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International Economics
Equilibrium in an open economy
Foreign Exchange Markets
May 10-17, 2005
International macroeconomics
• International microeconomics
– Individual production and consumption decisions produce
patterns of trade
– Free trade encourages the efficient resource use, government
intervention and amrket failures can cause waste
• International macroeconomics
– Effective use of resources  maximising long term economic
growth
• Unemployment (labour use)
• Savings (capital accumulation – a country can consume an amount
equal to its income  a country’s saving and borrowing
• Trade imbalance (EX=IM  international saving and borrowing)
– Connected to the previous elements:
• Money and the price level (barter theory)
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National income
• GNP: the value of all final goods and services
produced by the country’s factors of production,
and sold on the market in a given time period
• Calculating: measuring production,
consumption, incomes
– Adding up the market value of all expenditures on
final output (measuring consumption)
– Y=C+I+G
– Domestic demand (YD) – full demand in a closed
economy
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National income in an open
economy
• Difficulties in an open economy:
– Some of the goods purchased were not
produced using the country’s resources  IM
(-)
– Some of the goods produced with the
country’s resources are purchased abroad 
EX (+)
Y=YD+EX-IM
CA (current account)
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Current account balance
• The current account usually is not balanced
CA<0 (surplus)
CA>0 (deficit)
The country purchases more
than it sells to foreigners
The deficit must be
financed
The country borrows from
foreigners: increase in net
foreign debt, decrease in net
foreign wealth
The country purchases less
than it sells to foreigners
The surplus must be spent
The country lends to
foreigners
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Saving and current account
Closed economy
- National saving (part of the
income not consumed by the
country):
S=Y-C-G
- National income
Y=C+I+G  I=Y-C-G
- Equilibrium:
S=I
Open economy
- National saving (part of the
income not consumed by the
country):
S=Y-C-G
- National income
Y=C+I+G+CA  I+CA=Y-C-G
- Equilibrium:
S=I+CA
- Sources of investment: I=S-CA
- National savings (S)
- CA deficit (borrowing
foreign savings)
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Exercises
1. The following data are known: C=100+0,8Y; I=150; G=200; EX=400;
IM=50+0,2Y.
a) Give the value of income when the market of goods is in
equilibrium!
b) What is the current account balance at that income?
2. The autonomous consumption is 50, the autonomous import is 20,
the value of investments is 200, while it is also known that the
country borrows a value 90 from foreigners at the equilibrium
income which is equal to 800. It is also known that a 5% growth in
the country’s GDP will increase the country’s imports by 3%, and a
360 unit increase in exports is needed in order to ensure a balanced
current account.
a) Give the value of consumption, imports and exports! What is the
consumption and import function of the country?
b) What is the value of the new equilibrium income?
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Exchange rate
• The price of one currency in term of another one
• The relative price of a currency can be given in two
ways:
– Direct (American) terms: the price of the foreign currency in
terms of the home currency (Ft/€)
– Indirect (European) terms: the price of the home currency in
terms of the foreign currency (€/Ft)
• Changes in the exchange rate:
– Depreciation of euro against the forint: a fall in forint price of the
euro
– Appreciation of the euro against the forint: a rise in the euro price
in terms of forints
• When a currency depreciates against the other, the
second currency simultaneously appreciates against the
first
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The effects of depreciation
• When a country’s currency depreciates,
foreigners will find that its exports are
cheaper, and domestic residents find that
imports from abroad are more expensive
• Example
– E1FT/€=250; E2FT/€=400; PEX=1000 Ft; PIM=10€
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The effects of appreciation
• Appreciation has opposite effects: foreigners pay
more for the country’s export products, and
domestic consumers pay less for foreign
products
• Example:
– E1FT/€=250; E2FT/€=200; PEX=1000 Ft; PIM=10€
• All else equal an appreciation of a country’s
currency raises the relative price of its exports,
and lowers the relative price of its imports
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Foreign Exchange Market
• On foreign exchange markets currencies are
traded like any other asset
• Prices are determined by the interaction of
buyers and sellers of different sellers
• Actors of the foreign exchange market
– Commercial banks: the vast majority of foreign
exchange transactions involve the exchange of bank
deposits denominated in different currencies –
interbank trading
– Corporations and individuals
– Central banks – intervening in foreign exchange
markets
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Theories of exchange rate
determination
1. Interest rate, and exchange rates
2. Price levels, and exchange rates
3. Fixed exchange rate – market
intervention
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1. Interest rate, and exchange rates
– an asset approach
• The demand of major exchange market actors is
determined by the asset return
• Example
Jan. 2004
Jan. 2005
Price of 1 share (MOL) (Ft)
11,000
15,000
Dividend payed (Ft/share)
150
200
– What is the annual rate of return of a MOL share bought at
January 2004?
