroeconomic relationship between the Baltic countries and their close neighbours.
The IS-LM model is based on the IS and LM curve. The IS curve describes the combina-tions of income and interest rate where the goods market is in equilibrium and the LM curve describes at what levels of income and interest rate the money market is in equilib-rium.
The IS curve is derived from the national accounting identity equation (1). First the in-vestment function has to be defined. Investment (I) equals the autonomous level of in-vestment (Î) minus the interest rate (i) multiplied by a coefficient (b) that indicates how sensitive the level of investment is to the interest rate.
The level of investment is depending on the interest rate because; the higher interest rate, the more expensive will it be to borrow to finance one’s investments. When the goods market is in equilibrium aggregate demand will be the same as output:
From equation (13), that is the IS curve, we can see that an increase in interest rate reduces the aggregate demand for a certain level of income because a higher interest rate reduces investment spending. Consider that  is a part of aggregate demand that is totally unaf-fected by both income and interest rate. The IS curve is negatively sloped because a higher level of interest rate lowers the investment spending and by doing this reduces the aggre-gate demand and by this the equilibrium level of income. The slope of the curve is depen-dent on b, how sensitive the investments are to interest rates (Copeland, 2006 – Dorn-busch, Fischer & Startz, 2008).
The LM curve is, as mentioned, at what levels of income and interest rate the money mar-ket is in equilibrium. The demand for money depends on the income and the interest rate, this is because individuals will need to hold money to pay for their purchases (that are de-pendent on income). The cost for holding money is made up by the interest they are losing for holding money rather than other assets, the higher the interest rate the higher is the cost for holding money. The real demand for holding money (L) can be described as:
k and h are parameters describing the sensitivity for holding money to the level of income and interest rate respectively. In equilibrium the demand for holding money (L) will be equal to the real money supply which is the quantity of money (M) divided by price level (P):
Equation (16) is the LM curve, which represents the money market equilibrium showing combinations of interest rates and income levels where the demand for real balances is equal to its supply. The curve is positively sloped; an increase in the interest rates lowers the demand for real balances. The sensitivity constants k and h determines the slope of the curve and are related to income and interest rates respectively. Putting the IS-LM schedules together will present us a situation where both the goods market and the money market are in equilibrium (Copeland, 2006 – Dornbusch, Fischer & Startz, 2008).
The IS-LM curves are put together in figure 5.1, where the conditions for equilibrium in both the goods and money market are satisfied at . The LM curve can be shifted right by an expansionary monetary policy, lowering the interest rate and increasing the out-put. It can also be shifted the other way by a contractionary monetary policy, where the effects on interest rate and output are the opposite. These measures are controlled by the central bank. The IS curve can be shifted to the right by an expansionary fiscal policy and to the left by a contractionary fiscal policy, which can be done by changed government spending (Copeland, 2006 – Dornbusch, Fischer & Startz, 2008).

International Parity Relations

To understand the relationship between exchange rate, interest rate and inflation we need to introduce the parity relations framework. Usually countries utilize different currencies, and under these currencies they have independence in setting their own interest rate and monetary policy. This implies that interest rates and inflation will differ between different countries which also imply that exchange rates between currencies will not stay the same over time (Solnik & McLeavy, 2003).

Interest Rate Parity

If we assume open economies with substantially free capital movements, and that people want the highest return possible from their investments the Interest Rate Parity will look like:
Where
r = home interest rate
= foreign interest rate
= actual change between spot and future exchange rate.
The Interest Rate Parity must be covered by arbitrage; this is because people wants the highest return for their money and would simply move their capital to the country that would yield them the highest return (Copeland, 2005).

Relative Purchasing Power Parity

The Relative Purchasing Power Parity simply explains that the difference in exchange rates between two countries must be equal to the difference in inflation between the two coun-tries, ceteris paribus:
Where
S = change in exchange rate
I = home inflation rate
= foreign inflation rate
Put simply, when the inflation rate between two countries are different, the purchasing power of one country will compared to the other country change over time. To balance this on the world market the exchange rate between the two countries must change in ac-cordance with the difference in inflation (Solnik & McLeavy, 2003).

