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International Trade Exchange Rates and Open Macroeconomic Models October 17, 2006 International trade is more complicated than domestic trade.

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International trade l.jpg

International Trade

Exchange Rates and Open Macroeconomic Models

October 17, 2006


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  • If that same vintner ships her wine to Europe, however, consumers there will have only Euros with which to pay, rather than the Dollars the wine maker in California wants. Thus, for international trade to take place, there must be some way to convert one currency into another.


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  • The exchange rate states the price in consumers there will have only Euros with which to pay, rather than the Dollars the wine maker in California wants. Thus, for international trade to take place, there must be some way to convert one currency into another.

    terms of one currency at which such conversions are made. There is an exchange rate between every pair of currencies.


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  • For example the British Pound in 2002 was the equivalent of about $1.40. The exchange rate between the Pound and the Dollar, then, may be expressed as roughly "$1.40 to the Pound" (meaning that it costs $1.40 to buy a Pound) or about "71 pence to the Dollar" (meaning that it costs 71 British pence to buy a Dollar).

(Currently the rate is $1.86 and .57 respectively)


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  • A nation’s currency is said to appreciate when the exchange rates change so that a unit of its currency can buy more units of a foreign currency.

  • A nation’s currency is said to depreciate when the exchange rates change so that a unit of its currency can buy fewer units of a foreign currency.


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  • When an officially set exchange rate is altered so that a unit of a nation’s currency can buy fewer units of foreign currency, we say that a devaluation of that currency has taken place. When the exchange rate is changed so that the nation’s currency buys more units of a foreign currency, a revaluation has taken place.


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EXCHANGE RATE DETERMINATION IN A FREE MARKET unit of a nation’s currency can buy fewer units of foreign currency, we say that a devaluation of that currency has taken place. When the exchange rate is changed so that the nation’s currency buys more units of a foreign currency, a revaluation has taken place.


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Euro Market is equal to the number of Euros supplied.

Figure 1

$/Euro

S1

D shifts to the right

D shifts to the left

.90

S shifts to the right

S shifts to the left

D1

Q of Euros

0

Q1


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Why does anyone demand Euros? is equal to the number of Euros supplied.

  • International trade in goods and services. (In general, demand for Europe’s exports leads to demand for its currency, Euros)

  • International trade in financial instruments such as stocks and bonds. (In general demand for Europe’s financial assets leads to demand for it’s currency, Euros)


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Where does the supply of euros come from l.jpg
Where does the supply of Euros come from? as factories and machinery overseas by foreigners (e.g. U.S. citizens). (In general, direct foreign investment leads to demand for Europe’s currency, the Euro)

  • Europeans want to buy U.S. goods (the other side of 1 above)

  • Europeans want to buy U.S. stocks and bonds (the other side of 2 above)

  • Europeans purchase physical assets in the U.S. (the other side of 3 above)

    (can use the supply and demand graphs we have already created)


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  • In terms of the supply-demand diagram in Figure 2, the increased desire of Europeans to acquire U.S. stocks would shift the supply curve for Euros out from S1 to S2 . Equilibrium would shift from point Q1 to point Q4, and the exchange rate would fall: e.g. from $0.90 per Euro to $0.80 per Euro.


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Market for Euros increased desire of Europeans to acquire U.S. stocks would shift the supply curve for Euros out from S1 to

$/Euro

S1

D shifts to the right

D shifts to the left

.90

S shifts to the right

S shifts to the left

D1

Q of Euros

0

Q1


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Market for Euros increased desire of Europeans to acquire U.S. stocks would shift the supply curve for Euros out from S1 to

$/Euro

S1

D shifts to the right

D shifts to the left

S2

.90

S shifts to the right

S shifts to the left

.80

D1

Q of Euros

0

Q4

Q1


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Summary suppose that europeans have an interest in investing in the u s stock market l.jpg
Summary: Suppose that Europeans have an interest in investing in the U.S. stock market.

(straight forward supply and demand)

  • To purchase stocks, Europeans need to purchase $ => selling Euros.

  • (supply curve for Euros shifts to the right => causing the $ price of the Euro to fall) 


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Interest Rates and Exchange Rates: The Short Run investing in the U.S. stock market.

