Chapter One

Introduction to the World Economy

Chapter One Outline

1.

Introduction

2.

Studying international economics

International interdependence

3.

Introduction
International Economics is the main vehicle of international interdependence (globalization) through:

International trade in goods International trade in services International capital flows

Introduction
Microeconomics studies production and consumption of goods and services, and how firms, industries, and markets work Macroeconomics studies entire economys operations and the factors that determine total economic output International Economics a blend of Micro and Macro that studies the production, consumption, and distribution of goods, services, and capital on worldwide basis
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Studying International Economics

International economics usually divided into two parts:

1) Theory of international trade: Expends microeconomic analysis to global questions.

Goods and services available to consumers are maximized when each country specializes in producing those goods that it can produce relatively efficiently. Significant political pressure for protectionist policies: Restrict global trade to protect domestic producers from foreign competition.

Studying International Economics

2) International finance, balance-of-payments theory, or open-economy macroeconomics.

Applies macroeconomic analysis to aggregate international problems. Major concerns:

Level of employment and output Changes in price level, balance of payments, and exchange rates (relative prices of different national currencies). Interaction of international goals and influences with domestic ones in determining a nations macroeconomic performance and policy.
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International Interdependence
Interdependence in financial markets.

Has grown faster than that in markets for oil, steel, and cars. 24-hour global trading in stocks, currencies, and bonds.

In April 2010, average daily turnover of foreign exchange was approximately $4 trillion.

Figure 2: Daily Turnover in Foreign Exchange Markets,

1986-2004 (Trillions $)

International Interdependence

Global financial interdependence yields opportunities for international investment.

Lenders fund projects regardless of the projects locations. This growth of global trade has resulted from declines in costs of transportation and communication.
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Figure 3: Transport and Communication Cost, 1930-1990

(Index 1930 = 100)
Index (1930 = 100)
120 100 80 60 40 Cost of a 3-minute phone call New York to London Average ocean freight and port charges per short ton of cargo Average air-transport cost per passenger mile

20
0

1930 1940 1950 1960 1970 1980 1990

Year
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International Interdependence

Symptoms of international interdependence.

Rapid expansion of international trade.

Since 1950, trade has grown twice as fast as production. Global trade improves individuals potential well-being by increasing the quantity of goods and services available to consume.

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Figure 4a: Growth in World Merchandise Trade & Output,

1950-2002 (Percent)
Trade
12

Output

10
8 6 4 2

1950-63

1963-73

1973-90

1990-2002
12

Figure 4b: Growth in World Merchandise Trade & Output,

1990-2002 (Percent)

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International Interdependence

A second symptom of this global interdependence:

Synchronized changes in macroeconomic activity across countries.

Tendency toward simultaneous booms and recessions. Cautionary note: perhaps mere coincidence produced these patterns.

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Figure 8: Industrial Production in the Major

Industrialized Economies, 1979-2003

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International Monetary Economics

Now that we have highlighted the importance of International Economics through international interdependence of economic factors lets examine in closer detail International Monetary Economics.

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Chapter Two
Currency Markets and Exchange Rates
2003 South-Western/Thomson Learning

Chapter Two Outline

1. 2. 3.

Introduction Exchange Rates and Prices Demand and Supply in the Foreign Exchange Market How Are Exchange Rates determined under a Flexible Regime? How Are Exchange Rates determined under a Fixed Regime? Classification of Exchange Rate Regimes Foreign Exchange Markets Interest Parity
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4.

5.

6. 7. 8.

Introduction

One characteristic distinguishes international economic activity from domestic:

International transactions typically involve more than one currency.

We now examine the mechanics of currency markets and their role in global trade.
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Exchange Rates and Prices

What do prices tell us?

Relative prices convey information about the opportunity costs of various goods.

Relative price is sometimes referred to as a goods real price means the price is measured in real units (other goods), rather than monetary units.

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Exchange Rates and Prices

What do prices tell us?

We use money prices: they tell how many units of money (dollars, yen, etc.) we must pay to buy goods.

Money prices must reflect relative prices or opportunity costs: if 1 unit of X has a price of 10 and 1 unit of Y a price of 5, then 1X = 2Y, which is the opportunity cost of one good in terms of the other.
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Exchange Rates and Prices

How can we compare prices in different currencies?

