1. Eco 344 International Economic Relations 1

2. Instructor www.fsb.muohio.edu/lij14/ 2

3. Office 3

4. Textbook Robert C. Feenstra University of California, Davis Robert C. Feenstra Alan M. Taylor University of California, Davis Alan M. Taylor 4

5. Quiz (no grade) First Name_____, Last Name_______, Major_____ Q1: What would happen to the oil price if the civil war in Libya ends now? Please use the demand-and-supply diagram. Q2: People say that we need to bring jobs back to US from overseas. But how? Give one or two suggestions. 5

6. World Economy in 2010 http://www.economist.com/blogs/dailychart/20 10/12/charts_2010 Do you want to buy house soon? Do you want to complain about no salary raise? What happens to unemployment rate in US? Why are the young people in Egypt so unhappy? What’s wrong with Ireland and Greece? 6

7. Suggestions to bring jobs back Tax Tariff Minimum Wages Education, Infrastructure New Jobs 7

8. My Comments Most oversea jobs are labor-intensive. USA does not have (comparative) advantage producing labor-intensive goods. Companies make decisions. A workable solution should agree with companies’ interests. Tariff may trigger trade war. 8

9. External Debt US is running (current account) deficit because expenditure exceeds income The deficit is financed by borrowing from other countries (How about printing money?) The absolute amount of US external debt is huge Other countries have higher debt-income ratios than US http://en.wikipedia.org/wiki/List_of_countries_b y_external_debt http://en.wikipedia.org/wiki/List_of_countries_b y_external_debt 9

10. Default on US Debt? Interest rate will go up Investment will go down Stock price will go down Consumption will go down Export will go down Fiscal deficit will go up Less confidence in US 10

11. Credit Ratings of Sovereign Debts Credit score for country http://en.wikipedia.org/wiki/List_of_countries _by_credit_rating http://en.wikipedia.org/wiki/List_of_countries _by_credit_rating BB+ or lower is junk bond What’s wrong with Argentina? 11

12. International Perspective http://chartsbin.com/graph www.google.com 12

13. (Bilateral) Exchange Rate Exchange rate is price of currency Two ways to quote exchange rate One way is the reciprocal of the other: E A/B = 1/ E B/A Currency A appreciates if E B/A goes up Currency A appreciates if E A/B goes down To avoid confusion we use E A/B for currency A 13

14. Multilateral (Effective) Exchange Rate Available at http://research.stlouisfed.org/fred2/categorie s/15 http://research.stlouisfed.org/fred2/categorie s/15 Trade-weighted average of bilateral exchange rate Does currency A appreciate or depreciate against other currencies in general? 14

15. US Effective Exchange Rate 15

16. Discuss What is the variable on vertical axis? Why are there two lines? Has dollar depreciated or appreciated in general? Why is the red line steeper than the blue line? 16

17. Using Exchange Rates to Compare Prices P A is the currency-A price P B is the currency-B price Which price is cheaper? P A <> P B x E A/B P A <> P B / E B/A 17

18. Exchange Rates and Trade What happens to country A’s export and import if currency A depreciates? E A/B goes up The price of imported goods P B x E A/B goes up, so import goes down The price of exported goods P A / E A/B goes down, so export goes up In short, depreciation helps export but hurts import 18

19. Argentina’s Crisis Revisited During the 2002 (Peso) crisis, Argentina’s currency depreciated against US dollar Argentina’s export to US improved But, the price of imported goods went up, so inflation was high 19

20. Discuss: Chinese Yuan Suppose Yuan appreciates against US dollar What happens to US export to China? What happens to US import from China?, and, from other countries like Vietnam? What happens to US inflation rate? 20

21. Review Two ways to quote exchange rate (Corn Story) If currency A depreciates against B, then B must appreciate against A Depreciation increases export Depreciation decreases import Intuition is, if our currency becomes cheap (depreciate), our goods become cheap too. So more foreign people want to buy our goods and our export to foreign countries rises. Appreciation has opposite effects 21

22. Japanese Intervention Yen’s appreciation hurts Japanese export To stop the appreciation of Yen, supply curve for Yen should shift to right Japanese central bank sells (supplies) Yen and buys (demands) dollars Reality Check: http://www.usatoday.com/money/world/2011- 08-04-japan-yen-intervention_n.htm 22

23. Chinese Intervention To keep Yuan from appreciating, Chinese central bank keeps selling Yuan and buying dollars China’s dollar reserve accumulated, and money supply increased Inflation rate in China went up China is importing inflation (or expansionary monetary policy, QE) from US due to its fixed exchange rate Letting Yuan appreciate helps mitigate inflation in China 23

