INTERNATIONAL FINANCE

Eva Hromádková, 10.5 2010

Macroeconomics ECO 110/1, AAULecture 12

Overview

What determines the value of one country’s money as compared to the value of another’s?

What causes the international value of currencies to change?

Should governments intervene to limit fluctuations of exchange rate?

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Exchange Rates

The exchange rate is the price of one country’s currency expressed in terms of another’s.

e.g: CZK/EUR = 25.965 CZK/USD = 20.374

And also EUR/CZK = 0.0385 USD/CZK = 0.0491

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Foreign-Exchange Markets

Currency is a commodity to be bought and sold like any other.

Foreign-exchange markets are places where foreign currencies are bought and sold.

An exchange rate is subject to the same influences that determine all market prices: demand and supply. We will look at the example of the Czech

crown

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Foreign-Exchange MarketsThe Demand for CZK

The market demand for Czech crowns originates in: Foreign demand for Czech exports:

E.g. tourist in Czech restaurants Foreign demand for Czech investments:

E.g. when Telefonica O2 bought Eurotel Speculation.

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Foreign-Exchange MarketsThe Supply of CZK

The demand for foreign currency represents a supply of Czech crown.

The supply of dollars originates in: Czech demand for imports

E.g. import of IPods Czech investments in foreign countries. Speculation.

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The Value of the CZK

A higher crown price for euros (# of CZK for 1 euro) will raise the crown costs of German goods.

euro of

priceCrown

BMW of

price euro

BMW of

priceCrown X

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Foreign-Exchange Markets

The Supply Curve The supply of CZK is upward-sloping. If the value of the CZK rises, Czechs can

buy more euros/dolars.The Demand Curve The demand for CZK is downward-sloping As CZK becomes cheaper, all Czech

exports effectively fall in price – higher demand

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Foreign-Exchange MarketEquilibrium

0.5

1.5

2.0

2.5

3.0

QUANTITY OF CZK per time period

EU

RO

PR

ICE

OF

CZ

K(e

uros

pe

r do

llar)

0

Supply of CZK

Demand for CZK

Equilibrium0.90

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The Balance of Payments

The balance of payments is a summary of a country’s international economic transactions in a given period of time.

It is an accounting statement of all international money flows in a given time period.

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1. Trade Balance

The trade balance is the difference between exports and imports of goods and services.

Trade balance = exports – imports

A trade deficit represents a net outflow of currency to the rest of the world.

We had to buy foreign currency to import those goods and services => outflow of our currency

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2. Current-Account Balance

Includes trade balance as well as investment balances and private transfers

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3. Capital-Account Balance

The capital account balance takes into consideration assets bought and sold across international borders. Ex.: domestic bonds, foreign companies, …

–Capital account balance

Foreign purchase of

domestic assets

Domestic purchases of foreign assets

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3. Capital-Account Balance

The capital-account surplus must equal the current-account deficit. Flow of money against the flow of goods

and services

–Net

balance of payments

current-account balance

capital-account balance

0

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Market Dynamics

Exchange rates on foreign-exchange (FX) markets are always changing in response to shifts in demand and supply.

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Depreciation and Appreciation Depreciation (currency) refers to a fall

in the price of one currency relative to another.

Appreciation refers to a rise in the price of one currency relative to another. Whenever one currency depreciates,

another currency must appreciate!

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Market Forces

Some of the more important reasons supply and/or demand may shift:

• Relative income changes.• Higher income in country A => higher demand for

imports => appreciation of country’s B currency

• Relative price level changes.• Changes in product availability.• Relative interest-rate changes.

• If interest rate in country A goes up, it will increase demand for investment => appreciation of country A’s currency

• Speculation – based on anticipationLO2

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Quantity of Dollars

Yen

Pric

e of

Dol

lar

Quantity of Dollars

Eur

o P

rice

of D

olla

r Shifts in FX MarketsIntroduction of Japanese luxury cars in US

Dollar-yen market

P1

P2

S1

S2

D

S2

S1

D

P2

P1

Dollar-euro market

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The Asian Crisis of 1997-1998 The Asian crisis of 1997-1998 was

caused by several market forces moving in the same direction at the same time.

In July 1997, the Thai government decided the baht was overvalued and let market forces find a new equilibrium Within days, the dollar price of the baht

plunged 25 percent and the Thai price of the U.S. dollar increased.

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The Asian Crisis of 1997-1998 The devaluation of the baht had a

domino effect on other Asian currencies. Holders of the Malaysian ringget, the

Indonesian rupiah and the Korean won rushed to buy U.S. dollars.

This pushed the value of local currencies even lower

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The Asian Crisis of 1997-1998 The “Asian contagion” wasn’t confined

to that area of the world Hog farmers in the U.S. saw foreign demand

for their pork evaporate. Koreans stopped taking vacations in Hawaii. Thai Airways canceled orders for Boeing jets.

This loss of export markets slowed economic growth in the United States, Europe, Japan, and other nations.

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Resistance to Exchange-Rate Changes

People / investors / firms crave stable exchange rates

This resistance to exchange rate changes originates in various micro and macro economic interests.

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Resistance to exchange rate changesMicro Interests People who trade or invest in world markets

want a solid basis for forecasting future costs, prices, and profits.