The International Fisher Relation

The Fisher Relation claims that interest rates are the same between different countries, dif-ference in nominal interest rates between countries are only because of the differences in inflationary expectations. The International Fisher Relation looks like:
(19)
Where
r = home interest rate
= foreign interest rate
= expected foreign inflation rate
= expected home inflation rate
This means that the actual real interest rate should be the same between countries, the only difference between them comes from the different inflationary expectations that makes the nominal interest rate differ between countries (Solnik & McLeavy, 2003).

Uncovered Interest Rate Parity

Combining PPP (18) with the International Fisher Relation (19) yields the Uncovered In-terest Rate Parity, the difference from simple Interest Rate Parity is that while the first the-ory must hold by arbitrage the Uncovered Interest Rate Parity is an economic theory:
(20)
Where
r = home interest rate
= foreign interest rate
= expected change in exchange rate
This means that the domestic interest rate equals to the foreign interest rate plus the differ-ence between the spot and expected future exchange rate (expected change in exchange rate). (Copeland, 2005)
Table 5.1 illustrates the different parity relations, and how the different factors are connect-ing all these relationships. Even if some of these relationships are theoretical in their nature and does not always hold in a real world setting, they clearly give some pointer to how in-flation, interest and the exchange rate are linked together. In the real world they will of course not always hold for many different reasons that do not exist in this risk free full foresight world. While dealing with investments in different countries there will often be different risk premiums paid to investors when it’s considered that a certain investment they take adds extra risk to their portfolio (Solnik & McLeavy, 2003).

The Mundell-Flemming Model Under Fixed Exchange Rates

The Mundell-Flemming model extends the basic IS-LM model to an open economy under perfect capital mobility. In this model we also add the balance of payments line, as a straight line. The line is straight since under free capital mobility, this can be explained by the interest rate parity that all assets should yield the same return everywhere. The balance of payments is the record showing all the transactions between the residents of a country and the rest of the world. The two main sub-accounts in the balance of payments are the current account and the capital account. The head rule for the balance of payments is that any transaction that gives rise to a payment by a country’s residents becomes a deficit in that countries balance of payments. The current account records all trade in goods, services and transfers payments including net investment by foreigners. The capital account records the purchases and sales of assets, such as bonds, land and stocks. By accounting standards the sum of the current account and the capital account must equal zero. This means that if a country runs a current account deficit consuming from the rest of the world, this must be done by selling assets or borrowing from abroad, running a capital account surplus. Any current account deficit has to be financed by an offsetting capital inflow. The fact that the current account plus the capital account must equal zero will give the conclusion that a country without any assets to sell or with no willing lenders will have to achieve current ac-count balance even if this process might be very harsh on the country. The current account is simply put basically the same as the exports minus the imports, net exports (NX) (Dorn-busch, Fischer & Startz, 2008).
Under the setting of perfect capital mobility the slightest disturbance leading to an interest rate increase will cause infinite capital movements into the country, because investors want to take advantage of the difference in interest rate compared to the interest rate of the world market. As a result of this huge capital inflow where foreigners will try to buy do-mestic assets the exchange rate tends to appreciate. Here the central bank has to intervene to keep the exchange rate fixed; this will cause the initial change in the interest rate to go back to its original equilibrium situation. This means that under a fixed exchange rate the central bank has no possibility of using monetary policy. While monetary policy is not use-ful under fixed exchange rate, the fiscal policy is on the other hand more efficient. As an example: a fiscal expansion tends to move the IS curve to the right, increasing the output and interest rate. The new increase will set of a capital inflow and the central bank has to increase the money supply causing the LM curve to shift to the right to restore initial level of the interest rate but at a new higher output. While the assumption of perfect capital mo-bility is not fully true, it is not always too far from reality for some small open economies (Burda & Wyplosz, 2005 – Dornbusch, Fischer & Startz, 2008).
Understanding the linkage of the goods market, the money market and the foreign ex-change market is crucial to grasp this model since they are all interconnected. The different circumstances in a country’s good and money markets affect one another along with the foreign exchange rate market. Interest rates and exchange rates affect the domestic aggre-gate demand, the disposable income influences the demand for money and for a given amount of money supplied, the interest rates. General equilibrium in the Mundell-Flemming IS-LM-BP model will take place when equilibriums in the three markets are con-sistent with one another (Burda & Wyplosz, 2005).