Exchange rate: number of units of domestic currency required to purchase 1 unit of the foreign currency. (Note: a Briton would view it as /$, while an American as $/).

A change in the exchange rate, other things being equal, changes all foreign prices relative to all domestic prices.
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Foreign Exchange Markets

Foreign exchange market is generic term for the worldwide institutions that exist to exchange or trade different countries currencies. The participants are banks, firms, foreign exchange brokers, central banks, and other government agencies.

Daily exchange rate quotations:

Column one reports the number of U.S. dollars required to buy one unit of foreign currency (e). Column two reports the number of units of foreign currency required to purchase a U.S. dollar (e = 1/e).
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Foreign Exchange Markets

Exchange Rates (New York closing prices) Thursday, February 28, 2008 Americas
(selected countries)
In US $ Argentina peso Brazil real Canada dollar 1-mos forward 3-mos forward 6-mos forward Chile peso Colombia peso Ecuador US dollar Mexico peso 0.3169 0.5992 1.0240 1.0234 1.0222 1.0201 0.002196 0.0005438 1 0.0937 Per US $ 3.1556 1.6689 0.9766 0.9771 0.9783 0.9803 455.37 1838.91 1 10.6735 Euro area euro Switzerland franc 1-mos forward 3-mos forward 6-mos forward Turkey lira UK pound 1-mos forward 3-mos forward 6-mos forward

Europe
(selected countries)
In US $ 1.5214 0.9520 0.9524 0.9526 0.9525 0.8452 1.9917 1.9877 1.9789 1.9654 Per US $ 0.6573 1.0504 1.0500 1.0498 1.0499 1.1832 0.5021 0.5031 0.5053 0.5088
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Demand/Supply in Foreign Exchange Markets

Demand curve for a foreign currency: shows how many units of the currency individuals would want to hold at various exchange rates.

Relationship between the quantity demanded of foreign exchange and the spot exchange rate (expressed as the domestic currency price of a unit of foreign currency) is a negative one. As the exchange rate rises, the quantity of foreign exchange demanded falls. The negatively sloped line in Figure 5 illustrates the negative relationship between the quantity demanded of foreign exchange and the exchange rate.
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Figure 5: The Exchange Rate and the Quantity Demanded of Foreign Exchange
e = /$

The gains value against the $

The loses value against the $

e1: 2 = $1

e2: 1 = $1 D$

Quantity Demanded of $
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Demand/Supply in Foreign Exchange Markets

The supply curve for a foreign currency shows how many units of foreign currency are available for individuals to hold at various exchange rates.

Because the stock of foreign currency available at any time is fixed (depends on central bank and commercial banks loan decisions), one can represent the supply of foreign exchange by a vertical line, S$, in Figure 6.

The supply curve is vertical because the supply of deposits in existence at any time does not depend on the exchange rate.
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Figure 6: The Supply of Foreign Exchange

e = /$
S
$

Quantity Supplied of $
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Exchange Rate Regimes

Exchange rate regime: in each country, the monetary authorities decide the type of policy to follow regarding the exchange rate.

Four types of regimes:

1. 2.

3.
4.

Flexible or floating exchange rates; Fixed or pegged exchange rates; Special case: Official (Full) Dollarization Managed floating (a mixture of flexible and fixed); and Exchange controls.
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Exchange Rate Determination under a Flexible Rate Regime

Since the 1970s, most countries have moved towards the use of flexible, or floating, exchange rates.

Demand for and supply of each currency in FX market determine the exchange rate. Figure 7 shows the equilibrium exchange rate (e3) between the dollar and the pound. The exchange rate moves to equate the quantity demanded and the quantity supplied of pounds. We call a rise in the market-determined rate a depreciation of the currency whose price has fallen, and an appreciation of the currency whose price has risen.
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Figure 7: Equilibrium in the Foreign Exchange Market under a Flexible Rate Regime
e = /$ S$
Appreciation of the , or depreciation of the $ Depreciation of the , or appreciation of the $

Surplus of $ e1: 3 = $1

e3: 2 = $1

e2: 1 = $1

Shortage of $

D$

Quantity of $

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What Affects the Exchange Rates? (Flexible Rate Regime)

