Download Eco 344

Eco 344
International Economic Relations
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Instructor
• www.fsb.muohio.edu/lij14/
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Office
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Textbook
•
•
Robert C. Feenstra
University of California, Davis
Alan M. Taylor
University of California, Davis
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Quiz (no grade)
First Name_____, Last Name_______, Major_____
• Q1: What would happen to the oil price if the civil war in Libya
ends now? Please use the demand-and-supply diagram.
• Q2: People say that we need to bring jobs back to US from
overseas. But how? Give one or two suggestions.
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World Economy in 2010
http://www.economist.com/blogs/dailychart/20
10/12/charts_2010
Do you want to buy house soon?
Do you want to complain about no salary raise?
What happens to unemployment rate in US?
Why are the young people in Egypt so unhappy?
What’s wrong with Ireland and Greece?
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Suggestions to bring jobs back
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•
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Tax
Tariff
Minimum Wages
Education, Infrastructure
New Jobs
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My Comments
• Most oversea jobs are labor-intensive. USA
does not have (comparative) advantage
producing labor-intensive goods.
• Companies make decisions. A workable
solution should agree with companies’
interests.
• Tariff may trigger trade war.
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External Debt
• US is running (current account) deficit because
expenditure exceeds income
• The deficit is financed by borrowing from other
countries (How about printing money?)
• The absolute amount of US external debt is huge
• Other countries have higher debt-income ratios
than US
• http://en.wikipedia.org/wiki/List_of_countries_b
y_external_debt
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Default on US Debt?
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•
•
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•
•
Interest rate will go up
Investment will go down
Stock price will go down
Consumption will go down
Export will go down
Fiscal deficit will go up
Less confidence in US
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Credit Ratings of Sovereign Debts
• Credit score for country
• http://en.wikipedia.org/wiki/List_of_countries
_by_credit_rating
• BB+ or lower is junk bond
• What’s wrong with Argentina?
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International Perspective
• http://chartsbin.com/graph
• www.google.com
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(Bilateral) Exchange Rate
• Exchange rate is price of currency
• Two ways to quote exchange rate
• One way is the reciprocal of the other:
EA/B = 1/ EB/A
• Currency A appreciates if EB/A goes up
• Currency A appreciates if EA/B goes down
• To avoid confusion we use EA/B for currency A
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Multilateral (Effective) Exchange Rate
• Available at
http://research.stlouisfed.org/fred2/categorie
s/15
• Trade-weighted average of bilateral exchange
rate
• Does currency A appreciate or depreciate
against other currencies in general?
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US Effective Exchange Rate
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Discuss
• What is the variable on vertical axis?
• Why are there two lines?
• Has dollar depreciated or appreciated in
general?
• Why is the red line steeper than the blue line?
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Using Exchange Rates to
Compare Prices
• PA is the currency-A price
• PB is the currency-B price
• Which price is cheaper?
PA <> PB x EA/B
PA <> PB / EB/A
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Exchange Rates and Trade
• What happens to country A’s export and
import if currency A depreciates?
• EA/B goes up
• The price of imported goods PB x EA/B goes up,
so import goes down
• The price of exported goods PA / EA/B goes
down, so export goes up
• In short, depreciation helps export but hurts
import
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Argentina’s Crisis Revisited
• During the 2002 (Peso) crisis, Argentina’s
currency depreciated against US dollar
• Argentina’s export to US improved
• But, the price of imported goods went up, so
inflation was high
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Discuss: Chinese Yuan
• Suppose Yuan appreciates against US dollar
• What happens to US export to China?
• What happens to US import from China?, and,
from other countries like Vietnam?
• What happens to US inflation rate?
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Review
• Two ways to quote exchange rate (Corn Story)
• If currency A depreciates against B, then B must
appreciate against A
• Depreciation increases export
• Depreciation decreases import
• Intuition is, if our currency becomes cheap
(depreciate), our goods become cheap too. So
more foreign people want to buy our goods and
our export to foreign countries rises.
• Appreciation has opposite effects
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Japanese Intervention
• Yen’s appreciation hurts Japanese export
• To stop the appreciation of Yen, supply curve