A Simple Interpretation of Trade

Consider a world with only two countries, the two countries are open to trade and have equilibrium equations similar to (1). The net export (NX) of both home and foreign are made up of exports (X) minus imports (M)
Equation (26) implies that the net export of home must equal the nex export of foreign. Of course this is only a two country model, but this simple model implies that all the exports and imports in the world must add up to zero. Since imports in one country are exports of another country, an increase in income of one country will stimulate exports and therefore also the income in the other country. A country running a current account deficit against the rest of the world must, as mentioned previously, be running a financial account surplus.
This implies that in the short run it is possible for a country to stimulate their income by imports from another country, but in the long run there must be some current account bal-ance and financing long term growth by imports is not possible (Appleyard & Field, 1998).

Determinants of Exports and Imports

In this model exports and imports will be functions of domestic income (Y), foreign in-come ( ) and the real exchange rate (R) between two countries.
Exports (X) are given as a function of foreign income ( and the real exchange rate (R). If foreign income increases the exports in home will increase but if the real exchange rate increases the exports of home will decrease. This can be interpreted as when a country ex-periences an increase in income as they have done in the Baltics since the Soviet collapse this will lead to a more import orientated consumption pattern (Blanchard, 2009 – Dorn-busch, Fischer & Startz, 2008).

Hypotheses

From theory two hypotheses are formed and then tested in the next section. The first hy-pothesis will concern the current accounts of Sweden, Latvia and Estonia:
= The Swedish current account is negatively correlated to both the Latvian and Esto-nian current accounts
= The Swedish current account is not negatively correlated to both the Latvian and Es-tonian current account.
If this hypothesis is validated it will give some indication that Latvia and Estonia finances some of their growth with imports from Sweden and have over time build up a large cur-rent account deficit.
The second hypothesis concerns the stock markets of Sweden, Latvia and Estonia:
= The Swedish stock market is positively correlated to the stock markets of Latvia and Estonia
= The Swedish stock market is not positively correlated to the stock markets of Latvia and Estonia
If this hypothesis cannot be rejected it will indicate that when the Swedish stock market goes up in value so does the Latvian and Estonian stock markets.
If both hypotheses are validated it will support the theory that Latvia and Estonia have fi-nanced parts of their growth by imports from Sweden. At the same time they have also en-joyed increases in the values of their stock markets as the Swedish markets grows. If Estonia and Latvia have financed growth by taking on current account deficits they have done this by exporting financial assets. As long as the Swedish economy was in a boom this was possible, but as soon as the Swedish economy cooled down this would slow down the fi-nancial markets of Latvia and Estonia and stop the possibility of growing by lending from abroad. This implies that in the long run Latvia and Estonia are forced to reach current ac-count balances and this can be a very painful process.

Table of Contents
1 Introduction
2 Purpose
3 Background
3.1 The Estonian and Latvian Reforms
4 International Macroeconomic Development
4.1 A Brief History of International Monetary Systems
4.2 Central Bank, Currency Board and the Policy Trilemma
5 Macroeconomic Modelling
5.1 National Accounting and Equilibrium
5.2 The IS-LM Model
5.3 International Parity Relations
5.4 The Mundell-Flemming Model Under Fixed Exchange Rates
5.5 A Simple Interpretation of Trade
5.6 Hypotheses
6 Swedish Export to Neighbouring Countries and the Current Account Dependencies
6.1 The Nordic and Baltic Countries’ Current Accounts
6.2 Current Account Regressions
6.3 Estonia’s Current Account – Regressed
6.4 Latvia’s Current Account – Regressed
6.5 Testing the First Hypothesis
7 Nordic and Baltic Stock Market’s
7.1 The Correlation between Different Nordic and Baltic Markets
7.2 Looking Closer at Sweden’s relationship to Estonia and Latvia
7.3 Testing the Second Hypothesis
8 Analysis
9 Suggestions for Further Research
10 Summary and Conclusions
References
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