International Political Economy Prof Tyson Roberts Goals Exchange rate policies International Monetary Systems Foundation for the Unholy Trinity Exchange Rate Exchange rate Price in own currency for one unit of foreign currency ID: 526114
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Slide1
Economics of International Money & Finance
International Political Economy
Prof. Tyson RobertsSlide2
Goals
Exchange rate policies
International Monetary Systems
Foundation for the “Unholy Trinity”Slide3
Exchange Rate
Exchange rate:
Price
in own currency for one unit of foreign currency
Appreciation: currency stronger (fat?)
Exchange rate goes down – price of foreign currency Depreciation: currency weaker (thin?)Exchange rate goes up – price of foreign currency
3Slide4
Floating/Flexible Exchange R
ate
R
egime
Exchange rate determined by supply and demand
To buy goods from US, need USD. So high demand for US goods => USD appreciate To invest in US, need USD. So high demand for US financial assets => USD appreciate If the Fed increases money supply, more USD available => USD depreciate
4Slide5
American Market for Pesos
5
$ per peso
Number of Pesos
S
p
D
PSlide6
American Market for Pesos
Why would Americans want to buy pesos with dollars?
Travel to Mexico
Buy Mexican imports
Buy Mexican companies
Deposit in Mexican banksWhy would Mexicans want to sell pesos for dollars?Slide7
Why is the supply curve upward sloped?
Why is the demand curve downward sloped?
7Slide8
BoP Example
Suppose the
BoP
for the US & Mexico is 0
US invents a new camera people in Mexico want to buy
What foreign exchange transaction needs to take place?What happens to the current account in the US? (Deficit, surplus, or no change?) In Mexico?
What happens to the foreign currency reserves in the US? In Mexico?
What happens to the exchange rate? (Which appreciates? Which depreciates?)Slide9
$ per Peso
Number of Pesos bought & sold
Mexico buys cameras from US.
S
P
D
P
9Slide10
$ per peso
Number of
Pesos bought &
sold
Mexico sells pesos for dollars (demand for $ increases, supply of pesos to buy $ increases). Gives $ to camera shop in US for cameras.
S
P
D
P{
10Slide11
Number of
Pesos bought &
sold
2. Mexico’s
current account down (deficit), US current account up (surplus
)3. Mexico foreign reserves down or US foreign reserves up (depends who sold $)4. Peso depreciates (price of peso drops), dollar appreciates
S
p
D
P
11
$ per pesoSlide12
GDP impact
How does Mexico’s purchase of cameras from the US affect Mexico’s Consumption? Exports? Imports? What is the net effect on GDP?
How does the US’s sale of cameras to Mexico affect the US’s Consumption? Exports? Imports? What is the net effect on GDP?Slide13
Macroeconomic Accounting in Closed Economy
Y = C + I + G
I
ncome is earned from spending by consumers, investors, and governmentSlide14
Macroeconomic Accounting in Closed Economy
S
= Y – (G + C)
S
G
= T - EInvestment is financed from Savings, which is income minus current spending (C + G)Government savings is Tax revenues minus current ExpendituresSlide15
Macroeconomic Accounting in Trading Economy
Y = C + I + G + (X – M)
Exports are domestic production for foreigners in
exchange for income given to domestic residents
Imports are foreign production for domestic residents in exchange for income sent to foreigners
15Slide16
Macroeconomic Accounting
Y = C + I + G + (X – M)
S = Y – (G + C)
S
G
= T – E5. How does Mexico’s purchase of cameras from the US affect Mexico’s Consumption? Exports? Imports? What is the net effect on GDP?ANSWER: Mexico’s Consumption increases in equal amount to the increase in imports => no (direct) change in GDP.
16Slide17
Macroeconomic Accounting
Y = C + I + G + (X – M)
S = Y – (G + C)
S
G
= T – E6. How does the US’s sale of cameras to Mexico affect the US’s Consumption? Exports? Imports? What is the net effect on GDP?ANSWER: No (direct) change to US Consumption, but Exports increases, so GDP gains in amount of camera sales.
17Slide18
So now either Mexico has fewer dollars or US has more pesos. The peso is weaker and the dollar is stronger
How might the new exchange rate affect trade? What would this do to the
BoP
and the exchange rate?
