International monetarty

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Preview ¨ Partial equilibrium analysis of tariffs in a single industry: supply, demand, and trade ¨ Costs and benefits of tariffs ¨ Export subsidies ¨ Import quotas ¨ Voluntary export restraints ¨ Local content requirements 1 Types of Tariffs ¨ A tariff is a tax levied when a good is imported. ¨ A specific tariff is levied as a fixed charge for each unit of imported goods. ¤ For example, $3 per barrel of oil. ¨ An ad valorem tariff is levied as a fraction of the value of imported goods. ¤ For example, 25% tariff on the value of imported trucks. 2 Supply, Demand, and Trade in a Single Industry ¨ Consider how a tariff affects a single market, say that of wheat. ¨ Suppose that in the absence of trade the price of wheat is higher in Home than it is in Foreign. ¨ With trade, wheat will be shipped from Foreign to Home until the price difference is eliminated. 3 Supply, Demand, and Trade in a Single Industry (cont.) ¨ An import demand curve is the difference between the quantity that Home consumers demand minus the quantity that Home producers supply, at each price. ¨ The Home import demand curve MD = D – S intercepts the price axis at domestic equilibrium price (PA) and is downward sloping: ¤ As price increases, the quantity of imports demanded declines. 4 Fig. 9-1: Deriving Home’s Import Demand Curve 5 Supply, Demand, and Trade in a Single Industry (cont.) ¨ An export supply curve is the difference between the quantity that Foreign producers supply minus the quantity that Foreign consumers demand, at each price. ¨ The Foreign export supply curve XS* = S* – D* intersects the price axis at domestic equilibrium price (PA) and is upward sloping: ¤ As price increases, the quantity of exports supplied rises. 6 Fig. 9-2: Deriving Foreign’s Export Supply Curve 7 Supply, Demand, and Trade in a Single Industry (cont.) ¨ In equilibrium, import demand = export supply, home demand – home supply = foreign supply – foreign demand, home demand + foreign demand = home supply + foreign supply, world demand = world supply. 8 Fig. 9-3: World Equilibrium 9 The Effects of a Tariff ¨ A tariff acts like a transportation cost, making sellers unwilling to ship goods unless the Home price exceeds the Foreign price by the amount of the tariff: PT – t = P T ¨ A tariff makes the price rise in the Home market and fall in the Foreign market. 10 Fig. 9-4: Effects of a Tariff 11 The Effects of a Tariff (cont.) ¨ Because the price in the Home market rises from PW under free trade to PT with the tariff, ¤ Home producers supply more and Home consumers demand less, so ¤ the quantity of imports falls from QW under free trade to QT with the tariff. 12 The Effects of a Tariff (cont.) ¨ Because the price in the Foreign market falls from PW under free trade to PT * with the tariff, ¤ Foreign producers supply less, and Foreign consumers demand more, so ¤ the quantity of exports falls from QW to QT . 13 The Effects of a Tariff (cont.) ¨ The quantity of Home imports demanded equals the quantity of Foreign exports supplied when PT – P* T = t ¨ The increase in the price in Home can be less than the amount of the tariff. ¤ Part of the effect of the tariff causes the Foreign export price to decline. ¤ But this effect is sometimes very small. 14 The Effects of a Tariff in a Small Country ¨ When a country is “small,” it has no effect on the foreign (world) price because its demand is an insignificant part of world demand for the good. ¤ The foreign price does not fall, but remains at Pw . ¤ The price in the home market rises by the full amount of the tariff, to PT = Pw + t . 15 Fig. 9-5: A Tariff in a Small Country 16 Effective Rate of Protection ¨ The effective rate of protection measures how much protection a tariff (or other trade policy) provides. ¤ It represents the change in value that firms in an industry add to the production process when trade policy changes, which depends on the change in prices the trade policy causes. ¨ Effective rates of protection often differ from tariff rates because tariffs affect sectors other than the protected sector, causing indirect effects on the prices and value added for the protected sector. 17 Effective Rate of Protection (cont.) ¨ For example, suppose that automobiles sell in world markets for $8,000, and they are made from factors of production worth $6,000. ¤ The value added of the production process is $8,000 – $6,000. ¨ Suppose that a country puts a 25% tariff on imported autos so that home auto assembly firms can now charge up to $10,000 instead of $8,000. 18 Effective Rate of Protection (cont.) ¨ The effective rate of protection for home auto assembly firms is the change in value added: ($4,000 – $2,000)/$2,000 = 100% ¨ In this case, the effective rate of protection is greater than the tariff rate. 19 Costs and Benefits of Tariffs ¨ A tariff raises the price of a good in the importing country, so it hurts consumers and benefits producers there. ¨ In addition, the government gains tariff revenue. ¨ How to measure these costs and benefits? ¨ Use the concepts of consumer surplus and producer surplus. 20 Consumer Surplus ¨ Consumer surplus measures the amount that consumers gain from purchases by computing the difference in the price actually paid from the maximum price they would be willing to pay for each unit consumed. ¤ When price increases, the quantity demanded decreases as well as the consumer surplus. 21 Fig. 9-6: Deriving Consumer Surplus from the Demand Curve 22 Fig. 9-7: Geometry of Consumer Surplus 23 Producer Surplus ¨ Producer surplus measures the amount that producers gain from sales by computing the difference in the price received from the minimum price at which they would be willing to sell. ¤ When price increases, the quantity supplied increases as well as the producer surplus. 24 Fig. 9-8: Geometry of Producer Surplus 25 Costs and Benefits of Tariffs ¨ A tariff raises the price in the importing country: ¤ consumer surplus decreases (consumers worse off) ¤ producer surplus increases (producers better off). ¤ the government collects tariff revenue equal to the tariff rate times the quantity of imports with the tariff. t QT = (PT – PT * ) (D2 – S2) ¨ Change in welfare due to the tariff is e – (b + d). 26 Fig. 9-9: Costs and Benefits of a Tariff for the Importing (Big) Country 27 Costs and Benefits of Tariffs (cont.) ¨ For a “large” country, whose imports and exports affect world prices, the welfare effect of a tariff is ambiguous. ¨ The triangles b and d represent the efficiency loss. ¤ The tariff distorts production and consumption decisions: producers produce too much and consumers consume too little. ¨ The rectangle e represents the terms of trade gain. ¤ The tariff lowers the Foreign price, allowing Home to buy its imports cheaper. 28 Costs and Benefits of Tariffs (cont.) ¨ Part of government revenue (rectangle e) represents the terms of trade gain, and part (rectangle c) represents some of the loss in consumer surplus. ¤ The government gains at the expense of consumers and foreigners. ¨ If the terms of trade gain exceed the efficiency loss, then national welfare will increase under a tariff, at the expense of foreign countries. ¤ However, foreign countries are apt to retaliate. 29 Fig. 9-10: Net Welfare Effects of a Tariff in a Big Country Export Subsidy ¨ An export subsidy can also be specific or ad valorem: ¤ A specific subsidy is a payment per unit exported. ¤ An ad valorem subsidy is a payment as a proportion of the value exported. ¨ An export subsidy raises the price in the exporting country, decreasing its consumer surplus (consumers worse off) and increasing its producer surplus (producers better off). 31 Export Subsidy (cont.) ¨ Also, government revenue falls due to paying s XS * for the export subsidy. ¨ An export subsidy lowers the price paid in importing countries PS * = PS – s. ¨ In contrast to a tariff, an export subsidy worsens the terms of trade by lowering the price of exports in world markets. 32 Fig. 9-11: Effects of an Export Subsidy 33 Export Subsidy (cont.) ¨ An export subsidy damages national
welfare. ¨ The triangles b and d represent the efficiency loss. ¤ The export subsidy distorts production and consumption decisions: producers produce too much and consumers consume too little compared to the market outcome. ¨ The area b + d + e + f + g represents the cost of the subsidy paid by the government. ¤ The terms of trade decrease, because the price of exports falls. 34 Export Subsidy in Europe ¨ The European Union’s Common Agricultural Policy sets high prices for agricultural products and subsidizes exports to dispose of excess production. ¤ The subsidized exports reduce world prices of agricultural products. ¨ The cost of this policy for European taxpayers is almost $30 billion more than its benefits (in 2007). ¤ But the EU has proposed that farmers receive direct payments independent of the amount of production to help lower EU prices and reduce production. 35 Fig. 9-12: Europe’s Common Agricultural Program 36 Import Quota ¨ An import quota is a restriction on the quantity of a good that may be imported. ¨ This restriction is usually enforced by issuing licenses or quota rights. ¨ A binding import quota will push up the price of the import because the quantity demanded will exceed the quantity supplied by Home producers and from imports. 37 Import Quota (cont.) ¨ When a quota instead of a tariff is used to restrict imports, the government receives no revenue. ¤ Instead, the revenue from selling imports at high prices goes to quota license holders. ¤ These extra revenues are called quota rents. 38 Fig. 9-13: Effects of the U.S. Import Quota on Sugar 39 Voluntary Export Restraint ¨ A voluntary export restraint works like an import quota, except that the quota is imposed by the exporting country rather than the importing country. ¨ These restraints are usually requested by the importing country. ¨ The profits or rents from this policy are earned by foreign governments or foreign producers. ¤ Foreigners sell a restricted quantity at an increased price. 40 Local Content Requirement ¨ A local content requirement is a regulation that requires a specified fraction of a final good to be produced domestically. ¨ It may be specified in value terms, by requiring that some minimum share of the value of a good represent home value added, or in physical units. 41 Local Content Requirement (cont.) ¨ From the viewpoint of domestic producers of inputs, a local content requirement provides protection in the same way that an import quota would. ¨ From the viewpoint of firms that must buy home inputs, however, the requirement does not place a strict limit on imports, but allows firms to import more if they also use more home parts. 42 Local Content Requirement (cont.) ¨ Local content requirement provides neither government revenue (as a tariff would) nor quota rents. ¨ Instead, the difference between the prices of home goods and imports is averaged into the price of the final good and is passed on to consumers. 43 Other Trade Policies ¨ Export credit subsidies ¤ A subsidized loan to exporters ¤ U.S. Export-Import Bank subsidizes loans to U.S. exporters. ¨ Government procurement ¤ Government agencies are obligated to purchase from home suppliers, even when they charge higher prices (or have inferior quality) compared to foreign suppliers. ¨ Bureaucratic regulations ¤ Safety, health, quality, or customs regulations can act as a form of protection and trade restriction. 44 The Effects of Trade Policy ¨ For each trade policy, the price rises in the Home country adopting the policy. ¤ Home producers supply more and gain. ¤ Home consumers demand less and lose. ¨ The world price falls when Home is a “large” country that affects world prices. ¨ Tariffs generate government revenue; export subsidies drain it; import quotas do not affect government revenue. ¨ All these trade policies create production and consumption distortions. 45 Table 9-1: Effects of Alternative Trade Policies 46 Summary 1. A tariff increases the home price and the quantity supplied and reduces the quantity demanded and the quantity traded; also decreases the world price when the country is “large.” 2. A quota does the same; an export subsidy does the same. 3. Tariffs generate government revenue; export subsidies drain it; import quotas are revenue neutral. 47 Summary (cont.) 4. The welfare effect of a tariff, quota, or export subsidy can be measured by ¤ efficiency loss from consumption and production distortions. ¤ terms of trade gain or loss. 5. With import quotas, voluntary export restraints, and local content requirements, the government of the importing country receives no revenue. 6. With voluntary export restraints and occasionally import quotas, quota rents go to foreigners. 48 Problems (1/3) 49 ¨ What would be the effective rate of protection on bicycles in China if China places a 50% tariff on imported bicycles, which have a world price of $200, and no tariff on bike components, which together have a world price of 100? Problems (2/3) 50 ¨ The US is considered a “small” country in the market of “alfajores”. Assuming the US is a net importer, graph the effect of an import quota for the US and the rest of the world. Be sure to specify in your figure what happen with: ¤ The domestic price of “alfajores” ¤ The quota rents ¤ The consumption/production distortions loss ¤ The net welfare effect of the policy Problems (3/3) 51 ¨ The US is considered a “big” country in the market of “oil”. Assuming the US is a net importer, graph the effect of an import quota for the US and the rest of the world. Be sure to specify in your figure what happen with: ¤ The domestic price of “oil” ¤ The quota rents ¤ The consumption/production distortions loss ¤ The net welfare effect of the policy

