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International Finance

Macroeconomics ECO 110/1, AAU Lecture 12. International Finance. Eva Hrom á dkov á , 10.5 2010. Overview. What determines the value of one country’s money as compared to the value of another’s? What causes the international value of currencies to change ?

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International Finance

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  1. Macroeconomics ECO 110/1, AAU Lecture 12 International Finance Eva Hromádková, 10.5 2010

  2. Overview • What determines the value of one country’s money as compared to the value of another’s? • What causes the international value of currencies to change? • Should governments intervene to limit fluctuations of exchange rate?

  3. Exchange Rates • Theexchange rateis the price of one country’s currency expressed in terms of another’s. • e.g: • CZK/EUR = 25.965 • CZK/USD = 20.374 • And also • EUR/CZK = 0.0385 • USD/CZK = 0.0491

  4. Foreign-Exchange Markets • Currency is a commodity to be bought and sold like any other. • Foreign-exchange marketsare places where foreign currencies are bought and sold. • An exchange rate is subject to the same influences that determine all market prices: demand and supply. • We will look at the example of the Czech crown LO1

  5. Foreign-Exchange MarketsThe Demand for CZK • The market demand for Czech crowns originates in: • Foreign demand for Czech exports: • E.g. tourist in Czech restaurants • Foreign demand for Czech investments: • E.g. when Telefonica O2 bought Eurotel • Speculation. LO1

  6. Foreign-Exchange MarketsThe Supply of CZK • The demand for foreign currency represents a supply of Czech crown. • The supply of dollars originates in: • Czech demand for imports • E.g. import of IPods • Czech investments in foreign countries. • Speculation. LO1

  7. The Value of the CZK • A higher crown price for euros (# of CZK for 1 euro) will raise the crown costs of German goods. LO3

  8. Foreign-Exchange Markets The Supply Curve • The supply of CZK is upward-sloping. • If the value of the CZK rises, Czechs can buy more euros/dolars. The Demand Curve • The demand for CZK is downward-sloping • As CZK becomes cheaper, all Czech exports effectively fall in price – higher demand LO1

  9. 3.0 2.5 2.0 EURO PRICE OF CZK (euros per dollar) 1.5 0.5 0 QUANTITY OF CZK per time period Foreign-Exchange MarketEquilibrium Supply of CZK Equilibrium 0.90 Demand for CZK LO2

  10. The Balance of Payments • Thebalance of paymentsis a summary of a country’s international economic transactions in a given period of time. • It is an accounting statement of all international money flows in a given time period.

  11. 1. Trade Balance • The trade balance is the difference between exports and imports of goods and services. Trade balance = exports – imports • A trade deficit represents a net outflow of currency to the rest of the world. • We had to buy foreign currency to import those goods and services => outflow of our currency

  12. 2. Current-Account Balance • Includes trade balance as well as investment balances and private transfers

  13. Capital account balance Foreign purchase of domestic assets Domestic purchases of foreign assets = – 3. Capital-Account Balance • The capital account balance takes into consideration assets bought and sold across international borders. • Ex.: domestic bonds, foreign companies, …

  14. Net balance of payments current-account balance capital-account balance 0 = = – 3. Capital-Account Balance • The capital-account surplus must equal the current-account deficit. • Flow of money against the flow of goods and services

  15. Market Dynamics • Exchange rates on foreign-exchange (FX) markets are always changing in response to shifts in demand and supply. LO2

  16. Depreciation and Appreciation • Depreciation (currency)refers to a fall in the price of one currency relative to another. • Appreciationrefers to a rise in the price of one currency relative to another. • Whenever one currency depreciates, another currency must appreciate! LO2

  17. Market Forces • Some of the more important reasons supply and/or demand may shift: • Relative income changes. • Higher income in country A => higher demand for imports => appreciation of country’s B currency • Relative price level changes. • Changes in product availability. • Relative interest-rate changes. • If interest rate in country A goes up, it will increase demand for investment => appreciation of country A’s currency • Speculation – based on anticipation LO2

  18. Yen Price of Dollar Euro Price of Dollar Quantity of Dollars Quantity of Dollars Shifts in FX MarketsIntroduction of Japanese luxury cars in US Dollar-euro market Dollar-yen market S2 S1 S1 S2 P2 P1 P1 P2 D D LO2

  19. The Asian Crisis of 1997-1998 • The Asian crisis of 1997-1998 was caused by several market forces moving in the same direction at the same time. • In July 1997, the Thai government decided the baht was overvalued and let market forces find a new equilibrium • Within days, the dollar price of the baht plunged 25 percent and the Thai price of the U.S. dollar increased.

  20. The Asian Crisis of 1997-1998 • The devaluation of the baht had a domino effect on other Asian currencies. • Holders of the Malaysian ringget, the Indonesian rupiah and the Korean won rushed to buy U.S. dollars. • This pushed the value of local currencies even lower

  21. The Asian Crisis of 1997-1998 • The “Asian contagion” wasn’t confined to that area of the world • Hog farmers in the U.S. saw foreign demand for their pork evaporate. • Koreans stopped taking vacations in Hawaii. • Thai Airways canceled orders for Boeing jets. • This loss of export markets slowed economic growth in the United States, Europe, Japan, and other nations.

  22. Resistance to Exchange-Rate Changes • People / investors / firms crave stable exchange rates • This resistance to exchange rate changes originates in various micro and macro economic interests.

