The theory of relativity applied to international trade Exchange Rates The theory of relativity applied to international trade

Exchange Rates Before diving into something that sounds really complicated (but actually isn’t) – determining the relative value of different currencies – let’s start with something simple. Think of the $ (or Euro, Peso, or any other currency) as a commodity. What determines the price of any commodity in a free market system?

Floating Exchange Rates Yes, we are back to supply and demand. In a free market system, the relative value of currencies “float” up and down based on the forces of supply and demand. These are known as floating exchange rates. Floating exchange rates move continuously in response to market forces, unless (or until) government intervenes

Basic Exchange Rate Movements If demand for a currency goes up (or supply goes down) – the currency appreciates (or strengthens) If supply increases (or demand decreases) – the currency depreciates (weakens)

Factors that Impact Exchange Rates Change in Income Change in Relative Prices Change in Relative Investment Prospects Speculation Use of Foreign Reserves

Change in Income U.S. income goes up U.S. consumption increases – demand for European imports goes up Supply of US$ goes up, demand for Euro goes up Both forces act to depreciate the US$ relative to the Euro (takes fewer Euros to buy a US$)

A Graphical Example S1 E/$ S2 D Q of $

Change in Income – In Reverse EU income goes up Demand for U.S. imports increases Euros flood the currency market, in order to exchange for US$ Demand for US$ goes up US$ appreciates relative to the Euro (US$ is worth more in Euros)

Back to the Graph S E/$ D2 D1 Q of $

Change in Relative Prices Change in relative prices = relative rates of inflation Higher rates of domestic inflation in the U.S. make imports relatively cheaper – demand for European imports goes up. Higher inflation in the U.S. also make exports less competitive – exports to Europe go down Both factors act to weaken the US$

Change in Relative Prices Remember – it is the relative rate of inflation that counts. 5% inflation in the U.S. will not cause the US$ to weaken relative to the Euro if the inflation rate within the EU is running at 8%. But, 3% inflation in the U.S. will cause the US$ to depreciate relative to the Euro if inflation is only 1% in the EU.

Relative Investment Prospects Currency values change in response to relative investment opportunities US investors see more attractive risk adjusted investment opportunities in India versus in the domestic market – demand for Indian Rupees goes up, and supply of US$ goes up US$ depreciates relative to the Rupee

Relative Investment Prospects New government elected in India based on a platform of increased regulation and protectionist policies Perceived risk of investing in India increases, reducing the relative attractiveness of investing in India versus the U.S. Demand for US$ goes up – US$ appreciates relative to the Rupee

Relative Interest Rates In a global market, investors always have choices in terms of where (and in what form) to invest their money. Relative interest rates have a significant impact in determining the relative attractiveness of holding investments in one currency or another. Increasing interest rates in the U.S. (on a relative basis) provide an incentive for investors to hold US$ denominated financial instruments

Relative Interest Rates An increase in demand for US$ denominated instruments (think U.S. Treasuries) increases demand for US$ -- US$ strengthens When interest rates in the U.S. decline on a relative basis, demand for US$ denominated instruments goes down – and the US$ depreciates.

Speculation It just wouldn’t be a market without speculation. All markets (including currency markets) are driven by expectations of future performance The past and present are relevant only to the extent that they can help predict where markets are going in the future. Expectations of future changes that will impact the value of a currency will be factored into the current market price of the currency

Speculation Expectations regarding Relative rates of inflation … Which impact relative interest rates … Which will impact economic performance and income … Which can change views on investment prospects … Impact currency markets in a never ending circular loop of profit motivated speculation

Speculation The goal? Buy currencies (or investments denominated in currencies) that you think are undervalued Sell currencies that you think are overvalued Of course, these speculative trades create market movements that reduce or eliminate the perceived over or under valuation.

Use of Foreign Reserves Use of foreign reserves – otherwise known as government intervention Governments can buy or sell their own (or another) currency in order to stabilize or change the relative value of their currency When governments intervene in the currency markets = “dirty float”

Do these Factors Really Move Markets? Let’s take a look …

Exchange Rates Meet BOP The same factors that impact exchange rates also impact balance of payments. Change in income Increase in income Increased demand for imports Net exports decline (Current Account goes down)

Exchange Rates and BOP Change in Relative Prices High relative inflation Imports up; exports down Net exports decline (Current Account goes down) Relative Investment Prospects Strong investment prospects attract flows of capital from foreign investors Improves the Capital Account

Exchange Rates and BOP Relative Interest Rates Speculation Increase in domestic U.S. interest rates will increase demand for US$ denominated instruments When foreign investors buy U.S. financial instruments – Capital Account improves Speculation Speculative buying and selling of impacts the Capital Account and market exchange rates

Exchange Rates and BOP Use of Foreign Reserves If the Fed buys US$ -- positive impact on value of US$ But, negative impact on Capital Account (reduction in reserves)

Everything is Related Economic growth and income, balance of payments and exchange rates are all related Y = C + I + G + (X-M) Changes in net exports (X-M) cause changes in GDP (Y) Changes in economic growth (income) and net exports drive changes in exchange rates, which in a circular fashion impact net exports and national income

A Self-Correcting System A floating exchange rate system is self-correcting Balance of payments will adjust (or should adjust) automatically based on changes in exchange rates A country that runs a large trade deficit will devalue its currency, making its exports cheaper to the rest of the world Exports rise – self-correcting the BOP problem

Your Assignment Pick a currency (anything except the US$). Summarize the exchange rate changes for this currency over the last 12 months. Explain the underlying causes of these exchange rate movements. Predict where this currency will trade over the next 12 months – and support your prediction.