INTERNATIONAL MONETARY ECONOMICS BASED ON GIANCARLO GANDOLOFO’S INTERNATIONAL ECONOMICS II A Simplified Accounting Framework for Real and Financial Flows Slides: self Preview  This unit will help us acquire a deeper understanding of the relationship between the flow of goods and services and the changes in the stock of assets  We will revise the “accounting” of the balance of payments  We will construct a matrix that will be a simplified version of all the economic links between the different sectors and markets 1 Balance of Payments  Definition: The balance of payments of a country is a systematic record of all economic transactions which have taken place during a given period of time between the residents of the reporting country and residents of foreign countries. Note: This record is normally kept in terms of domestic currency of the compiling country 2 Economic Transaction  Definition: Economic Transaction means the transfer from one economic agent (individual, business, etc.) to another of an economic value. It includes both real transfers (transfer of an economic good or rendering of an economic service) and financial transfers (transfer of a financial asset, including the creation of a new one or the cancellation of an existing one). An economic transaction may involve either a quid pro quo (the transferee gives an economic value in return to the transferor: a two-way or bilateral transfer) or it may not (a one-way or unilateral transfer) 3 Economic Transaction (cont.)  Basic types of transaction: 4 Basic types of transactions Number of Entries Current account Capital account Goods and services Unrequited transfers 1) Exchange of goods and services for financial assets One None One 2) Exchange of goods and services for goods and services Two None None 3) Exchange of financial assets for financial assets None None Two 4) Real transfers without quid pro quo One One None 5) Financial without quid pro quo None One One Residents  The classification of economic transaction is obviously valid in general and not only in international economics; what qualifies a transaction as international is that it takes place between a resident and a non-resident  Residents and citizens are not necessarily the same!  As regards individuals, residents are the persons whose general center of interest is considered to rest in the given economy, that is, who consumes goods and services, participate in production, or engage in other economic activity in the territory of an economy on other than a temporary basis independently of their citizenship.  Regarding enterprises it is more complicated. Some enterprises might be legally divided into many, each one being resident of the country in which operates. 5 Accounting Principles  The balance of payments is kept under standard double-entry bookkeeping  Therefore, each international transaction of the residents of a country will result in two entries of equal magnitude and opposite sign: a credit (+) and a debit (-)  CREDITS: (a) real resources denoting exports and (b) financial items reflecting reductions in an economy’s foreign assets or increases in an economy’s foreign liabilities  DEBITS: (a) real resources denoting imports and (b) financial items reflecting increases in an economy’s foreign assets or decreases in an economy’s foreign liabilities In other words, for assets –whether real or financial- a positive figure (credit) represents a decrease in holdings and a negative figure (debit) represents an increase. For liabilities, a positive figure shows an increase and a negative figure a decrease 6 Accounting Principles In other words, for assets –whether real or financial- a positive figure (credit) represents a decrease in holdings and a negative figure (debit) represents an increase. In contrast, for liabilities, a positive figure shows an increase and a negative figure shows a decrease 7 Accounting Principles (Cont.)  Country 1 exports goods for a value of $100 to country 2. The payment is in country 2’s currency and is credited to an account that country 1’s exporter holds with a bank in country 2 (note that such account is a foreign asset for country 1 and a foreign liability for country 2) 8 Accounting Principles (Cont.)  Country 1 exports goods for a value of $100 to country 2. The payment is in country 2’s currency and is credited to an account that country 1’s exporter holds with a bank in country 2 (note that such account is a foreign asset for country 1 and a foreign liability for country 2) 9 Country 1 Current Account Capital Account Credit Debit Credit Debit Merchandise (exp) 100 Increase in claims on foreign bank 100 Country 2 Current Account Capital Account Credit Debit Credit Debit Merchandise (imp) 100 Increase in bank’s liabilities to foreigners 100 Accounting Principles (Cont.)  Country 1 supplies oil for a value of 100 to country 2 which, in turn, supplies machinery for an equivalent value to country 1 (barter) 10 Accounting Principles (Cont.)  Country 1 supplies oil for a value of 100 to country 2 which, in turn, supplies machinery for an equivalent value to country 1 (barter) 11 Country 1 Current Account Capital Account Credit Debit Credit Debit Merchandise (exp) Merchandise (imp) 100 100 Country 2 Current Account Capital Account Credit Debit Credit Debit Merchandise (imp) Merchandise (exp) 100 100 Accounting Principles (Cont.)  Country 1 purchases country 2’s bonds for a value of 200 in country 2’s currency and pays by drawing on a current account that country 1 holds with a bank in country 2. (note that bonds are a liability for the issuing country) 12 Accounting Principles (Cont.)  Country 1 purchases country 2’s bonds for a value of 200 in country 2’s currency and pays by drawing on a current account that country 1 holds with a bank in country 2. (note that bonds are a liability for the issuing country) 13 Country 1 Current Account Capital Account Credit Debit Credit Debit Increase in foreign bond assets Decrease in claims on foreign banks 200 200 Country 2 Current Account Capital Account Credit Debit Credit Debit Increase in bond liabilities to abroad Decrease in banks’ liabilities to foreigners 200 200 Accounting Principles (Cont.)  Country 1 pays pensions for a value of 20 to country 2 in country 1’s currency which accrues to country 2’s foreign exchange reserves. 14 Accounting Principles (Cont.)  Country 1 pays pensions for a value of 20 to country 2 in country 1’s currency which accrues to country 2’s foreign exchange reserves. 15 Country 1 Current Account Capital Account Credit Debit Credit Debit Unrequited transfers (pensions) 20 Increase in foreign liabilities 20 Country 2 Current Account Capital Account Credit Debit Credit Debit Unrequited transfers (pensions) 20 Increase in foreign reserve assets 20 A Simplified Accounting Framework for Real and Financial Flows  In this section we draw from national economic accounting and flow-of-funds analysis some elementary relations among the main macroeconomic (real and financial) aggregates in order to fit the balance of payments into the whole economic system, always keeping within an economic framework  This framework is exhaustive, in the sense that it includes all transactors and transactions  This accounting framework records flows, that is movements or changes that have occurred during a given period of time 16 A Simplified Accounting Framework for Real and Financial Flows (cont) 17 Sectors Markets Private Government Banking Central Bank Rest of the world Row Totals Goods and services I-S G-T X-M 0 Domestic monetary base DHp DHb DHc DHf 0 Domestic Bank Deposits DDp DDb — DDf 0 Domestic securities DNp DNg DNb DNc DNf 0 Foreign money DRp DRb DRc DR f 0 Foreign securities DFp DFb DFc DF f 0 Column totals 0 0 0 0 0 Note: D denotes change, subscript and superscript indicate the holding or issuing sector of the financial asset A Simplified Accounting Framework for Real and Financial Flows (cont)  Sectors: 1. Private: includes all the transactors that do not belong to any other sector, mainly the resident
producing and household sector (excluding banks!) 2. Government: refers to the general government and includes all departments, establishments, and agencies of the country’s central, regional and local governments 3. Banking: includes commercial banks, savings banks and all financial institutions other than the central bank 4. Central Bank: is the authority that manages the national currency by controlling the money supply or the interest rate 5. Rest of the world: includes all non-residents as explained before (see slide #5) 18 A Simplified Accounting Framework for Real and Financial Flows (cont)  Markets: 1. Goods and services: includes all transaction on goods and services (production, exchange and transfers) and gives rise to the real market. 2. Domestic monetary base: is the liability of the central bank and consists of coin, banknotes and the balances which the banks keep with the central bank. 3. Domestic bank deposits: money deposits made on resident banks 4. Domestic securities: includes securities or any form of marketable debt instrument 5. Foreign money: all foreign exchange in either of its forms (cash or deposits) is consolidated in this item 6. Foreign securities: Similar consideration as for domestic securities but issued by non-residents 19 A Simplified Accounting Framework for Real and Financial Flows (cont) Sectors:  The columns represents the “budget constraint” of each transactor, that is, the fact that total receipts and total outlays must necessarily coincide, where receipts and outlays are of course taken to include the change in financial liabilities and assets.  Therefore, an accounting link is establish between real and financial flows: for each transactor the excess of investment over savings coincides with the change in his net liabilities Markets:  The rows represents “excess demands” in each market. In equilibrium, markets should clear and thus excess demands should be equal to zero. 20 A Simplified Accounting Framework for Real and Financial Flows (cont) 21 Sectors Markets Private Government Banking Central Bank Rest of the world Row Totals Goods and services I-S G-T X-M 0 (I – S) + (G – T) + (X – M) = 0  Blank spaces correspond to the simplifying assumption that the real transactions of the banking sector and the central bank are negligible.  I – S = Investment minus savings or private sector’s excess demand for goods and services  G – T = government consumption minus tax revenues or government’s excess demand  X – M = exports minus imports or excess demand of the rest of the world A Simplified Accounting Framework for Real and Financial Flows (cont) 22 Sectors Markets Private Government Banking Central Bank Rest of the world Row Totals Domestic monetary base DHp DHb DHc DHf 0 DHp + DHb + DHc + DHf = 0  Domestic currency is a liability to the Central Bank (FED)  We assume for simplicity that the government does not hold domestic currency A Simplified Accounting Framework for Real and Financial Flows (cont) 23 DDp + DDb + DDf = 0  Blank spaces correspond to the simplifying assumption that only the private and foreign sectors hold domestic deposits.  