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Unformatted text preview: International Finance International Finance
Monetary Flows between Nations The International Role of Money The International Role of Money Until now trade has resembled barter Money avoids such constraints What if people in China don’t want dollars? People in U.S. must buy yuan first! U.S. sends laptops to China for textiles What if people in China don’t want laptops? Foreign Exchange Markets: Foreign Exchange Markets: The Demand for Yuan Who demands yuan? Downward sloping Americans who want Chinese goods/services Like for Chinesemade textiles P=$/yuan Why downward sloping? As price of yuan rises so does price of goods D Q (yuan) Foreign Exchange Markets: Foreign Exchange Markets: The Supply of Yuan Who Supplies? Upward sloping Chinese who want U.S. goods/services Like for textiles P=$/yuan S Why upward sloping? As price of yuan rises price of U.S. goods falls
Q (yuan) Foreign Exchange Markets: Foreign Exchange Markets: Equilibrium Pe is where D & S meet P=$/yuan Exchange Rate = equilibrium price of yuan If exchange rate is 0.1 $/ yuan: what is price of $1? Pe S D Q (yuan) What Shifts the Curves? What Shifts the Curves? Taste for U.S. (Chinese) goods & services Price level in the U.S. (China) Income level in the U.S. (China) Expectations of future exchange rates What Happens if … What Happens if … U.S. develops new, fuelefficient car? Inflation in China grows? China continues to grow while U.S remains mired in a recession? People begin to worry that the dollar will fall in value Dollar Has Fluctuated Wildly v. Dollar Has Fluctuated Wildly v. Euro Dollar Has Fallen v. Yen Dollar Has Fallen v. Yen Dollar Steady v. Yuan Dollar Steady v. Yuan Dollar Has Depreciated Lately Dollar Has Depreciated Lately Price of dollar has fallen in last few months $/¥ and $/€ Dollar has become weaker Price of foreign goods rise in U.S. Alternatively: price of other currencies has risen But not in Japan or Europe Depreciation is a relative measure Other currencies have become stronger Yen, & euro have appreciated Must be with respect to another currency Could depreciate wrt one & appreciate wrt other What Causes a Currency to What Causes a Currency to Depreciate? Trade Deficit (XM < 0) Speculation Domestic products undesirable to foreigners Relatively high domestic inflation: products become expensive Relatively high domestic growth: high consumption of all goods Expectations cause Demand & Supply to shift Why have the 3 currencies moved differently v. $? Manipulation/Managed exchange rates Is a Weak Dollar Bad? Is a Weak Dollar Bad? Bad for those buying foreign goods Good for those selling goods to foreigners Imports more expensive U.S. tourists abroad cannot afford as much Exports cheaper Foreign tourists in U.S. buy more The Balance of Payments The Balance of Payments Exchange rate is set by total international monetary flows Balance of payments records these flows Basic premise: payments must balance! Trade is only one aspect Consists of current account and capital account Monetary inflows must equal outflows Must get money from abroad to spend it abroad The Current Account The Current Account Shows net flows of income across borders Net exports: XM Net return on assets Net transfers: + Return on domesticallyowned foreign assets Return on foreignowned assets here + Received from foreigners – Paid to foreigners None of the above has to balance The Capital Account The Capital Account Looks at capital market Net purchases of capital Physical and longterm financial capital Purchase of bonds here – return on current account + Purchases of domestic capital by foreigners Purchases of foreign capital by natives Could have surplus or deficit Surplus on one account must match deficit on the other account Purchasing Power Parity Purchasing Power Parity Applies the law of one price internationally What happens if prices in China double? UM tshirts should cost the same in AA Traded goods should cost the same internationally Purchasing power the same wherever you buy $/Yuan falls by half Cost of Chinese goods to U.S. stays the same Purchasing power stays the same The Big Mac Index The Big Mac Index A cute test of PPP Big Macs available the world over Price should be roughly the same everywhere Economist looks at Big Mac prices and exchange rates to test PPP The Big Mac Index (7/09)
Country Local Cost of Big Mac Exchange Rate Implied by PPP Actual exchange rate Actual Cost in US$ Deviation USA Canada China Euro Area Japan $3.57 C$3.89 Yuan 12.5 Euro 3.31 Yen 320 1.09 3.50 1.08 89.6 1.16 6.83 1.39 92.6 $3.57 $3.35 $1.83 $4.62 $3.46 6% 49% +29% 3% Why Doesn’t PPP Always Hold? Why Doesn’t PPP Always Hold? PBig Mac is not identical to THE price level Big Macs are not perfectly transportable Trade policies can interfere with free flow of goods and funds Why Are We Mad At China? Why Are We Mad At China? We have ~$200 Billion trade deficit with China Why? Yuan is pegged to dollar (actually a mix of currencies) U.S. rich – Chinese goods cheap Look back at Big Mac Index Exchange rate is fixed – not allowed to vary When dollar depreciates wrt euro – so does yuan Exchange rate doesn’t “correct” trade imbalances What if Dollar Depreciated What if Dollar Depreciated Assume Big Mac index was right and yuan/$ fell by about half Price of Chinese goods would double Value of U.S. bonds to Chinese would fall CPI would jump Cost of living would rise Supply of loanable funds would fall Interest rates would rise ...
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- Fall '08