Your Assignment (Cont’d) Required work product: 1 – 2 page paper summarizing your analysis and support for your predictions (due at the beginning of next class) Short (5 minutes or less) presentation of your analysis and conclusions

Exchange Rates (Continued) Agenda: Floating versus fixed exchange rates Advantages and disadvantages of floating and fixed exchange rate systems Managed exchange rates Purchasing power parity Terms of trade

Floating vs. Fixed Exchange Rates Floating exchange rate systems allow exchange rates to move based on supply and demand dynamics in the market. In fixed exchange rate systems the exchange rate is pegged or locked in to a specific, fixed rate of exchange. Floating and fixed systems have some important (and fairly obvious) advantages and disadvantages

Fixed Exchange Rates Advantages: Certainty Increased trade Fixed exchange rates take the risk of currency fluctuations out of business transactions (usually) Increased trade If the greater certainty of fixed exchange rates leads to an increase in trade, this would create a net economic benefit Experience over the last 30 years does not support this correlation

Fixed Exchange Rates Advantages: Reduced speculation No opportunity to profit from day to day changes in the exchange rate Huge opportunity to take positions in expectation of devaluations or revaluations of a fixed exchange rate Government discipline Without the self-correcting mechanisms of a floating exchange rate, governments (theoretically) should be forced to exercise more disciplined in the management of fiscal and monetary policy

Fixed Exchange Rates Disadvantages: Reserves Governments must have sufficient reserves of gold and foreign currency to support frequent intervention in the market Loss of control over monetary policy If exchange rates are fixed, money supply and interest rates must “float” based on flow of trade and investment No auto-correction mechanism

Floating Exchange Rates Advantages: Self-correcting No reserves required for market intervention Control over fiscal and monetary policy Governments can adjust fiscal and monetary policy and allow changes in the exchange rate to adjust for changes in the balance of payments (let the self-correcting mechanism do its thing)

Floating Exchange Rates Advantages: No large jumps Exchange rates move constantly, but usually in very small daily increments No major jumps from devaluations or revaluations Reduction in speculation (maybe) In theory offsetting trades may cancel each other out and reduce the net impact of speculation on the market

Floating Exchange Rates Disadvantages: Less certainty Floating rates add an additional element of uncertainty (risk) to international transactions This risk can be mitigated by hedging in forward currency markets Difficult to hedge long-term investments Increased speculation (probably)

Floating Exchange Rates Lack of discipline Adjustments in exchange rates can mute (or at least delay) the impact of irresponsible economic policies on the part of government, businesses or labor. Example: Government adopts inflationary monetary and fiscal policy; inflation increases; currency decreases in value, which helps offset the negative impact of higher prices on exports

Managed Exchange Rates Managed exchange rate systems fall between the two extremes of perfectly fixed and pure floating rate systems Two types of managed systems: Adjustable peg Government “pegs” a target exchange rate Manages based on a preset band around this target rate Dirty float Floating system with some government intervention

Exchange Rate Management Tools Buy or sell currency (ex: buy to appreciate currency) Manipulate interest rates (ex: lower to depreciate currency) Adopt protectionist policies (use of tariffs or export subsidies to protect value of currency) Violates WTO agreement Adjustments to exchange rate can have the same effect “Expenditure switching”

Exchange Rate Management Tools Use fiscal and monetary policy to drive changes in GDP/national income “Expenditure changing” Reductions in national income reduce spending on imports, which decreases the supply of currency on the market – currency appreciates and balance of payments improves Tradeoff between manging balance of payments and domestic economic and political considerations (“internal versus external balance”)

Purchasing Power Parity Based on “law of one price’ Asserts that a good must sell for the same price in all locations Under this theory, each currency should have the same purchasing power in its “home” market, and Nominal exchange rates should reflect the price levels in different countries

Purchasing Power Parity If the theory of purchasing power parity holds, the currency adjusted price of like products (think “Big Mac”) should be the same when benchmarked against a single currency (like the dollar) Why wouldn’t this theory hold in practice? Many goods are not easily traded Even goods that are easily traded are often not perfect substitutes (product differentiation)

Terms of Trade Ratio of average export prices to average import prices If export prices rise faster than import prices – terms of trade improve If import prices rise more than export prices – terms of trade worsen

Terms of Trade What will happen to the volume of trade as the terms of trade improve or worsen? Depends on the elasticity of demand for exports and imports – the sensitivity of demand to changes in price If demand for exports and imports is elastic (highly sensitive to price changes), an improvement in terms of trade (export prices rising faster than import prices) will worsen the balance of payments (as demand for exports falls more than imports)