Economy Open Macroeconomics
Exchange rates
The weakness of the Yen a year ago'
"Democrats flex their muscles over yen" Claims by powerful US Democrats that Tokyo is deliberately keeping its currency weak to encourage exports shows that the new leaders in the House of Representatives are ready to expand their range of economic targets beyond Beijing.
Financial Times, February 9, 2007.
"S Korean exporters express their concern" The weakness of the yen has drawn concern from South Korean exporters, especially carmakers such as Hyundai Motor, as they struggle to compete against Japanese rivals in overseas markets.
Financial Times, February 9, 2007.
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On the other hand:
"Mazda earnings soar on yen" Mazda Motor Corp. posted a 7.5 percent rise in quarterly profit Thursday, powered by the yen's slide and increased exports to North America and Europe.
CNNMoney.com, February 8, 2007
The Foreign Exchange Market
Exchange rate: Price of one nation's money in terms of another nation's money.
Spot exchange rate: price for immediate exchange. Forward exchange rate: price for an exchange that will take place sometime in the future. Other currency prices: futures, swaps, options.
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Exchange rate determination
The market for British Pounds against US Dollars
$ per S
2.05 1.95 The demand comes from anyone who wants to buy Pounds. For example, US importers of goods from England; US investors who want to buy British Bonds or stocks of British companies. The supply comes from anyone who wants to sell Pounds. For example, US exporters who invoiced their deliveries to England in Pounds; British investors who wants to buy US treasury Bills or stocks of US companies.
D
300 320 Billions of
What makes prices of currencies consistent in different markets or traders?
Arbitrage
Purchase Pounds with Dollars in London; Sell Pounds for Dollars in New York.
Triangular arbitrage
Purchase Euro with Dollars in Frankfurt; Sell Euro for Pounds in London; Sell Pounds for Dollars in New York.
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Real Exchange Rate:
The price of domestic goods relative to foreign goods
RER
=
e Nom P P For
RER = Real exchange rate eNom = Nominal exchange rate (Foreign currency needed to buy
one unit of domestic currency) P = Domestic price PFor = Foreign price
Purchasing Power Parity (PPP)
The Purchasing Power Parity Theory (PPP) posits that foreign and domestic (basket of) goods should have the same price. That is, the real exchange rate should be 1 (RER=1) and the nominal exchange rate is only determined by the relative price
eNom =
PFor P
This is also called Law of One Price.
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The Law of One Price holds if:
Goods are tradable.
Households' services like house cleaning are not tradable. Transatlantic transportation is tradable because it can be provided by US or foreign companies.
Transportation costs are low.
The shipping cost of daily fresh milk from Switzerland to the US is very high. Transportation costs for high fashion clothing is small.
There are no artificial barriers to trade.
Quotas and trade tariffs are artificial barriers.
Implications of PPP
The rate of appreciation or depreciation will be approximately equal to the percentage-point difference in the inflation rates.
% Change eNom = % Change PFor - % Change P
A country with a relatively high inflation rate will have a depreciating currency (a declining nominal-exchange-rate value of its currency). A country with a relatively low inflation rate will have an appreciating currency (an increasing nominal-exchange-rate value of its currency).
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Inflation differential and exchange rate depreciation for some high inflation countries Annual averages in the period 1961-2002
Inflation differential with the U.S. Percent depreciation with the dollar
Argentina Brazil Chile Colombia Iceland Indonesia Israel Peru Uruguay
259.2 218.0 63.9 15.6 16.0 16.9 39.5 261.6 42.6
220.3 287.8 58.3 15.2 16.5 59.8 40.3 276.9 46.7
Trade-weighted nominal and real exchange rate of the dollar
160
140
1973 index=100
120
100
80
60 1973
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
Nominal exchange rate
Real exchange rate
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July 2007
Purchasing power of wages
A worker from Jakarta must toil for 1 hours to buy a Big Mac. A Moscow wage buys the burger in 25 minutes. A Tokyo salary buys one in just 10 minutes.
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Nominal prices and money supply
Nominal prices are ultimately linked to the money supply.
MV = PY
M = Money in circulation V = Velocity of money (it changes slowly) P = Nominal prices Y = Production
Higher growth rates of money lead to higher inflation rates and to a depreciation of the exchange rate.
Determinants of the exchange rate
Changes in income
Higher incomes usually lead to higher expenditure on imported goods, and therefore, higher demand of foreign currency to pay for the imports.
Changes in interest rates
Higher "domestic interest rates" attract foreign financial investments (capital inflows) and reduce capital outflows. This increases the demand for the domestic currency. The opposite arises when "foreign interest rates" increase.
