Download 4. Trading with the World: The gains from international trade

4.
Trading with the World:
The gains from international trade:
 Comparative advantage and specialization are the fundamental sources of gains
from trade,
 Comparative advantage: opportunity costs between two countries are divergent,
 The world price (the intermediate level of the opportunity costs in the two
countries) would change the optimal production portfolio,
 Both countries can consume outside of their production possibility frontiers (the
consumption possibility frontier is above the production possibility frontier).
Production Possibility Frontier & Consumption
Agricultural
Agricultural
Country A
Country B
C
T
C
A
A
T
Industrial
Industrial
Why is international trade restricted?
 Tariff revenue
 Rent seeking:
Protection brings a small loss to a large number of people and a large gain
per person to a small number of people
International trade restrictions:
 Tariffs, quotas, voluntary export restraints,
 Trade restrictions reduce both the value of imports (lower the volume of imports,
raise the domestic price of imported goods) and the total value of exports,
 Tariff revenue = (price with tariff – export price) * demand for imports
 Importer’s profit under quota = (price of imports – export price) * quota
The fallacies of the arguments for restricting international trades:
 For the national security: a subsidy to domestic producers is more efficient
 For the infant domestic-industry: a subsidy designed to induce spillover of the
learning by doing is more efficient
 Against the dumping by the exporters: how do you know the price is lower than
the cost? No company has a global monopoly to take- over the global market by
dumping.
 For saving domestic jobs: protection does save jobs but at a high cost, free trade
does cost some jobs but it also creates other jobs,
The Currency Exchange Rate:
 balance of payments accounts (FX flows):
current/ trade account: contemporaneous cashflows (income/spending)
export (goods and service) +, import –
the income on existing investment received (+), paid (-)
capital/ financial account: inter-temporal cashflows (borrowing/lending)
short-term and long-term capital transaction;
foreigners’ investment in the US +, US investment abroad –
official settlement account:
changes in the U.S. government’s deposits (reserves) in foreign
central banks
 the sum of the balances on the three accounts always equals zero.
Current account:
Trade balance
Balance of services
Net income
Capital account:
Unrequited transfers (foreign aid)
Portfolio investment
Official settlement account:
The foreign exchange market:
 The demand for one money is the supply of another money,
 demand for/ supply of foreign exchange,
Exports effect:
the larger the value of US exports, the larger is the quantity
demanded of US$
Imports effect:
the larger the value of US imports, the larger is the quantity supplied
of US$
Expected profit effect:
the larger the expected profit from holding US$ (e.g., interest rate
differentials, expected future exchange rate), the greater is the
quantity demanded of US$
Currency exchange rate quotation:
 Direct exchange rate:
the price of one unit of foreign currency in domestic currency,
 Indirect exchange rate:
the number of units of FX that one unit of domestic currency buys
 The profit on a triangular arbitrage:
The difference between the quoted cross rate and the implied cross rate
 Compute the implicit (i.e., internally consistent) cross rate:
Given the bid-ask for currency 1 in terms of 2,
And the bid-ask for currency 2 in terms of 3,
The cross bid-ask for currency 1 in term of 3 is
The bid price for 2 in 3 * bid price for 1 in 2,
The ask price for 2 in 3 * ask price for 1 in 2.
Currency Exchange Rates:
 An exchange rate is a price of one currency in terms of another.
 Trade-weighted index:
The average exchange rate of the US$ against other currencies weighted by
their relative importance in US international trade
 equilibrium exchange rate:
is determined by the interaction between the demand and supply,
 changes in demand and supply:
result in exchange rate fluctuations,
 Exchange rate policy:
Flexible/ floating exchange rate,
Fixed exchange rate,
Pegged exchange rate/ Crawling peg
Changes in Currency Exchange rates:
 The interaction between supply and demand causes a currency to appreciate or
depreciate,
Higher real interest rates and lower inflation rates tend to cause a country’s
currency to appreciate
 The balance of payments (current account + capital account) are restored to
equilibrium through exchange rate adjustment,
 a current account deficit is offset by a capital/ financial account surplus,
any current account deficits not offset by the capital account surpluses would
have a negative effect on the economy
 J-curve effect:
Depreciation of domestic currency would cause the trade balance to get
worse before it gets better
 factors affecting the financial accounts are changes in real interest rates, differences
in economic performances, changes in investment climates,
Is a large current account deficit sustainable when foreign investment comes
from foreign government debt investments rather than foreign private
investors?
 Monetary policy and the foreign exchange rate,
Monetary policy affects inflation rate (and the current account through
export price) and real interest rate (and the capital account):
An expansionary monetary policy will generally lead to a depreciation of the
home currency
A sudden increase in the money supply:
In the long run, the currency depreciates and the PPP is restored,
In the short run (i.e., sticky goods prices), the currency depreciates
more than the depreciation implied by the PPP.