for Yen should shift to right
• Japanese central bank sells (supplies) Yen and
buys (demands) dollars
• Reality Check:
http://www.usatoday.com/money/world/201108-04-japan-yen-intervention_n.htm
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Chinese Intervention
• To keep Yuan from appreciating, Chinese central
bank keeps selling Yuan and buying dollars
• China’s dollar reserve accumulated, and money
supply increased
• Inflation rate in China went up
• China is importing inflation (or expansionary
monetary policy, QE) from US due to its fixed
exchange rate
• Letting Yuan appreciate helps mitigate inflation in
China
23
1997 Asian Financial Crisis
• Some Asian currencies were overvalued, and
were expected to depreciate
• To stop depreciation, their governments sold
US dollar and bought domestic currencies
• The crisis (the rapid depreciation) occurred
when the government ran out of dollar
reserve
• http://en.wikipedia.org/wiki/1997_Asian_fina
ncial_crisis
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Exchange Rates: Developed Countries
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Exchange Rates: Developing Countries
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Remarks
• 1997 Asian Crisis
• 2002 Argentina Crisis
• Denmark uses fixed exchange rate against
Euro
• Ecuador dollarized in 2000, see
http://en.wikipedia.org/wiki/Dollarization
• Euro was introduced in 1999, see
http://en.wikipedia.org/wiki/Euro
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Spectrum of Exchange Rate Regimes
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Foreign Exchange (FX) Market
• Spot Contract; Spot Rate; Immediate Exchange
of One Currency for Another
• Derivatives (Forwards, Swaps, Futures,
Options)
• For forward contract, the delivery of currency
is in the future
• Forward rate tracks spot rate closely.
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Spot and Forward Rates
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Remarks about FX Market
• The FX market is highly volatile (risky)
• Government is an important player
• Some currencies are not fully convertible due
to reasons such as capital control
• Transactions on FX market have different
purposes: hedging, speculation, arbitrage,
government intervention….
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Arbitrage
•
•
•
•
Arbitrage means buying low and selling high
Arbitrage push prices to converge
Everyone buys low, so the low price will go up
Everyone sell high, so the high price will go
down
• Prices become stable when prices become
equalized (No Arbitrage Condition).
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Theory of Exchange Rates I:
No-Arbitrage with Two Currencies
• E1/2, A denotes the exchange rate at location A
• E1/2, B denotes the exchange rate at location B
• No-arbitrage condition requires that
E1/2, A = E1/2, B
• In reality the two rates can differ due to
factors such as transaction cost
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Two facts
• Currency A appreciates (become more
expensive) ↔ EA/B goes down
• Currency A depreciates (become less
expensive) ↔ EA/B goes up
• You can avoid many confusions if you keep
these two facts in mind
• When the corn price changes from Ecorn/$= 4 to
Ecorn/$= 5 , the corn becomes cheaper
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Euro
• Unit Europe monetarily: One central bank
• Remove (part of) risk of foreign exchange
• Make it easy to travel and do business within
Eurozone
• Next, one Treasury?
http://www.nytimes.com/2011/09/06/business/
global/reluctantly-europe-inches-closer-to-afiscal-union.html?_r=1&hp
• Challenge: heterogeneity in members
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Soros
• http://olesiafx.com/Kathy-Lien-Day-TradingThe-Currency-Market/George-Soros-the-ManWho-Broke-The-Bank-Of-England.html
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Q 5 on Page 61
• Suppose quotes for the dollar-euro exchange
rate E$/€ are as follows: in New York $1.50 per
euro, and in Tokyo $1.55 per euro. Describe
how investors use arbitrage to take advantage
of the difference in exchange rates. Explain
how this process will affect the dollar price of
the euro in New York and Tokyo.
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Answer
•
•
•
•
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Euro is more expensive at Tokyo
Buy euro at New York and sell euro at Tokyo
The New York rate, 1.50 will go up
The Tokyo rate, 1.55 will go down
Trick for exams: arbitrage always pushes lower
rate up and higher rate down (i.e., Two rates
converge).
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Theory of Exchange Rates II:
No-Arbitrage with Three Currencies
• E1/3 is the direct rate
• E1/2 E2/3 is the cross rate, and currency 2 is called
vehicle currency
• No triangular-arbitrage condition requires that
E1/3 = E1/2 x E2/3
or equivalently,
E1/3 = E1/2 / E3/2
• In short, arbitrage pushes the direct rate and
cross rate to be equal
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Covered Interest Parity (CIP)
Theory for Forward Exchange Rate
• F denotes the forward (exchange) rate
• An investor can use dollar deposit
• Alternatively an investor can convert dollar to
euro using spot rate, use euro deposit and
later convert euro back to dollar using forward
rate
• No arbitrage condition implies that
F$ / €