Expectations about the future exchange rate
For example, "expectations" about the appreciation of the dollar increases the current demand of dollars.
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Why do governments control the Foreign Exchange Market?
Due to speculation, the exchange rate fluctuates too much and generates instability in international trade and flows of capital. The government may desire to prevent an appreciation of the exchange rate to favor exports, especially in certain sectors. In other occasions the government may desire to prevent a depreciation of the exchange rate to keep low the price of essential imports. (For example, oil).
Exchange Rate Systems
Floating exchange rate
Determined by the forces of demand and supply without intervention from governments or central banks.
Fixed exchange rate
Official authorities stand ready to purchase or sell foreign currency in order to balance the demand and supply at the targeted (fixed) exchange rate.
Floating within a band
Official authorities stand ready to purchase or sell foreign currency if the exchange rate diverges from a predetermined range (band).
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Floating exchange rates
Operators are free to buy and sell currency in the market. The monetary authority is just another operator that can also buy and sell currency in the market.
1.
Clean float: The monetary authority never intervenes and let the demand and supply to determine the equilibrium price (exchange rate). Managed float: The monetary authority intervenes to influence the exchange rate in the desired direction.
2.
Fixed exchange rates
Operators are free to buy and sell currency in the market. The monetary authority compensates the excess demand or supply to keep the exchange rate to the target.
1.
Extreme peg: The monetary authority fixes a particular exchange rate and does not allow the rate to move from this target. Within a band: The monetary authority intervenes if market price diverges from the band.
2.
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Exchange Rates Arrangements, January 1, 2008
Currency Pegged To
Use Foreign Currency Andorra Ecuador El Salvador Kiribati Liechtenstein Marshall Is. Micronesia Monaco Nauru Palau Panama San Marino Timor-Leste Tuvalu Euro Area Austria Belgium Cyprus Finland France Germany Greece Ireland Italy Luxembourg Malta Netherlands Portugal Spain Slovenia Euro Denmark Estonia Latvia Lithuania Benin Burkina Faso Cameroon Cent. Africa R. Chad Congo, Rep. Cote d'Ivoire Equ. Guinea Gabon Guinea-Bissau Mali Niger Senegal Togo Bosnia Bulgaria Cape Verde Comoros Hungary Macedonia US Dollar Antigua&Barb. Aruba Bahamas Bahrain Barbados Belize Djibouti Dominica Eritrea Grenada Hong Kong Iraq Jordan Kuwait Lebanon Malaysia Maldives Netherlands Ant. Oman Qatar St. Kitts& Nevis St.Vincent&Gr. Saudi Arabia Seychelles Syria Trinidad&Tob. Turkmenistan Ukraine U.A. Emirates Venezuela Others Bhutan Brunei Lesotho Namibia Nepal Swaziland Currency Basket Fiji Libya Morocco Samoa Tonga Vanuatu Crawling Peg Belarus Bolivia Botswana Costa Rica Honduras Nicaragua Solomon Is. Heavily Managed Float Afghanistan Algeria Angola Argentina Azerbaijan Bangladesh Burundi Cambodia China Colombia Croatia Czech Republic Egypt Ethiopia Gambia Ghana Georgia Guatemala Guinea Guyana Haiti India Indonesia Iran Jamaica Kazakhstan Kenya Kyrgyz Rep. Lao PDR Mauritiana Mauritius Moldova Mongolia Mozambique Myanmar Nigeria Pakistan Paraguay Peru Romania Russia Rwanda Sao Tome&Pr. Serbia Singapore Slovak Rep. Sudan Suriname Tajikistan Thailand Tunisia Uzbekistan Vietnam Zambia Zimbabwe Market-Driven Float Albania Armenia Australia Brazil Canada Chile Congo D.R. Dominican R. Iceland Israel Japan Korea, South Liberia Madagascar Malawi Mexico New Zealand Norway Papua New G. Philippines Poland Sierra Leone Somalia South Africa Sri Lanka Sweden Switzerland Tanzania Turkey Uganda United Kingdom United States Uruguay Yemen
How to maintain a fixed exchange rates
1.
Intervening in the foreign exchange market by selling or buying foreign currency. Imposing some exchange controls that constrain demand and/or supply of currency. Changing the domestic interest rate which affects short-term capital flows. By implementing macroeconomic policies that solves the fundamental problems underlying the forces that undermine the exchange rate stability (fiscal and monetary policies).
2.
3.
4.
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Defending a fixed exchange rate from depreciation
Fixed regime Peso per $ S$
12 11 11 10
Peso per $
Partially floating regime (Fixed within a band)
S$
D$
20 23 Billions of $ 20 22.5 25
D$
Billions of $
Where does the monetary authority get currency to intervene?