The central bank does not hold deposits with the banking sector Sectors Markets Private Government Banking Central Bank Rest of the world Row Totals Domestic Bank Deposits DDp DDb — DDf 0 A Simplified Accounting Framework for Real and Financial Flows (cont) 24 DNp + DNg + DNb + DNc + DNf = 0  We assume that domestic securities are issued solely by the government Sectors Markets Private Government Banking Central Bank Rest of the world Row Totals Domestic securities DNp DNg DNb DNc DNf 0 A Simplified Accounting Framework for Real and Financial Flows (cont) 25 DRp + DRb + DRc + DR f = 0 DFp + DFb + DFc + DF f = 0  We assume that the government does not hold either foreign money or foreign securities Sectors Markets Private Government Banking Central Bank Rest of the world Row Totals Foreign money DRp DRb DRc DR f 0 Foreign securities DFp DFb DFc DF f 0 A Simplified Accounting Framework for Real and Financial Flows (cont) 26 (I – S) + DHp + DDp + DNp + DRp + DFp = 0 or (I – S) = – DHp – DDp – DNp – DRp – DFp  This means that excess investment over savings in the private sector is financed through decumulation (decrease in the stock owned) of financial assets. Sectors Markets Private Goods and services I-S Domestic monetary base DHp Domestic Bank Deposits DDp Domestic securities DNp Foreign money DRp Foreign securities DFp Column totals 0 A Simplified Accounting Framework for Real and Financial Flows (cont) 27 (G – T) + DNg= 0 or (G – T)= – DNg  This means that the government budget deficit is financed by issuing securities (debt)  At the same time, in order to pay the debts, the government needs to run a surplus Sectors Markets Government Goods and services G-T Domestic monetary base Domestic Bank Deposits Domestic securities DNg Foreign money Foreign securities Column totals 0 A Simplified Accounting Framework for Real and Financial Flows (cont) 28 DHb + DDb + DNb + DRb + DFb = 0 Or DHb + DNb + DRb + DFb= – DDb  This means that banks records on the debit side the change in deposits (-DDb ) and on the credit side the change in any other asset Sectors Markets Banking Goods and services Domestic monetary base DHb Domestic Bank Deposits DDb Domestic securities DNb Foreign money DRb Foreign securities DFb Column totals 0 A Simplified Accounting Framework for Real and Financial Flows (cont) 29 DHc + DNc+ DRc + DFc = 0 or DNc + DRc + DFc = – DHc  Issuing monetary base (DHc ) for the central bank is a debit item while acquiring any other asset is a credit Sectors Markets Central Bank Goods and services Domestic monetary base DHc Domestic Bank Deposits — Domestic securities DNc Foreign money DRc Foreign securities DFc Column totals 0 A Simplified Accounting Framework for Real and Financial Flows (cont) 30 (X – M) + DHf + DDf + DNf + DR f + DF f = 0  The above equation is the expression of the balance of payments!  (X – M) represents the current account  DHf+DDf+DNf+DR f+DF f represents the capital account Sectors Markets Rest of the world Goods and services X-M Domestic monetary base DHf Domestic Bank Deposits DDf Domestic securities DNf Foreign money DR f Foreign securities DF f Column totals 0 Example 31 The nation of Pecunia had a current account deficit of $1 billion and the private sector has increased their holdings of domestic securities by $500 million in 2008 1. What was the balance of payments of Pecunia that year? What happened to the country’s net foreign assets? Assume all adjustment is due to government spending. 2. Assume that foreign central banks do not trade Pecunia’s assets. How did the Pecunia central bank’s foreign reserve changed in 2008? How this official intervention show up in the balance of payments? 3. How would answer “2” changes if you learn that foreign central bank’s bought $600 million of Pecunia’s assets? How these official purchases are registered in the balance of payments of Pecunia? A Simplified Accounting Framework for Real and Financial Flows (cont) 32 Sectors Markets Private Government Banking Central Bank Rest of the world Goods and services I-S G-T X-M -1b Domestic monetary base DHp DHb DHc DHf Domestic Bank Deposits DDp DDb — DDf Domestic securities DNp +.5b DNg DNb DNc DNf Foreign money DRp DRb DRc DR f Foreign securities DFp DFb DFc DF f Example (cont) 33 Sectors Markets Private Government Banking Central Bank Rest of the world Goods and services I-S -.5b G-T +1.5b X-M -1b Domestic monetary base DHp DHb DHc DHf Domestic Bank Deposits DDp DDb — DDf Domestic securities DNp +.5b DNg DNb DNc DNf Foreign money DRp DRb DRc DR f Foreign securities DFp DFb DFc DF f Note: The market for Goods and Services is in equilibrium but the market for Securities is not! Example (cont) 34 Sectors Markets Private Government Banking Central Bank Rest of the world Goods and services I-S -.5b G-T +1.5b X-M -1b Domestic monetary base DHp DHb DHc DHf Domestic Bank Deposits DDp DDb — DDf Domestic securities DNp +.5b DNg -1.5b DNb DNc DNf+1b Foreign m
oney DRp DRb DRc DR f Foreign securities DFp DFb DFc DF f Example (cont) 35 Sectors Markets Private Government Banking Central Bank Rest of the world Goods and services I-S -.5b G-T +1.5b X-M -1b Domestic monetary base DHp DHb DHc DHf Domestic Bank Deposits DDp DDb — DDf Domestic securities DNp +.5b DNg -1.5b DNb DNc DNf+1b Foreign money DRp DRb DRc DR f Foreign securities DFp DFb DFc DF f Net foreign asset have to diminish by 1b! Example (cont) 36 The nation of Pecunia had a current account deficit of $1 billion and the private sector has increased their holdings of domestic securities by $500 million in 2008 1. What was the balance of payments of Pecunia that year? What happened to the country’s net foreign assets? Assume all adjustment is due to government spending. 2. Assume that foreign central banks do not trade Pecunia’s assets. How did the Pecunia central bank’s foreign reserve changed in 2008? How this official intervention show up in the balance of payments? 3. How would answer “2” changes if you learn that foreign central bank’s bought $600 million of Pecunia’s assets? How these official purchases are registered in the balance of payments of Pecunia? Example (cont) 37 Sectors Markets Private Government Banking Central Bank Rest of the world Goods and services I-S -.5b G-T +1.5b X-M -1b Domestic monetary base DHp DHb DHc DHf Domestic Bank Deposits DDp DDb — DDf Domestic securities DNp +.5b DNg DNb DNc DNf Foreign money DRp DRb DRc DR f Foreign securities DFp DFb DFc DF f Note: The market for Goods and Services does not change, but now foreigners do not accept dollars! Example (cont) 38 Sectors Markets Private Government Banking Central Bank Rest of the world Goods and services I-S -.5b G-T +1.5b X-M -1b Domestic monetary base DHp DHb DHc DHf Domestic Bank Deposits DDp DDb — DDf Domestic securities DNp +.5b DNg -1.5b DNb DNc +1b DNf Foreign money DRp DRb DRc -1b DR f +1b Foreign securities DFp DFb DFc DF f Reserves diminish by 1 billion! Example (cont) 39 The nation of Pecunia had a current account deficit of $1 billion and the private sector has increased their holdings of domestic securities by $500 million in 2008 1. What was the balance of payments of Pecunia that year? What happened to the country’s net foreign assets? Assume all adjustment is due to government spending. 2. Assume that foreign central banks do not trade Pecunia’s assets. How did the Pecunia central bank’s foreign reserve changed in 2008? How this official intervention show up in the balance of payments? 3. How would answer “2” changes if you learn that foreign central bank’s bought $600 million of Pecunia’s assets? How these official purchases are registered in the balance of payments of Pecunia? Example (cont) 40 Sectors Markets Private Government Banking Central Bank Rest of the world Goods and services I-S -.5b G-T X-M -1b Domestic monetary base DHp DHb DHc DHf +.6b Domestic Bank Deposits DDp DDb — DDf Domestic securities DNp +.5b DNg DNb DNc DNf Foreign money DRp DRb DRc DR f Foreign securities DFp DFb DFc DF f Example (cont) 41 Sectors Markets Private Government Banking Central Bank Rest of the world Goods and services I-S -.5b G-T +1.5b X-M -1b Domestic monetary base DHp DHb DHc -.6b DHf +.6b Domestic Bank Deposits DDp DDb — DDf Domestic securities DNp +.5b DNg -1.5b DNb DNc +1b DNf Foreign money DRp DRb DRc -.4b DR f +.4b Foreign securities DFp DFb DFc DF f Note: now the Central Bank can expand the monetary base with minimum impact on inflation! There are still .4b of foreign currency flowing out of the country. Summary 42  We learnt how to register the balance of payment’s trades  We explicitly model the interaction between the economic sectors and markets.  We have been silent on how a disequilibrium in the current account adjust (X – M can’t be positive or negative forever!)  The main topics left in this class deal with the adjustment process observed in the balance of payments when the current account is not in equilibrium Problem 43  The current account of a country has a surplus of $1 billion. The government maintains a deficit of $0.5 billions. All foreign transactions are made in foreign currency but local transactions are made in local currency. Show in the real and financial flows’ matrix the situation in this economy. Problem 44 Sectors Markets Private Government Banking Central Bank Rest of the world Goods and services I-S G-T +.5b X-M +1b Domestic monetary base DHp DHb DHc DHf Domestic Bank Deposits DDp DDb — DDf Domestic securities DNp DNg DNb DNc DNf Foreign money DRp DRb DRc DR f Foreign securities DFp DFb DFc DF f Problem 45  Now assume that the government increases revenues to balance its budget and that the current account remains the same. What would change? Problem 46 Sectors Markets Private Government Banking Central Bank Rest of the world Goods and services I-S G-T X-M +1b Domestic monetary base DHp DHb DHc DHf Domestic Bank Deposits DDp DDb — DDf Domestic securities DNp DNg DNb DNc DNf Foreign money DRp DRb DRc DR f Foreign securities DFp DFb DFc DF f

INTERNATIONAL MONETARY ECONOMICS CHAPTER 16 Price Levels and the Exchange Rate in the Long Run Slides: Pearsons and self Preview  Law of one price  Purchasing power parity  Long-run model of exchange rates: monetary approach  Relationship between interest rates and inflation: Fisher effect  Shortcomings of purchasing power parity  Long-run model of exchange rates: real exchange rate approach  Real interest rates 1 The Behavior of Exchange Rates  What models can predict how exchange rates behave?  In the last chapter we developed a short-run model and a long-run model that used movements in the money supply.  In this chapter, we develop 2 more models, building on the long-run approach from last chapter.  Long run means a sufficient amount of time for prices of all goods and services to adjust to market conditions so that their markets and the money market are in equilibrium.  Because prices are allowed to change, they will influence interest rates and exchange rates in the long-run models. 2 The Behavior of Exchange Rates (cont.)  The long-run models are not intended to be completely realistic descriptions about how exchange rates behave, but ways of representing how market participants may form expectations about future exchange rates and how exchange rates tend to move over long periods. 3 Law of One Price  The law of one price simply says that the same good in different competitive markets must sell for the same price, when transportation costs and barriers between those markets are not important.  Why? Suppose the price of pizza at one restaurant is $20, while the price of the same pizza at an identical restaurant across the street is $40.  What do you predict will happen? Many people will buy the $20 pizza, few will buy the $40 one. 4 Law of One Price (cont.)  Due to the price difference, entrepreneurs would have an incentive to buy pizza at the cheap location and sell it at the expensive location for an easy profit.  Due to strong demand and decreased supply, the price of the $20 pizza would tend to increase.  Due to weak demand and increased supply, the price of the $40 pizza would tend to decrease.  People would have an incentive to adjust their behavior and prices would tend to adjust until one price is achieved across markets (across restaurants). 5 Law of One Price (cont.)  Consider a pizza restaurant in Seattle and one across the border in Vancouver.  The law of one price says that the price of the same pizza (using a common currency to measure the price) in the two cities must be the same if markets are competitive and transportation costs and barriers between markets are not important. P pizza US = (EUS$/C$) x (P pizza Canada) P pizza US = price of pizza in Seattle P pizza Canada = price of pizza in Vancouver EUS$/C$ = U.S. dollar/Canadian dollar exchange rate 6 Purchasing Power Parity  Purchasing power parity is the application of the law of one price across countries for all goods and services, or for representative groups (“baskets”) of goods and services. PUS = (EUS$/C$) x (PCanada) PUS = level of average prices in the U.S. PCanada = level of average prices in Canada EUS$/C$ = U.S. dollar/Canadian dollar exchange rate 7 Purchasing Power Parity (cont.)  Purchasing power parity (PPP) implies that the exchange rate is determined by levels of average prices EUS$/C$ = PUS/PCanada  If the price level in the U.S. is US$200 per basket, while the price level in Canada is C$400 per basket, PPP implies that the C$/US$ exchange rate should be C$400/US$200 = C$2/US$1.  Predicts that people in all countries have the same purchasing power with their currencies: 2 Canadian dollars buy the same amount of goods as 1 U.S. dollar, since prices in Canada are twice as high. 8 Purchasing Power Parity (cont.)  Purchasing power parity (PPP) comes in 2 forms:  Absolute PPP: purchasing power parity that has already been discussed. Exchange rates equal the level of relative average prices across countries. E$/€ = PUS/PEU  Relative PPP: changes in exchange rates equal changes in prices (inflation) between two periods: (E$/€,t – E$/€, t –1 )/E$/€, t –1 = US, t – EU, t where t = inflation rate from period t –1 to t: t = (Pt – Pt –1 )/Pt –1 9 A Long-Run Exchange Rate Model Based on PPP: Monetary Approach to Exchange Rates  Monetary approach to the exchange rate: uses monetary factors to predict how exchange rates adjust in the long run, based on the absolute version of PPP.  