Any change in economic conditions that increases the demand for a particular currency causes that currency to appreciate. These factors include:

Domestic and foreign income (GDP). Domestic and foreign interest rates (i). Domestic and foreign price changes (P). Domestic and foreign expectations (ee, ef). Non-economic factors (wars, political turmoil).
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Figure 8: Shifts in the Demand for Foreign Exchange Change the Exchange Rate
GDPUK

e = /$

i ee ef i

i$ ee ef i

GDPUK

S$

PUS

PUS

e1: 3 = $1

e0: 2 = $1 D$ 1 e2: 1 = $1 D$ 0
$ D2

Quantity of $

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Exchange Rate Determination under a Fixed Rate Regime

Exchange rates have not been flexible through most of modern economic history.

Central banks used fixed or pegged exchange rates for their respective currencies.

Figure 9 shows a pegged exchange rate above the equilibrium rate.

To maintain the exchange rate at a certain point, a central bank must stand ready to absorb the excess quantity supplied of a foreign currency.
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Figure 9: A Pegged Exchange Rate above the Equilibrium Rate

e = /$ S$
Intervention

ep 1

D$ 0 Quantity of $
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Exchange Rate Determination under a Fixed Rate Regime

Intervention: when a central bank steps into the market to buy or sell a particular currency.

If a countrys central bank chooses to adjust the pegged exchange rate downward, the policy is called a revaluation of that currency.

Analogous to an appreciation under a flexible regime.

Figure 10 shows a pegged exchange rate below the equilibrium rate.

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Figure 10: A Pegged Exchange Rate below the Equilibrium Rate

e = /$ S$

ep 2
Intervention

D$ 0 Quantity of $
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Exchange Rate Determination under a Fixed Rate Regime

For intervention purposes, governments hold stocks of deposits denominated in various foreign currencies, called foreign exchange reserves. Depletion of these reserves due to support of fixed rate lead to

Foreign exchange borrowing from foreign central banks or IMF to continue intervention. Reset the pegged rate at a higher level. Allow the exchange rate to flow.
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Exchange Rate Determination under a Fixed Rate Regime

Under a fixed regime, if the central bank chooses to reset the exchange rate at a level higher than equilibrium, the policy is called a devaluation.

This is analogous to a depreciation under a flexible regime.

Later we will discuss the implications of a fixed exchange rate regime for the conduct of macroeconomic policy (induces uncertainty).
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Classification of Exchange Rate Regime (Rose, 2011)

Classification of regimes is not straightforward

Based on

Official statements of de jure policy intent by national authorities (IMF classification) Actual de facto behaviour

Levy-Yeyati and Sturzenegger (2003) Reinhart and Rogoff (2004) Shambaugh (2004)
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Classification of Exchange Rate Regime

These classifications are available

For different spans of data across countries and time At different frequencies (monthly vs. annual) With various numbers of classifications (two to fifteen) At different levels of volatility (how often countries switch regime) They clash for some countries or periods
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Notes: Taken from Rose (2011)

42

Choice of Exchange Rate Regime

What is the distribution of exchange rate regimes across the world?

Figure 1 shows that most countries fix their exchange rates Figure 2 shows that only a small fraction of world output has been produced in economies with fixed rates Figure 3 shows that exchange rate regimes have become more persistent; switches are rare

43

Notes: Taken from Rose (2011)

44

Notes: Taken from Rose (2011)

45

Notes: Taken from Rose (2011)

46

Choice of Exchange Rate Regime

What is the distribution of exchange rate regimes across the world?

Figure 4 shows that small (population-wise) countries tend to fix their exchange rates; less than 2.5 million people Figure 5 shows that a countrys level of real income plays no role in the choice of a regime

47

Notes: Taken from Rose (2011)

48

Notes: Taken from Rose (2011)

49

Choice of Exchange Rate Regime

To summarize

Fixed rates characterize a large number of countries but a small proportion of global GDP and market activity Switches in exchange rate regimes are becoming rare A disproportionate number of the smallest countries of the world maintain fixed exchange rates Beyond a point, population size has little effect on regime choice Income has no impact on regime choice
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Foreign Exchange Markets

What type of transactions happen in foreign exchange markets?

