Transcript Deficits and Surpluses: The Balance of Payments

Deficits and Surpluses: The Balance of Payments
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Darlings and Deadbeats: Defaults and Other Risks
• Countries that default, or are in danger of default, suffer from high
country risk and poor credit ratings.
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Independence and Monetary Policy:
The Choice of Exchange Rate Regime

Most countries have their own currency as sovereign nations. But what is
their exchange rate regime choice?
 Fixed or floating? Both are important:
(2006)
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Institutions and Economic Performance:
The Quality of Governance


The Great Divergence
 Advanced countries are about 50 times richer than
poorest countries.
Quality of institutions and economic performance


Fact: Countries with higher quality institutions tend to have
higher levels and lower volatility of income per person
Why?
 Governance failures (corruption, poor rule of law, etc.)
 Instability creates uncertainty in income and employment.
 Risk of expropriations for investors
 Both domestic and foreign
 Bureaucratic inefficiency, red tape, bribery
 Poor monetary and fiscal policies
 Weak financial sector regulation
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Institutions and Economic Performance:
The Quality of Governance
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Riskless Arbitrage: Covered Interest
Parity

Covered Interest Parity (CIP) condition
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No arbitrage condition
For the market to be in equilibrium the riskless
returns must be equal when expressed in a
common currency:
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Riskless Arbitrage: Covered Interest
Parity
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Riskless Arbitrage: Covered Interest
Parity

Arbitrage profit?

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
Considers the German deutschmark (GER) relative to
the British pound (UK), 1970-1994.
Determine whether foreign exchange traders could
earn a profit through establishing forward and spot
contracts
The profit from this type of arrangement is:
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Evidence on Covered Interest Parity

Arbitrage profit: German DM and British £
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Evidence on Covered Interest Parity

Are there arbitrage profits?

We observe that once capital controls were
removed, arbitrage profits disappeared.
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
In financial systems that have become liberalized,
riskless arbitrage opportunities have disappeared.
CIP holds, except for tiny spreads.
The CIP equation is used to exactly price forward
contracts (if we know interest rates and E then we
can solve for F):
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Risky Arbitrage: Uncovered Interest
Parity
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Risky Arbitrage: Uncovered Interest
Parity

Uncovered Interest Parity (UIP)



No arbitrage condition for expected returns
States that the expected returns must be equal when
expressed in a common currency
We assume risk neutrality; e.g. that a risk neutral US
investor does not care that the left hand side is certain,
while the right hand side is risky.
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Risky Arbitrage: Uncovered Interest
Parity

Uncovered Interest Parity (UIP)

Knowing the expected exchange rate and the
interest rates for each currency, we can solve
for the spot exchange rate:
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Evidence on Uncovered Interest
Parity

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Interest parity conditions
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CIP:

UIP:

Thus CIP plus UIP imply:
Intuition: If F did not equal Ee one party to the
forward contract would be better off waiting for
the more favorable Ee to materialize (if the
investors are risk neutral).
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Evidence on Uncovered Interest
Parity

An important testable implication:
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Left-hand side is the forward premium (+ or –)
Says how much more/less investors are willing to pay
for the forward versus the spot.
Right-hand side is expected rate of depreciation (+
or –)
In order to estimate the right-hand side, researchers
have used surveys of foreign exchange traders.
Test: plot right hand side versus left hand side…
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UIP: A Useful Approximation

Intuition

Reward, or net return on one dollar deposit


In dollar-denominated deposit = interest on dollar deposits
In euro-denominated deposit = interest on euro deposits +
gain/loss associated with euro appreciation/depreciation
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Empirical Evidence on PPP

According to relative PPP, the percentage change in the
exchange rate should equal the inflation differential.
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The Big Mac Index

For over 20 years The Economist newspaper has
used PPP to evaluate whether currencies are
undervalued or overvalued.


Recall, home currency is x% overvalued/undervalued
when the home basket costs x% more/less than the
foreign basket.
The test is really based on Law of One Price
because it relies on a basket with one good.

Invented (1986) by economics editor Pam Woodall. She
asked correspondents around the world to visit
McDonalds and get prices of a Big Mac, then compute
price relative to the U.S.
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The Big Mac Index
Big Mac
q
1 
“Big Mac index” =



Big Mac
E $/local currencyPlocal
Big Mac
US
P
1
The % deviation (+/–) from the US price
measures the over/under valuation of the local
based on the burger basket.
currency
Updated every year:
http://www.economist.com/markets/Bigmac/
In 2004 they tried the same exercise with
another global, uniform product: the Starbucks
tall latte.
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The Big Mac Index
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Evidence for the Monetary Approach
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Evidence for the Monetary Approach
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Inflation and Interest Rates in the Long
Run

Combine two expressions that are equal:
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Relative PPP (and take expectations)

UIP (approximation)
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Right hand sides must be equal.
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The Fisher Effect

Relative PPP and UIP imply:
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
This is known as the Fisher effect.
An increase in the inflation rate in one country
leads to a one-for-one increase in the nominal
interest rate in that country.
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Real Interest Parity

This expression can be rewritten as:
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
This is known as real interest parity.
Real interest parity implies that (expected) real
interest rates should be equal across
countries:
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Real Interest Parity

