Lecture 1 ECON30621

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Chapter One

Introduction to the World Economy

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Chapter One Outline

1. Introduction

2. Studying international economics

3. International interdependence

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Introduction

International Economics is the main vehicleof international interdependence

(globalization) through: International trade in goods International trade in services

International capital flows

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Introduction

Microeconomicsstudies production and consumption of goods andservices, and how firms, industries, and marketswork

Macroeconomicsstudies entire economys operations and the factorsthat determine total economic output

International Economicsa blend of Micro and Macro that studies theproduction, consumption, and distribution of goods,services, and capital on worldwide basis

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Studying International Economics

International economics usually divided into twoparts:

1) Theory of international trade: Expends

microeconomic analysis to global questions. Goods and services available to consumers are

maximized when each country specializes in producingthose goods that it can produce relatively efficiently.

Significant political pressure forprotectionist policies:Restrict global trade to protect domestic producers fromforeign competition.

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Studying International Economics

2) International finance, balance-of-paymentstheory, or open-economy macroeconomics. Applies macroeconomic analysis to aggregate

international problems. Major concerns:

Level of employment and output

Changes in price level, balance of payments, andexchange rates (relative prices of different national

currencies). Interaction of international goals and influences with

domestic ones in determining a nations macroeconomicperformance and policy.

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International Interdependence

Interdependence in financial markets.

Has grown faster than that in markets for oil,steel, and cars.

24-hour global trading in stocks, currencies,and bonds.

In April 2010, average daily turnover of foreignexchange was approximately $4 trillion.

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Figure 2:Daily Turnover in Foreign Exchange Markets,1986-2004 (Trillions $)

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Global financial interdependenceyields opportunities for international

investment. Lenders fund projects regardless of the

projects locations.

This growth of global trade has resultedfrom declines in costs of transportation andcommunication.

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Cost of a

3-minute

phone call

New Yorkto London

Figure 3:Transport and Communication Cost, 1930-1990(Index 1930 = 100)

01930 19901940 1950 1960 1970 1980

20

40

60

80

100

120

Index(1930 = 100)

Year

Average

air-transport cost

per passenger mile

Average ocean freightand port charges

per short ton of cargo

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Symptoms of internationalinterdependence.

Rapid expansion of international trade. Since 1950, trade has grown twice as fast as

production.

Global trade improves individuals potential

well-being by increasing the quantity of goodsand services available to consume.

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2

4

6

8

10

1950-63 1963-73 1973-90 1990-2002

Output

Trade

Figure 4a:Growth in World Merchandise Trade & Output,1950-2002 (Percent)

12

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Figure 4b:Growth in World Merchandise Trade & Output,1990-2002 (Percent)

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A second symptom of this globalinterdependence:

Synchronized changes inmacroeconomic activity across countries.

Tendency toward simultaneous booms andrecessions.

Cautionary note: perhaps mere coincidenceproduced these patterns.

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Figure 8:Industrial Production in the MajorIndustrialized Economies, 1979-2003

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International Monetary Economics

Now that we have highlighted the importanceof International Economics throughinternational interdependence of economic

factors

lets examine in closer detail International

Monetary Economics.

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Chapter Two

Currency Markets andExchange Rates

2003 South-Western/Thomson Learning

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Chapter Two Outline1. Introduction

2. Exchange Rates and Prices

3. Demand and Supply in the Foreign ExchangeMarket

4. How Are Exchange Rates determined under aFlexible Regime?

5. How Are Exchange Rates determined under aFixed Regime?

6. Classification of Exchange Rate Regimes7. Foreign Exchange Markets

8. Interest Parity

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Introduction

One characteristic distinguishesinternational economic activity fromdomestic:

International transactions typically involvemore than one currency.

We now examine the mechanics ofcurrency markets and their role in globaltrade.

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Exchange Rates and Prices

What do prices tell us?

Relative prices convey information about

the opportunity costs of various goods. Relative price is sometimes referred to as a

goods real price means the price ismeasured in real units (other goods), rather

than monetary units.

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What do prices tell us?

We use money prices: they tell how manyunits of money (dollars, yen, etc.) we mustpay to buy goods.

