2 Drawing GraphAn economic relationship can be represented either mathematically or graphically.For example, consider the demand relation:Quantity Demanded = f (price, other factors) where other factors include income, preference, and etc.This relationship can be represented by the demand curve, a two-dimensional diagram.
3 A Two-Dimensional Diagram In general, a two-dimensional diagram can represent the relationship ofY = f (X, Z)The diagram is upward sloping if Y and X move in the same directionThe diagram is downward sloping if Y and X move in the opposite directionWe move along the diagram when X varies, holding Z constant.
4 What if Z changes? The diagram shifts when Z changes. For example, let Y = quantity demanded, X = price, Z = income. After income (Z) rises, quantity demanded (Y) rises for each given price (X). So the demand curve shifts up.Exercise: what happens to demand curve if Z = price of substitute rises?
5 Two Special CasesThe diagram is a horizontal line if Y remains unchanged when X variesThe diagram is a vertical line if X remains unchanged when Y variesExercise: draw the demand curve when the demand is perfectly inelastic
6 UIP and Asset ApproachUIP is the fundamental equation of the (short-run) asset approach to exchange rateWe use UIP to solve for current spot exchange rate provided that we know the interest rates and expected future spot rate:
7 FX Market DiagramThe Y variable is dollar rate of returns of dollar deposit and euro depositThe X variable is current spot rateWe use FX market diagram to solve for
8 DR Curve DR stands for domestic (US) rate of return Mathematically, DR =DR curve is horizontal because it is independent of current spot rate (i.e., DR remains unchanged when current spot rate varies)
9 FR Curve FR stands for foreign (EUR) rate of return Mathematically, FR =FR curve is downward sloping because FR and current spot rate move in opposite direction (Intuition?)The Z variable for FR curve is and
10 FX Market EquilibriumThe foreign exchange market is in equilibrium where DR and FR curve intersectTo the left of equilibrium point, FR > DR. Euro deposit is more attractive. People will buy euro and sell dollar. Dollar depreciates.To the right of equilibrium point, FR < DR. Dollar deposit is more attractive. People will buy dollar and sell euro. Dollar appreciates.
11 What if dollar interest rate rises? DR curve shifts upFR curve remains fixedDollar appreciates instantaneouslyFigure 4-3-(a)Intuition?
12 What if Euro interest rate falls? DR curve remains fixedFR curve shifts downDollar appreciates instantaneouslyFigure 4-3-(b)Intuition?
13 What if expected future rate falls? DR curve remains fixedFR curve shifts downDollar appreciates instantaneouslyFigure 4-3-(c)This example shows that expectation is self-fulfilling: expected future appreciation for dollar will lead to actual instantaneous appreciation for dollar
14 (Current) Euro Crisis http://www.google.com/finance?q=EURUSD# What causes the recent depreciation of euro against dollar?Due to the debt crisis in Euro-zone, people expect that euro will depreciate in future (or in long run)Expectation is self-fulfilling. We see euro has actually been depreciating.
15 Expectation Management Because expectation is self-fulfilling, it is vital for the government to do something in order to revert people’s unfavorable expectation1997 Asian crisis revisited: Soros bet against Hong Kong Dollar, and he expected HK dollar would depreciate against US dollarChina central government announced that it would back up HK dollar. This credible announcement changed people’s expectationIn the end Soros suffered a big loss
31 Discuss: Tariff and US CA Deficit CA = S – I = (Y – C - G) - IWhat are the effects of tariff on Chinese import on C, G and I
32 Why do American people save so little Cultural of consumptionDemographic reasonGovernment entitlement programHousing market boom
33 Why do Chinese people save so much? Cultural of saving Lack of social benefits Even old people save (for the down payment of new house bought by their child)
34 Private and Public Savings Private Saving (Sp) = Y – T – CPublic Saving (Sg) = T – GTotal Saving S = Sp + SgThe current account identity becomesCA = Sp + Sg – IEverything else equal, rising government budget deficit leads to rising current account deficit (foreign debt)
35 Greece Crisis Widespread tax evasion Huge government expenditure (on entitlement program)Huge government budget deficitPrivate saving is low (unlike Japan)Huge foreign debt (from French banks)The crisis is caused by the potential default of foreign debt (downgrade of its credit rating)
36 Euro Crisis Crisis is contagious Greece is member of EU Greece borrows a lot from French and German banksGermany is increasingly reluctant to support Greece
37 Dilemma for USIn long run, in order to cut the current account deficit, US should cut budget deficit and increase personal savingIn short run, however, double-dip recession is looming.
38 Twin Deficits: Greece and USA CA = Sp + Sg – IAssuming Sp = 0, I = 0Then Sg < 0 (government budget deficit) indicates that CA < 0 (current account deficit)So there are twin deficits.Greece and USA have twin deficits now.
40 Japan and China Sg is negative but small (small budget deficit) Sp is positive and big (big personal saving)Overall, national saving (S = Sg + Sp) is greater than investmentSo Japan and China are running CA surplus (lending money to other countries)Government budget deficit does not necessarily lead to CA deficit
41 Balance of Payment (BOP) Account BOP = CA + FA + KAFA: Financial accountKA: Capital account (close to zero for US)FA and KA record international transactions in assets. They show how the current account is financed.
42 One PrincipleEvery transaction is two-way. If A receives from B an item of given value, in return B receives from A an item of equal value.For example. When you buy an Iphone at ATT store, you get the phone, and the ATT store gets the payment (either cash or check).
43 Double-Entry Bookkeeping Any transaction resulting in a payment to foreigners is entered in the BOP account as a debit and is given a negative sign(-).Any transaction resulting in a receipt from foreigners is entered in the BOP account as a credit and is given a positive sign(+).
44 Asset US asset is a claim on US; Foreign asset is a claim on ROW There is capital inflow (receipt) to US if US exports US asset to ROW (borrow from ROW). So exporting US asset is entered in the BOP account as a credit and is given a plus sign(+).There is capital outflow (payment) if US imports foreign asset from ROW (lend to ROW). So importing asset abroad is entered in the BOP account as a debit and is given a minus sign(-).
45 Import of foreign good, - $10 ExampleAn American student uses credit card to buy a Astro Boy book worth $10 in TokyoCurrent Account (CA):Import of foreign good, - $10Financial Account (FA):Export of US asset, + $10Note: US asset is a claim on US. Credit card is one form of IOU, an asset.Note CA + FA = 0 for this transaction
46 BOP IdentityFrom microeconomic view, because of double-entry bookkeeping, the following BOP identity holds:CA + FA + KA = 0From macroeconomic view, BOP identity holds because
47 Implications of BOP Identity For simplicity, let KA = 0FA < 0 if CA > 0. A country lends money to ROW if it is running current account surplusFA > 0 if CA < 0. A country borrows money from ROW if it is running current account deficit
48 Statistical Discrepancy In practice, because of data error, BOP identity holds only when statistical discrepancy (SD), a correction term, is included:CA + FA + KA + SD = 0The above identity holds because by definitionSD = -(CA + FA + KA )
50 RemarksItem 7: US-owned assets abroad = importing foreign assets (lending to ROW). There is capital outflow (payment), so entered in BOP with a minus sign.Item 8: Foreign-owned assets in US = exporting US assets (borrowing from ROW). There is capital inflow (receipt), so entered in BOP with a plus sign.