  • Main determinant in the short run: interest rates, in particular interest rate differentials, and financial flows.


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  • Italian investors will be attracted by the higher interest rates in the United States and will offer Euros for sale.

  • Why?

  • To buy Dollars and use those Dollars to buy U.S. securities.

  • At the same time, U.S. investors will find it more attractive to keep their money at home, so fewer Euros will be demanded by Americans.


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Euro Market rates in the United States and will offer Euros for sale.

$/Euro

Figure 3

S1

D shifts to the right

D shifts to the left

P1

S shifts to the right

S shifts to the left

D1

Q of Euros

0

Q1


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Euro Market rates in the United States and will offer Euros for sale.

Figure 3

$/Euro

S1

D shifts to the right

D shifts to the left

S2

P1

S shifts to the right

P4

S shifts to the left

D1

Q of Euros

0

Q4

Q1


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Euro Market rates in the United States and will offer Euros for sale.

Figure 3

$/Euro

S1

D shifts to the right

D shifts to the left

S2

P1 =

1.20

S shifts to the right

S shifts to the left

D1

P2=1.10

D2

Q of Euros

0

Q2

Q1


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  • When the demand schedule shifts rates in the United States and will offer Euros for sale. inward and the supply curve shifts outward, the effect on price is predictable.


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The Result: because they no longer desire to invest as much in Italian securities. Thus, the demand curve shifts inward from D1 to D2.

  • In our example, there is a depreciation of the Euro from $1.20 to $1.10.

  • Exercise: Suppose that interest rates are higher in Europe than in the U.S. Demonstrate using supply and demand curves that this would cause the Euro to appreciate.


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In general because they no longer desire to invest as much in Italian securities. Thus, the demand curve shifts inward from D1 to D2.

  • Other things equal, countries that offer investors higher rates of return attract more capital than countries that offer lower rates.

  • Thus, a rise in interest rates often will lead to an appreciation of the currency, and a drop in interest rates will lead to a depreciation of the currency.


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  • Interest rate differentials certainly played a predominant role in the stunning movements of the U.S. Dollar in the 1980s.

  • In the early 1980s, American interest rates rose well above comparable interest rates abroad.

  • As a result, foreign capital was attracted to the U.S. American capital stayed at home, and the Dollar soared. That is, the Dollar appreciated.


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Interest Rates and Exchange Rates: The Medium Run Argentina in 2001, must offer extremely high interest rates to attract foreign capital.

  • The medium run is where the theory of exchange rate determination is most unsettled.


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  • Economists once reasoned as follows: Because consumer spending increases when income rises and decreases when income falls, the same thing is likely to happen to spending on imported goods.

  • So a country's imports will rise quickly when its economy booms and rise only slowly when its economy stagnates.


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  • For the reasons illustrated in Figure 4, a boom in the United States should shift the demand curve for Euros outward as Americans seek to acquire more Euros to buy more European goods and services.

  • And that, in turn, should lead to an appreciation of the Euro (depreciation of the Dollar). In the figure, the Euro rises in value from P1 to P2 Dollars per Euro.


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Euro Market United States should shift the

Figure 4

$/Euro

S1

D shifts to the right

D shifts to the left

P1

S shifts to the right

S shifts to the left

D1

Quantity of Euros

0

Q1


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Euro Market United States should shift the

Figure 4

$/Euro

S1

D shifts to the right

P2

D shifts to the left

P1

D2

S shifts to the right

S shifts to the left

D1

Quantity of Euros

0

Q1

Q2


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Euro Market would be buying more American exports, which would shift the

Figure 4

$/Euro

S1

D shifts to the right

S2

D shifts to the left

P3

P1

D2

S shifts to the right

S shifts to the left

D1

0

Q3

Q1

Quantity of Euros


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  • A country whose aggregate demand grows faster than the rest of the world's normally finds its imports growing faster than its exports.

  • Thus, its demand curve for foreign currency shifts outward more rapidly than its supply curve. Other things equal, that will make its currency depreciate.

  • In the context of figure 4 if the U.S. is growing faster than Europe, D1 will shift out by a larger amount than S1, leading to an appreciation of the Euro.


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Conclusion: of the world's normally finds its imports growing faster than its exports.