Money prices must reflect relative prices oropportunity costs: if 1 unit ofXhas a price of

10 and 1 unit ofYa price of 5, then 1X=2Y, which is the opportunity cost of one goodin terms of the other.

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How can we compare prices in differentcurrencies?

Exchange rate: number of units of

domestic currency required to purchase 1unit of the foreign currency. (Note: a Britonwould view it as /$, while an American as$/). A change in the exchange rate, other things being

equal, changes all foreign prices relative to alldomestic prices.


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Foreign Exchange Markets

Foreign exchange market is generic term forthe worldwide institutions that exist toexchange or trade different countries

currencies. The participants are banks, firms,foreign exchange brokers, central banks, andother government agencies.

Daily exchange rate quotations:

Column one reports the number of U.S. dollarsrequired to buy one unit of foreign currency (e).

Column two reports the number of units of foreigncurrency required to purchase a U.S. dollar(e = 1/e).

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Exchange Rates (New York closing prices) Thursday, February 28, 2008

Americas(selected countries)

Europe(selected countries)

In US $ Per US $ In US $ Per US $

Argentina peso 0.3169 3.1556 Euro area euro 1.5214 0.6573

Brazil real 0.5992 1.6689 Switzerland franc 0.9520 1.0504

Canada dollar 1.0240 0.9766 1-mos forward 0.9524 1.0500

1-mos forward 1.0234 0.9771 3-mos forward 0.9526 1.0498


6-mos forward 1.0201 0.9803 Turkey lira 0.8452 1.1832

Chile peso 0.002196 455.37 UK pound 1.9917 0.5021

Colombia peso 0.0005438 1838.91 1-mos forward 1.9877 0.5031

Ecuador US dollar 1 1 3-mos forward 1.9789 0.5053

Mexico peso 0.0937 10.6735 6-mos forward 1.9654 0.5088

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Demand/Supply in Foreign ExchangeMarkets

Demand curve for a foreign currency: showshow many units of the currency individuals wouldwant to hold at various exchange rates.

Relationship between the quantity demanded of foreignexchange and the spot exchange rate (expressed as thedomestic currency price of a unit of foreign currency) is anegative one.

As the exchange rate rises, the quantity of foreign

exchange demanded falls. The negatively sloped line in Figure 5 illustrates the

negative relationship between the quantity demandedof foreign exchange and the exchange rate.

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Figure 5: The Exchange Rate and theQuantity Demanded of Foreign Exchange

e = /$

D$

e1: 2 = $1

e2: 1 = $1

0 Quantity Demanded of $

Th

egainsvalueagainstthe$

Th

elosesvalueagainstthe$

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The supply curve for a foreign currencyshows how many units of foreign currency areavailable for individuals to hold at variousexchange rates. Because the stock of foreign currency available at

any time is fixed (depends on central bank andcommercial banks loan decisions), one canrepresent the supply of foreign exchange by a

vertical line, S$, in Figure 6. The supply curve is vertical because the supply of

deposits in existence at any time does not depend onthe exchange rate.

Demand/Supply in Foreign ExchangeMarkets

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Figure 6: The Supply of Foreign Exchange

e = /$

0 Quantity Supplied of $

S$

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Exchange rate regime: in each country,the monetary authorities decide the type ofpolicy to follow regarding the exchangerate.

Four types of regimes:1. Flexible or floating exchange rates;

2. Fixed or pegged exchange rates;

Special case: Official (Full) Dollarization3. Managed floating (a mixture of flexible and

fixed); and

4. Exchange controls.

Exchange Rate Regimes

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Exchange Rate Determination under aFlexible Rate Regime

Since the 1970s, most countries have moved towardsthe use of flexible, or floating, exchange rates.

Demand for and supply of each currency in FX market

determine the exchange rate. Figure 7 shows the equilibrium exchange rate (e3) between

the dollar and the pound.

The exchange rate moves to equate the quantitydemanded and the quantity supplied of pounds.

We call a rise in the market-determined rate a depreciationofthe currency whose price has fallen, and an appreciation ofthe currency whose price has risen.