It predicts that levels of average prices across countries adjust so that the quantity of real monetary assets supplied will equal the quantity of real monetary assets demanded: PUS = Ms US/L (R$ , YUS) PEU = Ms EU/L (R€ , YEU) 10 Monetary Approach to Exchange Rates (cont.)  To the degree that PPP holds and to the degree that prices adjust to equate the quantity of real monetary assets supplied with the quantity of real monetary assets demanded, we have the following prediction:  The exchange rate is determined in the long run by prices, which are determined by the relative supply and demand of real monetary assets in money markets across countries. 11 Monetary Approach to Exchange Rates (cont.) Predictions about changes in 1. Money supply: a permanent rise in the domestic money supply  causes a proportional increase in the domestic price level,  thus causing a proportional depreciation in the domestic currency (since PPP implies E$/€ = PUS/PEU).  This is same prediction as long-run model without PPP. 2. Interest rates: a rise in domestic interest rates  lowers the demand of real monetary assets,  and is associated with a rise in domestic prices (P/P = Ms/Ms – L/L),  thus causing a proportional depreciation of the domestic currency (through PPP). 12 Monetary Approach to Exchange Rates (cont.) 3. Output level: a rise in the domestic level of production and income (output)  raises domestic demand of real monetary assets,  and is associated with a decreasing level of average domestic prices (for a fixed quantity of money supplied, since P/P = Ms/Ms – L/L),  thus causing a proportional appreciation of the domestic currency (since PPP implies E$/€ = PUS/PEU).  All 3 changes affect money supply or money demand, and cause prices to adjust so that the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded, and cause exchange rates to adjust according to PPP. 13 Monetary Approach to Exchange Rates (cont.)  A change in the money supply results in a change in the level of average prices.  A change in the growth rate of the money supply results in a change in the growth rate of prices (inflation).  A constant growth rate in the money supply results in a persistent growth rate in prices (persistent inflation) at the same constant rate, when other factors are constant.  Inflation does not affect the productive capacity of the economy and real income from production in the long run.  Inflation, however, does affect nominal interest rates. How? 14 Monetary Approach to Exchange Rates (cont.) The Fisher Effect  The Fisher effect (named after Irving Fisher) describes the relationship between nominal interest rates and inflation.  Derive the Fisher effect from the interest parity condition: R$ – R€ = (E e $/€ – E$/€ )/E$/€  If financial markets expect (relative) PPP to hold, then expected exchange rate changes will equal expected inflation between countries: (E e $/€ – E$/€ )/E$/€ =  e US –  e EU  Therefore, R$ – R€ =  e US –  e EU  The Fisher effect: a rise in the domestic inflation rate causes an equal rise in the nominal interest rate on deposits of domestic currency in the long run, when other factors remain constant. 15 Monetary Approach to Exchange Rates  Suppose that the U.S. central bank unexpectedly increases the growth rate of the money supply at time t0 .  Suppose also that the inflation rate is  in the US before t0 and  +  after this time, but that the European inflat
ion rate remains at 0%.  According to the Fisher effect, the interest rate in the U.S. will adjust to the higher inflation rate. 16 Fig. 16-1: Long-Run Time Paths of U.S. Economic Variables After a Permanent Increase in the Growth Rate of the U.S. Money Supply 17 Fig. 16-1: Long-Run Time Paths of U.S. Economic Variables After a Permanent Increase in the Growth Rate of the U.S. Money Supply (cont.) 18 Monetary Approach to Exchange Rates (cont.)  The increase in nominal interest rates decreases the demand of real monetary assets.  In order for the money market to maintain equilibrium in the long run, prices must jump so that PUS = Ms US/L (R$ , YUS)  In order to maintain PPP, the exchange rate must jump (the dollar must depreciate) so that E$/€ = PUS/PEU  Thereafter, the money supply and prices are predicted to grow at rate  +  and the domestic currency is predicted to depreciate at the same rate. 19 The Role of Inflation and Expectations In the long-run model without PPP:  Changes in money supply lead to changes in the level of average prices.  No inflation is predicted to occur in the long run, but only during the transition to the long-run equilibrium.  During the transition, inflation causes the nominal interest rate to increase to its long-run value.  Expectations of higher domestic inflation cause the expected return on foreign currency deposits to increase, making the domestic currency depreciate before the transition period. 20 The Role of Inflation and Expectations (cont.)  In the monetary approach (with PPP), the rate of inflation increases permanently when the growth rate of the money supply increases permanently.  With persistent domestic inflation (above foreign inflation), the monetary approach also predicts an increase in the domestic nominal interest rate.  Expectations of higher domestic inflation cause the expected purchasing power of domestic currency to decrease relative to the expected purchasing power of foreign currency, thereby making the domestic currency depreciate. 21 The Role of Inflation and Expectations (cont.)  In the long-run model without PPP, the level of average prices does not immediately adjust even if expectations of inflation adjust,  causing the exchange rate to overshoot (causing the domestic currency to depreciate more than) its long-run value.  In the monetary approach (with PPP), the level of average prices adjusts with expectations of inflation,  causing the domestic currency to depreciate, but with no overshooting. 22 Fig. 16A-1: How a Rise in U.S. Monetary Growth Affects Dollar Interest Rates and the Dollar/Euro Exchange Rate When Goods Prices Are Flexible Note: E$/€ = PUS/PEU = (MUS/PEU)/ (MUS/PUS) Then, the relationship between E$/€ and MUS/PUS can be represented by a downward-sloping hyperbola 23 Shortcomings of PPP  There is little empirical support for absolute purchasing power parity.  The prices of identical commodity baskets, when converted to a single currency, differ substantially across countries.  Relative PPP is more consistent with data, but it also performs poorly to predict exchange rates. 24 Fig. 16-2: The Yen/Dollar Exchange Rate and Relative Japan-U.S. Price Levels, 1980–2009 Source: IMF, International Financial Statistics. Exchange rates and price levels are end-of-year data. 25 Shortcomings of PPP (cont.) Reasons why PPP may not be accurate: the law of one price may not hold because of 1. Trade barriers and nontradable products 2. Imperfect competition 3. Differences in measures of average prices for baskets of goods and services 26 Shortcomings of PPP (cont.)  Trade barriers and nontradable products  Transport costs and governmental trade restrictions make trade expensive and in some cases create nontradable goods or services.  Services are often not tradable: services are generally offered within a limited geographic region (for example, haircuts).  The greater the transport costs, the greater the range over which the exchange rate can deviate from its PPP value.  One price need not hold in two markets. 27 Shortcomings of PPP (cont.)  Imperfect competition may result in price discrimination: “pricing to market.”  A firm sells the same product for different prices in different markets to maximize profits, based on expectations about what consumers are willing to pay.  One price need not hold in two markets. 28 Shortcomings of PPP (cont.)  Differences in the measure of average prices for goods and services  levels of average prices differ across countries because of differences in how representative groups (“baskets”) of goods and services are measured.  Because measures of groups of goods and services are different, the measure of their average prices need not be the same.  One price need not hold in two markets. 29 Law of One Price for Hamburgers? 30 Fig. 16-3: Price Levels and Real Incomes, 2007 Source: Penn World Table, version 6.3. 31 The Real Exchange Rate Approach to Exchange Rates  Because of the shortcomings of PPP, economists have tried to generalize the monetary approach to PPP to make a better theory.  The real exchange rate is the rate of exchange for goods and services across countries.  In other words, it is the relative value/price/cost of goods and services across countries.  For example, it is the dollar price of a European group of goods and services relative to the dollar price of an American group of goods and services: qUS/EU = (E$/€ x PEU)/PUS 32 The Real Exchange Rate Approach to Exchange Rates (cont.) qUS/EU = (E$/€ x PEU)/PUS  If the EU basket costs €100, the U.S. basket costs $120, and the nominal exchange rate is $1.20 per euro, then the real exchange rate is 1 U.S. basket per 1 EU basket.  A real depreciation of the value of U.S. products means a fall in a dollar’s purchasing power of EU products relative to a dollar’s purchasing power of U.S. products.  This implies that U.S. goods become less expensive and less valuable relative to EU goods.  This implies that the value of U.S. goods relative to value of EU goods falls. 33 The Real Exchange Rate Approach to Exchange Rates (cont.) qUS/EU = (E$/€ x PEU)/PUS  A real appreciation of the value of U.S. products means a rise in a dollar’s purchasing power of EU products relative to a dollar’s purchasing power of U.S. products.  This implies that U.S. goods become more expensive and more valuable relative to EU goods.  This implies that the value of U.S. goods relative to value of EU goods rises. 34 The Real Exchange Rate Approach to Exchange Rates (cont.)  According to PPP, exchange rates are determined by relative average prices: E$/€ = PUS/PEU  According to the more general real exchange rate approach, exchange rates may also be influenced by the real exchange rate: E$/€ = qUS/EU x PUS/PEU  What influences the real exchange rate? 35 The Real Exchange Rate Approach to Exchange Rates (cont.)  A change in relative demand of U.S. products  An increase in relative demand of U.S. products causes the value (price) of U.S. goods relative to the value (price) of foreign goods to rise.  A real appreciation of the value of U.S. goods: PUS rises relative to E$/€ x PEU  The real appreciation of the value of U.S. goods makes U.S. exports more expensive and imports into the U.S. less expensive (thereby reducing the relative quantity demanded of U.S. products).  A decrease in relative demand of U.S. products causes a real depreciation of the value of U.S. goods. 36 The Real Exchange Rate Approach to Exchange Rates (cont.)  A change in relative supply of U.S. products  An increase in relative supply of U.S. products (caused by an increase in U.S. productivity) causes the price/cost of U.S. goods relative to the price/cost of foreign goods to fall.  A real depreciation of the value of U.S. goods: PUS falls relative to E$/€ x PEU  The real depreciation of the value of U.S. goods makes U.S. exports less expensive and imports into the U.S. more expensive (thereby increasing relative quantity demanded to match