1  i$ 
 1  i€ 

E$ / €
Dollar return on dollar deposits

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Dollar return on euro deposits
Remarks about CIP
• We can solve for forward rate if we know
interest rates and spot rate
• Forward rate and spot rate are positively
correlated, explaining Figure 2-5 on page 40
• CIP implies that
F$ / €  E$ / €

i$  i€ 


E$ / €
Interest Rate Differential

Forward Premium
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Evidence on CIP
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Uncovered Interest Parity (UIP)
Theory for Spot Exchange Rate
• No-Arbitrage also indicates UIP, which states
that
E$e/ €

1  i$   1  i€ 

E$ / €
Dollar return on

dollar deposits
Expected dollar return
on euro deposits
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Implication of UIP
• Everything else equal, a rise in American
interest rate leads to a fall in current spot rate,
i.e., instantaneous appreciation of dollar
• Everything else equal, a rise in American
interest rate leads to a rise in expected future
spot rate, i.e., expected future depreciation of
dollar
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Remarks about UIP
• We can solve for current spot exchange rate if
we know interest rates and expected future
spot rate
• The expected future spot rate is determined
by the long-term PPP model discussed in the
next chapter
𝑒
• Big Picture: 𝑖$ , 𝑖€ , 𝐸$ €
/
𝑈𝐼𝑃
𝐸$ €
/
𝐶𝐼𝑃
𝐹$ €
/
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Lesson for International Investment
• When making decision regarding international
investment, one needs to take both interest
rate and exchange rate into account
• If American interest rate is higher than euro
interest rate, then according to UIP, dollar is
expected to depreciate against euro
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Drawbacks of UIP and CIP
• They are short-term models
• They ignore the effect of trade on exchange
rate
• One cannot apply UIP or CIP for countries with
capital control
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Q 6 on Page 61
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Bond Yields
• http://www.economist.com/blogs/dailychart/201
1/09/government-bonds/print
• Bond price is negatively related to yield (interest
rate)
• The yield of Greek bond is highest, so the price of
Greek bond is lowest.
• US bond is still popular
• Demand-and-supply diagram can be applied to
the bond market
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Critical Thinking
Fine-Tuning CIP and UIP
• Read key points 12-15 on page 59
• We can improve a theory by relaxing its
assumption
• Assumptions for the basic form of CIP and UIP:
(a) No capital control
(b) No tax
(c) No fee for currency transaction
(d) No inflation…
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Modified CIP
• Let denote the inflation rate, t the tax rate
for interest payment, and fee the fee rate for
foreign transaction. The modified CIP may
look like
F$ / €

1  i$   $ (1  t$ )  1  i€   € (1  t € )(1  fee)

E$ / €
Dollar return on dollar deposits

Dollar return on euro deposits
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Purchasing Power Parity (PPP)
A Long-Term Theory for Exchange Rate
• Intuition: The long-run value of a currency is
determined by its purchasing power
• Purchasing power is negatively related to price
• The currency of a country with high inflation is
expected to lose its value, i.e., depreciate
against a currency with low inflation
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Law of One Price (LOOP)
• PPP is derived from LOOP
• LOOP says that, under certain assumptions,
arbitrage force will make the same goods have
same prices at different locations:
𝑔
𝑔
𝑃𝑈𝑆 = 𝑃𝐸𝑈𝑅 𝐸$ €
/
• When we generalize LOOP for a specific goods to
a basket of goods we have absolute PPP:
𝑃𝑈𝑆 = 𝑃𝐸𝑈𝑅 𝐸$ €
/
E$ / €  PUS / PEUR (Absolute PPP)