  23. Resistance to exchange rate changesMicro Interests • People who trade or invest in world markets want a solid basis for forecasting future costs, prices, and profits. • Fluctuating currency exchange rates are an unwanted burden on trade, as a change in the price of a country’s money automatically alters the price of all of its exports and imports • Import-competing industries suffer when currency depreciations make imports cheaper • E.g. steel from Russia and Japan in US LO3

  24. Resistance to exchange rate changesMacro Interests • A micro problem that becomes widespread enough can turn into a macro one. Example of US: • The huge U.S. trade deficits of the 1980s effectively exported jobs to foreign nations. • Trade deficits were offset by capital-account surpluses – foreign investment in US, increase of US foreign debt and interest costs LO3

  25. Exchange-Rate Intervention • Governments often intervene in foreign-exchange markets to achieve greater exchange-rate stability. LO2

  26. Fixed Exchange Rates • One way to eliminate fluctuations is to fix the exchange rate • Gold Standard - An agreement by countries to fix the price of their currencies in terms of gold; a mechanism for fixing exchange rates. • each country determines that its currency is worth so much gold • Bretton-Woods, 1944 LO2

  27. Fixed exchange rateBalance of Payment Problems • Market supply and demand of currency naturally shift (e.g. changing demand for imports) • This moves the equilibrium exchange rate away from the fixed exchange rate => excess demand for certain currencies • E.g. higher demand for IPods – higher demand for USD – at given exchange rate limited supply – excess demand for USD LO2

  28. Fixed exchange rateBalance of Payment Problems • Excess demand for a foreign currency implies: • balance-of-payments deficit for the domestic nation, • A balance-of-payments surplus for the foreign nation. • There are only two ways to deal with balance-of-payments problems • Allow exchange rates to change. • Alter market supply or demand so that they intersect at the established exchange rate. • Only second alternative is viable LO2

  29. Dollar Price of Pounds 0 Quantity of Pounds Fixed Rates and Market Imbalance D2 D1 S1 Excess demand for pounds e2 e1 qS qD LO2

  30. Fixed exchange rate The Need for Reserves • Existence of Foreign-Exchange Reserves- Holdings of foreign exchange by official government agencies, usually the central bank or treasury. • The central bank can help maintain the officially established exchange rate by selling some of its foreign exchange reserves. LO2

  31. Dollar Price of Pounds Excess demand 0 Quantity of Pounds The Impact of Monetary Intervention D2 S1 S2 e1 qS qD LO2

  32. Fixed exchange rate The Need for Reserves • Foreign exchange reserves may not be adequate to maintain fixed exchange rates. Case of USA I: • The long-term string of U.S. balance-of-payments deficits overwhelmed its stock of foreign exchange reserves • Gold reserves (stocks of gold held by a government to purchase foreign exchange) are a potential substitute for foreign-exchange reserves LO2

  33. +$4 +2 0 –2 Balance (billions of dollars) –4 –6 –8 –10 1950 1955 1960 1965 1970 1973 1975 The U.S. Balance of Payments: 1950 – 1973 Surplus Deficit

  34. Fixed exchange rate The Need for Reserves Case of USA II: • Continuing U.S. balance-of-payments deficits exceeded the holdings of gold in Fort Knox. • As a result, U.S. gold reserves lost their credibility as a potential guarantee of fixed exchange rates. • September 15, 1971 – Bretton-Wood golden standard was abolished LO2

  35. Fixed exchange rate Domestic Adjustments • Trade protection can be used to prop up fixed exchange rates. • Deflationary (or restrictive) policies help correct a balance-of-payments deficit by lowering domestic incomes and thus the demand for imports. LO2

  36. Flexible Exchange Rates • Flexible exchange ratesis a system in which exchange rates are permitted to vary with market supply and demand conditions. • Also called floating exchange rates. • With flexible exchange rates, the quantity of foreign exchange demand always equals the quantity supplied. LO2

  37. Flexible Exchange RatesEffect on trade • Someone is always hurt (and others are helped) by exchange-rate movements. (all the above discussed micro and macro arguments apply), e.g. • Currency depreciation may cause domestic cost-push inflation by pushing up input prices. • Currency appreciationreduces exports by raising the price of domestically produced goods to foreigners. LO2

  38. Flexible Exchange RatesSpeculation • Speculators often counteract short-term changes in foreign-exchange supply and demand (stabilizing) • Sometimes, speculators move “with the market” and make swings in the exchange rate even more extreme (destabilizing) LO2

  39. Managed Exchange Rates • Governments may buy and sell foreign exchange for the purpose of narrowing exchange-rate movements. • Such limited intervention in foreign-exchange markets is referred to as managed exchange rates. LO2

  40. Currency Bailouts • The world has witnessed a string of currency crises: • The Asian crisis of 1997-1998. • The Brazilian crisis of 1999. • The Argentine crisis of 2001-2. • The recurrent ruble crises in Russia. • Periodic panics in Mexico and South America.

  41. Currency Bailouts • In most cases a currency “bailout” was arranged by the International Monetary fund, joined by the central banks of the strongest economies. • These authorities lend the troubled economy enough reserves to defend its currency

  42. The Case for Bailouts • The case for currency bailouts typically rests on the domino theory. • Weakness in one currency can undermine another. • Industrial countries often offer currency bailout as a form of self-defense.

  43. The Case Against Bailout • Once a country knows that currency bailouts will occur, it may not pursue domestic policy adjustments to stabilize its currency. • A nation can avoid politically unpopular options such as high interest rates, tax hikes, or cutbacks in government spending. • It can also turn a blind eye to trade barriers, monopoly power, lax lending policies, and other constraints on productive growth.

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