Transcript International Finance - CERGE-EI
Macroeconomics ECO 110/1, AAU Lecture 12
INTERNATIONAL FINANCE
Eva Hromádková, 10.5 2010
Overview
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What determines the value of one country’s money as compared to the value of another’s?
What causes the international value of currencies to change ?
Should governments intervene exchange rate?
to limit fluctuations of
Exchange Rates
3
The
exchange rate
is the price of one country’s currency expressed in terms of another’s.
e.g: CZK/EUR = 25.965
CZK/USD = 20.374
And also EUR/CZK = 0.0385
USD/CZK = 0.0491
Foreign-Exchange Markets
4
Currency is a commodity to be bought and sold like any other.
Foreign-exchange markets
are places where foreign currencies are bought and sold.
An exchange rate is subject to the same influences that determine all market prices: demand and supply.
We will look at the example of the Czech crown LO1
5
Foreign-Exchange Markets
The Demand for CZK The market demand for Czech crowns originates in: Foreign demand for Czech exports: E.g. tourist in Czech restaurants Foreign demand for Czech investments: E.g. when Telefonica O2 bought Eurotel Speculation.
LO1
6
Foreign-Exchange Markets
The Supply of CZK The demand for foreign currency represents a supply of Czech crown.
The supply of dollars originates in: Czech demand for imports E.g. import of IPods Czech investments in foreign countries.
Speculation.
LO1
The Value of the CZK
7
A higher crown price for euros (# of CZK for 1 euro) will raise the crown costs of German goods.
Crown price of BMW
euro price of BMW
X
Crown price of euro
LO3
Foreign-Exchange Markets
8 The Supply Curve
The supply of CZK is upward-sloping.
If the value of the CZK rises, Czechs can buy more euros/dolars.
The Demand Curve
The demand for CZK is downward-sloping As CZK becomes cheaper, all Czech exports effectively fall in price – higher demand LO1
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Foreign-Exchange Market
Equilibrium 3.0
2.5
2.0
1.5
0.90
0.5
0 Supply of CZK Equilibrium Demand for CZK QUANTITY OF CZK per time period LO2
The Balance of Payments
10
The
balance of payments
is a summary of a country’s international economic transactions in a given period of time.
It is an accounting statement of all international money flows in a given time period.
U. S. Balance of Payments, 2006 Item 1. Merchandise exports 2. Merchandise imports 3. Service exports 4. Service imports
Trade Balance
(items 1-4) 5. Income from U.S. overseas investments 6. Income outflow for foreign U.S. investments 7. Net U.S. government grants 8. Net private transfers and pensions
Current-Account Balance
(items 1-8) 9. U.S. capital inflow 10. U.S. captial outflow 11. Increase in U.S. official reserves 12. Increase in foreign official assets in U.S.
Capital-Account Balance
(items 9-12) 13. Statistical discrepancy
Net Balance
(items 1-13) Amount (in billions) $1,035 (1,880) 431 (349) –763 621 (630) (28) (56) –856 1,464 (1,043) (2) 300 723 133 0
1. Trade Balance
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The trade balance is the difference between exports and imports of goods and services.
Trade balance = exports – imports
A trade deficit represents a the rest of the world.
net outflow of currency to We had to buy foreign currency to import those goods and services => outflow of our currency
2. Current-Account Balance
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Includes trade balance as well as investment balances and private transfers
Current - account balance
trade balance
unilateral transfer
3. Capital-Account Balance
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The capital account balance takes into consideration assets bought and sold across international borders.
Ex.: domestic bonds, foreign companies, …
Capital account balance
Foreign purchase of domestic assets – Domestic purchases of foreign assets
3. Capital-Account Balance
15
The capital-account surplus must equal the current account deficit.
Flow of money against the flow of goods and services
Net balance of payments
current account balance
–
capital account balance
0
Market Dynamics
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Exchange rates on foreign-exchange (FX) markets are always changing in response to shifts in demand and supply.
LO2
Depreciation and Appreciation
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Depreciation (currency)
refers to a fall in the price of one currency relative to another.
Appreciation
refers to a rise in the price of one currency relative to another.
Whenever one currency depreciates, another currency must appreciate!
LO2
Market Forces
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LO2 Some of the more important reasons supply and/or demand may shift: • Relative income changes .
• Higher income in country A => higher demand for imports => appreciation of country’s B currency • Relative price level changes.
• Changes in product availability.
• Relative interest-rate changes.
• If interest rate in country A goes up, it will increase demand for investment => appreciation of country A’s currency • Speculation – based on anticipation
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Shifts in FX Markets Introduction of Japanese luxury cars in US
Dollar-euro market
S 2 S 1
Dollar-yen market
S 1 S 2 P 2 P 1 P 1 P 2
Quantity of Dollars
D
Quantity of Dollars
D
LO2
The Asian Crisis of 1997-1998
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The Asian crisis of 1997-1998 was caused by several market forces moving in the same direction at the same time.
In July 1997, the Thai government decided the baht was overvalued and let market forces find a new equilibrium Within days, the dollar price of the baht plunged 25 percent and the Thai price of the U.S. dollar increased.
The Asian Crisis of 1997-1998
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The devaluation of the baht had a domino effect on other Asian currencies.
Holders of the Malaysian ringget, the Indonesian rupiah and the Korean won rushed to buy U.S. dollars.
This pushed the value of local currencies even lower
The Asian Crisis of 1997-1998
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The “Asian contagion” wasn’t confined to that area of the world Hog farmers in the U.S. saw foreign demand for their pork evaporate.
Koreans stopped taking vacations in Hawaii.
Thai Airways canceled orders for Boeing jets.
This loss of export markets slowed economic growth in the United States, Europe, Japan, and other nations.