Exchange rate
Ratio of price levels
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Remarks about Absolute PPP
• 𝐸$ € =
/
𝑃𝑈𝑆
𝑃𝐸𝑈𝑅
• When the US price goes up, the exchange rate
of dollar against euro goes up, so dollar
depreciates against euro.
• Intuition: when US price goes up, dollar loses
its purchasing power (the same amount of
dollar can buy less goods and services). So
dollar becomes less valuable, and depreciates
54
Absolute PPP says
In long term, due to arbitrage:
(1) The same basket of goods has the same
common-currency prices in different
countries
(2) Because of (1), nominal exchange rate equals
the ratio of price levels
(3) Because of (1), the same currency has the
same purchasing power in different countries
(4) The real exchange rate equals one
55
Real Exchange Rate
• 𝑞𝑈𝑆/𝐸𝑈𝑅 =
𝑃𝐸𝑈𝑅 𝐸
𝑃𝑈𝑆
$ €
/
• Macroeconomic counterpart for relative price
• Real exchange rate is the nominal rate
corrected for price
• Absolute PPP implies that the denominator
equals the numerator. So the real exchange
rate, the whole ratio, equals one
56
Real Exchange Rate and Trade (I)
• International trade depends on real exchange
rate, not nominal exchange rate
• 𝑃𝑈𝑆 is the price American consumers pay if the
goods is made in US
• 𝑃𝐸𝑈𝑅 𝐸$ € is the price American consumers pay
/
if the goods
is imported from Eurozone
• Importing or not depends on which price is
higher, i.e., whether real exchange rate is
greater or less than one.
57
Real Exchange Rate and Trade (II)
• US imports from Eurozone
if 𝑃𝑈𝑆 > 𝑃𝐸𝑈𝑅 𝐸𝑑𝑜𝑙𝑙𝑎𝑟/𝑒𝑢𝑟𝑜
or if 𝑞𝑈𝑆/𝐸𝑈𝑅 <1
• US exports to Eurozone
if 𝑃𝑈𝑆 < 𝑃𝐸𝑈𝑅 𝐸𝑑𝑜𝑙𝑙𝑎𝑟/𝑒𝑢𝑟𝑜
or if 𝑞𝑈𝑆/𝐸𝑈𝑅 >1
58
Chinese Real Exchange Rate
• Chinese nominal exchange rate appreciates
slowly
• But, Chinese real exchange rate appreciates
quickly, because China has higher inflation rate
than US
• In other words, the prices of imported Chinese
goods will rise at a rate much higher than the
appreciation rate of Yuan
• This helps rebalance US current account faster
• http://www.economist.com/blogs/freeexchange/
2011/01/chinas_currency
59
Mathematical Notes
• Percentage change in (XY) = percentage
change in X + percentage change in Y
• Percentage change in (X/Y) = percentage
change in X - percentage change in Y
60
Percentage Change of Exchange Rate
• According to absolute PPP, exchange rate is
ratio of prices
• Using the second mathematical note in the
previous slide, we can derive a formula for the
percentage change of exchange rate, called
relative PPP.
61
Relative PPP
• Absolute PPP implies relative PPP:
E$ / € ,t
E$ / € ,t
E$ / € ,t 1  E$ / € ,t

E$ / € ,t


Rate of depreciation of the nominal exchange rate
E$ / € ,t
E$ / € ,t

  US ,t   EUR ,t

Inflation differential
Rate of depreciation
of the nominal exchange rate
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Implications of Relative PPP
E$ / € ,t
E$ / € ,t

0
if
 US ,t   EUR ,t

 