Alternatively, how might the new exchange rate affect investment flows? What would this do to the
BoP and the exchange rate?Alternatively, what if Mexico doesn’t want the exchange rate to change. How could it stop it from changing?Slide19
So now either Mexico has fewer dollars or US has more pesos. The peso is weaker and the dollar is stronger
How might the new exchange rate affect trade? What would this do to the
BoP
and the exchange rate
?
ANSWER: Mexico will import less and/or export more…Slide20
7
. If Mexico has fewer dollars, it can buy fewer imports from US, which means. Or, if US has more pesos, it can buy more exports from Mexico. It now costs fewer $ to buy pesos, so slide
down peso demand
curve to higher number of pesos demanded. It now costs more pesos to buy $, so slide down peso supply curve to fewer pesos offered for dollars. The
BoP
returns to zero (balanced) and new equilibrium price – peso depreciated. Number of Pesos bought & sold
S
p
D
P
$ per pesoSlide21
So now either Mexico has fewer dollars or US has more pesos. The peso is weaker and the dollar is stronger
How might the new exchange rate affect trade? What would this do to the
BoP
and the exchange rate
?
ANSWER: Mexico will import less and/or export more… Balance of Payments returns to balance. Dollar remains stronger reflecting increase in competitiveness from camera technology; Mexico must have weaker currency to remain competitive.Slide22
So now either Mexico has fewer dollars or US has more pesos. The peso is weaker and the dollar is stronger
8
. Alternatively
, how might the new exchange rate affect investment flows? What would this do to the
BoP
and the exchange rate?ANSWER: The US will increase investment in Mexico (maybe buy a Mexican company or lend to Mexican government). This will add to Mexico’s capital account, which will return the BoP to 0. Dollar stronger at new equilibrium. Slide23
So now either Mexico has fewer dollars or US has more pesos. The peso is weaker and the dollar is stronger
9
. Alternatively
, what if Mexico doesn’t want the exchange rate to change. How could it stop it from changing?
ANSWER:
Capital Controls (e.g., don’t let residents buy cameras – hurts consumption, growth)Currency Board/Monetary Policy
Currency transactions (sell dollars from reserves to buy pesos – could run out of dollars)
Raise interest rates to encourage dollar-owners to purchase pesos. But hurts investment, growth
)Slide24
Number of
Pesos bought &
sold
S
p
D
P
$ per peso
9
. If peso doesn’t depreciate, there will be a
BoP
deficit because Mexican buyers will not decrease demand for dollars and US buyers will not increase demand for pesos. Mexicans will import more from the US than the US will import from Mexico.
BoP
DeficitSlide25
Number of
Pesos bought &
sold
S
p
D
P
$ per peso
9
. The Mexican government can use capital controls to stop peso sellers from selling pesos for camera imports. (This may result in black market activity, etc.) Slide26
Number of
Pesos bought &
sold
S
p
D
P
$ per peso
9. … or, the Mexican government can raise demand for pesos by using dollar currency reserves to buy pesos (which, over time, will burn through all of the the governments dollar reserves), or by raising interest rates in Mexico (which may lead to recession). Slide27
Foreign exchange markets between countries are a mirror of one another
An event that increases demand for dollars will cause dollar to appreciate
Dollars can buy pesos more cheaply
Price of peso in dollars goes down
The same event will cause an increase in supply of pesos (to sell for dollars), which causes the peso to depreciate
Pesos buy dollars more dearlyPrice of dollars in pesos goes up
27Slide28
$ per peso
Number of Pesos
Apple invents new iPhone
How will the exchange rate market in pesos respond?
S
p
D
P
28Slide29
$ per peso
Number of Pesos
Apple invents new iPhone
Increase in supply of pesos in the foreign exchange market (Mexicans offer up pesos for dollars to buy iPhones)
S
p
D
P
29Slide30
$ per peso
Number of Pesos
Increase in supply of pesos in the foreign exchange market reduces the price in dollars for pesos (peso depreciates, dollar appreciates)
S
p
D
P
30Slide31
$ per peso
Number of Pesos
Increase in supply of pesos in the foreign exchange market reduces the price for pesos (dollar appreciates), and increases number of pesos sold in the foreign exchange market
S
p
D
P
31Slide32
Foreign exchange markets between countries are a mirror of one another
An event that increases demand for dollars will cause dollar to appreciate
Dollars can buy pesos more cheaply
Price of peso in dollars goes down
The same event will cause an increase in supply of pesos (to sell for dollars), which causes the peso to depreciate
Pesos buy dollars more dearlyPrice of dollars in pesos goes up
32Slide33
Pesos per $
Number of
Dollars
Apple invents new iPhone
How will the exchange rate market in
dollars respond?
