Eco 344 International Economic Relations 1. Instructor 2.

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Eco 344

International Economic Relations

Instructor

• www.fsb.muohio.edu/lij14/

Office

Textbook• Robert C. Feenstra

University of California, Davis• Alan M. Taylor

University of California, Davis

Quiz (no grade)First Name_____, Last Name_______, Major_____

• Q1: What would happen to the oil price if the civil war in Libya ends now? Please use the demand-and-supply diagram.

• Q2: People say that we need to bring jobs back to US from overseas. But how? Give one or two suggestions.

World Economy in 2010

http://www.economist.com/blogs/dailychart/2010/12/charts_2010Do you want to buy house soon?Do you want to complain about no salary raise?What happens to unemployment rate in US?Why are the young people in Egypt so unhappy?What’s wrong with Ireland and Greece?

Suggestions to bring jobs back

• Tax• Tariff• Minimum Wages• Education, Infrastructure• New Jobs

My Comments

• Most oversea jobs are labor-intensive. USA does not have (comparative) advantage producing labor-intensive goods.

• Companies make decisions. A workable solution should agree with companies’ interests.

• Tariff may trigger trade war.

External Debt

• US is running (current account) deficit because expenditure exceeds income

• The deficit is financed by borrowing from other countries (How about printing money?)

• The absolute amount of US external debt is huge• Other countries have higher debt-income ratios

than US• http://

en.wikipedia.org/wiki/List_of_countries_by_external_debt

Default on US Debt?

• Interest rate will go up• Investment will go down• Stock price will go down• Consumption will go down• Export will go down• Fiscal deficit will go up• Less confidence in US

Credit Ratings of Sovereign Debts

• Credit score for country• http://

en.wikipedia.org/wiki/List_of_countries_by_credit_rating

• BB+ or lower is junk bond• What’s wrong with Argentina?

International Perspective

• http://chartsbin.com/graph• www.google.com

(Bilateral) Exchange Rate

• Exchange rate is price of currency• Two ways to quote exchange rate• One way is the reciprocal of the other:

EA/B = 1/ EB/A

• Currency A appreciates if EB/A goes up

• Currency A appreciates if EA/B goes down

• To avoid confusion we use EA/B for currency A

Multilateral (Effective) Exchange Rate

• Available at http://research.stlouisfed.org/fred2/categories/15

• Trade-weighted average of bilateral exchange rate

• Does currency A appreciate or depreciate against other currencies in general?

US Effective Exchange Rate

Discuss

• What is the variable on vertical axis?• Why are there two lines?• Has dollar depreciated or appreciated in

general?• Why is the red line steeper than the blue line?

Using Exchange Rates to Compare Prices

• PA is the currency-A price

• PB is the currency-B price• Which price is cheaper?

PA <> PB x EA/B

PA <> PB / EB/A

Exchange Rates and Trade

• What happens to country A’s export and import if currency A depreciates?

• EA/B goes up

• The price of imported goods PB x EA/B goes up, so import goes down

• The price of exported goods PA / EA/B goes down, so export goes up

• In short, depreciation helps export but hurts import

Argentina’s Crisis Revisited

• During the 2002 (Peso) crisis, Argentina’s currency depreciated against US dollar

• Argentina’s export to US improved• But, the price of imported goods went up, so

inflation was high

Discuss: Chinese Yuan

• Suppose Yuan appreciates against US dollar• What happens to US export to China?• What happens to US import from China?, and,

from other countries like Vietnam?• What happens to US inflation rate?

Review

• Two ways to quote exchange rate (Corn Story)• If currency A depreciates against B, then B must

appreciate against A• Depreciation increases export • Depreciation decreases import • Intuition is, if our currency becomes cheap

(depreciate), our goods become cheap too. So more foreign people want to buy our goods and our export to foreign countries rises.