US infation is higher than Eurozone Inflation
US dollare depreciates
E$ / € ,t
E$ / € ,t

0
if
 US ,t   EUR ,t

 

US infation is lower than Eurozone Inflation
US dollare appreciates
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Long-Run Trend for
Dollar-Yen Exchange Rate
• http://finance.yahoo.com/q/bc?s=USDJPY=X+
Basic+Chart&t=5y
64
US and Japan Inflation Rates
• http://www.tradingeconomics.com/
65
In Long Run, Relative PPP Works
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In Short-Run PPP Fails
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Remarks
• Absolute PPP says the level of exchange rate is
determined by the price ratio
• Relative PPP says that the change of exchange
rate is determined by the inflation differential
• Absolute PPP implies relative PPP, not vice
versa.
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Why Does PPP Fail?
•
•
•
•
Transaction Cost
Non-Traded Goods
Imperfect Competition and Legal Obsacles
Price Stickiness
69
Monetary Model for Exchange Rate
• Absolute PPP says that exchange rate is
determined by price ratio
• So we need a theory to explain price
• The theory is called Quantity Theory of Money
70
Quantity Theory of Money
• 𝑀𝑑 = 𝐿𝑃𝑌
𝑀𝑑 denotes the aggregate money demand, 𝐿
denotes a constant that measures how much
demand for liquidity (money) is generated for
each dollar of nominal income (the inverse of 𝐿
is the income velocity of money), 𝑃 the price
level, and Y the real income.
71
Money Market
• When the money market is in equilibrium, the
demand and supply of money are equal:
𝑀𝑑 = 𝑀
• Then we get a formula (theory) for price level
𝑀
𝑃=
𝐿𝑌
72
Remarks
• 𝑃=
𝑀
𝐿𝑌
implies that
(1) Everything else equal, price will go up if money
supply (numerator) rises
(2) Everything else equal, price will go down if real
income (denominator) rises
(3) 𝜋 = 𝜇 − 𝑔
where 𝜋 denotes the inflation rates, 𝜇 the growth
rates of money supply, and 𝑔 the growth rates of
real income.
73
Monetary Model
• 𝐸$ € =
/
•
𝐸
$ €t 1
/ , +
𝐸
𝑃𝑈𝑆
𝑃𝐸𝑈𝑅
−𝐸
$ €t
/ ,
=
𝑀𝑈𝑆
𝐿𝑈𝑆 𝑌𝑈𝑆
𝑀𝐸𝑈𝑅
𝐿𝐸𝑈𝑅 𝑌𝐸𝑈𝑅
(3-3)
= 𝜋𝑈𝑆,𝑡 − 𝜋𝐸𝑈𝑅,𝑡 = 𝜇𝑈𝑆,𝑡 −
$ €t
/ ,
74
Hyperinflation
• If inflation is very high, PPP holds even in short
run
75
L is not constant when inflation is high
76
Story of Hyperinflation
•
•
•
•
•
Huge budget deficit leads to
Printing a lot of money, which leads to
Hyperinflation, which leads to
Rapid deprecation, which leads to
Dollarization or Redenominating (see Side Bar
on page 90)
77
Fixed Exchange Rate
• China uses fixed exchange rate. Relative PPP
still applies:
EYuan / $
E /$

Yuan


  China   US

Inflation differential
Rate of depreciation
of Chinese Yuan
• Fixed exchange rate means zero depreciation
(or appreciation) rate.
• China needs to anchor its inflation as
 China   US
78
Remarks
• If US increases money supply, China needs to
increases money supply too if China wants to
keep exchange rate fixed
• If US increases money supply, but China does
not want to increase its money supply, then
China has to let its currency appreciate
79
How to Anchor Inflation
• One way to anchor inflation is to target money
supply, 𝜇 , according to Quantity Theory of
Money
𝜋 = 𝜇−𝑔
• The other way to anchor inflation is to target
nominal interest rate, 𝑖 , according to Fisher
equation
𝜋 =𝑖−𝑟
80
Homework: Q-7 on page 107
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