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International Economics 3. Currency Politics

International Economics 3. Currency Politics. International Economics. 3.1. Exchange Rate Theory 3.1.1. Demand and Supply on Foreign Exchange Markets 3.1.2. Purchasing Power Parity and Interest Parity 3.2. Exchange Rate Policy 3.2.1. The Power of Central Banks

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International Economics 3. Currency Politics

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  1. International Economics3. Currency Politics Prof. Dr. Rainer Maurer

  2. International Economics 3.1. Exchange Rate Theory 3.1.1. Demand and Supply on Foreign Exchange Markets 3.1.2. Purchasing Power Parity and Interest Parity 3.2. Exchange Rate Policy 3.2.1. The Power of Central Banks 3.2.2. Fixed Exchange Rate Systems 3.2.3. Flexible Exchange Rate Systems 3.3. Is the European Monetary Union an Optimal Currency Area? 3.3.1. The Theory of Optimal Currency Areas 3.3.2. Empirical Findings for the EMU 3.4. Questionsfor Review Additional Literature: ◆ Chapter 12, Mankiw, Gregory; Macroeconomics, Worth Publishers. Prof. Dr. Rainer Maurer

  3. International Economics 3.1. Exchange Rate Theory 3.1.1. Demand and Supply on Foreign Exchange Markets Prof. Dr. Rainer Maurer

  4. 3. Currency Politics3.1.1. Demand and Supply on Foreign Exchange Markets Definition foreign exchange rate: „ Price of domestic currency in units of foreign currency“ = „ Foreign currency per domestic currency“ Example: Exchange rate of Euro vs. Dollar: 1,135 => 1 € = 1,135 $ Shortcut: „e“ = 1,135 $ pro 1€ Dimension „e“ = $ / € = e$€ = foreign currency / domestic currency Prof. Dr. Rainer Maurer

  5. 3. Currency Politics3.1.1. Demand and Supply on Foreign Exchange Markets Definition: „Appreciation of domestic currency“: For „one unit “ domestic currency “more units” of foreign currency is paid. e$€↑ = (Number of Dollars ↑ / Number of Euros ) Prof. Dr. Rainer Maurer

  6. Why do people demandforeign currencies? 3. Currency Politics3.1.1. Demand and Supply on Foreign Exchange Markets Balance of capital payments Balance of current account X – M S – (I + DG) = • Domestic savers (or their banks and investment funds) want to buy foreign securities and need foreign currencies to do so. • Foreign investors, who have received in domestic currency credits. • Domestic consumers (or their retailers and intermediaries) want to buy foreign goods and need foreign currencies to do so. • Foreign producer, who want to exchange sales made in the domestic market in foreign currency. Prof. Dr. Rainer Maurer

  7. These considerations show, demand and supply on foreign exchange markets are influenced by two factors: The relation between domestic and foreign prices for goods: P€ versus P$ The relation between domestic and foreign interest rates: i€ versus i$ In the following we will study these relationships in some more detail. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity Prof. Dr. Rainer Maurer

  8. We can find the accurate relation between the exchange rate and prices for domestic and foreign goods with the help of a numerical experiment: Where would you buy your cookies at the following exchange rate and prices: Example: Price per kg domestic cookies = 1 € = P€ Price per kg foreign cookies = 2 $ = P$ Exchange rate = 4$€ How would this affect the demand for Euro? 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity Prof. Dr. Rainer Maurer e↓

  9. We can find the accurate relation between the exchange rate and prices for domestic and foreign goods with the help of a numerical experiment: Where would you buy your cookies at the following exchange rate and prices: Example: Price per kg domestic cookies = 1 € = P€ Price per kg foreign cookies = 2 $ = P$ Exchange rate = 1$€ How would this affect the demand for Euro? 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity Prof. Dr. Rainer Maurer e↓

  10. Man kann die genaue Beziehung zwischen dem Wechselkurs und den Preisen inländischer und ausländischer Güter über eine kleines Experiment herleiten: Example: price per kg domestic cookies = 1 € = P€ price per kg foreign cookies = 2 $ = P$ exchange rate = ??? How would the affect the demand for Euro? 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity Prof. Dr. Rainer Maurer