 Fiscal policy and the foreign exchange rate,
What is the effect of fiscal policy on real interest rate and inflation? Perhaps,
its effect on real interest rate dominates over that on inflation effect.
Expansionary fiscal policy will generally lead to an appreciation of the home
currency
 The asset market approach to pricing exchange rate expectations:
The exchange rate is the relative price of two currencies determined by
investors’ expectations about these currencies. Foreign capital investment is
attracted by economic growth and high interest rates; this capital inflow
leads to an appreciation of the currency.
 A traditional flow market approach:
An increase in domestic consumption would lead to increased import and
increased inflation; this would lead to a weakening of the currency in the
short run.
 The balance of payments:
Is the borrowing for growth or consumption?
 Exchange rate expectations:
Are influenced by purchase power parity and interest rate parity
Currency Forward Rate:
Forward discount/premium:
Forward discount /premium = (forward rate – spot rate)
Spot rate
= (F – S)
S
Where F, S are the price of $ in FX
Covered interest rate arbitrage:
 Borrowing in domestic currency, converting into FX at spot rate, lending it in foreign
market, repatriating it into domestic currency at the forward rate,
 The net profit of such an arbitrage should be nil.
1=
S (1 + Rf)
F (1+ Rd)
Hence,
F=
S (1 + Rf)
(1+ Rd)
Where F, S are the price of $ in FX
 It follows from the covered interest arbitrage-free condition that
(F – S) =
S
(Rf - Rd)
( 1 + Rd)
 The forward discount/ premium = interest rate differentials between two currencies
(F - S) ~
S
(Rf
-
Rd)
International Parity Relations:
The interplay between exchange rate, interest rates and inflation rates in a perfect world
(theory):
1.
2.
3.
4.
5.
the (covered) interest rate parity,
the purchasing power parity,
the international Fisher relation,
the uncovered interest rate parity,
the foreign exchange expectation relation.
Forward Rate  Expected Spot Rate
Spot Rate
Interest Rates  Inflation Rates / Expected Inflation Rates
(1) (Covered) Interest Rate Parity:
Linking spot exchange rate, forward exchange rate and interest rates:
1=
S (1 + Rf)
F (1+ Rd)
(F – S) =
S
(Rf - Rd)
( 1 + Rd)
=>
S
F
= (1+ Rd)
(1 + Rf)
~ (Rf - Rd)
Where F, S are the price of $ in FX
 It must hold: a financial arbitrage free condition, not a theory
(2) Purchasing Power Parity:
Linking spot exchange rate and inflation (theory):
The spot exchange rate adjusts to inflation differentials between two countries.
 Absolute PPP:
The spot exchange rate should be such that the real price of a good must be the same
in all countries (i.e., the law of one price)
the exchange rate = the ratio of the average price levels in their own currencies
 Relative PPP:
The percentage movement of the exchange rate vs. inflation rates
Exchange rate at the end of period
Exchange rate at the beginning
=
(1 + foreign inflation rate)
(1 + domestic inflation rate)
S1/ So= (1 + If ) / (1 + Id )
~
S1/So – 1 = If - Id
S1 = So [1 + (If – Id )]
 Deviation from PPP should be corrected in the long run (theory)
(3) The international Fisher Relation:
Linking interest rates and expected inflation rates (theory):
 (1 + nominal interest rate) = (1 + real interest rate) * (1 + the expected inflation rate)
Real interest rate = the nominal interest rate – the expected inflation rate
 The international Fisher relation:
real interest rates are equal across the world:
i.e., the difference in nominal interest rates
= the difference in expected inflation rate
(4) Uncovered Interest Rate Parity:
Linking spot exchange rate, expected spot exchange rate and interest rates (theory):
 the expected currency depreciation should offset the interest rate differentials
between two countries: the expected return on default free bills should be the same in
all countries
 this parity condition combines the international Fisher relation and purchasing power
parity
(5) Foreign Exchange Expectation relation:
Linking forward exchange rate and the expected spot exchange rate (theory):
 F0 = E0 (S1)
The forward exchange rate = the expected spot exchange rate
 If, the expected change in the spot exchange rate ~
(the foreign interest rate – the domestic interest rate)
The forward rate discount (premium) =
The expected change in the spot exchange rate
Then, the forward rate discount (premium) =
(the foreign interest rate – the domestic interest rate)
(F – S) =
S
(Rf – Rd)
Given inflation rates differential:
Get the expected change in the FX spot rate from the (relative) Purchasing Power
Parity,
S1
So
= 1+ inflation f
1+ inflation d
Where F, S are the price of $ in FX
Get the difference in nominal interest rate assuming that the real rates are the same
(the international Fisher relation),
1 + Rf = (1+ expected inflation f) * (1+ real rate of return)
1+ Rd
(1+ expected inflation d) * (1+ real rate of return)
Given interest rates differential:
Get the forward discount/premium from covered interest rate parity
(F - S) ~
(Rf - Rd)
S
Get the expected change in the spot exchange rate from uncovered interest rate parity