• Expected rate of return: The decision is based on
expected rate – the percentage difference between the
expected future value, and the price paid for the asset
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• Expected real rate of return: the expected rate of return
divided with the rate of price change
• Calculating the rate of return of different currencies
– How the money value of a deposit will change – interest rate: the
amount of currency an individual can earn by lending a unit of
that currency for a year
• When someone deposits money in a given currency for a year, he
acquires an asset denominated in that currency, and the rate of
return of this asset is the interest rate
– How the forint value of an asset denominated in a foreign
currency will change – changes in exchange rates
•
Calculating the forint rate of a euro deposit: if 1 forint
worth of euro is deposited, how many forints will the
deposit yield in a year’s time?
– What the interest rate of the euro deposit is?
– What the exchange rate will be in 1 year’s time
• Exercise: The current exchange rate is 250Ft/€, and it is
expected to rise to 300 for next year. The interest rate on
forint deposits is 10%, on euro deposits 2%. Which of
the two deposits offers the higher forint return?
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• 5-step solution
– What is the forint price of a 1€ deposit?
– What is the future return of a 1 € deposit?
– What is the future forint value of a 1 € deposit?
– What is the expected forint rate of return of a 1 € deposit?
– Comparing the two rates of return
• Generalising:
–
–
–
–
–
R€ - today’s interest rate on a one-year € deposit
RFt - today’s interest rate on a one-year Ft deposit
EFt/€ - today’s direct exchange rate
EeFt/€ - expected direct exchange rate in one year’s time
The expected rate of euro deposits measured in terms of forints:
R€+(EeFt/€-EFt/€)/EFt/€
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• Equilibrium in the foreign exchange
market: when deposits of all currencies
offer the same expected rate of return –
interest parity condition
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Changes in exchange rates
•
All else stays unchanged
•
•
•
Depreciation of a country’s currency today lowers
the expected domestic currency return on foreign
currency deposits (a fall in the direct forint exchange
rate lowers the expected forint return on euro
deposits)
Appreciation of the forint raises the expected forint
return of euro deposits
Example: How will affect the decision on
investment a fall in forint exchange rate to 270
Ft/€, or a rise to 200 Ft/€?
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Exchange rates always adjust to maintain
interest parity
a
EFt/€
• E1Ft/€ - the strong
forints makes the
euro deposits more
valuable – demand
for euro grows, the E2
Ft/€
euro gets more
expensive
• E2Ft/€ - the strong
euro makes the
EFt/€
forint deposits more
1
valuable – demand E Ft/€
for forints grows,
the forint gets more
expensive
RFt=R€+(EeFt/€-EFt/€)/EFt/€
Expected Ft return
on € deposits
R2€
RFt
R1€
Rates of return in
Ft term
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Changes in interest rates
E
E
E2
R2€(Ft)
E1
E2
R€(Ft) E1
R1
Ft
R2
R (Ft)
Ft
R1€(Ft)
R (Ft)
RFt
All else equal, an increase in the interest paid on deposits of a currency
causes the currency to appreciate against foreign currencies
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2. Price level, and exchange rates
• Law of one price: in competitive markets
identical goods sold in different countries must
sell for the price when expressed in term of the
same currency
• Example: EFt/€=250; PxHU=10000 Ft; PxEU=40€.
What if the exchange rate drops to E=200?