  11. Consequently, a necessary condition for an equilibrium on the exchange market is that all goods, which can be traded between the two currency areas, have the sameprice, whether measured in € or measured in $. This relation is called the “purchasing power parity”. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity Prof. Dr. Rainer Maurer

  12. The “purchasing power parity” formula: P€ = P$ / e$€ | prices measured in € <=> e$€*P€ = P$ | prices measured in $ <=> e$€= P$ / P€| the PPP-exchange rate However, the simple purchasing power formula does only hold for goods whose transportationcosts are close to zero. For most goods this assumption is not justified. In this case the formula must take care of transportation costs. As a result there is a “band” around the PPP-exchange rate, in which the exchange rate is not affected by goods prices. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity Prof. Dr. Rainer Maurer

  13. If there are transport costs, the formula for the PPP-exchange (e$€) rate has to be modified:1) =>The higher transport costs per piece (C$) the lower is the effect of international trade on the exchange rate: If transport costs are infinitely high (C$ → ∞), there will be no tradeand the exchange rate will not be affected by trade. If transport costs are zero(C$ = 0), the exchange rate will be completely determined by the prices for tradable goods. In reality, where transport costs for most goods lies somewhere between zero and infinity, there will be an “exchange rate band” around the PPP-exchange rate, in which the actual exchange rate is not affected by trade. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity Upper border of the transport costs band Lower border of the transport costs band

  14. PDM/ PFF eDMFF Prof. Dr. Rainer Maurer PDM/ PFF eDMFF

  15. Prof. Dr. Rainer Maurer

  16. In reality transport cost for most goods are between zero and infinte. Beside transport costs, there are also other factors preventing strict empirical validity of the purchasing power theorem: Tariffs and quantitative restrictions act like transport costs. Monopolies & oligopolies allow companies to apply profit maximizing price differentiation strategies between different currency areas. => Consequently, there exists a kind of “band width” around the PPP-exchange rate, within which the actual exchange rate cannot be affected by international trade. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity Prof. Dr. Rainer Maurer

  17. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity e$€ = P$ / P€ <=> 0,661 $€ =42,99 $ / 64,98 € => At an exchange rate of 1,141 $€ the Euro is “overvalued” 42,99 $ / 1,141 $€ = 37,67 € Prof. Dr. Rainer Maurer

  18. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity => Because of this trade restriction by Levi’s (“monopolistic competition”), no additional supply of Euro follows, such that the Euro does not depreciate against the Dollar and the deviation from PPP-exchange rate is maintained. Prof. Dr. Rainer Maurer

  19. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity The more $ is paid for one €, the more US-goods are cheaper than Euro-goods and the more € is hence supplied in exchange for $. e$€ The less $ has to be paid for one €, the more Euro-goods are cheaper than $-goods and the more € is demanded in exchange for $. € €-supply €-demand Prof. Dr. Rainer Maurer

  20. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity e$€ € Equilibrium on the exchange market in terms of €-supply and €-demand €-supply(P$,1) e1 €-demand(P$,1) Prof. Dr. Rainer Maurer €1

  21. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity e$€ € What happens to the equilibrium exchange rate if inflation in the USA is higher than inflation in the €-Area (P$,1 < P$,2 und P€,1 = P€,2 )? €-supply(P$,1) e1 €-demand(P$,1) Prof. Dr. Rainer Maurer €1

  22. International trade causes the exchange rate to adjust for inflation differentials between to countries (at least in the long run): If inflation in the USA is higher than inflation in the €-area the €-exchange rate (e$€) will appreciate. If inflation in the USA is lower than inflation in the €-area the €-exchange rate (e$€) will depreciate. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity Prof. Dr. Rainer Maurer

  23. Next we start with the discussion of two other important factors of influence on the exchange rate: The relation between domestic and foreign prices for goods: P€ versus P$ The relation between domestic and foreign interest rates: i€ versus i$ 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity Prof. Dr. Rainer Maurer

