Exchange Rates, International Trade, and Capital Flows - PowerPoint Presentation

Slide1

Exchange Rates, International Trade, and Capital Flows

Chapter 26

McGraw-Hill/Irwin

Copyright ©

2015

by

McGraw-Hill Education (Asia).

All rights reserved.Slide2

Learning Objectives

Define the nominal exchange rate and discuss the advantages and disadvantages of flexible versus fixed exchange ratesUse supply and demand to analyze how the nominal exchange rate is determined in the short runDefine the real exchange rate, summarize the law of one price, and understand how purchasing power parity determines the long-run real exchange rateUse the relationship between domestic saving and the trade balance to understand how domestic saving, the trade balance, and net capital inflows are relatedAnalyze the factors that determine international capital flows and how these flows affect domestic saving and the domestic interest rateSlide3

The International Economy

Every day, news draws our attention to the global economyThe U.S. sub-prime mortgage crisis of 2007 – 2008 quickly became a worldwide event because of the trade in mortgage securitiesSince the mid 1980s, international trade has grown twice as fast as world GDPChanging trade patterns have reduced the sensitivity of foreign economies to events in the U.S.Innovations in transportation and communication can make events abroad an immediate issue worldwideSlide4

Importance of Exchange Rates

Domestic purchases are made with local currencyPurchasing goods abroad requires converting your local currency to their local currencyThe exchange rate measures the rate of conversionExchange rates are set in the foreign exchange market, with a small number of exceptionsRates are determined by supply and demandAffect the value of imported goods and the value of financial investments made across bordersChanges in exchange rates can have a significant effect on most economiesSlide5

Nominal Exchange Rates

The nominal exchange rate is the rate at which two currencies can be traded for each otherRates for July 5, 2013

Foreign Currency / Dollar

Dollar / Foreign Currency

China (

yuan

, ¥)

6.132

0.163

Hong Kong (HK$)

7.755

0.129

Japan (¥)

100.940

0.010

Singapore (S$)

1.281

0.781Thailand (baht, ฿) 31.240 0.032Slide6

Consider 3 currencies: US$, Singapore dollars (S$), and Chinese

yuan (¥)One dollar buys ¥ 6.132 or S$ 1.281The exchange rate between Chinese yuan and Singaporean dollars can be calculated from this information¥ 6.132 = S$ 1.281¥ 1 = S$ 1.281 / 6.132¥ 1 = S$ 0.209OR

S$ 1 = ¥ 6.132 / 1.281

S$ 1 = ¥ 4.787

Nominal Exchange

RatesSlide7

U.S. Nominal Exchange Rate,

1973 - 2012Slide8

Changes in Exchange Rates

Appreciation is an increase in the value of a currency relative to other currenciesExample: U.S. dollar appreciates when it goes from $1 = £ 0.5 to $1 = £ 0.6A dollar buys more of the foreign currencyDepreciation is a decrease in the value of a currency relative to other currenciesExample: the Canadian dollar depreciates when it goes from C$ 1 = ¥ 96 to C$ 1 = ¥ 95A Canadian dollar buys fewer yenSlide9

Exchange Rates

Definitione = the number of units of foreign currency that each unit of domestic currency will buyExample, e is the number of Japanese yen you can buy with $1e is the nominal exchange rateDomestic currency appreciates if e increasesDomestic currency depreciates if e decreasesSlide10

Exchange Rate Strategies

The foreign exchange market is the market on which currencies of various nations are tradedA flexible exchange rate is an exchange rate whose value is not officially fixed but varies according to the supply and demand for the currency in the foreign exchange marketA fixed exchange rate is an exchange rate set by official government policyCan be set independently or by agreement with a number of other governmentsFixed rates can be set relative to the dollar, the euro, or even goldSlide11

Flexible Exchange Rate in the Short Run

Exchange rates are set by supply and demand in the foreign exchange marketUS dollars are demanded by foreigners who seek to purchase U.S. goods or financial assetsNumber of dollars foreigners seek to buyUS dollars are supplied by U.S. residents who need foreign currency to buy foreign goods or financial assetsNot the same as the money supply set by the FedNumber of dollars offered in exchange for other currenciesSlide12

Supply of U.S. Dollars in Foreign Exchange Market

Anyone who holds US$ is a potential supplierUS households and firms are the most common suppliersSupply curve has a positive slopeThe more foreign currency each US dollar can buy, the larger the quantity of dollars suppliedThis makes foreign goods cheaperWhen US$1 = ¥100, a ¥5,000 item costs US$50If US$1 = ¥200, that same ¥5,000 item costs US$25When the US dollar appreciates, the quantity of dollars supplied increasesSlide13