increased relative quantity supplied).  A decrease in relative supply of U.S. products causes a real appreciation of the value of U.S. goods. 37 Fig. 16-4: Determination of the LongRun Real Exchange Rate 38 Note: this “relative demand” is upward slopping because a fall in US prices implies an increase in q The Real Exchange Rate Approach to Exchange Rates  The real exchange rate is a more general approach to explain exchange rates. Both monetary factors and real factors influence nominal exchange rates: 1a. Increases in monetary levels lead to temporary inflation and changes in expectations about inflation. 1b. Increases in monetary growth rates lead to persistent inflation and changes in expectations about inflation. 2a. Increases in relative demand of domestic products lead to a real appreciation. 2b. Increases in relative supply of domestic products lead to a real depreciation. 39 Note: changes in monetary variables do not affect the real exchange rate “q” The Real Exchange Rate Approach to Exchange Rates (cont.)  What are the effects on the nominal exchange rate? E$/€ = qUS/EU x PUS/PEU  When only monetary factors change and PPP holds, we have the same predictions as before.  No changes in the real exchange rate occurs.  When factors influencing real output change, the real exchange rate changes.  With an increase in relative demand of domestic products, the real exchange rate adjusts to determine nominal exchange rates.  With an increase in relative supply of domestic products, the situation is more complex. 40 The Real Exchange Rate Approach to Exchange Rates (cont.)  With an increase in the relative supply of domestic products, the real exchange rate adjusts to make the price/cost of domestic goods depreciate, but the relative amount of domestic output also increases.  This second effect increases the demand of real monetary assets in the domestic economy: PUS = Ms US/L (R$ , YUS)  Thus the level of average domestic prices is predicted to decrease relative to the level of average foreign prices.  The effect on the nominal exchange rate is ambiguous: E$/€ = qUS/EU x PUS/PEU ? 41 The Real Exchange Rate Approach to Exchange Rates (cont.)  When economic changes are influenced only by monetary factors, and when the assumptions of PPP hold, nominal exchange rates are determined by PPP.  When economic changes are caused by factors that affect real output, exchange rates are not determined by PPP only, but are also influenced by the real exchange rate. 42 Interest Rate Differences  A more general equation of differences in nominal interest rates across countries can be derived from (q e US/EU – qUS/EU)/qUS/EU = [(E e $/€ – E$/€ )/E$/€ ] – ( e US –  e EU) R$ – R€ = (E e $/€ – E$/€ )/E$/€ R$ – R€ = (q e US/EU – qUS/EU)/qUS/EU + ( e US –  e EU)  The difference in nominal interest rates across two countries is now the sum of  the expected rate of depreciation in the value of domestic goods relative to foreign goods, and  the difference in expected inflation rates between the domestic economy and the foreign economy. 43 Table 16-1: Effects of Money Market and Output Market Changes on the Long-Run Nominal Dollar/Euro Exchange Rate, E$/€ 44 Real Interest Rates  Real interest rates are inflation-adjusted interest rates: r e = R – e where e represents the expected inflation rate and R represents a measure of nominal interest rates.  Real interest rates are measured in terms of real output:  the quantity of goods and services that savers can purchase when their assets pay interest  the quantity of goods and services that borrowers cannot purchase when they must pay interest on their loans  What are the predicted differences in real interest rates across countries? 45 Real Interest Rates (cont.)  Real interest rate differentials are derived from r e US – r e EU = (R$ –  e US) – (R€ –  e EU) R$ – R€ = (q e US/EU – qUS/EU)/qUS/EU + ( e US –  e EU) Then, r e US – r e EU = (q e US/EU – qUS/EU)/qUS/EU  The last equation is called real interest parity.  It says that differences in real interest rates (in terms of goods and services that are earned or forgone when lending or borrowing) between countries are equal to the expected change in the value/price/cost of goods and services between countries. 46 Summary 1. The law of one price says that the same good in different competitive markets must sell for the same price, when transportation costs and barriers between markets are not important. 2. Purchasing power parity applies the law of one price for all goods and services among all countries.  Absolute PPP says that currencies of two countries have the same purchasing power.  Relative PPP says that changes in the nominal exchange rate between two countries equals the difference in the inflation rates between the two countries. 47 Summary (cont.) 3. The monetary approach to exchange rates uses PPP and the supply and demand of real monetary assets.  Changes in the growth rate of the money supply influence inflation and exchange rates.  Expectations about inflation influence the exchange rate.  The Fisher effect shows that differences in nominal interest rates are equal to differences in inflation rates. 4. Empirical support for PPP is weak.  Trade barriers, non-tradable products, imperfect competition and differences in price measures may cause the empirical shortcomings of PPP. 48 Summary (cont.) 5. The real exchange rate approach to exchange rates generalizes the monetary approach.  It defines the real exchange rate as the value/price/cost of domestic products relative to foreign products.  It predicts that changes in relative demand and relative supply of products influence real and nominal exchange rates.  Interest rate differences are explained by a more general concept: expected changes in the value of domestic products relative to the value of foreign products plus the difference of inflation rates between the domestic and foreign economies. 49 Summary (cont.) 6. Real interest rates are inflation-adjusted interest rates, and show how much purchasing power savers gain and borrowers give up. 7. Real interest parity shows that differences in real interest rates between countries equal expected changes in the real value of goods and services between countries. 50 Problems 1. Suppose Russia’s inflation rate is 100 percent over one year but the inflation rate in Switzerland is only 5 percent. According to relative PPP what should happen over the year to the Swiss franc’s exchange rate against the Russian ruble? 2. Other things equal, how would you expect the following shifts to affect a currency’s real exchange rate against foreign currencies? 1. The overall level of spending does not change, but domestic residents decide to shift consumption from tradeable goods toward non-tradeable goods. 2. Foreign residents shift their demand away from their own goods toward our exports. 3. Explain how permanent shifts in the national real money demand function affect real and nominal exchange rates in the long run. 51 Problems (cont) 4. A country impose a tariff on imports from abroad. How does this action change the long-run real exchange rate between the home and foreign currencies? How is the long run nominal exchange rate affected? 5. Imagine two identical countries have restricted imports to identical levels, but one has done so using tariffs while the other has done so using quotas. After these policies are in place, both countries experience identical, balanced expansions of domestic spending. Where should the demand expansion cause a greater real currency appreciation, in the tariff country or in the quota country? Why? 6. Suppose residents of the US consume relatively more of US exports goods than residents of foreign countries. In other words, US exports goods have a higher weight in the US CPI than they do in other countries. Conversely, foreign exports have a lower weight in the US CPI than they do abroad. What would be the effect on the dollar
’s real exchange rate of a rise in US terms of trade (the relative price of US goods exports in terms of US imports)? 52

INTERNATIONAL MONETARY ECONOMICS CHAPTER 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach Slides: Pearsons and self Preview  The basics of exchange rates  Exchange rates and the prices of goods  The foreign exchange markets  The demand of currency and other assets  A model of foreign exchange markets  role of interest rates on currency deposits  role of expectations of exchange rates 1 14-2 Definitions of Exchange Rates  Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency.  How much can be exchanged for one dollar? ¥89.40/$  How much can be exchanged for one yen? $0.011185/¥  Exchange rates allow us to denominate the cost or price of a good or service in a common currency.  How much does a Nissan cost? ¥2,500,000  Or, ¥2,500,000 x $0.011185/¥ = $27,962.50 2 Table 14-1: Exchange Rate Quotations 3 Depreciation and Appreciation  Depreciation is a decrease in the value of a currency relative to another currency.  A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency.  $1/€ → $1.20/€ means that the dollar has depreciated relative to the euro. It now takes $1.20 to buy one euro, so that the dollar is less valuable.  The euro has appreciated relative to the dollar: it is now more valuable. 4 Depreciation and Appreciation (cont.)  Appreciation is an increase in the value of a currency relative to another currency.  An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency.  $1/€ → $0.90/€ means that the dollar has appreciated relative to the euro. It now takes only $0.90 to buy one euro, so that the dollar is more valuable.  The euro has depreciated relative to the dollar: it is now less valuable. 5 Depreciation and Appreciation (cont.)  A depreciated currency is less valuable, and therefore it can buy fewer foreign produced goods that are denominated in foreign currency.  A Nissan costs ¥2,500,000 = $25,000 at $0.010/¥  becomes more expensive $27,962.50 at $0.011185/¥  A depreciated currency means that imports are more expensive and domestically produced goods and exports are less expensive.  A depreciated currency lowers the price of exports relative to the price of imports. 6 Depreciation and Appreciation (cont.)  An appreciated currency is more valuable, and therefore it can buy more foreign produced goods that are denominated in foreign currency.  A Nissan costs ¥2,500,000 = $27,962.50 at $0.011185/¥  becomes less expensive $25,000 at $0.010/¥  An appreciated currency means that imports are less expensive and domestically produced goods and exports are more expensive.  An appreciated currency raises the price of exports relative to the price of imports. 7 Table 14-2: $/£ Exchange Rates and the Relative Price of American Designer Jeans and British Sweaters 8 Foreign Exchange Markets  The set of markets where foreign currencies and other assets are exchanged for domestic ones  Institutions buy and sell deposits of currencies or other assets for investment purposes.  The daily volume of foreign exchange transactions was $4.0 trillion in April 2010  up from $500 billion in 1989.  Most transactions (85% in April 2010) exchange foreign currencies for U.S. dollars. 9 Foreign Exchange Markets The participants: 1. Commercial banks and other depository institutions: transactions involve buying/selling of deposits in different currencies for investment purposes. 2. Non-bank financial institutions (mutual funds, hedge funds, securities firms, insurance companies, pension funds) may buy/sell foreign assets for investment. 3. Non-financial businesses conduct foreign currency transactions to buy/sell goods, services and assets. 4. Central banks: conduct official international reserves transactions. 10 Foreign Exchange Markets (cont.)  Buying and selling in the foreign exchange market are dominated by commercial and investment banks.  Inter-bank transactions of deposits in foreign currencies occur in amounts $1 million or more per transaction.  Central banks sometimes intervene, but the direct effects of their transactions are small and transitory in many countries. 11 Foreign Exchange Markets (cont.)  Computer and telecommunications technology transmit information rapidly and have integrated markets.  The integration of financial markets implies that there can be no significant differences in exchange rates across locations.  Arbitrage: buy at low price and sell at higher price for a profit.  If the euro were to sell for $1.1 in New York and $1.2 in London, you could buy euros in New York (where cheaper) and sell them in London at a profit. 12 Spot Rates and Forward Rates  Spot rates are exchange rates for currency exchanges “on the spot,” or when trading is executed in the present.  Forward rates are exchange rates for currency exchanges that will occur at a future (“forward”) date.  Forward dates are typically 30, 90, 180, or 360 days in the future.  Rates are negotiated between two parties in the present, but the exchange occurs in the future. 13 Fig. 14-1: Dollar/Pound Spot and Forward Exchange Rates, 1983–2011 Source: Datastream. Rates shown are 90-day forward exchange rates and spot exchange rates, at end of month. 14 Other Methods of Currency Exchange  Foreign exchange swaps: a combination of a spot sale with a forward repurchase.  Swaps allow parties to meet each other’s needs for a temporary amount of time and often cost less in fees than separate transactions.  For example, suppose Toyota receives $1 million from American sales, plans to use it to pay its California suppliers in three months, but wants to invest the money in euro bonds in the meantime. 15 Futures contract An agreement made today regarding the terms of a trade that will take place later. Option contract An agreement that gives the owner the right, but not the obligation, to buy or sell a specific asset at a specified price for a set period of time (American option). 16 Other Methods of Currency Exchange (cont.) Futures contract  Potential gains/losses:  At maturity, you gain if your contracted price is better than the market price of the underlying asset, and vice versa.  If you sell your contract before its maturity, you may gain or lose depending on the market price for the contract.  Note that enormous gains/losses are possible. 17 Other Methods of Currency Exchange (cont.) Option contract  A call option gives the owner the right, but not the obligation, to buy an asset, while a put option gives the owner the right, but not the obligation, to sell an asset.  The price you pay to buy an option is called the option premium.  The specified price at which the underlying asset can be bought or sold is called the strike price, or exercise price. 18 Other Methods of Currency Exchange (cont.) Option contract  An American option can be exercised anytime up to and including the expiration date, while a European option can be exercised only on the expiration date.  Options differ from futures in two main ways: There is no obligation to buy/sell the underlying asset. There is a premium associated with the contract. 19 Other Methods of Currency Exchange (cont.) Option contract  Potential gains/losses on a call option:  Buyers gain if the strike price plus the premium is lower than the market price. In the worst case, buyers lose the entire premium.  Sellers gain the entire premium if the market price is lower than strike price.  Sellers gain part of the premium if the market price is in between the strike price and the strike price plus the premium.  For the seller the gain is limited but the loss is not. 20 Other Methods of Currency Exchange (cont.) Option contract  Potential gains/losses on a put option:  Buyers gain if the strike price minus the premium is higher than the market price. In the w