  • This reasoning is sound - so far as it goes. And it leads to the conclusion that a "strong economy" might produce a "weak currency."

  • But the three most important words in the preceding statement are "other things equal."


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  • As we see, thinking only about trade in goods and services leads to the conclusion that faster growth should weaken the currency.

  • But thinking about trade in financial assets (such as stocks and bonds) leads to precisely the opposite conclusion: Faster growth should strengthen the currency. Which side will win this "tug of war"?


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  • In the modern world, the evidence seems to say that trade in financial assets is the dominant factor.

  • Rapid growth in the United States in the second half of the 1990s led to a sharply appreciating Dollar even though U.S. imports soared.

  • Why? Investors from all over the world brought funds to America.


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We conclude that: financial assets is the dominant factor.

  • Stronger economic performance appears to lead to currency appreciation because it improves prospects for investing in the country.


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Purchasing Power Parity Theory: The Long Run financial assets is the dominant factor.


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  • In the long run, an apparently simple principle ought to govern exchange rates. As long as goods can move freely across national borders, exchange rates should eventually adjust so that the same product costs the same amount of money, whether measured in Dollars in the United States, Euros in Germany, or Yen in Japan -- except for differences in transportation costs and the like.


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This simple statement forms the basis of the major theory of exchange rate determination in the long run:

  • The purchasing-power parity theory of exchange rate determination holds that the exchange rate between any two national currencies adjusts to reflect differences in the price levels in the two countries.


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Example: exchange rate determination in the long run:

  • Suppose German and American steel is identical and that these two nations are the only producers of steel for the world market.

  • Suppose further that steel is the only tradeable good that either country produces.


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Question: exchange rate determination in the long run: If American steel costs $180 per ton and German steel costs 200 Euros per ton, what must be the exchange rate between the dollar and the euro?


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Answer: exchange rate determination in the long run: Because 200 Euros and $180 each buy a ton of steel, the two sums money must be of equal value.

Hence, each Euro must be worth $0.90.

The Dollar price of the Euro is $.90


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Why? Any higher price for a Euro, such as $1, would mean that steel would cost $200 per ton (200 Euros at $1 each) in Germany but only $180 per ton in the United States.


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  • In that case, all foreign customers would buy their steel in the United States -- which would increase the demand for Dollars and decrease the demand for Euros.

  • In our diagram for the market for Euros the supply of Euros would shift to the right and the result would be a lower Dollar price of the Euro.


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Similarly, any exchange rate below $0.90 per Euro would send all the steel business to Germany, driving the value of the Euro up toward its purchasing-power parity level.


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Exercise: Show why an exchange rate of $0.80 per Euro is too low to lead to an equilibrium in the international steel market.


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Exercise (continued) too low to lead to an equilibrium in the international steel market.

Dollar price of Euro: $.80

$/Euro =.80

At this exchange rate the:

cost of steel in Germany is $160

cost of steel in the U.S. is $180


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The purchasing-power parity theory is used to make long-run predictions about the effects of inflation on exchange rates.


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To continue our example, suppose that steel (and other) prices in the United States rise while prices in Europe remain constant. The purchasing-power parity theory predicts that the Euro will appreciate relative to the Dollar. It also predicts the amount of the appreciation.


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According to the purchasing-power parity theory steel is $220 per ton, while German steel still costs 200 Euros per ton.

  • differences in domestic inflation rates are a major cause of exchange rate movements.

  • If one country has higher inflation than another, its exchange rate should be depreciating.


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For many years, this theory seemed to work tolerably well. Although precise numerical predictions based on purchasing-power parity calculations were never very accurate (see "Purchasing Power Parity and the Big Mac"), nations with higher inflation did at least experience depreciating currencies.


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But in the 1980s and 1990s, even this rule broke down. Although precise numerical predictions based on purchasing-power parity calculations were never very accurate (see "Purchasing Power Parity and the Big Mac"), nations with higher inflation did at least experience depreciating currencies.

  • For example, although the U.S. inflation rate was consistently higher than both Germany's and Japan's, the Dollar nonetheless rose sharply relative to both the German Mark and the Japanese Yen from 1980 to 1985.

  • The same thing happened again between 1995 and 2000.