24. 1997 Asian Financial Crisis Some Asian currencies were overvalued, and were expected to depreciate To stop depreciation, their governments sold US dollar and bought domestic currencies The crisis (the rapid depreciation) occurred when the government ran out of dollar reserve http://en.wikipedia.org/wiki/1997_Asian_fina ncial_crisis http://en.wikipedia.org/wiki/1997_Asian_fina ncial_crisis 24

25. Exchange Rates: Developed Countries 25

26. Exchange Rates: Developing Countries 26

27. Remarks 1997 Asian Crisis 2002 Argentina Crisis Denmark uses fixed exchange rate against Euro Ecuador dollarized in 2000, see http://en.wikipedia.org/wiki/Dollarization http://en.wikipedia.org/wiki/Dollarization Euro was introduced in 1999, see http://en.wikipedia.org/wiki/Euro http://en.wikipedia.org/wiki/Euro 27

28. Spectrum of Exchange Rate Regimes 28

29. Foreign Exchange (FX) Market Spot Contract; Spot Rate; Immediate Exchange of One Currency for Another Derivatives (Forwards, Swaps, Futures, Options) For forward contract, the delivery of currency is in the future Forward rate tracks spot rate closely. 29

30. Spot and Forward Rates 30

31. Remarks about FX Market The FX market is highly volatile (risky) Government is an important player Some currencies are not fully convertible due to reasons such as capital control Transactions on FX market have different purposes: hedging, speculation, arbitrage, government intervention…. 31

32. Arbitrage Arbitrage means buying low and selling high Arbitrage push prices to converge Everyone buys low, so the low price will go up Everyone sell high, so the high price will go down Prices become stable when prices become equalized (No Arbitrage Condition). 32

33. Theory of Exchange Rates I: No-Arbitrage with Two Currencies E 1/2, A denotes the exchange rate at location A E 1/2, B denotes the exchange rate at location B No-arbitrage condition requires that E 1/2, A = E 1/2, B In reality the two rates can differ due to factors such as transaction cost 33

34. Two facts Currency A appreciates (become more expensive) ↔ E A/B goes down Currency A depreciates (become less expensive) ↔ E A/B goes up You can avoid many confusions if you keep these two facts in mind When the corn price changes from E corn/$ = 4 to E corn/$ = 5, the corn becomes cheaper 34

35. Euro Unit Europe monetarily: One central bank Remove (part of) risk of foreign exchange Make it easy to travel and do business within Eurozone Next, one Treasury? http://www.nytimes.com/2011/09/06/business/ global/reluctantly-europe-inches-closer-to-a- fiscal-union.html?_r=1&hp http://www.nytimes.com/2011/09/06/business/ global/reluctantly-europe-inches-closer-to-a- fiscal-union.html?_r=1&hp Challenge: heterogeneity in members 35

36. Soros http://olesiafx.com/Kathy-Lien-Day-Trading- The-Currency-Market/George-Soros-the-Man- Who-Broke-The-Bank-Of-England.html http://olesiafx.com/Kathy-Lien-Day-Trading- The-Currency-Market/George-Soros-the-Man- Who-Broke-The-Bank-Of-England.html 36

37. Q 5 on Page 61 Suppose quotes for the dollar-euro exchange rate E $/€ are as follows: in New York $1.50 per euro, and in Tokyo $1.55 per euro. Describe how investors use arbitrage to take advantage of the difference in exchange rates. Explain how this process will affect the dollar price of the euro in New York and Tokyo. 37

38. Answer Euro is more expensive at Tokyo Buy euro at New York and sell euro at Tokyo The New York rate, 1.50 will go up The Tokyo rate, 1.55 will go down Trick for exams: arbitrage always pushes lower rate up and higher rate down (i.e., Two rates converge). 38

39. Theory of Exchange Rates II: No-Arbitrage with Three Currencies E 1/3 is the direct rate E 1/2 E 2/3 is the cross rate, and currency 2 is called vehicle currency No triangular-arbitrage condition requires that E 1/3 = E 1/2 x E 2/3 or equivalently, E 1/3 = E 1/2 / E 3/2 In short, arbitrage pushes the direct rate and cross rate to be equal 39

40. Covered Interest Parity (CIP) Theory for Forward Exchange Rate F denotes the forward (exchange) rate An investor can use dollar deposit Alternatively an investor can convert dollar to euro using spot rate, use euro deposit and later convert euro back to dollar using forward rate No arbitrage condition implies that 40

41. Remarks about CIP We can solve for forward rate if we know interest rates and spot rate Forward rate and spot rate are positively correlated, explaining Figure 2-5 on page 40 CIP implies that 41

42. Evidence on CIP 42

43. Uncovered Interest Parity (UIP) Theory for Spot Exchange Rate No-Arbitrage also indicates UIP, which states that 43

44. Implication of UIP Everything else equal, a rise in American interest rate leads to a fall in current spot rate, i.e., instantaneous appreciation of dollar Everything else equal, a rise in American interest rate leads to a rise in expected future spot rate, i.e., expected future depreciation of dollar 44