orst case, buyers lose the entire premium.  Sellers gain the entire premium if the market price is higher than the strike price.  Sellers gain part of the premium if the market price is in between the strike price and the strike price minus the premium. 21 Other Methods of Currency Exchange (cont.) Investing in the asset vs the asset’s option Example: You have 10,000 AR$ and you want to buy dollars. The exchange rate is AR$50/$  Dollars bought = $10,000 / $50 = 200  If the exchange rate is AR$55/$ 3 months later, gain = (AR$55  200) – AR$10,000 = AR$1,000  If the exchange rate is AR$45/$, 3 months later, gain = (AR$45  200) – AR$10,000 = – AR$1,000 22 Other Methods of Currency Exchange (cont.) Example: …continued  A call option with a AR$50/$ strike price and 3 months to maturity is also available at a premium of AR$4.  A call contract costs AR$4  100 = AR$400, so number of contracts bought =AR$10,000 / AR$400 = 25 (for 25  100 = 2500 dollars!)  If the exchange rate is AR$55/$ 3 months later, gain = {(AR$55 – AR$50)  2500} – AR$10,000 = AR$2,500  If the exchange rate is AR$45/$ 3 months later, gain = (AR$0  2500) – AR$10,000 = – AR$10,000 23 Other Methods of Currency Exchange (cont.) The Demand of Currency Deposits  What influences the demand of (willingness to buy) deposits denominated in domestic or foreign currency?  Factors that influence the return on assets determine the demand of those assets. 24 The Demand of Currency Deposits (cont.)  Rate of return: the percentage change in value that an asset offers during a time period.  The annual return for $100 savings deposit with an interest rate of 2% is $100 x 1.02 = $102, so that the rate of return = ($102 – $100)/$100 = 2%.  Real rate of return: inflation-adjusted rate of return,  which represents the additional amount of goods & services that can be purchased with earnings from the asset.  The real rate of return for the above savings deposit when inflation is 1.5% is approx. 2% – 1.5% = 0.5%. After accounting for the rise in the prices of goods and services, the asset can purchase 0.5% more goods and services after 1 year. 25 The Demand of Currency Deposits (cont.)  If prices are fixed, the inflation rate is 0% and (nominal) rates of return = real rates of return.  Because trading of deposits in different currencies occurs on a daily basis, we often assume that prices do not change from day to day.  A good assumption to make for the short run. 26 The Demand of Currency Deposits (cont.)  Risk of holding assets also influences decisions about whether to buy them.  Liquidity of an asset, or ease of using the asset to buy goods and services, also influences the willingness to buy assets.  But we assume that risk and liquidity of currency deposits in foreign exchange markets are essentially the same, regardless of their currency denomination.  Risk and liquidity are only of secondary importance (for major currencies) when deciding to buy or sell currency deposits.  Importers and exporters may be concerned about risk and liquidity, but they make up a small fraction of the market. 27 The Demand of Currency Deposits (cont.)  We therefore say that investors are primarily concerned about the rates of return on currency deposits.  Rates of return that investors expect to earn are determined by  interest rates that the assets will earn  expectations about appreciation or depreciation 28 The Demand of Currency Deposits (cont.)  A currency deposit’s interest rate is the amount of a currency that an individual or institution can earn by lending a unit of the currency for a year.  The rate of return for a deposit in domestic currency is the interest rate that the deposit earns.  To compare the rate of return on a deposit in domestic currency with one in foreign currency, consider  the interest rate for the foreign currency deposit  the expected rate of appreciation or depreciation of the foreign currency relative to the domestic currency. 29 Fig. 14-2: Interest Rates on Dollar and Yen Deposits, 1978–2011 Source: Datastream. Three-month interest rates are shown. 30 The Demand of Currency Deposits (cont.)  Suppose the interest rate on a dollar deposit is 2%.  Suppose the interest rate on a euro deposit is 4%.  Does a euro deposit yield a higher expected rate of return?  Suppose today the exchange rate is $1/€1, and the expected rate one year in the future is $0.97/€1.  $100 can be exchanged today for €100.  These €100 will yield €104 after one year.  These €104 are expected to be worth $0.97/€1 x €104 = $100.88 in one year. 31 The Demand of Currency Deposits (cont.)  The rate of return in terms of dollars from investing in euro deposits is ($100.88 – $100)/$100 = 0.88%.  Let’s compare this rate of return with the rate of return from a dollar deposit.  The rate of return is simply the interest rate.  After 1 year the $100 is expected to yield $102: ($102 – $100)/$100 = 2%  The euro deposit has a lower expected rate of return: thus, all investors should be willing to hold dollar deposits and none should be willing to hold euro deposits. 32 The Demand of Currency Deposits (cont.)  Note that the expected rate of appreciation of the euro was ($0.97 – $1)/$1 = –0.03 = –3%.  We simplify the analysis by saying that the dollar rate of return on euro deposits approximately equals  the interest rate on euro deposits  plus the expected rate of appreciation of euro deposits  4% + –3% = 1% ≈ 0.88%  R€ + (E e $/€ – E$/€ )/E$/€ 33 The Demand of Currency Deposits (cont.)  The difference in the rate of return on dollar deposits and euro deposits is R$ – (R€ + (E e $/€ – E$/€ )/E$/€ ) = R$ –R€ –(E e $/€ – E$/€ )/E$/€ expected rate of return = interest rate on dollar deposits interest rate on euro deposits expected rate of return on euro deposits expected exchange rate current exchange rate expected rate of appreciation of the euro 34 Table 14-3: Comparing Dollar Rates of Return on Dollar and Euro Deposits 35 Model of Foreign Exchange Markets  We use the  demand of (rate of return on) dollar denominated deposits  and the demand of (rate of return on) foreign currency denominated deposits to construct a model of foreign exchange markets.  This model is in equilibrium when deposits of all currencies offer the same expected rate of return: interest parity.  Interest parity implies that deposits in all currencies are equally desirable assets.  Interest parity implies that arbitrage in the foreign exchange market is not possible. 36 Model of Foreign Exchange Markets (cont.)  Interest parity says: R$ = R€ + (E e $/€ – E$/€ )/E$/€  Why should this condition hold? Suppose it didn’t.  Suppose R$ > R€ + (E e $/€ – E$/€ )/E$/€  Then no investor would not want to hold euro deposits, driving down the demand and price of euros.  Then all investors would want to hold dollar deposits, driving up the demand and price of dollars.  The dollar would appreciate and the euro would depreciate, increasing the right side until equality was achieved: R$ > R€ + (E e $/€ – E$/€ )/E$/€ 37 Model of Foreign Exchange Markets (cont.)  Interest parity says: R$ = R€ + (E e $/€ – E$/€ )/E$/€  Why should this condition hold? Suppose it didn’t.  Suppose R$ > R€ + (E e $/€ – E$/€ )/E$/€  Then no investor would not want to hold euro deposits, driving down the demand and price of euros.  Then all investors would want to hold dollar deposits, driving up the demand and price of dollars.  The dollar would appreciate and the euro would depreciate, increasing the right side until equality was achieved: R$ = R€ + (E e $/€ – E$/€ )/E$/€ 38 Model of Foreign Exchange Markets (cont.)  How do changes in the current exchange rate affect the expected rate of return of foreign currency deposits? 39 Model of Foreign Exchange Markets (cont.)  Depreciation of the domestic curr
ency today lowers the expected rate of return on foreign currency deposits. Why?  When the domestic currency depreciates, the initial cost of investing in foreign currency deposits increases, thereby lowering the expected rate of return of foreign currency deposits. 40 Model of Foreign Exchange Markets (cont.)  Appreciation of the domestic currency today raises the expected return of deposits on foreign currency deposits. Why?  When the domestic currency appreciates, the initial cost of investing in foreign currency deposits decreases, thereby increasing the expected rate of return of foreign currency deposits. 41 Table 14-4: Today’s Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits When E e $/€ = $1.05 per Euro 42 Fig. 14-3: The Relation Between the Current Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits 43 Fig. 14-4: Determination of the Equilibrium Dollar/Euro Exchange Rate 44 Model of Foreign Exchange Markets  The effects of changing interest rates:  an increase in the interest rate paid on deposits denominated in a particular currency will increase the rate of return on those deposits.  This leads to an appreciation of the currency.  Higher interest rates on dollar-denominated assets cause the dollar to appreciate.  Higher interest rates on euro-denominated assets cause the dollar to depreciate. 45 Fig. 14-5: Effect of a Rise in the Dollar Interest Rate 46 Fig. 14-6: Effect of a Rise in the Euro Interest Rate 47 The Effect of an Expected Appreciation of the Euro  If people expect the euro to appreciate in the future, then euro-denominated assets will pay in valuable euros, so that these future euros will be able to buy many dollars and many dollar-denominated goods.  The expected rate of return on euros therefore increases.  An expected appreciation of a currency leads to an actual appreciation (a self-fulfilling prophecy).  An expected depreciation of a currency leads to an actual depreciation (a self-fulfilling prophecy). 48 Fig. 14-7: Cumulative Total Investment Return in Australian Dollar Compared to Japanese Yen, 2003-2010 Source: Exchange rates and three-month treasury yields from Global Financial Data. 49 Covered Interest Parity  Covered interest parity relates interest rates across countries and the rate of change between forward exchange rates and the spot exchange rate: R$ = R€ + (F$/€ – E$/€ )/E$/€ where F$/€ is the forward exchange rate.  It says that rates of return on dollar deposits and “covered” foreign currency deposits are the same.  How could you earn a risk-free return in the foreign exchange markets if covered interest parity did not hold?  Covered positions using the forward rate involve little risk. 50 Summary 1. An exchange rate is the price of one country’s currency in terms of another country’s currency. • It enables us to translate different countries’ prices into comparable terms. 2. Depreciation of a currency means that it becomes less valuable and goods denominated in it are less expensive: exports are cheaper and imports more expensive. 3. Appreciation of a currency means that it becomes more valuable and goods denominated in it are more expensive: exports are more expensive and imports cheaper. 51 Summary (cont.) 4. Commercial and investment banks that invest in deposits of different currencies dominate the foreign exchange market.  Expected rates of return are most important in determining the willingness to hold these deposits. 5. Rates of return on currency deposits in the foreign exchange market are influenced by interest rates and expected exchange rates. 6. Equilibrium in the foreign exchange market occurs when rates of returns on deposits in domestic currency and in foreign currency are equal: interest rate parity. 7. An increase in the interest rate on a currency’s deposit leads to an increase in its expected rate of return and to an appreciation of the currency. 52 Summary (cont.) 8. An expected appreciation of a currency leads to an increase in the expected rate of return for that currency, and leads to an actual appreciation. 9. Covered interest parity says that rates of return on domestic currency deposits and “covered” foreign currency deposits using the forward exchange rate are the same. 53 Problems 54 1. A US dollar costs 7.5 Norwegian kroner, but the same dollar can be purchased for 1.25 Swiss francs. What is the Norwegian krone/Swiss franc exchange rate? 2. Calculate the dollar rates of returns of the following assets:  A bottle of rare Burgundy whose price rises from $255 to $275 between 2013 and 2014.  A €10,000 in a German bank in a year in which the Euro interest rate is 10% and the $/€ exchange rate moves from $1.50 per Euro to $1.38 per Euro. Problems (cont) 55 3. Suppose the dollar exchange rate of the euro and the yen are equally variable. The euro, however, tends to depreciate unexpectedly against the dollar when the return on the rest of your wealth is unexpectedly high, while the yen tend to appreciate unexpectedly under the same circumstances. As a US resident, which currency, the euro or the yen, would you consider riskier? 4. Europe’s single currency, the Euro, was introduced in January 1999, replacing the currencies of 11 European Union members, including Germany, France, Italy and Spain. Do you think that immediately after the Euro’s introduction, the value of foreign exchange trading in euros was greater or less than the euro value of the pre- 1999 trade in the 11 original national currencies? Explain. Problems (cont) 56 Real and Financial Flows’ matrix: Suppose the current account is in equilibrium (X = M). What would be the impact in the economy of an increase in the interest rate of the dollar? – Assume that international transaction are made in dollars and that foreigners, given the higher interest rates in the US, would like to buy domestic securities from US banks. (Hint: what would happen with X – M?) Problems (1/3) 57 Sectors Markets Private Government Banking Central Bank Rest of the world Goods and services I-S G-T X-M — Domestic monetary base DHp DHb DHc DHf Domestic Bank Deposits DDp DDb — DDf Domestic securities DNp DNg DNb DNc DNf Foreign money DRp DRb DRc DR f Foreign securities DFp DFb DFc DF f