Each bank, firm, or individual must choose how to allocate its available wealth among various assets.

Asset: something of value. Asset portfolio: set of assets owned by a firm or individual.

Portfolio choice: allocating ones wealth among various types of assets in order to maximize future income.

Primary determinant of any particular assets desirability is its expected rate of return. However, these assets may be located in different countries; hence in different currencies.
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Foreign Exchange Markets

Spot exchange market: the market in which participants trade currencies for current delivery, which actually means within two business days. Clearing function of foreign exchange market

Example: a U.S. firm decides to buy a British (firm or government) bond. The U.S. firm typically enters the spot foreign exchange market to buy the pounds in which the British firm wants to be paid. This happens when the U.S. firm instructs its bank to debit its dollar account and credit the pound bank account of the British firm.
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Foreign Exchange Markets

Arbitrage: refers to process by which banks, firms, or individuals seek to earn a profit by taking advantage of discrepancies among prices that prevail simultaneously in different markets. It is a riskless process.

Ensures not only that currencies exchange at same rate in different locations, but that exchange rates will be consistent across currencies. Two-point arbitrage: use of 2 currencies in arbitrage. Three-point (Triangular) arbitrage: use of 3 currencies in arbitrage. Inconsistent cross-rates: quoted exchange rates in different locations that offer arbitrage opportunities consistency restored by arbitrage actions.
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Two-Point Arbitrage

Suppose eNY = $2/1 and eLON = $2.2/1, or equivalently eNY = 0.5/$1 and eLON = 0.45/$1. How can an Arbitrager make a profit? NY: sell $1, buy 0.5 ( appreciates) London: sell 0.5, buy $1.1 ($ appreciates) Outcome: profit of $0.1 per $1 traded.

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Two-Point Arbitrage
$/ S /$ S$

0.48=$1 0.5=$1

0.48=$1
0.45=$1 D 0

D$ 0 $

New York

London
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Three-Point Arbitrage

Suppose NY: 1 = $1, London: 1 = 2 , and Tokyo: $3 = 1. How can an Arbitrager make a profit? NY: sell $1, buy 1 ( appreciates) London: sell 1, buy 0.5 ( appreciates) Tokyo: sell 0.5, buy $1.5 ($ appreciates) Outcome: profit of $0.5 per $1 traded. How would the results change if originally in Tokyo: $2 = 1?
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Foreign Exchange Markets

Hedging: a way to transfer part of the foreign exchange risk inherent in all non-instantaneous transactions that involve two currencies.

Entering the foreign exchange market to hedge insulates wealth from effects of adverse changes in the exchange rate. Short position: being short of a particular currency you will need in the near future. Balanced, or closed, position: owning as many units of a particular currency as you need to cover your upcoming payment in that currency.
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Foreign Exchange Markets

Speculation: just the opposite of hedging it means deliberately making your wealth depend on changes in the exchange rate by
1.

2.

Buying a foreign currency (taking a long position) in the expectation that the currency's price will rise, allowing you to sell it later at a profit; or Promising to sell a foreign currency in the near future (taking a short position) in the expectation that its price will fall, allowing you to buy the currency cheaply and sell it at a profit.
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Foreign Exchange Markets

Obviously, speculation becomes a much easier job if one has inside information! An interesting Washington Post piece on recent inside information about Feds decision not to slow down its bond purchases: http://www.washingtonpost.com/blogs/wonkblog/wp/2 013/09/24/traders-may-have-gotten-last-weeksfed-news-7-milliseconds-early/

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Foreign Exchange Markets

Buying currency now for delivery later.

Major markets for foreign exchange other than spot markets are forward markets.

Participants sign contracts for foreign-exchange deliveries to be made at some specified future date. 30-day forward rate for pounds: the dollar price at which you can buy a contract today for a pound deposit to be delivered in 30 days.