Countries own international reserves in several currencies. Countries can borrow from other countries or international institutions.
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Who owns foreign reserves?
In what currencies?
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Temporary Disequilibrium
Peso per $
Demand in 6 months Demand in 12 months
S$
11
D$
17 20 23 Billions of $
Financial crisis in Turkey
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Direct Exchange foreign Controls
All exchange proceeds must be turned over to the country monetary authority. Anyone needing foreign currency must request it from the monetary authority. Sometimes only some operations are subject to exchange controls. For example, for transaction in goods and services, operators can get currency directly from the market. For some international financial activities, instead, operators need approval from the proper authority.
Arguments in favor and against fixed exchange rates
Microeconomic effects (Favorable to fixed rates).
The elimination of the exchange rate risk increases the efficiency in the allocation of resources because it encourages cross-country business. In the case of a single currency (ex. European countries), transaction costs are eliminated because there is no need to exchange currencies.
Macroeconomic effects (Against fixed rates).
With fixed rates the monetary tools cannot be used for stabilization policies. In general, the effectiveness of monetary policy, relative to fiscal policy, is greater under flexible exchange rates.
Monetary Discipline (Favorable to fixed rates).
A system of fixed exchange rates helps the country to avoid inflationary political pressures because to keep the exchange rate fixed the country needs to control the growth rate of money.
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Monetary policy discipline
Ultimately, nominal prices are linked to the money supply. Higher growth rates of money lead to higher inflation rates and to a depreciation of the exchange rate. The temptation to finance government deficits by printing money leads to the loss of monetary discipline. The commitment to a fixed exchange rate requires a commitment to monetary discipline, and therefore, fiscal discipline.
3500 3000 2500 2000 1500 1000 500 0 -500 1961
Monetary Discipline: Inflation rate in Argentina
1966
1971
1976
1981
1986
1991
1996
2001
2006
16
100 90 80 70 60 50 40 30 20 10 0
1961
Monetary Disciple: Inflation Rate in Argentina
1966
1971
1976
1981
1986
1991
1996
2001
2006
Financial Crisis - Asia 1997
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Major forces of Financial Crises
1.
Waves of over-lending and over-borrowing Exogenous negative international shocks Excessive exposure to exchange rate risks Volatile international short-term lending Global contagion
2.
3.
4.
5.
1. Waves of over-lending and overborrowing
Sometimes there is over-lending to governments (ex. Mexico in the late 70s and early 80s and Argentina in the 90s). Sometimes there is over-lending to the private sector (ex. Asian countries in the 90s, especially banks). When the government accumulates too much debt it has an incentive to default. Increasing expectations of default trigger the crisis. Similar considerations apply to the private sector: when the investors start to doubt about the possibility of recovering their loans, they ask for the repayment and trigger the crisis.
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Net Long-Term Financial Flows to Developing Countries, 1991-2005
(Billions of Dollars)
Source and type Official Loans Grants Private debt Bank & other Bonds Portfolio equity (stocks) Foreign direct investment 1991 62 28 34 13 5 8 5 32 1992 53 23 30 36 27 9 13 44 1993 52 24 28 48 15 33 43 67 1994 46 15 32 42 13 29 36 90 1995 54 22 32 54 30 23 17 107 1996 29 3 27 82 33 49 33 129 1997 35 10 25 85 47 38 23 168 1998 47 20 27 85 45 40 7 171 1999 45 16 29 22 -8 30 13 182 2000 34 5 29 7 -10 17 12 166 2001 35 8 28 -7 -18 11 6 175 2002 23 -9 32 0 -11 11 6 154 2003 29 -14 43 23 -4 27 25 152 2004 33 -14 47 55 -8 63 27 166
Total
113
146
210
213
232
273
310
310
261
220
210
184
229
281
Source: World Bank, Global Development Finance
Developing Countries' Debt Outstanding, 1970-2004
(Billions of US Dollars)
Type of Debt Long-Term Debt Public and publicly guaranteed Private nonguaranteed Loans from the IMF Short-term debt Total debt 1970 61 45 15 1 9 70 1980 407 339 68 12 122 541 1985 757 672 85 38 134 929 1990 1,099 1,039 60 35 203 1,337 1995 1,566 1,346 220 61 345 1,972 2000 1,907 1,363 543 58 317 2,283 2004 2,041 1,459 582 96 460 2,597
Debt/GNP ratio (percentage) Debt service-exports (percentage)
10.6 NA
21.4 12.8
33.4 24
36.1 19.7
39.6 17.1
40.2 20.0
35.2 12.5
Source: World Bank, Global Development Finance
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2. Exogenous negative international shocks
When exogenous international shocks hit a country's economy, international lenders and borrowers must reassess the borrower's ability to meet its obligations. For example, the fall in the international price of important exports for the borrowing country. Another example is the increase of the interest rate in the international market. This increases the cost of servicing the loan.