• Appreciation has opposite effects

Japanese Intervention

• Yen’s appreciation hurts Japanese export• To stop the appreciation of Yen, supply curve

for Yen should shift to right • Japanese central bank sells (supplies) Yen and

buys (demands) dollars • Reality Check:http://www.usatoday.com/money/world/2011-08-04-japan-yen-intervention_n.htm

Chinese Intervention

• To keep Yuan from appreciating, Chinese central bank keeps selling Yuan and buying dollars

• China’s dollar reserve accumulated, and money supply increased

• Inflation rate in China went up• China is importing inflation (or expansionary

monetary policy, QE) from US due to its fixed exchange rate

• Letting Yuan appreciate helps mitigate inflation in China

1997 Asian Financial Crisis

• Some Asian currencies were overvalued, and were expected to depreciate

• To stop depreciation, their governments sold US dollar and bought domestic currencies

• The crisis (the rapid depreciation) occurred when the government ran out of dollar reserve

• http://en.wikipedia.org/wiki/1997_Asian_financial_crisis

Exchange Rates: Developed Countries

Exchange Rates: Developing Countries

Remarks

• 1997 Asian Crisis• 2002 Argentina Crisis• Denmark uses fixed exchange rate against

Euro• Ecuador dollarized in 2000, see http://

en.wikipedia.org/wiki/Dollarization• Euro was introduced in 1999, see http://

en.wikipedia.org/wiki/Euro

Spectrum of Exchange Rate Regimes

Foreign Exchange (FX) Market

• Spot Contract; Spot Rate; Immediate Exchange of One Currency for Another

• Derivatives (Forwards, Swaps, Futures, Options)

• For forward contract, the delivery of currency is in the future

• Forward rate tracks spot rate closely.

Spot and Forward Rates

Remarks about FX Market

• The FX market is highly volatile (risky)• Government is an important player• Some currencies are not fully convertible due

to reasons such as capital control• Transactions on FX market have different

purposes: hedging, speculation, arbitrage, government intervention….

Arbitrage

• Arbitrage means buying low and selling high• Arbitrage push prices to converge• Everyone buys low, so the low price will go up• Everyone sell high, so the high price will go

down• Prices become stable when prices become

equalized (No Arbitrage Condition).

Theory of Exchange Rates I: No-Arbitrage with Two Currencies

• E1/2, A denotes the exchange rate at location A

• E1/2, B denotes the exchange rate at location B• No-arbitrage condition requires that

E1/2, A = E1/2, B

• In reality the two rates can differ due to factors such as transaction cost

Two facts

• Currency A appreciates (become more expensive) ↔ EA/B goes down

• Currency A depreciates (become less expensive) ↔ EA/B goes up

• You can avoid many confusions if you keep these two facts in mind

• When the corn price changes from Ecorn/$= 4 to Ecorn/$= 5 , the corn becomes cheaper

• Unit Europe monetarily: One central bank • Remove (part of) risk of foreign exchange• Make it easy to travel and do business within

Eurozone• Next, one Treasury?

http://www.nytimes.com/2011/09/06/business/global/reluctantly-europe-inches-closer-to-a-fiscal-union.html?_r=1&hp

• Challenge: heterogeneity in members

• http://olesiafx.com/Kathy-Lien-Day-Trading-The-Currency-Market/George-Soros-the-Man-Who-Broke-The-Bank-Of-England.html

Q 5 on Page 61

• Suppose quotes for the dollar-euro exchange rate E$/€ are as follows: in New York $1.50 per euro, and in Tokyo $1.55 per euro. Describe how investors use arbitrage to take advantage of the difference in exchange rates. Explain how this process will affect the dollar price of the euro in New York and Tokyo.

Answer

• Euro is more expensive at Tokyo• Buy euro at New York and sell euro at Tokyo• The New York rate, 1.50 will go up• The Tokyo rate, 1.55 will go down• Trick for exams: arbitrage always pushes lower

rate up and higher rate down (i.e., Two rates converge).