INTERNATIONAL MONETARY ECONOMICS CHAPTER 13 National Income Accounting and the Balance of Payments Slides: Pearsons and self Preview to the rest of the course  From Microeconomics to Macroeconomics  Microeconomics studies the problem “from the bottom up”  Previously we studied the problem of resource allocation and government intervention from the perspective of the individuals and firms  Now we move to Macroeconomics  We will study the problem of resource allocation, but from the perspective of the economy as a whole: how overall levels of employment, production and growth are determined.  We will focus on the interaction between countries 1 Preview to this chapter  National income accounts  measures of national income  measures of value of production  measures of value of expenditure  National saving, investment, and the current account  Balance of payments accounts 2 National Income Accounts  Records the value of national income that results from production and expenditure.  Producers earn income from buyers who spend money on goods and services.  The amount of expenditure by buyers = the amount of income for sellers = the value of production.  National income is often defined to be the income earned by a nation’s factors of production. 3 National Income Accounts: GNP  Gross national product (GNP) is the value of all final goods and services produced by a nation’s factors of production in a given time period.  What are factors of production? Factors that are used to produce goods and services: workers (labor services), physical capital (like buildings and equipment), natural resources and others.  The value of final goods and services produced by US-owned factors of production are counted as US GNP. 4 National Income Accounts: GNP (cont.)  GNP is calculated by adding the value of expenditure on final goods and services produced: 1. Consumption: expenditure by domestic consumers 2. Investment: expenditure by firms on buildings & equipment 3. Government purchases: expenditure by governments on goods and services 4. Current account balance (exports minus imports): net expenditure by foreigners on domestic goods and services 5 Fig. 13-1: U.S. GNP and Its Components Source: U.S. Department of Commerce, Bureau of Economic Analysis. 6 National Income Accounts  GNP is one measure of national income, but a more precise measure of national income is GNP adjusted for following: 1. Depreciation of physical capital results in a loss of income to capital owners, so the amount of depreciation is subtracted from GNP. 2. Unilateral transfers to and from other countries can change national income: payments of expatriate workers sent to their home countries, foreign aid and pension payments sent to expatriate retirees. 7 National Income Accounts (cont.)  Another approximate measure of national income is gross domestic product (GDP): – Gross domestic product measures the final value of all goods and services that are produced within a country in a given time period. – GDP = GNP – payments from foreign countries for factors of production + payments to foreign countries for factors of production 8 GNP = Expenditure on a Country’s Goods and Services  The national income identity for an open economy is Y = C + I + G + EX – IM = C + I + G + CA Expenditure by domestic individuals and institutions Net expenditure by foreign individuals and institutions 9 Expenditure and Production in an Open Economy CA = EX – IM = Y – (C + I + G )  When production > domestic expenditure, exports > imports: current account > 0 and trade balance > 0  when a country exports more than it imports, it earns more income from exports than it spends on imports  net foreign wealth is increasing  When production < domestic expenditure, exports < imports: current account < 0 and trade balance < 0  when a country exports less than it imports, it earns less income from exports than it spends on imports  net foreign wealth is decreasing 10 Table 13-1: National Income Accounts for Agraria, an Open Economy (bushels of wheat) 11 Saving and the Current Account  National saving (S) = national income (Y) that is not spent on consumption (C) or government purchases (G). S = Y – C – G S = (Y – C – T) + (T – G) S = S p + S g 12 Fig. 13-2: U.S. Current Account and Net Foreign Wealth, 1976–2009 Source: U.S. Department of Commerce, Bureau of Economic Analysis. 13 How Is the Current Account Related to National Saving? CA = Y – (C + I + G ) = (Y – C – G ) – I = S – I current account = national saving – investment current account = net foreign investment  A country that imports more than it exports has low national saving relative to investment. 14 How Is the Current Account Related to National Saving? (cont.) CA = S – I or I = S – CA  Countries can finance investment either by saving or by acquiring foreign funds equal to the current account deficit.  a current account deficit implies a financial asset inflow or negative net foreign investment.  When S > I, then CA > 0 so that net foreign investment and financial capital outflows for the domestic economy are positive. 15 How Is the Current Account Related to National Saving? (cont.) CA = S p + S g – I = S p – government deficit – I  Government deficit is negative government saving  equal to G – T  A high government deficit causes a negative current account balance when other factors remain constant. 16 Balance of Payments Accounts  A country’s balance of payments accounts for its payments to and its receipts from foreigners.  An international transaction involves two parties, and each transaction enters the accounts twice: once as a credit (+) and once as a debit (–). 17 Balance of Payments Accounts (cont.)  The balance of payments accounts are separated into 2 broad accounts:  current account: accounts for flows of goods and services (imports and exports).  capital account: accounts for flows of financial assets (financial account according to the book) and some other special categories of assets: typically nonmarket, nonproduced, or intangible assets like copyrights and trademarks  note: the book distinguish between Financial Account and Capital Account. In this class we will treat both of them as Capital Account. 18 13-19 Example of Balance of Payments Accounting  You import a fax machine from Olivetti.  Olivetti deposits your check in a U.S. bank. Fax machine (current account, U.S. good import) –$80 Bank deposit (capital account, U.S. asset sale) +$80 13-20 Example of Balance of Payments Accounting (cont.)  You buy lunch in France and pay by credit card.  French restaurant receives payment from your credit card company. Meal purchase (current account, U.S. service import) –$30 Sale of credit card claim (capital account, U.S. asset sale) +$30 Example of Balance of Payments Accounting (cont.)  You buy a share of BP.  BP deposits the money in a U.S. bank. Stock purchase (capital account, U.S. asset purchase) –$90 Bank deposit (capital account, U.S. asset sale) +$90 21 Debt forgiveness (capital account, U.S. transfer payment) –$50 M Reduction in bank’s claims (capital account, U.S. asset sale) +$50 M Example of Balance of Payments Accounting (cont.)  U.S. banks forgive a $50 M debt owed by the government of Argentina through debt restructuring.  U.S. banks who hold the debt thereby reduce the debt by crediting Argentina’s bank accounts. 22 How Do the Balance of Payments Accounts Balance?  Due to the double entry of each transaction, the balance of payments accounts will balance by the following equation: current account + capital account = 0 23 U.S. Balance of Payments Accounts  The U.S. has the most negative net foreign wealth in the world, and so is therefore the world’s largest debtor nation.  Its current account deficit in 2009 was $378 billion dollars, so that net foreign wealth continues to decrease.  The value of foreign assets held by the U.S. has grown since 1980, but liabiliti
es of the U.S. (debt held by foreigners) has grown faster. 24 Fig. 13-3: U.S. Gross Foreign Assets and Liabilities, 1976-2009 Source: U.S. Department of Commerce, Bureau of Economic Analysis, June 2010. 25 U.S. Balance of Payments Accounts (cont.)  About 70% of foreign assets held by the U.S. are denominated in foreign currencies and almost all of U.S. liabilities (debt) are denominated in dollars.  Changes in the exchange rate influence value of net foreign wealth (gross foreign assets minus gross foreign liabilities).  Appreciation of the value of foreign currencies makes foreign assets held by the U.S. more valuable, but does not change the dollar value of dollar-denominated debt for the U.S. 26 Summary 1. A country’s GNP is roughly equal to the income received by its factors of production. 2. In an open economy, GNP equals the sum of consumption, investment, government purchases, and the current account. 3. GDP is equal to GNP minus net income from foreign countries for factors of production. It measures the value of output produced within a country’s borders. 4. National saving minus domestic investment equals the current account (≈ exports minus imports). 5. The current account equals the country’s net foreign investment (net outflows of financial assets). 27 Summary (cont.) 4. The balance of payments accounts records flows of goods & services and flows of financial assets across countries.  It has 2 parts: current account and capital account, which balance each other.  Transactions of goods and services appear in the current account; transactions of financial assets appear in the capital account. 7. Official international reserve assets are a component of the capital account, which records official assets held by central banks. 8. The U.S. is the largest debtor nation, and its foreign debt continues to grow because its current account continues to be negative. 28 Problems (1/2) 29 Register and classify each of the following transactions in the US balance of payments accounts: 1. An American buys shares of a German company paying with a check from a Swiss bank account 2. An American buys shares of a German company paying with a check from an American bank account 3. The Korean government intervenes its foreign exchange market by using dollars held in an American bank to buy Korean currency from its citizens 4. An American tourist buys an expensive meal in France paying with a traveler’s check 5. A California winemaker contributes a case of cabernet sauvignon to a London wine tasting 6. A US owned factory in Britain uses local earnings to buy additional machinery Problems (2/2) 30 The nation of Pecunia had a current account deficit of $1 billion and a non-reserve financial account of $500 million in 2008 1. What was the balance of payments of Pecunia that year? What happened to the country’s net foreign assets? 2. Assume that foreign central banks do not trade Pecunia’a assets. How did the Pecunia central bank’s foreign reserve changed in 2008? How this official intervention show up in the balance of payments? 3. How would answer “2” changes if you learn that foreign central bank’s bought $600 million of Pecunia’s assets? How these official purchases are registered in the balance of payments of Pecunia? 4. Draw up the balance of payments of Pecunia for 2008 assuming that event “3” happened in that year.