According to real interest parity, we can define an
expected world interest rate r* for all countries:
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Nominal interest rates in the home and foreign
countries are therefore given by r* plus expected
inflation in each country:
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Evidence on Fisher Effect

The Fisher effect: nominal interest rate differentials should
move one-for-one with inflation differentials.
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Evidence on Real Interest Parity
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RIP: real interest rates should equalize in the long run.
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The Rise and Fall of the Dollar,
1999-2004
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Long-Run Policy Analysis:
Overshooting
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The Trilemma

Consider three policy goals:
1.
Fixed exchange rate
2.
International capital
mobility
Promote stability in trade and
investment.
Promote integration, risk
sharing and efficiency.
3.
Monetary policy autonomy
Tool for managing home
country’s business cycle.
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The Trilemma


From our comparison of fixed and floating
exchange rates, we can see that it is not possible
to achieve all three of these goals.
 (1) + (2) imply interest rates must be equal—
contradicting (3)
 (2) + (3) imply an expected change in the
exchange rate—contradicting (1)
 (3) + (1) imply a difference between domestic
and foreign returns—contradicting (2)
These choices represent a trilemma. One of the
three goals must be sacrificed to achieve the
other two.
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The Trilemma
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The Trilemma in Europe


Denmark has adopted a fixed exchange rate
regime, pegging the Danish krone to the euro.
This implies that Denmark has sacrificed its
monetary policy autonomy.
What if Denmark wanted monetary policy
autonomy?
 It has two options: sacrifice either
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(1) the fixed exchange rate, or
(2) international capital mobility.
 The United Kingdom has opted to sacrifice (1) in order
to achieve monetary policy autonomy.
 Based on the model, nominal interest rates in Denmark
should move with those in the Eurozone. For the U.K.,
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however, this need not be the case.
The Trilemma in Europe

U.K. interest rates do not move in sync with Eurozone
rates; Denmark’s interest rates do.
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Understanding Data on Balance of
Payments

U.S. trends for
BOP items.

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Since 1990,
U.S. current
account deficit
has grown.
CA deficit
financed
through
borrowing
from abroad
(FA surplus).
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Historical timeline

1870–1913: Gold standard and metallic standards.
1918–1939: Gold standard returns, then declines.
1945–1970s: Fixed exchange rate regimes common.
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1970s–present: Divergence; richer more likely to float.
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Optimum Currency Areas: Europe
vs. the U.S.
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In practice, it is difficult to measure the
true costs and benefits of currency union.
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Alternative: Take a comparative approach.
How does Europe compare with the United
States on each of the OCA criteria?
Assumption: U.S. is an optimal currency area.
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Optimum Currency Areas: Europe
vs. the U.S.

Goods Market Integration within the EU
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Measure: Manufacturing
exports to other regions
Result: Individual states within
the U.S. trade more heavily
than EU countries.
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U.S: 20-70% of gross state
product EU: 3-58% of GDP.
On average, manufacturing trade
accounts for roughly 45% across
the U.S., compared with
approximately 25% in the EU.
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Optimum Currency Areas: Europe
vs. the U.S.

Symmetry of Shocks within the EU
 Measure:
correlation of
state/country’s GDP growth
rate relative to the entire
region.
 Result: EU average
correlation similar to that of
the U.S.

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U.S. and EU average correlation
approximately 0.5.
EU countries subject to no
more/fewer local shocks than
states in the U.S.
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Optimum Currency Areas: Europe
vs. the U.S.

Labor Mobility within the EU

Measure: Population born in different
state/country.
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Optimum Currency Areas: Europe
vs. the U.S.
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Labor Mobility within the EU
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Result: Labor far less mobile in the EU vs. U.S.
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More than 30% of U.S. residents born in a different state.
Only 1.5% of EU residents born in a different EU country.
Also true for year-to-year flow of labor across regions.
Why poor labor mobility EU?
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Culture and language
Local regulatory environment make it difficult for Europeans
to live and work in another EU country.
Labor markets in Europe generally less flexible – more
difficult to hire/fire workers, dissuading people from leaving
one country in search of better opportunities.
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Optimum Currency Areas: Europe
vs. the U.S.
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Fiscal Transfers
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Measure: Changes in state/country tax
revenues offset by federal/regional transfers.
Result: U.S. has stabilizing fiscal transfers. EU
does not.

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For a $1 decline in state government revenue,
federal transfers refund $0.15
In the EU, individual states attempt to offset, but
there is no system-wide fiscal transfer program.
EU budget accounts for only 1% of EU GDP and is
dedicated to other purposes.
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Optimum Currency Areas: Europe
vs. the U.S.
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Summary

Eurozone likely falls short of the U.S. as OCA.
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EU has similar shocks, lower trade volumes, poor labor
market mobility, and lack of fiscal federalism.
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Are the OCA Criteria Self-Fulfilling?
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Potential effects on efficiency gains
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Joining a currency union promotes trade
through reducing transactions costs.
Even if OCA criteria indicate trade volumes are
too low, ex ante, act of joining union increases
potential gains.
Evidence is mixed and there is no consensus
on the magnitude of these effects
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A Brief History of Europe
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Euro-Pessimists

Rules versus practice

Rules mean governments cannot pressure ECB to lower
rates to reduce debt burdens, but government can
trump central bank preferences.
(2005)
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