Theory of Exchange Rates II: No-Arbitrage with Three Currencies

• E1/3 is the direct rate

• E1/2 E2/3 is the cross rate, and currency 2 is called vehicle currency

• No triangular-arbitrage condition requires that E1/3 = E1/2 x E2/3

or equivalently,E1/3 = E1/2 / E3/2

• In short, arbitrage pushes the direct rate and cross rate to be equal

Covered Interest Parity (CIP)Theory for Forward Exchange Rate

• F denotes the forward (exchange) rate• An investor can use dollar deposit• Alternatively an investor can convert dollar to

euro using spot rate, use euro deposit and later convert euro back to dollar using forward rate

• No arbitrage condition implies that

deposits euroon return Dollar

€/$€

depositsdollar on return Dollar

Remarks about CIP

• We can solve for forward rate if we know interest rates and spot rate

• Forward rate and spot rate are positively correlated, explaining Figure 2-5 on page 40

• CIP implies that

Premium Forward

€/$ €/$

alDifferenti RateInterest

€$ E

Evidence on CIP

Uncovered Interest Parity (UIP)Theory for Spot Exchange Rate

• No-Arbitrage also indicates UIP, which states that

deposits euroon returndollar Expected

€/$€

depositsdollar onreturn Dollar

Implication of UIP

• Everything else equal, a rise in American interest rate leads to a fall in current spot rate, i.e., instantaneous appreciation of dollar

• Everything else equal, a rise in American interest rate leads to a rise in expected future spot rate, i.e., expected future depreciation of dollar

Remarks about UIP

• We can solve for current spot exchange rate if we know interest rates and expected future spot rate

• The expected future spot rate is determined by the long-term PPP model discussed in the next chapter

• Big Picture:

Lesson for International Investment

• When making decision regarding international investment, one needs to take both interest rate and exchange rate into account

• If American interest rate is higher than euro interest rate, then according to UIP, dollar is expected to depreciate against euro

Drawbacks of UIP and CIP

• They are short-term models• They ignore the effect of trade on exchange

rate• One cannot apply UIP or CIP for countries with

capital control

Q 6 on Page 61

Bond Yields

• http://www.economist.com/blogs/dailychart/2011/09/government-bonds/print

• Bond price is negatively related to yield (interest rate)

• The yield of Greek bond is highest, so the price of Greek bond is lowest.

• US bond is still popular• Demand-and-supply diagram can be applied to

the bond market

Critical ThinkingFine-Tuning CIP and UIP

• Read key points 12-15 on page 59• We can improve a theory by relaxing its

assumption• Assumptions for the basic form of CIP and UIP:(a) No capital control(b) No tax(c) No fee for currency transaction(d) No inflation…

Modified CIP

• Let denote the inflation rate, the tax rate for interest payment, and the fee rate for foreign transaction. The modified CIP may look like

deposits euroon return Dollar

€/$€€€

depositsdollar on return Dollar

$$$ )1)(1(1)1(1E

Ffeetiti

Purchasing Power Parity (PPP)A Long-Term Theory for Exchange Rate

• Intuition: The long-run value of a currency is determined by its purchasing power

• Purchasing power is negatively related to price • The currency of a country with high inflation is

expected to lose its value, i.e., depreciate against a currency with low inflation

Law of One Price (LOOP)

• PPP is derived from LOOP• LOOP says that, under certain assumptions, arbitrage

force will make the same goods have same prices at different locations:

• When we generalize LOOP for a specific goods to a basket of goods we have absolute PPP:

(Absolute PPP)

levels price of Ratiorate Exchange

€/$ / EURUS PPE

Remarks about Absolute PPP

• When the US price goes up, the exchange rate of dollar against euro goes up, so dollar depreciates against euro.

• Intuition: when US price goes up, dollar loses its purchasing power (the same amount of dollar can buy less goods and services). So dollar becomes less valuable, and depreciates

Absolute PPP says

In long term, due to arbitrage:(1) The same basket of goods has the same

common-currency prices in different countries(2) Because of (1), nominal exchange rate equals

the ratio of price levels(3) Because of (1), the same currency has the same purchasing power in different countries(4) The real exchange rate equals one

Real Exchange Rate

• Macroeconomic counterpart for relative price• Real exchange rate is the nominal rate

corrected for price • Absolute PPP implies that the denominator

equals the numerator. So the real exchange rate, the whole ratio, equals one

Real Exchange Rate and Trade (I)

• International trade depends on real exchange rate, not nominal exchange rate

• is the price American consumers pay if the goods is made in US

• is the price American consumers pay if the goods is imported from Eurozone

• Importing or not depends on which price is higher, i.e., whether real exchange rate is greater or less than one.