INTERNATIONAL MONETARY ECONOMICS CHAPTER 15 Money, Interest Rates, and Exchange Rates Slides: Pearsons and self Preview  What is money?  Control of the supply of money  The willingness to hold monetary assets  A model of real monetary assets and interest rates  A model of real monetary assets, interest rates, and exchange rates  Long-run effects of changes in money on prices, interest rates, and exchange rates 1 What Is Money?  Money is an asset that is widely used as a means of payment.  Different groups of assets may be classified as money.  Money can be defined narrowly or broadly.  Currency in circulation, checking deposits, and debit card accounts form a narrow definition of money.  Deposits of currency are excluded from this narrow definition, although they may act as a substitute for money in a broader definition. 2 What Is Money? (cont.)  Money is a liquid asset: it can be easily used to pay for goods and services or to repay debt without substantial transaction costs.  But monetary or liquid assets earn little or no interest.  Illiquid assets require substantial transaction costs in terms of time, effort, or fees to convert them to funds for payment.  But they generally earn a higher interest rate or rate of return than monetary assets. 3 What Is Money? (cont.)  Let’s group assets into monetary assets (or liquid assets) and nonmonetary assets (or illiquid assets).  The demarcation between the two is arbitrary,  but currency in circulation, checking deposits, debit card accounts, savings deposits, and time deposits are generally more liquid than bonds, loans, deposits of currency in the foreign exchange markets, stocks, real estate, and other assets. 4 Money Supply  The central bank substantially controls the quantity of money that circulates in an economy, the money supply.  In the U.S., the central banking system is the Federal Reserve System.  The Federal Reserve System directly regulates the amount of currency in circulation.  It indirectly influences the amount of checking deposits, debit card accounts, and other monetary assets. 5 Money Demand  Money demand represents the amount of monetary assets that people are willing to hold (instead of illiquid assets).  What influences willingness to hold monetary assets?  We consider individual demand of money and aggregate demand of money. 6 What Influences Demand of Money for Individuals and Institutions? 1. Interest rates/expected rates of return on monetary assets relative to the expected rates of returns on non-monetary assets. 2. Risk: the risk of holding monetary assets principally comes from unexpected inflation, which reduces the purchasing power of money.  But many other assets have this risk too, so this risk is not very important in defining the demand of monetary assets versus nonmonetary assets. 3. Liquidity: A need for greater liquidity occurs when the price of transactions increases or the quantity of goods bought in transactions increases. 7 What Influences Aggregate Demand of Money? 1. Interest rates/expected rates of return: monetary assets pay little or no interest, so the interest rate on non-monetary assets like bonds, loans, and deposits is the opportunity cost of holding monetary assets.  A higher interest rate means a higher opportunity cost of holding monetary assets  lower demand of money. 2. Prices: the prices of goods and services bought in transactions will influence the willingness to hold money to conduct those transactions.  A higher level of average prices means a greater need for liquidity to buy the same amount of goods and services  higher demand of money. 3. Income: greater income implies more goods and services can be bought, so that more money is needed to conduct transactions.  A higher real national income (GNP) means more goods and services are being produced and bought in transactions, increasing the need for liquidity  higher demand of money. 8 A Model of Aggregate Money Demand The aggregate demand of money can be expressed as: Md = P x L(R,Y) where: P is the price level Y is real national income R is a measure of interest rates on nonmonetary assets L(R,Y) is the aggregate demand of real monetary assets Alternatively: Md/P = L(R,Y) Aggregate demand of real monetary assets is a function of national income and interest rates. 9 Fig. 15-1: Aggregate Real Money Demand and the Interest Rate 10 Fig. 15-2: Effect on the Aggregate Real Money Demand Schedule of a Rise in Real Income 11 A Model of the Money Market  The money market is where monetary or liquid assets, which are loosely called “money,” are lent and borrowed.  Monetary assets in the money market generally have low interest rates compared to interest rates on bonds, loans, and deposits of currency in the foreign exchange markets.  Domestic interest rates directly affect rates of return on domestic currency deposits in the foreign exchange markets. 12 A Model of the Money Market  When no shortages (excess demand) or surpluses (excess supply) of monetary assets exist, the model achieves an equilibrium: Ms = Md  Alternatively, when the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded, the model achieves an equilibrium: Ms/P = L(R,Y) 13 A Model of the Money Market (cont.)  When there is an excess supply of monetary assets, there is an excess demand for interest- bearing assets like bonds, loans, and deposits.  People with an excess supply of monetary assets are willing to offer or accept interest-bearing assets (by giving up their money) at lower interest rates.  Others are more willing to hold additional monetary assets as interest rates (the opportunity cost of holding monetary assets) fall. 14 A Model of the Money Market (cont.)  When there is an excess demand of monetary assets, there is an excess supply of interest- bearing assets like bonds, loans, and deposits.  People who desire monetary assets but do not have access to them are willing to sell nonmonetary assets in return for the monetary assets that they desire.  Those with monetary assets are more willing to give them up in return for interest-bearing assets as interest rates (the opportunity cost of holding money) rise. 15 Fig. 15-3: Determination of the Equilibrium Interest Rate 16 Fig. 15-4: Effect of an Increase in the Money Supply on the Interest Rate 17 Fig. 15-5: Effect on the Interest Rate of a Rise in Real Income 18 Fig. 15-6: Simultaneous Equilibrium in the U.S. Money Market and the Foreign Exchange Market 19 Fig. 15-7: Money Market/Exchange Rate Linkages 20 Fig. 15-8: Effect on the Dollar/Euro Exchange Rate and Dollar Interest Rate of an Increase in the U.S. Money Supply 21 Changes in the Domestic Money Supply  An increase in a country’s money supply causes interest rates to fall, rates of return on domestic currency deposits to fall, and the domestic currency to depreciate.  A decrease in a country’s money supply causes interest rates to rise, rates of return on domestic currency deposits to rise, and the domestic currency to appreciate. 22 Changes in the Foreign Money Supply  How would a change in the supply of euros affect the U.S. money market and foreign exchange markets?  An increase in the supply of euros causes a depreciation of the euro (an appreciation of the dollar).  A decrease in the supply of euros causes an appreciation of the euro (a depreciation of the dollar). 23 Fig. 15-9: Effect of an Increase in the European Money Supply on the Dollar/Euro Exchange Rate 24 Changes in the Foreign Money Supply (cont.)  The increase in the supply of euros reduces interest rates in the EU, reducing the expected rate of return on euro deposits.  This reduction in the expected rate of return on euro deposits causes the euro to depreciate.  We predict no change in the U.S. money market due to the change in the supply of euros. 25 Long Run and Short Run  In the short run, prices do not have sufficient time to adjust to market conditions.  The analysis heretofore has been a short-run analysis.  In the long
run, prices of factors of production and of output have sufficient time to adjust to market conditions.  Wages adjust to the demand and supply of labor.  Real output and income are determined by the amount of workers and other factors of production —by the economy’s productive capacity— not by the quantity of money supplied.  (Real) interest rates depend on the supply of saved funds and the demand of saved funds. 26 Long Run and Short Run (cont.)  In the long run, the quantity of money supplied is predicted not to influence the amount of output, (real) interest rates, and the aggregate demand of real monetary assets L(R,Y).  However, the quantity of money supplied is predicted to make the level of average prices adjust proportionally in the long run.  The equilibrium condition Ms/P = L(R,Y) shows that P is predicted to adjust proportionally when Ms adjusts, because L(R,Y) does not change. 27 Long Run and Short Run (cont.)  In the long run, there is a direct relationship between the inflation rate and changes in the money supply. Ms = P x L(R,Y) P = Ms/L(R,Y) P/P = Ms/Ms – L/L  The inflation rate is predicted to equal the growth rate in money supply minus the growth rate in money demand. 28 Fig. 15-10: Average Money Growth and Inflation in Western Hemisphere Developing Countries, by Year, 1987–2007 Source: IMF, World Economic Outlook, various issues. Regional aggregates are weighted by shares of dollar GDP in total regional dollar GDP. 29 Money and Prices in the Long Run  How does a change in the money supply cause prices of output and inputs to change? 1. Excess demand of goods and services: a higher quantity of money supplied implies that people have more funds available to pay for goods and services.  To meet high demand, producers hire more workers, creating a strong demand of labor services, or make existing employees work harder.  Wages rise to attract more workers or to compensate workers for overtime.  Prices of output will eventually rise to compensate for higher costs. 30 Money and Prices in the Long Run (cont.) 2. Inflationary expectations:  If workers expect future prices to rise due to an expected money supply increase, they will want to be compensated.  And if producers expect the same, they are more willing to raise wages.  Producers will be able to match higher costs if they expect to raise prices.  Result: expectations about inflation caused by an expected increase in the money supply causes actual inflation.  Alternatively, for a fixed amount of output and inputs, producers can charge higher prices and still sell all of their output due to the high demand. 31 Fig. 15-11: Month-to-Month Variability of the Dollar/Yen Exchange Rate and of the U.S./Japan Price Level Ratio, 1980–2009 Source: International Monetary Fund, International Financial Statistics. 32 Money, Prices, Exchange Rates, and Expectations  When we consider price changes in the long run, inflationary expectations will have an effect in foreign exchange markets.  Suppose that expectations about inflation change as people change their minds, but actual adjustment of prices occurs afterwards. 33 Fig. 15-12: Short-Run and Long-Run Effects of an Increase in the U.S. Money Supply (Given Real Output, Y) 34 Money, Prices, and Exchange Rates in the Long Run (cont.)  A permanent increase in a country’s money supply causes a proportional long-run depreciation of its currency.  However, the dynamics of the model predict a large depreciation first and a smaller subsequent appreciation.  A permanent decrease in a country’s money supply causes a proportional long-run appreciation of its currency.  However, the dynamics of the model predict a large appreciation first and a smaller subsequent depreciation. 35 Fig. 15-13: Time Paths of U.S. Economic Variables After a Permanent Increase in the U.S. Money Supply 36 Exchange Rate Overshooting  The exchange rate is said to overshoot when its immediate response to a change is greater than its long-run response.  Overshooting is predicted to occur when monetary policy has an immediate effect on interest rates, but not on prices and (expected) inflation.  Overshooting helps explain why exchange rates are so volatile. 37 Summary 1. Money demand for individuals and institutions is primarily determined by interest rates and the need for liquidity, the latter of which is influenced by prices and income. 2. Aggregate money demand is primarily determined by interest rates, the level of average prices, and national income. • Aggregate demand of real monetary assets depends negatively on the interest rate and positively on real national income. 38 Summary (cont.) 3. When the money market is in equilibrium, there are no surpluses or shortages of monetary assets: the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded. 4. Short-run scenario: changes in the money supply affect domestic interest rates, as well as the exchange rate. An increase in the domestic money supply 1. lowers domestic interest rates, 2. thus lowering the rate of return on deposits of domestic currency, 3. thus causing the domestic currency to depreciate. 39 Summary (cont.) 5. Long-run scenario: changes in the quantity of money supplied are matched by a proportional change in prices, and do not affect real income and real interest rates. An increase in the money supply 1. causes expectations about inflation to adjust, 2. thus causing the domestic currency to depreciate further, 3. and causes prices to adjust proportionally in the long run, 4. thus causing interest rates to return to their long-run values, 5. and causes a proportional long-run depreciation in the domestic currency. 6. Interest rates adjust immediately to changes in monetary policy, but prices and (expected) inflation may adjust only in the long run, which results in overshooting of the exchange rate. • Overshooting occurs when the immediate response of the exchange rate due to a change is greater than its long-run response. • Overshooting helps explain why exchange rates are so volatile. 40 Problems 1. Suppose there is a reduction in aggregate real money demand, that is, a negative shift in the aggregate real money demand function. Trace the short-run and long run effects on the exchange rate, interest rate and price levels. 2. What is the short run effect on the exchange rate of an increase in domestic real GNP, given expectations about future exchange rates_ 3. How might a zero interest rate complicates the task of monetary policy? 41 Problems Register the following transactions in the Real and Financial Flows matrix: 1. Assume that the the US current account is in equilibrium and due to a macroeconomic shock the terms of trade worsen for the US but the quantities imported and exported remain unchanged. Assume transaction are made in dollars deposited in US banks and that foreign companies keep the money in the US banks. 2. Register the same situation as above but now foreign companies exchange the money at the FED for their country’s of origin currencies and send the money back to their respective countries abroad. 3. Answer the following: What is the impact on the exchange rate in each scenario? 42 Problems: Matrix 1 43 Sectors Markets Private Government Banking Central Bank Rest of the world Goods and services I-S G-T X-M Domestic monetary base Hp Hb Hc Hf Domestic Bank Deposits Dp Db — Df Domestic securities Np Ng Nb Nc Nf Foreign money Rp Rb Rc R f Foreign securities Fp Fb Fc F f Problems: Matrix 2 44 Sectors Markets Private Government Banking Central Bank Rest of the world Goods and services I-S G-T X-M Domestic monetary base Hp Hb Hc Hf Domestic Bank Deposits Dp Db — Df Domestic securities Np Ng Nb Nc Nf Foreign money Rp Rb Rc R f Foreign securities Fp Fb Fc F f More Problems! Register the following transactions in the Real and Financial Flows matrix: 1. Assume the government sells several billions of dollars in bonds in orde
r to pay the bills for the new healthcare law and that the FED buys a large quantity of them, increasing the monetary base. Register the short term effects. 45 Problems: Matrix 3 46 Sectors Markets Private Government Banking Central Bank Rest of the world Goods and services I-S G-T X-M Domestic monetary base Hp Hb Hc Hf Domestic Bank Deposits Dp Db — Df Domestic securities Np Ng Nb Nc Nf Foreign money Rp Rb Rc R f Foreign securities Fp Fb Fc F f