S
$
D
$
33Slide34
Pesos per $
Number of Dollars
Apple invents new iPhone
Increase demand for dollars in the foreign exchange market (Mexicans offer up pesos for dollars to buy iPhones)
S
$
D
$
34Slide35
Pesos per $
Number of Dollars
Increase in
demand for dollars in
the foreign exchange market
increases the price in pesos for dollars (peso depreciates, dollar appreciates
) and increases number of dollars bought in the foreign exchange market
S
$
D
$
35Slide36
Foreign exchange markets between countries are a mirror of one another
An event that decreases demand for dollars will cause peso to appreciate
Pesos can buy dollars more cheaply
Price of dollars in pesos goes down
The same event will cause a decrease in supply of pesos (to sell for dollars), which causes the dollar to depreciate
Dollars buy pesos more dearly Price of pesos in dollars goes up
36Slide37
$ per peso
Number of Pesos
US reduces interest rates
How will the exchange rate market in pesos respond?
S
p
D
P
37Slide38
$ per peso
Number of Pesos
US reduces interest rates
Supply of pesos falls (fewer peso holders offer pesos for dollars)
S
p
D
P
38Slide39
$ per peso
Number of Pesos
US reduces interest rates
Supply of pesos falls (fewer peso holders offer pesos for dollars)
Dollar depreciates (more dollars needed to buy pesos), peso appreciates (fewer pesos needed to buy dollars). Fewer pesos exchanged for dollars.
S
p
D
P
39Slide40
Pesos per $
Number of
Dollars
US reduces interest rates
How will the exchange rate market in
dollars respond?
S
$
D
$
40Slide41
Pesos per $
Number of
Dollars
US reduces interest rates
Demand for dollars falls
S
$
D
$
41Slide42
Pesos per $
Number of
Dollars
US reduces interest rates
Price of dollars in pesos falls (peso appreciates, dollar depreciates)
Fewer pesos exchanged for dollars.
S
$
D
$
42Slide43
Swiss Franc example
What was the nature of the Swiss franc crisis in 2011, according to the podcast?Slide44
Swiss Franc example
What was the nature of the Swiss franc crisis in 2011, according to the podcast?
Euro crisis increased demand for Swiss franc (safe), which strengthened franc
Strong
S
wiss franc undermined export industries in SwitzerlandSlide45
Swiss Franc example
How did Switzerland address crisis? Slide46
Swiss Franc example
How did Switzerland address crisis?
Made commitment to buy sufficient Euros to keep Swiss franc below a certain value (currency board approach)
When they abandoned this pledge, value of Swiss franc rose
Attempted to keep Swiss devalued by further lowering negative interest rateSlide47
Fixed exchange rate regime
Exchange rate determined by the government
Revaluation: Increase official value of own currency
Market equivalent: appreciation
Devaluation: Decrease official value of own currency
Market equivalent: depreciation47Slide48
Fixed exchange rate methods
Intervention in foreign exchange market (Currency Board)
Sell foreign currency to prop up own currency (increase supply of foreign currency, reduce supply of own currency)
“Overvaluation”
Problem 1: Can run out of foreign currency
Problem 2: Exports become less competitiveProblem 3: Expectations that peg will fail reduces demand for currency, increasing downward pressureCommonly cited example: Argentina “dollarization”
48Slide49
Fixed exchange rate methods
Intervention in foreign exchange market (Currency Board)
Buy foreign currency to devalue own currency (reduce supply of foreign currency, increase supply of own currency)
Problem 1: what to do with foreign currency?