  24. Digression: The difference between spot and forward market On the spot exchange market Euro today t=0 is traded gainst Dollar today t=0 at the exchange rate today. Purchase agreement and exchange of currencies take place at the same point in time. : On the forward exchange market, Euro at e.g. day t+3 is traded against Dollar at day t+3 at an exchange rate fixed today t for day t+3. Purchase agreement inclusive fixation of exchange rate takes place today t, while the exchange of currencies takes place at day t+3: t=2 t=0 t=3 t=1 t Agreement between buyer and seller today Currency delivered by seller to buyer at t+3 t=0 t=2 t=2 t=3 t=1 t Agreement between buyer and seller today Currency delivered by seller to buyer today Prof. Dr. Rainer Maurerr Prof. Dr. Rainer Maurerr - 29 -

  25. Again, we can find the accurate relation between the exchange rate and prices for domestic and foreign goods with the help of a numerical experiment: Where would you invest your money at the following exchange and interest rates? Example: Interest rate for a fixed rate bond denominated in € with maturity of one year is: i€ = 10 % Interest rate for a fixed rate bond denominated in $ with maturity of one year is: i$ = 6 % Spot market exchange rate: e$€ = 1 Forward market exchange rate for € paid in one year: f$€ = 0,92 How would this affect the demand for Euro? 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity 1) The „exchange rate“ we have discussed so far has been the „spot exchange rate“ . Prof. Dr. Rainer Maurer

  26. Where would you invest your money at the following exchange and interest rates? Example: Interest rate for a fixed rate bond denominated in € with maturity of one year is: i€ = 10% Interest rate for a fixed rate bond denominated in $ with maturity of one year is: i$ = 6% Spot market exchange rate: e$€ = 0,94 Forward market exchange rate for € paid in one year: f$€ = 0,92 How would this affect the demand for Euro? 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity 1) Der Wechselkurs, über den wir bisher gesprochen haben, war immer der Kassakurs. Prof. Dr. Rainer Maurer

  27. At what spot market exchange rate would you be indifferent between an investment in € and $ bonds? Example: Interest rate for a fixed rate bond denominated in € with maturity of one year is: i€ = 10% Interest rate for a fixed rate bond denominated in $ with maturity of one year is: i$ = 6% Spot market exchange rate: e$€ = ??? Forward market exchange rate for € paid in one year : f$€ = 0,92 How would this affect the demand for Euro? 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity 1) Der Wechselkurs, über den wir bisher gesprochen haben, war immer der Kassakurs. Prof. Dr. Rainer Maurer

  28. This example demonstrates that an equilibrium on the exchange market can only exist, if interest and exchange rates are such that investors are indifferent between investing money at home or on foreign capital markets. This relationship is called „interest parity“. The corresponding equation is called „interest parity equation“. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity Prof. Dr. Rainer Maurer

  29. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity 1€ * (1+i€,t,t+1) 1€ * e$€,t * (1+i$,t,t+1) / f$€,t+1 Return on investment of 1€ in a €-bond Exchange of 1€ in $ Return on investment of 1$ in a $-bond Exchange of $-return in € Return on €-bond = Return on $-bonds = Prof. Dr. Rainer Maurer

  30. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity Return on €-bond = Return on $-bonds = 1€ * (1+i€,t,t+1) 1€ * e$€,t * (1+i$,t,t+1) / f$€,t+1 „interest parity equation“ If this equation is solved for the spot exchange rate e$€,t the resulting formula shows the influence of the other variables on the spot exchange rate: Prof. Dr. Rainer Maurer

  31. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity = 1€ * (1+i€,t,t+1) 1€ * e$€,t * (1+i$,t,t+1) / f$€,t+1 (1+i€,t,t+1 ) * f$€,t+1 e$€,t = (1+i$,t,t+1) ↑ ↑ <=> An increaseof the domestic interest rate causes an appreciation of the Euro. Economic interpretation: If the domestic interest rate increases and everything else stays constant, Euro-bonds offer a higher return than Dollar-bonds. Consequently, investors will want to buy Euro-bonds and sell Dollar-bonds. To do so, they have to exchange Dollar against Euro so that the demand for Euro grows and the supply of Dollar increases and the Euro appreciates against the Dollar. Prof. Dr. Rainer Maurer