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Figure 7: Equilibrium in the Foreign ExchangeMarket under a Flexible Rate Regime

e = /$

0 Quantity of $

Surplus

of $

Shortageof $

S$

D$Depreciationofthe,orapprec

iationofthe$

Appreciationofthe,ordeprec

iationofthe$

e3: 2 = $1

e1: 3 = $1

e2: 1 = $1

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Any change in economic conditions thatincreases the demand for a particularcurrency causes that currency toappreciate. These factors include: Domestic and foreign income (GDP).

Domestic and foreign interest rates (i).

Domestic and foreign price changes (P). Domestic and foreign expectations (ee, ef).

Non-economic factors (wars, political turmoil).

What Affects the Exchange Rates?(Flexible Rate Regime)

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Figure 8: Shifts in the Demand for ForeignExchange Change the Exchange Rate

e = /$

0 Quantity of $

S$

ieei

$

e

f

i

eei

$

ef

D$0

D$1

D$2

e0: 2 = $1

e2: 1 = $1

e1: 3 = $1

GDPUKGDPUK

PUSPUS

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Exchange Rate Determination under aFixed Rate Regime

Exchange rates have not been flexiblethrough most of modern economic history.

Central banks used fixed or peggedexchange rates for their respectivecurrencies.

Figure 9 shows a pegged exchange rate above

the equilibrium rate. To maintain the exchange rate at a certain point, a

central bank must stand ready to absorb the excessquantity supplied of a foreign currency.

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Figure 9: A Pegged Exchange Rate abovethe Equilibrium Rate

e = /$

e1

0 Quantity of $

Intervention

S$

D$

p

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Intervention: when a central bank steps intothe market to buy or sell a particularcurrency. If a countrys central bank chooses to adjust the

pegged exchange rate downward, the policy iscalled a revaluation of that currency. Analogous to an appreciation under a flexible

regime.

Figure 10 shows a pegged exchange ratebelow the equilibrium rate.


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Figure 10: A Pegged Exchange Rate belowthe Equilibrium Rate

e = /$

e2

0 Quantity of $

Intervention

S$

D$

p

E h R t D t i ti d

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For intervention purposes, governments holdstocks of deposits denominated in variousforeign currencies, called foreign exchange

reserves. Depletion of these reserves due to support of

fixed rate lead to Foreign exchange borrowing from foreign central

banks or IMF to continue intervention. Reset the pegged rate at a higher level.

Allow the exchange rate to flow.


E h R t D t i ti d

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Under a fixed regime, if the central bankchooses to reset the exchange rate at a levelhigher than equilibrium, the policy is called a

devaluation. This is analogous to a depreciation under a flexible

regime.

Later we will discuss the implications of a fixedexchange rate regime for the conduct ofmacroeconomic policy (induces uncertainty).


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Classification of Exchange Rate Regime(Rose, 2011)

Classification of regimes is not straightforward

Based on Official statements of de jure policy intent by

national authorities (IMF classification)

Actual de facto behaviour

Levy-Yeyati and Sturzenegger (2003) Reinhart and Rogoff (2004)

Shambaugh (2004)

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Classification of Exchange Rate Regime

These classifications are available For different spans of data across countries and

time

At different frequencies (monthly vs. annual)

With various numbers of classifications (two tofifteen)

At different levels of volatility (how often countriesswitch regime)

They clash for some countries or periods

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Notes: Taken from Rose (2011)

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Choice of Exchange Rate Regime

What is the distribution of exchange rateregimes across the world?

Figure 1 shows that most countries fix their exchangerates

Figure 2 shows that only a small fraction of worldoutput has been produced in economies with fixedrates

Figure 3 shows that exchange rate regimes havebecome more persistent; switches are rare

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44Notes: Taken from Rose (2011)

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What is the distribution of exchange rateregimes across the world?

Figure 4 shows that small (population-wise) countriestend to fix their exchange rates; less than 2.5 million

people

Figure 5 shows that a countrys level of real income

plays no role in the choice of a regime

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To summarize Fixed rates characterize a large number of countries

but a small proportion of global GDP and marketactivity

Switches in exchange rate regimes are becoming rare

A disproportionate number of the smallest countriesof the world maintain fixed exchange rates

Beyond a point, population size has little effect onregime choice

Income has no impact on regime choice

F i E h M k t

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What type of transactions happen in foreignexchange markets? Each bank, firm, or individual must choose how to

allocate its available wealth among various assets. Asset: something of value.