Fluctuating currency exchange rates are an unwanted burden on trade, as a change in the price of a country’s money automatically alters the price of all of its exports and imports

Import-competing industries suffer when currency depreciations make imports cheaper E.g. steel from Russia and Japan in US

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Resistance to exchange rate changesMacro Interests A micro problem that becomes widespread

enough can turn into a macro one.Example of US: The huge U.S. trade deficits of the 1980s

effectively exported jobs to foreign nations. Trade deficits were offset by capital-account

surpluses – foreign investment in US, increase of US foreign debt and interest costs

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Exchange-Rate Intervention

Governments often intervene in foreign-exchange markets to achieve greater exchange-rate stability.

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Fixed Exchange Rates

One way to eliminate fluctuations is to fix the exchange rate

Gold Standard - An agreement by countries to fix the price of their currencies in terms of gold; a mechanism for fixing exchange rates. each country determines that its currency

is worth so much gold Bretton-Woods, 1944

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Fixed exchange rateBalance of Payment Problems

Market supply and demand of currency naturally shift (e.g. changing demand for imports)

This moves the equilibrium exchange rate away from the fixed exchange rate => excess demand for certain currencies E.g. higher demand for IPods – higher

demand for USD – at given exchange rate limited supply – excess demand for USD

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Fixed exchange rateBalance of Payment Problems

Excess demand for a foreign currency implies: balance-of-payments deficit for the domestic nation, A balance-of-payments surplus for the foreign nation.

There are only two ways to deal with balance-of-payments problems Allow exchange rates to change. Alter market supply or demand so that they intersect

at the established exchange rate. Only second alternative is viable

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0Quantity of Pounds

Dol

lar

Pric

e of

Pou

nds

Fixed Rates and Market Imbalance

Excess demand for pounds

S1D2D1

e2

e1

qS qD

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Fixed exchange rate The Need for Reserves

Existence of Foreign-Exchange Reserves - Holdings of foreign exchange by official government agencies, usually the central bank or treasury.

The central bank can help maintain the officially established exchange rate by selling some of its foreign exchange reserves.

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0Quantity of Pounds

Dol

lar

Pric

e of

Pou

nds

The Impact of Monetary Intervention

Excess demand

qS qD

S2S1D2

e1

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Fixed exchange rate The Need for Reserves

Foreign exchange reserves may not be adequate to maintain fixed exchange rates.

Case of USA I: The long-term string of U.S. balance-of-payments

deficits overwhelmed its stock of foreign exchange reserves

Gold reserves (stocks of gold held by a government to purchase foreign exchange) are a potential substitute for foreign-exchange reserves

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The U.S. Balance of Payments: 1950 – 1973

+$4

+2

0

–2

–4

–6

–8

–101950 1955 1960 1965 1970 1973 1975

Bala

nce

(billi

ons

of d

olla

rs) Surplus

Deficit

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Fixed exchange rate The Need for Reserves

Case of USA II: Continuing U.S. balance-of-payments

deficits exceeded the holdings of gold in Fort Knox.

As a result, U.S. gold reserves lost their credibility as a potential guarantee of fixed exchange rates.

September 15, 1971 – Bretton-Wood golden standard was abolished

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Fixed exchange rate Domestic Adjustments

Trade protection can be used to prop up fixed exchange rates.

Deflationary (or restrictive) policies help correct a balance-of-payments deficit by lowering domestic incomes and thus the demand for imports.

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Flexible Exchange Rates

Flexible exchange rates is a system in which exchange rates are permitted to vary with market supply and demand conditions. Also called floating exchange rates.

With flexible exchange rates, the quantity of foreign exchange demand always equals the quantity supplied.

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Flexible Exchange RatesEffect on trade

Someone is always hurt (and others are helped) by exchange-rate movements.(all the above discussed micro and macro arguments apply), e.g. Currency depreciation may cause

domestic cost-push inflation by pushing up input prices.

Currency appreciation reduces exports by raising the price of domestically produced goods to foreigners.

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Flexible Exchange RatesSpeculation

Speculators often counteract short-term changes in foreign-exchange supply and demand (stabilizing)

Sometimes, speculators move “with the market” and make swings in the exchange rate even more extreme (destabilizing)

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Managed Exchange Rates

Governments may buy and sell foreign exchange for the purpose of narrowing exchange-rate movements.

Such limited intervention in foreign-exchange markets is referred to as managed exchange rates.

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Currency Bailouts

The world has witnessed a string of currency crises: The Asian crisis of 1997-1998. The Brazilian crisis of 1999. The Argentine crisis of 2001-2. The recurrent ruble crises in Russia. Periodic panics in Mexico and South

America.

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Currency Bailouts

In most cases a currency “bailout” was arranged by the International Monetary fund, joined by the central banks of the strongest economies.

These authorities lend the troubled economy enough reserves to defend its currency

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The Case for Bailouts

The case for currency bailouts typically rests on the domino theory.

Weakness in one currency can undermine another.

Industrial countries often offer currency bailout as a form of self-defense.

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The Case Against Bailout

Once a country knows that currency bailouts will occur, it may not pursue domestic policy adjustments to stabilize its currency.

A nation can avoid politically unpopular options such as high interest rates, tax hikes, or cutbacks in government spending.

It can also turn a blind eye to trade barriers, monopoly power, lax lending policies, and other constraints on productive growth.

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