  32. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity = 1€ * (1+i€,t,t+1) 1€ * e$€,t * (1+i$,t,t+1) / f$€,t+1 (1+i€,t,t+1 ) * f$€,t+1 e$€,t = (1+i$,t,t+1 ) <=> ↓ ↑ An increaseof the foreigh interest rate causes an depreciation of the Euro. Economic interpretation: If the foreign interest rate increases and everything else stays constant, Dollar-bonds offer a higher return than Euro-bonds. Consequently, investors will want to buy Dollar-bonds and sell Euro-securities. To do so, they have to exchange Euro against Dollar so that the demand for Dollar grows and the supply of Euro increases and the Euro depreciates against the Dollar. Prof. Dr. Rainer Maurer

  33. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity = 1€ * (1+i€,t,t+1) 1€ * e$€,t * (1+i$,t,t+1) / f$€,t+1 (1+i$,t,t+1 ) e$€,t+1 * = f$€,t (1+i€,t,t+1) <=> f$€,t+1 (1+i$,t,t+1 ) = <=> e$€,t (1+i€,t,t+1 ) • The interest rate parity theory is an important mechanism that helps us understand the interrelationships between the exchange market and domestic and foreign capital markets. • How well does the interest parity theory perform empirically? • Do check this, we can reformulate the interest parity equation in the following way: Prof. Dr. Rainer Maurer

  34. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity Source: Dt. Bundesb. (Juli, 2005), Daily data 04.01.1999 – 30.06.2005 Empirical Evidence: Strict validity of the interest parity theory would imply that all points lie on the 45°-line. This is obviously not the case. The standard ex-planation for these devi-ations are transaction costs in buying assets and exchanging cur-rencies. Nevertheless the diagram shows that the correlation between both factors does to a large extent correspond to the prediction of the interest parity theory. Spot exchange rate of the Euro is undervalued given the interest rates!

  35. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity e$€ € The more $ is paid for one € the cheaper US-assets get so that the return on investment in US-assets grows => The more € is supplied to the spot market. €-supply eo The more € is paid for one $ the cheaper Euro-assets get so that the return on an investment in Euro-assets grows. => The more € is asked for on the spot market. €-demand Prof. Dr. Rainer Maurer €o

  36. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity e$€ € What happens to the equilibrium exchange rate, if the $-interest rate grows ( i$,1 < i$,2 )? €-supply(i$,1) e1 €-demand(i$,1) Prof. Dr. Rainer Maurer €1

  37. 3. Currency Politics3.1.2. Purchasing Power Parity and Interest Parity e$€ € What happens to the equilibrium exchange rate, if the €-interest rate grows (i€,1 < i€,2)? €-supply(i$€1) e1 €-demand(i€,1) Prof. Dr. Rainer Maurer €1

  38. International Economics 3.1. Exchange Rate Theory 3.1.1. Demand and Supply on Foreign Exchange Markets 3.1.2. Purchasing Power Parity and Interest Parity 3.2. Exchange Rate Policy 3.2.1. The Power of Central Banks 3.2.1.1. The Direct Impact on the Exchange Market Prof. Dr. Rainer Maurer

  39. 3. Currency Politics3.2.1.1. The Direct Impact on the Exchange Market If the central bank sells own currency on the exchange market the exchange rate of its currency depreciates: Prof. Dr. Rainer Maurer

  40. 3. Currency Politics3.2.1.1. The Direct Impact on the Exchange Market e = $ / € €-supply e1 €-demand Volumes in € €1 Prof. Dr. Rainer Maurer

  41. 3. Currency Politics3.2.1.1. The Direct Impact on the Exchange Market e = $ / € €-supply of central bank €-supply €-supply with central bank e1 e2 €-demand => Depreciation of Euro Volumes in € €1 €2 Prof. Dr. Rainer Maurer

  42. 3. Currency Politics3.2.1.1. The Direct Impact on the Exchange Market If the central bank buys own currency on the exchange market the exchange rate of its currency appreciates: Prof. Dr. Rainer Maurer

  43. 3. Currency Politics3.2.1.1. The Direct Impact on the Exchange Market e = $ / € €-supply e2 e1 €-demand with central bank € demand of central bank €-demand => Appreciation of Euro Volumes in € €1 €2 Prof. Dr. Rainer Maurer