Asset portfolio: set of assets owned by a firm orindividual. Portfolio choice: allocating ones wealth among various types of

assets in order to maximize future income.

Primary determinant of any particular assetsdesirability is its expected rate of return. However,these assets may be located in different countries;hence in different currencies.


F i E h M k t

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Spot exchange market: the market in whichparticipants trade currencies for current delivery,which actually means within two business days.

Clearing function of foreign exchange market Example: a U.S. firm decides to buy a British (firm or

government) bond. The U.S. firm typically enters the spotforeign exchange market to buy the pounds in which the

British firm wants to be paid. This happens when the U.S.firm instructs its bank to debit its dollar account and creditthe pound bank account of the British firm.


F i E h M k t

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Arbitrage: refers to process by which banks, firms, orindividuals seek to earn a profit by taking advantage ofdiscrepancies among prices that prevail simultaneouslyin different markets. It is a riskless process.

Ensures not only that currencies exchange at same rate indifferent locations, but that exchange rates will be consistentacross currencies.

Two-point arbitrage: use of 2 currencies in arbitrage.

Three-point (Triangular) arbitrage: use of 3 currencies in

arbitrage. Inconsistent cross-rates: quoted exchange rates in different

locations that offer arbitrage opportunities consistencyrestored by arbitrage actions.


Two Point Arbitrage

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Suppose eNY = $2/1 and eLON = $2.2/1, orequivalently eNY = 0.5/$1 and eLON = 0.45/$1.

How can an Arbitrager make a profit?

NY: sell $1, buy 0.5 ( appreciates)

London: sell 0.5, buy $1.1 ($ appreciates)

Outcome: profit of $0.1 per $1 traded.

Two-Point Arbitrage

Two Point Arbitrage

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Two-Point Arbitrage

0

$/

New York

0

0.5=$1

S

D

London

D$

/$

$

S$

0.45=$1

0.48=$1

0.48=$1

Three Point Arbitrage

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Suppose NY: 1 = $1, London: 1 = 2, and Tokyo: $3= 1.

How can an Arbitrager make a profit?

NY: sell $1, buy 1 ( appreciates)London: sell 1, buy 0.5 ( appreciates)

Tokyo: sell 0.5, buy $1.5 ($ appreciates)

Outcome: profit of $0.5 per $1 traded.

How would the results change if originally in Tokyo:$2 = 1?

Three-Point Arbitrage


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Hedging: a way to transfer part of the foreignexchange risk inherent in all non-instantaneoustransactions that involve two currencies.

Entering the foreign exchange market to hedge insulateswealth from effects of adverse changes in the exchangerate.

Short position: being short of a particular currency you willneed in the near future.

Balanced, or closed, position: owning as many units of aparticular currency as you need to cover your upcomingpayment in that currency.



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Speculation: just the opposite of hedging itmeans deliberately making your wealthdepend on changes in the exchange rateby

1. Buying a foreign currency (taking a longposition) inthe expectation that the currency's price will rise,allowing you to sell it later at a profit; or

2. Promising to sell a foreign currency in the near

future (taking a shortposition) in the expectationthat its price will fall, allowing you to buy thecurrency cheaply and sell it at a profit.


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Obviously, speculation becomes a much easier job ifone has inside information!

An interesting Washington Post piece on recent

inside information about Feds decision not to slowdown its bond purchases:

http://www.washingtonpost.com/blogs/wonkblog/wp/2

013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/

59

http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/24/traders-may-have-gotten-last-weeks-fed-news-7-milliseconds-early/

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Buying currency nowfor delivery later. Major markets for foreign exchange other than

spot markets are forwardmarkets.

Participants sign contracts for foreign-exchange

deliveries to be made at some specified future date.

30-day forward rate for pounds: the dollar price atwhich you can buy a contract today for a pounddeposit to be delivered in 30 days.

% difference between the 30-day forward rate (ef) on acurrency and the spot rate is called the forward premium ifpositive and forward discountif negative.