Real Exchange Rate and Trade (II)

• US imports from Eurozone if >

or if <1• US exports to Eurozone

if < or if >1

Chinese Real Exchange Rate

• Chinese nominal exchange rate appreciates slowly• But, Chinese real exchange rate appreciates quickly,

because China has higher inflation rate than US• In other words, the prices of imported Chinese

goods will rise at a rate much higher than the appreciation rate of Yuan

• This helps rebalance US current account faster• http://

www.economist.com/blogs/freeexchange/2011/01/chinas_currency

Mathematical Notes

• Percentage change in (XY) = percentage change in X + percentage change in Y

• Percentage change in (X/Y) = percentage change in X - percentage change in Y

Percentage Change of Exchange Rate

• According to absolute PPP, exchange rate is ratio of prices

• Using the second mathematical note in the previous slide, we can derive a formula for the percentage change of exchange rate, called relative PPP.

Relative PPP

• Absolute PPP implies relative PPP:

rate exchange nominal theofon depreciati of Rate

,€/$

,€/$1,€/$

,€/$

, €/$

aldifferentiInflation

rate exchange nominal theofondepreciati of Rate

,€/$

,€/$tEURtUS

Implications of Relative PPP

Inflation Eurozone lower than isinfation US

sappreciate dollare US

,€/$

Inflation Eurozonen higher tha isinfation US

sdepreciate dollare US

,€/$

tEURtUSt

Long-Run Trend forDollar-Yen Exchange Rate

• http://finance.yahoo.com/q/bc?s=USDJPY=X+Basic+Chart&t=5y

US and Japan Inflation Rates

• http://www.tradingeconomics.com/

In Long Run, Relative PPP Works

In Short-Run PPP Fails

Remarks

• Absolute PPP says the level of exchange rate is determined by the price ratio

• Relative PPP says that the change of exchange rate is determined by the inflation differential

• Absolute PPP implies relative PPP, not vice versa.

Why Does PPP Fail?

• Transaction Cost• Non-Traded Goods• Imperfect Competition and Legal Obsacles• Price Stickiness

Monetary Model for Exchange Rate

• Absolute PPP says that exchange rate is determined by price ratio

• So we need a theory to explain price• The theory is called Quantity Theory of Money

Quantity Theory of Money

denotes the aggregate money demand, denotes a constant that measures how much demand for liquidity (money) is generated for each dollar of nominal income (the inverse of is the income velocity of money), the price level, and Y the real income.

Money Market

• When the money market is in equilibrium, the demand and supply of money are equal:

• Then we get a formula (theory) for price level

Remarks

• implies that(1) Everything else equal, price will go up if

money supply (numerator) rises(2) Everything else equal, price will go down if real

income (denominator) rises(3) where denotes the inflation rates, the growth rates of money supply, and the growth rates of real income.

Monetary Model

• (3-3)• (3-6)

Hyperinflation

• If inflation is very high, PPP holds even in short run

L is not constant when inflation is high

Story of Hyperinflation

• Huge budget deficit leads to• Printing a lot of money, which leads to• Hyperinflation, which leads to• Rapid deprecation, which leads to• Dollarization or Redenominating (see Side Bar

on page 90)

Fixed Exchange Rate

• China uses fixed exchange rate. Relative PPP still applies:

• Fixed exchange rate means zero depreciation (or appreciation) rate.

• China needs to anchor its inflation as

aldifferentiInflation

Yuan Chinese ofondepreciati of Rate

$/USChina

USChina

Remarks

• If US increases money supply, China needs to increases money supply too if China wants to keep exchange rate fixed

• If US increases money supply, but China does not want to increase its money supply, then China has to let its currency appreciate

How to Anchor Inflation

• One way to anchor inflation is to target money supply, , according to Quantity Theory of Money

• The other way to anchor inflation is to target nominal interest rate, , according to Fisher equation

Homework: Q-7 on page 107

Eco 344 International Economic Relations 1. Instructor 2.

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