3. Excessive exposure to exchange rate risks
Sometimes the international debt is denominated in the foreign currency. If the loan is denominated in hard currencies, its cost is usually lower. However, this exposes the lender to an exchange rate risk. A depreciation of the national currency compromises the ability of the borrower to repay the loan.
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4. Volatile international short-term lending
This is a problem because the lenders may refuse to re-finance the borrower when these loans expire. With long-term loans and a balanced expiration structure, only a fraction of the total debt need to be refinanced every quarter or every year. For example, in the Mexican crisis of 1994-95, an important role was played by the inability of the government to refinance the short-term tesobonos.
5. Global contagion
When a crisis hits one country, it usually spreads to other countries. Contagion may work through different channels. For instance, the economic difficulties of one country may be transmitted to other countries through international trade. Sometimes it can result from an over-reaction of lenders who interpret the bad news from one country as necessarily implying that bad news will quickly arrive from other countries. Sometimes is the recognition of real problems similar to the problem found in the originating country.
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Resolving Financial Crises
1.
Rescue package by the IMF, World Bank or Governments.
It compensates for the lack of private lending during the crisis. It can restore investor confidence by signaling international support. It may reduce the contagion to other countries. The rescuers usually recommend policy reforms. The expectations of these package create moral hazard problems.
2.
Debt restructuring (rescheduling and reduction)
This is difficult because it requires the coordination of a large number of creditors. Each creditor has an incentive not to participate in restructuring the debt (free riding).
Reducing the Frequency of Financial Crises
1.
2.
3.
4.
Developing countries should adopt macroeconomic policies that do not create conditions for over-borrowing. Developing countries should avoid short-term borrowing denominated in foreign currency. Improve the regulation and supervision of the banking sector, reducing the propensity to take excessive risk. Other proposals are controversial:
Countries should not try to keep a fixed exchange rate. Countries should impose capital controls, especially on short-term flows. The IMF should not intervene. It creates moral hazard problems as investors rely on the IMF intervention for the repayment of the loans.
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How responsive are net exports to the exchange rate?
Real exchange rate and net exports for the US
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Net exports respond with delay
After a dollar depreciation, it takes a while for the quantities of imported goods to decrease and the quantities of exported goods to increase. Because in the short-term we pay more for the imports, the value of net exports deteriorates. So a depreciation makes things worse. Only in the long-term the value of net exports improve (the J-curve). The current pattern of the US trade deficits exceeds the typical delay (about 18 months).
Would import tariffs reduce the US trade deficit?
An increase in tariffs would not necessarily reduce the trade deficit. It may reduce both imports and exports.
Fewer imports would mean fewer dollars flowing into the international currency markets, raising the value of the dollar relative to other currencies. The stronger dollar would make U.S. exports more expensive for foreign consumers and imports more attractive to Americans. Then exports would fall and imports would rise.
Another way to think about it is as follows: If the U.S. imports less from Japan, then the Japanese have fewer dollars to spend on U.S. goods. As a result U.S. exports to Japan would decline.
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Would import tariffs improve the US trade deficit? (continue)
The main determinant of the trade balance is the difference between National Savings and Domestic investment.
S N = I + CA
SN = National savings I = Private and Government investment CA = Current account balance (Net international lending)
Therefore, the only way to change the trade deficit is to increase savings or reduce investment.
The Forward Exchange Market
1.
It can be used to hedge against the exchange rate risk. To speculate against the appreciation or depreciation of a particular currency.
2.
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Uncovered interest parity
e Nom (1 + i For ) ex e Nom
1+ i =
i = Domestic nominal interest rate iFor = Foreign nominal interest rate eNomex = Expected future spot exchange rate eNom = Current spot exchange rate
(1+i) is the gross return, in domestic currency, from investing in domestic assets (e.g. government bonds). (eNom/eNomex)(1+iFor) is the expected gross return, in domestic currency, from investing in foreign assets. Investment arbitrage for risk neutral investors requires that the two investment opportunities have the same expected return.
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Covered interest parity
e Nom (1 + i For ) f
1+ i =
f =Forward exchange rate
(1+i) is the gross return from investing in domestic assets (e.g. bonds). (eNom/f)(1+iFor) is the return, in domestic currency, from investing in foreign assets and using the forward market to hedge against the exchange risk. Investment arbitrage by risk-neutral operators implies that:
f t = e tex 1 +
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