45. Remarks about UIP 45

46. Lesson for International Investment When making decision regarding international investment, one needs to take both interest rate and exchange rate into account If American interest rate is higher than euro interest rate, then according to UIP, dollar is expected to depreciate against euro 46

47. Drawbacks of UIP and CIP They are short-term models They ignore the effect of trade on exchange rate One cannot apply UIP or CIP for countries with capital control 47

48. Q 6 on Page 61 48

49. Bond Yields http://www.economist.com/blogs/dailychart/201 1/09/government-bonds/print http://www.economist.com/blogs/dailychart/201 1/09/government-bonds/print Bond price is negatively related to yield (interest rate) The yield of Greek bond is highest, so the price of Greek bond is lowest. US bond is still popular Demand-and-supply diagram can be applied to the bond market 49

50. Critical Thinking Fine-Tuning CIP and UIP Read key points 12-15 on page 59 We can improve a theory by relaxing its assumption Assumptions for the basic form of CIP and UIP: (a)No capital control (b)No tax (c)No fee for currency transaction (d)No inflation… 50

51. Modified CIP Let denote the inflation rate, the tax rate for interest payment, and the fee rate for foreign transaction. The modified CIP may look like 51

52. Purchasing Power Parity (PPP) A Long-Term Theory for Exchange Rate Intuition: The long-run value of a currency is determined by its purchasing power Purchasing power is negatively related to price The currency of a country with high inflation is expected to lose its value, i.e., depreciate against a currency with low inflation 52

53. Law of One Price (LOOP) 53

54. Remarks about Absolute PPP 54

55. Absolute PPP says In long term, due to arbitrage: (1)The same basket of goods has the same common-currency prices in different countries (2)Because of (1), nominal exchange rate equals the ratio of price levels (3) Because of (1), the same currency has the same purchasing power in different countries (4) The real exchange rate equals one 55

56. Real Exchange Rate 56

57. Real Exchange Rate and Trade (I) 57

58. Real Exchange Rate and Trade (II) 58

59. Chinese Real Exchange Rate Chinese nominal exchange rate appreciates slowly But, Chinese real exchange rate appreciates quickly, because China has higher inflation rate than US In other words, the prices of imported Chinese goods will rise at a rate much higher than the appreciation rate of Yuan This helps rebalance US current account faster http://www.economist.com/blogs/freeexchange/ 2011/01/chinas_currency http://www.economist.com/blogs/freeexchange/ 2011/01/chinas_currency 59

60. Mathematical Notes Percentage change in (XY) = percentage change in X + percentage change in Y Percentage change in (X/Y) = percentage change in X - percentage change in Y 60

61. Percentage Change of Exchange Rate According to absolute PPP, exchange rate is ratio of prices Using the second mathematical note in the previous slide, we can derive a formula for the percentage change of exchange rate, called relative PPP. 61

62. Relative PPP Absolute PPP implies relative PPP: 62

63. Implications of Relative PPP 63

64. Long-Run Trend for Dollar-Yen Exchange Rate http://finance.yahoo.com/q/bc?s=USDJPY=X+ Basic+Chart&t=5y http://finance.yahoo.com/q/bc?s=USDJPY=X+ Basic+Chart&t=5y 64

65. US and Japan Inflation Rates http://www.tradingeconomics.com/ 65

66. In Long Run, Relative PPP Works 66

67. In Short-Run PPP Fails 67

68. Remarks Absolute PPP says the level of exchange rate is determined by the price ratio Relative PPP says that the change of exchange rate is determined by the inflation differential Absolute PPP implies relative PPP, not vice versa. 68

69. Why Does PPP Fail? Transaction Cost Non-Traded Goods Imperfect Competition and Legal Obsacles Price Stickiness 69

70. Monetary Model for Exchange Rate Absolute PPP says that exchange rate is determined by price ratio So we need a theory to explain price The theory is called Quantity Theory of Money 70

71. Quantity Theory of Money 71

72. Money Market 72

73. Remarks 73

74. Monetary Model 74

75. Hyperinflation If inflation is very high, PPP holds even in short run 75

76. L is not constant when inflation is high 76

77. Story of Hyperinflation Huge budget deficit leads to Printing a lot of money, which leads to Hyperinflation, which leads to Rapid deprecation, which leads to Dollarization or Redenominating (see Side Bar on page 90) 77

78. Fixed Exchange Rate China uses fixed exchange rate. Relative PPP still applies: Fixed exchange rate means zero depreciation (or appreciation) rate. China needs to anchor its inflation as 78

79. Remarks If US increases money supply, China needs to increases money supply too if China wants to keep exchange rate fixed If US increases money supply, but China does not want to increase its money supply, then China has to let its currency appreciate 79

80. How to Anchor Inflation 80

81. Homework: Q-7 on page 107 81