  44. 3. Currency Politics3.2.1.1. The Direct Impact on the Exchange Market This shows: If the central bank wants to depreciate the exchange rate of its own currency, it has to sell own currency. This is no problem, since the central bank has the monopoly to print its own currency. If the central bank wants to appreciatethe exchange rate of its own currency, it has to buyown currency. To do this the central bank needs foreign currency. Consequently, the central bank must own foreign currency reserves or precious metals, which can be exchanged for foreign currency. Prof. Dr. Rainer Maurer

  45. 3. Currency Politics3.2.1.1. The Direct Impact on the Exchange Market How does such a foreign exchange market intervention affect the remaining domestic economy? For the sake of simplicity, we restrict the analysis to the case of a depreciation of the euro: A depreciation of the euro makes foreign goods more expensive from the perspectives of domestic consumers: They have to spend more euros for one foreign currency unit. Therefore the demand for foreign goods (= import demand) will fall:IM↓ A depreciation of the euro makes domestic goods less expensive from the perspectives of foreign consumers: They have to spend less foreign currency units for one euro. Therefore, the foreign demand for domestic goods (= export demand) will grow:EX↑ Prof. Dr. Rainer Maurer

  46. 3. Currency Politics3.2.1.1. The Direct Impact on the Exchange Market If we combine the two effects, the current account balance1)grows: EX↑ - IM↓ => (EX - IM) This means, a devaluation causes an increase in the demand for domestic goods. Thus, if the bank is sells euro on the exchange market, it stimulates domestic demand for goods.. In the end, the same thing happens as in the case of where the central bank supplies euro on the domestic capital market as a credit: The demand for domestic goods grows. Both cases are therefore called „expansionary monetary policy“. ↑ 1)Strictly speaking is EX-IM only equal to the so called „Net exports“ (Domestic concept). In order to achieve the complete balance of capital and current account (national concept), the balance of income with foreign countries as well as the balance of the transfers between nationals and foreigners must be added. The exact current account balance is obtained if the above calculation steps are carried out not with the GDP but with the Gross National Product (GNP). For the sake of simplicity, these subtleties are neglected. Prof. Dr. Rainer Maurer

  47. International Economics 3.1. Exchange Rate Theory 3.1.1. Demand and Supply on Foreign Exchange Markets 3.1.2. Purchasing Power Parity and Interest Parity 3.2. Exchange Rate Policy 3.2.1. The Power of Central Banks 3.2.1.1. The Direct Impact on the Exchange Market 3.2.1.2. The Impact via the Interest Parity Channel Prof. Dr. Rainer Maurer

  48. 3. Currency Politics3.2.1.2. The Impact via the Interest Parity Channel Beside the direct impact on the exchange rate via interventions on the spot exchange market, the central bank can affect the exchange rate also in a more indirect way via “normal” monetary policy on the domestic capital market: Here, basically two channels exists: the interest parity channel the purchasing power parity channel Prof. Dr. Rainer Maurer

  49. The interest parity channel: Under the assumptions of the neoclassical as well as Keynesian model, the domestic interest rate falls, if the central bank increases money supply on the domestic capital market: M ↑ Via the interest parity channel, this leads to a depreciation of the domestic currency: The economic explanation is: A lower return of domestic assets causes a decrease of foreign demand for domestic assets. If foreigners demand less domestic assets, they need less domestic currency. As a consequence the demand for domestic currency falls, so that the exchange rate depreciates. 3. Currency Politics3.2.1.2. The Impact via the Interest Parity Channel (1+i€,t,t+1 ) * f$€,t+1 e$€,t = (1+i$,t,t+1) => i ↓ ↓ ↓ Prof. Dr. Rainer Maurer

  50. The interest parity channel: The central bank can also use the interest parity channel to appreciate the domestic currency, even if it does not own foreign currency reserves of precious metals: In this case, the central bank can reduce domestic money supply, such that the interest rate grows: ΔM<0 => i ↑ However, this implies potentially negative side effects: The higher domestic interest rate can cause reduction of domestic consumption demand C(i ↑) ↓ and investment demand I(i ↑) ↓, which respond negatively to the level of the interest rate. This reduction of domestic demand might cause a recession in the short-run. 3. Currency Politics3.2.1.2. The Impact via the Interest Parity Channel (1+i€,t,t+1 ) * f$€,t+1 e$€,t = (1+i$,t,t+1) ↑ ↑ Prof. Dr. Rainer Maurer

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