Demand for U.S. Dollars in Foreign Exchange Market

Anyone who holds yen can demand US dollarsJapanese households and firms are the most common demandersDemand curve has a negative slopeThe more foreign currency needed to buy a dollar, the smaller the quantity of dollars demandedThis makes U.S. goods more expensiveWhen US$1 = ¥100, a US$30 item costs ¥3,000If US$1= ¥200, that same US$30 item costs ¥6,000When the dollar appreciates, the quantity of dollars demanded decreasesSlide14

The Dollar –

Yen MarketThe market equilibrium value of the exchange rate equates the quantities of the currency supplied and demanded in the foreign exchange marketUS dollar appreciates e* increasesUS dollar depreciates if e* decreasesMarket for Dollars

Quantity of US dollars traded

Yen/US dollar

exchange rate

Demand for

dollars

Supply

of dollars

e*

Q*

Dollar

appreciatesSlide15

Supply of U.S. Dollars in Foreign Exchange Market

Supply of US dollars for Japanese yen is determined by The preference for Japanese goodsThe stronger the preference, the greater the supply of US dollarsU.S. real GDPThe higher GDP, the greater the supply of dollarsReal interest rate on Japanese assets and the real interest rate on US assetsSupply of US dollars will be greater if Real interest rate on Japanese assets is higherReal interest rate on US assets is lowerSlide16

An Increase in the Supply of U.S. Dollars

Initial equilibrium at ESuppose consumers prefer the new video game system made in JapanShift in preferencesIncrease in the supply of US dollars shifts dollar supply curve to the rightNew equilibrium at FUS dollar depreciates to e*'Quantity of US dollars traded increases to Q*’

Quantity of US dollars

Yen /

US dollar exchange rate

D

S

e*

E

F

S'

Q*

e*'

Q*'Slide17

Demand for U.S. Dollars in Foreign Exchange Market

Demand for US dollars by holders of yen is determined by The preference for US goodsThe stronger the preference, the greater the demand for US dollarsReal GDP in JapanThe higher GDP, the greater the demand for dollarsReal interest rate on Japanese assets and real interest rate on U.S. assetsSupply of US dollars will be greater if Real interest rate on Japanese assets is lowerReal interest rate on U.S. assets is higherSlide18

Strong Currency

A strong currency is unrelated to a strong economyUS dollar was strong in 1973, a time of recessionThe US dollar was weak in 2007 but the domestic economy was strongA strong currency means its value is high in terms of other countries currenciesStrong currencies reduce net exportsJapanese goods look cheap, so NX goes downLower sales and profits for U.S. industriesSlide19

Monetary Policy and the Exchange Rate

Monetary policy affects interest rates which affect the exchange rateTighter U.S. monetary policy leads to a higher real interest rate in the United StatesHigher interest rates make U.S. assets more attractive than foreign assetsDemand for the US dollar increases by foreignersDemand curve shifts to the rightSupply of US dollars by U.S. decreasesSupply curve shifts to the leftUS dollar appreciatesSlide20

Tighter Monetary Policy

Higher real interest rates in U.S. increase demand for US dollars and decrease supplyUS dollar appreciatesChange in quantity of US dollars traded depends on Size of the two shiftsSlopes of the curves

Quantity of US dollars

Yen /

US dollar exchange rate

e*'

F

S

D

e*

E

S'

D'Slide21

Monetary Policy Results

U.S. Monetary policy was the main cause of recent changes in the US dollar exchange rateUS dollar appreciation in the early 1980sReal interest rate rose from negative values in 1979 and 1980 to over 5% in 1983 and 1984US dollar depreciation 2002 - 2005U.S. economy grew faster than our trading partners' economiesForeign exchange demand for imports increasedFed funds rate went from 6% in 2001 to 1% in 2003Demand for U.S. assets decreasedSlide22

Monetary Policy and the Exchange Rate

Flexible exchange rates make monetary policy more effectiveWhen the central bank tightens monetary policy, it sets off a chain of domestic eventsAnd a chain of international eventsMonetary policy is more effective in an open economy with flexible exchange ratesSlide23

Fixed Exchange Rates

Most large industrialized countries use a flexible exchange rateSmall and developing countries may use a fixed exchange rateFixed exchange rate system was set up after World War IIBegan to break down in the 1960sAbandoned by 1976Fixed exchange rates greatly reduce the effectiveness of monetary policy as a stabilization toolSlide24