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Exchange Rates (New York closing prices) Thursday, February 28, 2008

Americas(selected countries)

Europe(selected countries)

In US $ Per US $ In US $ Per US $

Argentina peso 0.3169 3.1556 Euro area euro 1.5214 0.6573

Brazil real 0.5992 1.6689 Switzerland franc 0.9520 1.0504

Canada dollar 1.0240 0.9766 1-mos forward 0.9524 1.0500



6-mos forward 1.0201 0.9803 Turkey lira 0.8452 1.1832

Chile peso 0.002196 455.37 UK pound 1.9917 0.5021

Colombia peso 0.0005438 1838.91 1-mos forward 1.9877 0.5031

Ecuador US dollar 1 1 3-mos forward 1.9789 0.5053

Mexico peso 0.0937 10.6735 6-mos forward 1.9654 0.5088

Interest Parit

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Interest Parity

Uncovered interest parityapplies to transactions inwhich participants do not use forward markets totransfer foreign exchange risk.

Covered interest parityapplies to transactions inwhich they do.

Uncovered interest parity Individuals and firms must form an expectation

about the future spot rate of a particular currencyand base their asset decision on that. This expectation is called the expected future spot

rate(ee) what people expect today about the spotrate that will prevail in the future.

I t t P it

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Uncovered interest parity (cont.) When all participants in an economy choose between

purchasing dollar- and pound-deposits in a way to maximizeexpected rate of return, the result is a relationship amonginterest rates, the current spot rate, and the participants

expectations of the future value of the spot rate. Expected dollar rate of return on a dollar-denominated

deposit is just the interest rate (i$).

Expected dollar rate of return on a pound-denominateddeposit has 2 components: the interest rate on the deposit(i), and the expected rate of change in value of poundsrelative to the dollar ([ee e] / e).

Interest Parity

Interest Parity

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Uncovered interest parity (cont.)

Using the pound example in the text, the generalcase algebraically is:

If i$ < i + (ee-e)/e, purchase the pound-denominated deposits.

If i$

> i

+ (ee

-e)/e, purchase the dollar-denominated deposits.

Interest Parity

Interest Parity

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Uncovered interest parity (cont.) From the previous two equations, we see that there

will be no incentive to shift from one currency to theother when the expected dollar rates of return onthe two types of deposits are equal. This equilibrium condition is known as uncovered

interest parity. It holds when

General Case

i$ = i + (ee-e)/e

Numerical Example

2% = 1% + [($2.02/1 - $2.00/1)/$2.00/1)] = 2%

Interest Parity

Interest Parity

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Uncovered interest parity (cont.)An alternative way of writing the uncovered

parity condition puts the interest differential(i$ - i) on the left-hand side.

i$ - i = (ee-e)/e

The term on the right-hand side is the expected

increase (if positive) or decrease (if negative) in thevalue of pounds against dollars, expressed inpercentage terms.

Interest Parity

Interest Parity

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Covered interest parity Using the nominal interest at any country to find

the gross return on a deposit:

US: $f= $p (1+i$)

UK: f= p (1+i)

Divide: ($f / f)= ($p / p )[(1+i$) / (1+i)]

Or ef

= ep

[(1+i$

) / (1+i

)]

Or [(ef- ep) / ep](1 + i) = i$ - i

Interest Parity

$f= $ value at maturity

$p = $ value at present

Interest Parity

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Covered interest parity (cont.): Using the pound example in the text and

letting efrepresent the forward rate, the

general case is:If i$ < i + (ef-e)/e, purchase the pound-denominated deposits.

If i$ > i + (ef-e)/e, purchase the dollar-denominated deposits.

Interest Parity

Interest Parity

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69

Covered interest parity (cont.) Both the interest differential and the forward premium

or discount on foreign exchange must be taken intoaccount in choosing deposits denominated indifferent currencies based on their rates of return.

When participants make their decisions based on theprevious two equations, the resulting equilibriumcondition is known as covered interest parity. Itholds when

General Case

i$ = i + (ef-e)/e

Numerical Example

2% = 1% + [($2.02/1 - $2.00/1)/($2.00/1)] = 2%

Interest Parity

Interest Parity

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Does interest parity hold? Empirical support for the relationship is quite

strong, but the results are sensitive to the

testing technique. The parity relationship holds more closely

when all deposits used in the test are issuedin a single country.

A 2nd country could impose restrictions on themovement of funds across their borders.

Interest Parity

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Lecture 1 ECON30621

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