% difference between the 30-day forward rate (ef) on a currency and the spot rate is called the forward premium if positive and forward discount if negative.
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Foreign Exchange Markets

Exchange Rates (New York closing prices) Thursday, February 28, 2008 Americas
(selected countries)
In US $ Argentina peso Brazil real Canada dollar 1-mos forward 3-mos forward 6-mos forward Chile peso Colombia peso Ecuador US dollar Mexico peso 0.3169 0.5992 1.0240 1.0234 1.0222 1.0201 0.002196 0.0005438 1 0.0937 Per US $ 3.1556 1.6689 0.9766 0.9771 0.9783 0.9803 455.37 1838.91 1 10.6735 Euro area euro Switzerland franc 1-mos forward 3-mos forward 6-mos forward Turkey lira UK pound 1-mos forward 3-mos forward 6-mos forward

Europe
(selected countries)
In US $ 1.5214 0.9520 0.9524 0.9526 0.9525 0.8452 1.9917 1.9877 1.9789 1.9654 Per US $ 0.6573 1.0504 1.0500 1.0498 1.0499 1.1832 0.5021 0.5031 0.5053 0.5088
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Interest Parity

Uncovered interest parity applies to transactions in which participants do not use forward markets to transfer foreign exchange risk. Covered interest parity applies to transactions in which they do. Individuals and firms must form an expectation about the future spot rate of a particular currency and base their asset decision on that.

Uncovered interest parity

This expectation is called the expected future spot rate (ee) what people expect today about the spot rate that will prevail in the future.
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Interest Parity

Uncovered interest parity (cont.)

When all participants in an economy choose between purchasing dollar- and pound-deposits in a way to maximize expected rate of return, the result is a relationship among interest rates, the current spot rate, and the participants expectations of the future value of the spot rate. Expected dollar rate of return on a dollar-denominated deposit is just the interest rate (i$). Expected dollar rate of return on a pound-denominated deposit has 2 components: the interest rate on the deposit (i), and the expected rate of change in value of pounds relative to the dollar ([ee e] / e).

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Interest Parity

Uncovered interest parity (cont.)

Using the pound example in the text, the general case algebraically is: If i$ < i + (ee-e)/e, purchase the pounddenominated deposits. If i$ > i + (ee-e)/e, purchase the dollardenominated deposits.

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Interest Parity

Uncovered interest parity (cont.)

From the previous two equations, we see that there will be no incentive to shift from one currency to the other when the expected dollar rates of return on the two types of deposits are equal.

This equilibrium condition is known as uncovered interest parity. It holds when

General Case

i$ = i + (ee-e)/e
Numerical Example 2% = 1% + [($2.02/1 - $2.00/1)/$2.00/1)] = 2%
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Interest Parity

Uncovered interest parity (cont.)

An alternative way of writing the uncovered parity condition puts the interest differential (i$ - i) on the left-hand side. i$ - i = (ee-e)/e

The term on the right-hand side is the expected increase (if positive) or decrease (if negative) in the value of pounds against dollars, expressed in percentage terms.
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Interest Parity

Covered interest parity

Using the nominal interest at any country to find the gross return on a deposit: $f = $ value at maturity US: $f = $p (1+i$) $p = $ value at present UK: f = p (1+i) Divide: ($f / f)= ($p / p )[(1+i$) / (1+i)] Or ef = ep [(1+i$) / (1+i)] Or [(ef - ep) / ep](1 + i) = i$ - i
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Interest Parity

Covered interest parity (cont.):

Using the pound example in the text and letting ef represent the forward rate, the general case is:
If i$ < i + (ef-e)/e, purchase the pounddenominated deposits.
If i$ > i + (ef-e)/e, purchase the dollardenominated deposits.

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Interest Parity

Covered interest parity (cont.)

Both the interest differential and the forward premium or discount on foreign exchange must be taken into account in choosing deposits denominated in different currencies based on their rates of return. When participants make their decisions based on the previous two equations, the resulting equilibrium condition is known as covered interest parity. It holds when
General Case i$ = i + (ef-e)/e Numerical Example 2% = 1% + [($2.02/1 - $2.00/1)/($2.00/1)] = 2%
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Interest Parity

Does interest parity hold?

Empirical support for the relationship is quite strong, but the results are sensitive to the testing technique.

The parity relationship holds more closely when all deposits used in the test are issued in a single country.

A 2nd country could impose restrictions on the movement of funds across their borders.

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