Fixed Exchange Rates

To establish a fixed exchange rate system, the government states the value of its currency in terms of a major currency May use an average of the currencies of its major trading partnersGovernment attempts to maintain the fixed exchange rate at its existing levelThe government may change the value of its currency in response to market eventsSlide25

Exchange Rates and Monetary Policy

Flexible exchange rates strengthen the effectiveness of monetary policy for stabilizationFixed rates require the central bank to choose between defending the currency and stabilizing the economyFixed rates can be beneficial for small economiesArgentina fought hyperinflation by valuing its peso on par with the dollarInflation quickly decreased and stayed stable for more than 10 yearsFixed exchange system broke down because unsound domestic policies created fears that Argentina would default on international loansSlide26

Exchange Rates, Trade, and Integration

Fixed exchange rates have benefitsPredictability and stability in foreign transactionsCertainty of future value of the currenciesHowever, fixed rates are not fixed foreverSudden and unforeseen large changes are possiblePredicting exchange rates over the long term is difficult under either fixed or flexible ratesSlide27

The Euro

European Common Market was formed in 1957Free trade between member countriesFixed exchange rate system set up in the 1970s was abandoned in 1992European Union was created by the Maastricht Treaty in 1991Agreed to work toward adopting a common currencyThe euro was phased inBegan as an accounting unitEuro currency was phased in and local currency phased out in 11 member countriesSlide28

The Euro

Countries with a single currency must have a common monetary policyThe European Central Bank became the central bank for the euro countriesCountries sacrifice some control to be part of the euroEconomic conditions vary between countries and the central bank cannot respond to eachSlow growth in Germany and rapid growth in IrelandSlide29

Real Exchange Rate – An Example

Choose between a U.S. computer and a comparable Japanese computer, based on priceUS computer costs US$2,400Japanese computer costs ¥242,000US$1 = ¥110The Japanese computer cost is ¥242,000/(¥110/US$1) or $2,200The Japanese computer is cheaperThe relative price of the U.S. computer to the Japanese computer is US$2,400 / US$2,200 = 1.09U.S. computer costs 9% more than the Japanese oneSlide30

Real Exchange Rates

In the short run, domestic prices of goods are fixedIn the long run, this assumption is relaxedThe real exchange rate is the price of the average domestic good relative to the price of the average foreign good when prices are expressed in a common currency The nominal exchange rate, e, is the number of units of foreign currency per US dollarTo convert a foreign price, Pf, to the dollar price, Pf$, divide Pf by ePf / e = ¥242,000 / (¥110/US$1) = US$2,200Slide31

Real Exchange Rates

Price of domestic goodPrice of foreign good in US$Real exchange rate =Real exchange rate =

P

Pf / e

Real exchange rate =

(P) (e)

P

f

Real exchange rate =

(US$2,400

)

(¥110/ US$1

)

¥242,000

Real exchange rate = 1.09Slide32

Real Exchange Rate

In our example, the real exchange rate of 1.09 meant the U.S. computer is more expensive than the Japanese computerIn the general case, the real exchange rate uses an average price of all goods and services in both countriesIf the real exchange rate is high, domestic goods are expensive relative to foreign goodsNet exports will tend to be low when the real exchange rate is highAn increase in e increases the real exchange rate if P and Pf are constantSlide33

Law of One Price

The law of one price states that if transportation costs are relatively small, the price of an internationally traded commodity must be the same in all locationsSuppose wheat in Sydney was half the price of wheat in BangkokBuy wheat in Sydney, increasing demand and priceSell wheat in Bangkok, increasing supply and decreasing the priceThe law of one price implies that real exchange rates prevail in the long runSlide34

Purchasing Power Parity (PPP)

Purchasing power parity is the theory that nominal exchange rates are determined as necessary for the law of one price to holdIn the long run, the currencies of countries that experience significant inflation will tend to depreciateSlide35

PPP – An Example

A bushel of grain costs A$ 5 in Sydney and ฿ 150 in BangkokFor the price of the bushel of grain to be the same in both countries, the implied nominal exchange rate is A$ 1 = ฿ 30Suppose that India experiences inflation and the bushel of grain now costs ฿ 300 in BangkokThe Australian dollar appreciates to A$ 1 = ฿ 60Price of the wheat is the same in both countriesSlide36

Inflation and Currency Depreciation

in South America, 1995-2004

45

º lineSlide37

PPP Examined

Shortcomings of the PPP TheoryThe theory works well in the long run but not the short runLimits to the PPP TheoryNot all goods and services are traded internationallyThe greater the share of non-traded goods, the less precise the PPP theoryFor example, the market for haircuts is very localNot all internationally traded goods and services are perfectly standardized commoditiesSlide38

