Macroeconomic, Interest Rate, and Exchange Rate Linkages Between Economies

How do the dealings of one country affect the economies of other countries across the globe? Most countries are linked via a global economic network of trade. Countries with more extensive, robust, and diverse economies tend to be less influenced than smaller, less robust, and specialized economies. For example, an economy like that of the Cayman Islands is almost entirely dependent on tourism and banking services. It is much more likely to be influenced by the policies of the former NAFTA countries than vice versa.

Macroeconomic Linkages

Current account: This is a ‘registry’ or unofficial track record of net exports of goods and services, net investment income flows, and unilateral transfers for a given country in a year.

Capital Account: This is another unofficial registry that accounts for foreign investments.

The following formula identifies the variables at work in international trade and helps explain the workings of the current and capital accounts:

$$ (X – M) = (S – I) + (T – G) $$

Where:

\(X\) = Exports.

\(M\) = Imports.

\(S\) = Savings (private citizens).

\(I\) = Investment (private citizens).

\(T\) = Tax revenue.

\(G\) = Governmental spending.

The primary mechanisms by which current and capital accounts are balanced include income (GDP) changes, relative prices, interest and asset prices, and exchange rates.

Interest and Exchange Rate Linkages

One of the linkages of most significant concern to investors involves interest rates and exchange rates, which are inextricably linked. There is a proposition that it is impossible for a country to simultaneously:

• Allow unrestricted capital flows.
• Maintain a fixed exchange rate.
• Pursue an independent monetary policy.

The essence of this proposition is that if the central bank attempts to push interest rates down, capital will flow out, putting downward pressure on the exchange rate. Consequently, the bank would be forced to buy its currency, thereby reversing the expansionary policy.

From the above proposition, we can conclude that given perfect capital mobility and a fixed exchange rate, countries whose currencies are pegged to each other should have the same interest rate. When the currencies are not independent of each other, the link between interest rate differentials and currency movements shows the following factors:

• If a currency is significantly overvalued and expected to decline, bond interest rates are expected to be higher to compensate overseas investors for the expected decline in the currency value.
• Relative bond yields increase with intense economic activity and increasing demand for funds.
• Savings, investment decisions, and capital productivity drive accurate rates.

Question

To maintain the balance of capital and current accounts, an increase in net exports would have to be accompanied by which of the following?

1. An increase in private savings to investment.
2. A decrease in private savings to investment.
3. An increase in government spending to tax receipts.

Solution

The correct answer is A.

According to the formula, an increase in net exports would need to be balanced by an increase in net savings.

$$ (X – M) = (S – I) + (T – G) $$

This is intuitive as a net exporting country will be bringing in more money than it takes out. Such revenue would have to either accumulate in private savings or as a governmental budget surplus.

B and C are incorrect. They would increase the capital and financial accounts surplus, which would not maintain the balance of capital and current accounts when there is an increase in net exports.

Reading 1: Capital Market Expectations – Part 1 (Framework and Macro Considerations)

Los 1 (j) Identify and interpret macroeconomic, interest rate, and exchange rate linkages between economies