• PiFt – forint price of good i in Hungary
• Pi€ - euro cost of good i in the EU
• PiFt=Pi€*EFt/€
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Purchasing Power Parity (PPP)
• There are not one, but a lot of products – prices are shown by the
price level (price of a reference basket of goods and services)
• Absolute PPP: exchange rates between two countries’ currencies
equal the ratio of the countries’ price levels – all countries’ price
levels are equal if measured in terms of one currency
– PFt – forint price of the reference basket in Hungary
– P€ - euro price of the reference basket in the EU
– EFt/€=PFt/P€
• The value of the reference basket in Hungary is 100,000 HUF, in the
EU 1,000 €. What the exchange rate would be if calculated using the
absolute PPP?
• Relative PPP: any change in the exchange rate is explained by the
changes in price levels
• ΠFt- Π€=(E2-E1)/E1
• Example: The inflation was 10% in Hungary and 2 in the euro-zone? How
will the E1Ft/€=250 exchange rate change?
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Real exchange rate
• qFt/€=EFt/€*P€/PFt
• Example: the nominal exchange rate is 250, the value of
the Hungarian reference basket is 25.000 Ft, the one of
the European is 100 €.
• Real depreciation of the forint: a fall of forint’s purchasing
power within the Euro-zone – the forint price of Eurozone goods (P€*EFt/€) rises relative to that of the
Hungarian goods (PFt) – qFt/€>1
• Real appreciation of the forint: a rise in forint’s
purchasing power within the Euro-zone – the forint price
of Euro-zone goods (P€*EFt/€) drops relative to that of the
Hungarian goods (PFt) – qFt/€<1
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Fixed exchange rates
• Gold Standard
• Managed floating – ‘dirty floating’: central
banks often intervene in currency markets
to to influence the exchange rates
• Regional currency arrangements –
exchange rate unions
• Many countries peg their currencies to a
reference currency
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Gold standard
•
•
Each country fixes the price of its currency in terms of gold – gold
parity of currencies
Gold can be used to pay debts as well as notes
•
Exercise
1. In the gold standard system 900 Fts are paid for 1 gram of gold in
Hungary, and 20 DMs in Germany. Gold’s cost of transport between
the two countries is 60 Fts. The following demand and supply
curves characterise the Hungarian foreign exchange market:
DDM=200-0,5e; SDM=28+e.
a) Calculate the exchange rate determined by the gold parity, and the
value of the gold export, and gold import points.
b) How will the official reserves change in the two countries?
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Fixed exchange rate – anchored
currencies
•
•
Desired exchange rate – if market forces divert the exchange rate from the
desired value, the central bank intervenes
Central banks use their reserves to intervene
Balance sheet of the Central Bank
•
•
•
Assets
Liabilities
Foreign assets (official international reserves; foreign
currency bonds)
Domestic assets (domestic government bonds, loans to
commercial banks)
Deposits held by private banks
Currency in circulation
When the central bank intervenes, both sides of the balance sheet change.
Purchase of assets automatically results in an increase in domestic money
supply, a sale a decline
Example: The central bank has 900 € in foreign assets, 1500€ in domestic
assets, the value of deposited money is 500€, and the currency in
circulation is 1900€. What happens if the central bank sells 200€ worth of
domestic bonds, or buys 100€ worth of foreign assets?
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Market sterilisation
• Nullifying the impact of foreign exchange
market operations
• Example: The central bank sells 100€
worth of foreign assets, and buys 100€
worth of domestic bonds.
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Exercises
1.
2.
3.
The equation of the currency supply curve in Hungary is S$=2e10, and the demand curve: D$=190-3e. The official exchange rate
is fixed at 50Ft/$, the allowed range of exchange rate fluctuations
is ±10%. What is the task of the Hungarian Central Bank in this
situation.
The equation of currency supply and demand curves are S$=2e10, and D$=180-3e respectively. How will affect the exchange rate
if the central bank:
a) sells 10$ from its reserves;
b) purchases 10$?
The current currency supply and demand curves are S$=4705/3e, and D$=450-5/4e, the fixed exchange rate is e=60Ft/$.
a) What is the current account balance at the fixed exchange
rate?
b) How can the current account be levelled (devaluation,
appreciation, introducing a free floating policy)?
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