International Trade

Trade is important even to a large economy such as the U.S.Exports 13% of GDP in 2008Imports 17% of GDP in 2008Trade and capital flows are easily politicizedFree trade can be seen to cost U.S. jobsForeign control of "essential" assets such as ports or telecommunications infrastructureSlide39

Trade Balance

Trade balance is another name for net exports (NX)Value of a country's exports minus the value of its importsA trade surplus is a positive trade balanceExports > importsA trade deficit is a negative trade balanceImports > exportsSlide40

US Trade Balance, 1960 - 2012Slide41

Capital Flows

International capital flows are purchases or sales of real and financial assets across international bordersCapital inflows are purchases of domestic assets by foreign households and firmsCapital outflows are purchases of foreign assets by domestic households and firmsNet capital inflows (KI) are capital inflows minus capital outflowsCapital flows are not counted as imports or exports since they refer to the purchase of existing assets rather than currently produced goods and servicesSlide42

Trade Balance (NX) and Net Capital Inflows (KI)

NX + KI = 0U.S. resident purchases Japanese car for US$20,000Imports = US$20,000Manufacturer holds US$20,000 in a U.S. bank accountOption 1: purchase US$20,000 of U.S. goods and services so exports = US$20,000Option 2: purchase U.S. bonds or U.S. real estateNX = – US$20,000, KI = US$20,000Option 3: sell US dollars for yenFollow the US dollars and see what the purchaser does with them to determine NX and KISlide43

International Capital Flows

Highly developed financial markets allow borrowing and lending across bordersTransactions are subject to laws in the originating country and the target countrySize of international flows for a country depend on its regulations and lawsAlso depend on economic integration and political stabilityLending is acquiring a real or financial assetBuying a share of stock or a government bond or a parcel of landBorrowing is selling a real or financial assetSlide44

Two Roles of International Capital FlowsSlide45

International Capital Flows

Capital inflows to the U.S. include foreign purchases of Stocks and bonds of U.S. companiesU.S. government bondsReal assets such as land and buildings owned by US residentsCapital flows respond to real interest ratesHigher domestic interest rates mean greater capital inflows

Domestic Real

Interest Rate (r)

Net Capital Inflows (KI)

0

KI > 0

Net capital

inflows

KI < 0

Net capital

outflows

KISlide46

Risk and Capital Inflows

For a given real interest rate, increase in riskiness of domestic assets decreases capital inflowsShifts the capital inflow curve to the leftForeigners are less willing to buy domestic assetsDomestic savers are more willing to buy foreign assets

Domestic Real

Interest Rate (r)

Net Capital Inflows (KI)

0

KI

KI'Slide47

Savings, Investment, Capital Inflows

Definition of outputY = C + I + G + NXSolve for IY – C – G – NX = INational savings, S, is (Y – C – G)S – NX = IAlsoNX + KI = 0 OR KI = – NXSoS + KI = ISlide48

S + KI = I

Savings plus net capital inflows equals investment in new capital goodsForeign savings can supplement domestic savings to create capital goods to support economic growthIn a closed economy,S = IIn an open economy,S + KI = ICapital inflows mean more investment and lower interest rates

Saving and investment

Real interest rate (%)

I

S + KI

S, I

r*Slide49

The Saving Rate and the Trade Deficit

What causes trade deficits?Not the production of inferior goodsNot the result of unfair trade restrictionsA low rate of national saving is the primary causeRecall S – I = NXHold I fixedHigh level of S implies a high level of NXLow level of S implies a low level of NXSlide50

The Saving Rate and the Trade Deficit

Why is a low rate of national saving associated with a trade deficit?Low savings implies high spendingHigh spending includes more spent on importsHigh domestic spending leaves less available for exportHigh imports and low exportsTrade deficit country receives capital inflowsLack sufficient saving to finance domestic investmentInterest rate will rise and attract capital inflowsSlide51

The U.S. Trade Deficit

U.S. trade balanced until the mid 1970’sLarge deficits since the mid 1970’sNational saving has been less than investment since the mid 1970’sLarge government budget deficits, especially in the 1908’sDecline in private saving in the 1990’s as consumption spending surgedMore spending on importsLarge government budget deficits in the 2000’sTrade deficits are not a problem as long as the economy continues to growSlide52

Exchange Rates, International Trade, and Capital Flows

Exchange ratesNominal and realFixed and flexibleShort run and long runPurchasing power parityMonetary policy and the exchange rateTrade balance and net capital inflowsInternational capital flowsThe saving rate and the trade deficit