Problem 2: Reduced investment & consumption in own country
Commonly cited example: China49Slide50
Fixed (pegged) exchange rate methods
Capital controls
Restrict how much money can be exchanged to maintain peg
Problem 1: Market distortions, black market
Problem 2: Deters investment
Problem 3: Reduced exports (if overvalued) or reduced consumption (if undervalued)50Slide51
Balance of Payments (
BoP
)
Current account
Current account balance =
Current receipts – Current ExpendituresCurrent account includes Goods & services (i.e., TRADE)Income receipts (interest & dividends)Transfers (foreign aid, remittances)
51Slide52
Balance of Payments (
BoP
)
Capital account
Capital Account Balance =
Capital Inflows – Capital OutflowsCapital includes FDI (managerial control)Indirect investment (shares & bonds without control)Cross-national checking accounts
52Slide53
Balance of Payments (
BoP
)
Financial
In the three-account system,
Capital account includes non-financial & non-produced assets & fixed assets (debt forgiveness, gifts, payment for land, etc.)Financial account includes financial assets (FDI, bonds, payment for real estate, etc.)We’ll use the two-account system in class
53Slide54
BoP adjustment under flexible exchange rate regime
Adjustment is automatic (via market)
If
BoP
surplus, (i.e., exports > imports and/or inflows > outflows)
Supply of foreign currency => home currency appreciates Exports
, imports
, inflows
, outflows
Supply of foreign currency
=> home currency depreciates
54Slide55
Adjustment under fixed exchange rate regime
Currency Board Interventions
Interest rates (increase to revalue, decrease to devalue)
Buy (to devalue) or sell (to revalue) foreign currency with home currency
Borrow or receive transfers from foreign government (to revalue)
Capital Controls55Slide56
International Monetary System
1
st
Age of Globalization: Gold Standard
Fixed exchange rate: pegged to gold
Balance of Payment surplus in form of gold reservesAutomatic (market) adjustment mechanism:56Slide57
Automatic (market) adjustment mechanism under Gold Standard
BoP
deficit =>
G
old shortage =>
High interest rates (to attract gold/currency) => Less domestic borrowing for local investment => Fewer jobs=> Lower wages => Lower prices for domestic produced goods =>
I
ncreased exports, decrease imports =>
BoP
balance
57Slide58
International Monetary System
1
st
Age of Globalization: Gold Standard
Fixed exchange rate: pegged to gold
Balance of Payment surplus in form of gold reservesAutomatic (market) adjustment mechanism:No monetary policy autonomyInterest rates dictated by marketCentral bank goal is to hold gold, not to create jobs or tame inflation
58Slide59
WWI & Interwar
WWI & early 1920s
Gold standard suspended, replaced with exchange controls
Paper money printed to finance government, hyperinflation in parts of Europe
59Slide60
Mid-1920s
USD & British pound reserve currencies
Trade credit readily available => global trade growth
International capital flows => deficit countries such as Germany over-consumeSlide61
1928: US concerned about financial market exuberance
Fed hiked interest rates => foreign central banks followed (to fixed exchange rates) => Great Depression
Germany responds to capital flight with exchange controls, freeze loans from UK banks
Investors withdraw from UK banks
Value of British pounds fallsSlide62
1930s: Chaotic floating exchange rate system
British pound & USD no longer trusted as reserve currencies
Larger countries devalued currencies to increase exports (competitive devaluation)
Chaotic liquidation of foreign exchange reserves made credit scarce, interest rates
Disorderly exchange rates disrupted tradeRecession, war loans, etc. => WW2
62Slide63
Bretton Woods
http://www.youtube.com/watch?v=GVytOtfPZe8
63Slide64
Bretton Woods system
Goal: stable exchange rates AND domestic economic autonomy
Components:
Exchange rate “flexibility” (adjustable
peg
to gold – NOT a “flexible exchange rate” policy)Capital controls (currency exchange restrictions)Stabilization fund (all members contribute, can borrow during BoP deficits)IMF (to monitor members’ policies &
BoP
, decide when devaluation warranted, and manage fund)
64Slide65
What should the following events do to the US exchange rate (stronger vs. weaker)?
Interest rate on US Treasury bonds goes up
Interest rate on Greek sovereign debt goes up
S&P says Europe is likely to default on its loans
Unemployment benefits for US workers cut off
US Trade deficit with China increases
Chinese government buys US Treasury bonds
Japan buys American movie studio
65Slide66
Takeaways
Various international monetary systems are available
Gold Standard: Fixed, market-maintained, state-enforced
Bretton Woods: (Adjustable) Fix, maintained by states & IMF
Float: Market-determined
(Managed) Float: Market-determined, government-influenced66Slide67
Takeaways
Each international monetary system has its pros and cons
Gold Standard: Exchange rate stability, capital freedom, price instability, economic volatility
Bretton Woods: Exchange rate stability, some capital restrictions, liquidity problem
Float: Exchange rate volatility, capital freedom