Resistance to Exchange-Rate Changes
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People / investors / firms crave stable exchange rates This resistance to exchange rate changes originates in various micro and macro economic interests.
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Resistance to exchange rate changes
Micro Interests People who trade or invest in world markets want a solid basis for forecasting future costs, prices, and profits.
Fluctuating currency exchange rates are an unwanted burden on trade , as a change in the price of a country’s money automatically alters the price of all of its exports and imports Import-competing industries suffer when currency depreciations make imports cheaper E.g. steel from Russia and Japan in US LO3
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Resistance to exchange rate changes Macro Interests
A micro problem that becomes widespread enough can turn into a macro one.
Example of US: The huge U.S. trade deficits of the 1980s effectively exported jobs to foreign nations.
Trade deficits were offset by capital-account surpluses – foreign investment in US, increase of US foreign debt and interest costs LO3
Exchange-Rate Intervention
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Governments often intervene in foreign-exchange markets to achieve greater exchange-rate stability.
LO2
Fixed Exchange Rates
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One way to eliminate fluctuations is to fix the exchange rate Gold Standard - An agreement by countries to fix the price of their currencies in terms of gold; a mechanism for fixing exchange rates.
each country determines that its currency is worth so much gold Bretton-Woods, 1944 LO2
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Fixed exchange rate
Balance of Payment Problems Market supply and demand of currency naturally shift (e.g. changing demand for imports) This moves the equilibrium exchange rate away from the fixed exchange rate => excess demand for certain currencies E.g. higher demand for IPods – higher demand for USD – at given exchange rate limited supply – excess demand for USD LO2
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Fixed exchange rate
Balance of Payment Problems Excess demand for a foreign currency implies: balance-of-payments deficit for the domestic nation, A balance-of-payments surplus for the foreign nation.
There are only two ways to deal with balance-of payments problems Allow exchange rates to change.
Alter market supply or demand so that they intersect at the established exchange rate.
Only second alternative is viable LO2
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Fixed Rates and Market Imbalance
D 1 D 2 e 2 e 1 S 1
Excess demand for pounds 0
q S q
Quantity of Pounds
D
LO2
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Fixed exchange rate
The Need for Reserves Existence of
Foreign-Exchange Reserves
- Holdings of foreign exchange by official government agencies, usually the central bank or treasury.
The central bank can help maintain the officially established exchange rate by selling some of its foreign exchange reserves .
LO2
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The Impact of Monetary Intervention
D 2 S 1 S 2 e 1
0 Excess demand
q S
Quantity of Pounds
q D
LO2
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Fixed exchange rate
The Need for Reserves Foreign exchange reserves may not be adequate to maintain fixed exchange rates.
Case of USA I: The long-term string of U.S. balance-of-payments deficits overwhelmed its stock of foreign exchange reserves Gold reserves (stocks of gold held by a government to purchase foreign exchange) are a potential substitute for foreign-exchange reserves LO2
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The U.S. Balance of Payments: 1950 – 1973
+$4 +2 0 –2 –4 –6 –8 –10 1950 1955 1960 1965 Surplus Deficit 1970 1973 1975
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Fixed exchange rate
The Need for Reserves
Case of USA II:
Continuing U.S. balance-of-payments deficits exceeded the holdings of gold in Fort Knox.
As a result, U.S. gold reserves lost their credibility as a potential guarantee of fixed exchange rates.
September 15, 1971 – Bretton-Wood golden standard was abolished LO2
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Fixed exchange rate
Domestic Adjustments Trade protection can be used to prop up fixed exchange rates.
Deflationary (or restrictive) policies help correct a balance-of-payments deficit by lowering domestic incomes and thus the demand for imports.
LO2
Flexible Exchange Rates
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Flexible exchange rates
is a system in which exchange rates are permitted to vary with market supply and demand conditions.
Also called floating exchange rates.
With flexible exchange rates, the quantity of foreign exchange demand always equals the quantity supplied.
LO2
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Flexible Exchange Rates
Effect on trade Someone is always hurt (and others are helped) by exchange-rate movements.
(all the above discussed micro and macro arguments apply), e.g.
Currency depreciation may cause domestic cost push inflation by pushing up input prices.
Currency appreciation reduces exports by raising the price of domestically produced goods to foreigners.
LO2
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Flexible Exchange Rates
Speculation Speculators often counteract short-term changes in foreign-exchange supply and demand (stabilizing) Sometimes, speculators move “with the market” and make swings in the exchange rate even more extreme (destabilizing) LO2
Managed Exchange Rates
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Governments may buy and sell foreign exchange for the purpose of
narrowing
exchange-rate movements.
Such
limited intervention
in foreign-exchange markets is referred to as managed exchange rates.
LO2
Currency Bailouts
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The world has witnessed a string of currency crises: The Asian crisis of 1997-1998.
The Brazilian crisis of 1999.
The Argentine crisis of 2001-2.
The recurrent ruble crises in Russia.
Periodic panics in Mexico and South America.
Currency Bailouts
42
In most cases a currency “bailout” was arranged by the International Monetary fund, joined by the central banks of the strongest economies.
These authorities lend the troubled economy enough reserves to defend its currency
The Case for Bailouts
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The case for currency bailouts typically rests on the domino theory.
Weakness in one currency can undermine another.
Industrial countries often offer currency bailout as a form of self-defense.
The Case Against Bailout
44
Once a country knows that currency bailouts will occur, it may not pursue domestic policy adjustments to stabilize its currency.
A nation can avoid politically unpopular options such as high interest rates, tax hikes, or cutbacks in government spending.
It can also turn a blind eye to trade barriers, monopoly power, lax lending policies, and other constraints on productive growth.