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Clearly, the theory is missing something. What? Although precise numerical predictions based on purchasing-power parity calculations were never very accurate (see "Purchasing Power Parity and the Big Mac"), nations with higher inflation did at least experience depreciating currencies.

  • Many things. But perhaps the principal failing of the purchasing-power parity theory is, once again, that it focuses too much on trade in goods and services.


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  • Financial assets such as stocks and bonds are also traded actively across national borders -- and in vastly greater dollar volumes than goods and services.

  • In fact, the astounding daily volume of foreign exchange transactions, more than $1.5 trillion, exceeds an entire month’s worth of world trade in goods and services.


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The vast majority of these transactions are financial. If investors decide that, say, U.S. assets are a better bet than Japanese assets, the Dollar will rise, even if our inflation rate is well above Japan's.


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For this and other reasons: investors decide that, say, U.S. assets are a better bet than Japanese assets, the Dollar will rise, even if our inflation rate is well above Japan's.

Most economists believe that other factors are much more important than relative price levels for exchange rate determination in the short run. But in the long run, purchasing-power parity plays an important role.


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Market Determination of Exchange Rates: Summary investors decide that, say, U.S. assets are a better bet than Japanese assets, the Dollar will rise, even if our inflation rate is well above Japan's.

You may have noticed a theme here.

International trade in financial assets:

  • certainly dominates short-run exchange rate changes,

  • may dominate medium-run changes, and

  • also influences long-run changes.


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We can summarize this discussion of exchange rate determination in free markets as follows:

  • We expect to find appreciating currencies in countries that offer investors higher rates of return because these countries will attract capital from all over the world.


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  • To some extent, these are the countries that are determination in free markets as follows: growing faster than average because strong growth tends to produce attractive investment prospects. However, such fast-growing countries will also be importing relatively more than other countries, which tends to pull their currencies down.


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  • For these reasons, we turn next to a system of fixed exchange rates, or rates that are set by governments.

  • Naturally, under such a system the exchange rate, being fixed, is not closely watched.

  • Instead, international financial specialists focus on a country’s balance of payments to gauge movements in the supply of and demand for a currency.


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I. Defining the Balance of Payments in Practice exchange rates, or rates that are set by governments.

  • The preceding discussion makes it look simple to measure a nation's balance of payments position:

  • count up the private demand for and supply of its currency

  • and subtract quantity supplied from quantity demanded.

  • Go to discussion of AD


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  • Conceptually, that is all there is to it. exchange rates, or rates that are set by governments.

  • But in practice the difficulties are great because we never directly observe the number of dollars demanded and supplied.


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  • Easy, you say. Just look at the transactions of the central bank, whose purchases or sales must make up the difference between private demand and private supply.

  • If the Federal Reserve is buying dollars, its purchases measure our balance of payments deficit.

  • If the Fed is selling, its sales represent our balance of payments surplus.


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  • In practice, the balance of payments accounts come in two main parts.

  • The current account balance account totals up exports and imports of goods and services, cross-border payments of interest and dividends, and cross-border gifts.

  • The United States has been running large current account deficits for years.


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  • But that represents only one part of our balance of payments, for it leaves out all purchases and sales of assets.

  • Purchases of U.S. assets by foreigners bring foreign currency to the United States, and

  • purchases of foreign assets cost us foreign currency.


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Equilibrium is where Figures below, the two accounts need not balance one another.

Qd = Qs

Price of Euros

1.00

S

0.90

0.80

0.70

0.60

0.50

0.40

0.30

0.20

D

0.10

Billions of Euros/Year

0

1 2 3 4 5 6 7 8 9 10

5


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Equilibrium is where Figures below, the two accounts need not balance one another.

QS = QD

Price of Euros

Balance of payments deficit

1.00

S

0.90

0.80

0.70

0.60

0.50

0.40

0.30

0.20

D

0.10

Billions of Euros per year

0

1 2 3 4 5 6 7 8 9 10

5


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Equilibrium is where Figures below, the two accounts need not balance one another.

Qs = Qd

Price of Euros

1.00

S

0.90

0.80

0.70

0.60

0.50

0.40

.33

0.30

Balance of payments surplus

0.20

D

0.10

Billions of Euros per year

0

1 2 3 4 5 6 7 8 9 10

5


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