Level 5 Economics: International Topics [2]

2. Foreign Exchangerelationship between exchange rates and:

• exports/imports• interest rates

Economic Principles Economic Environment

Level 5 Economics: Foreign Exchange Rate

-2%

0%

2%

4%

6%

8%

10%

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

perc

ent c

hang

e

New Zealand CPI Annual Inflation: Tradable vs. Non-Tradable Sectors

Tradable Non-Tradablesource: www.rbnz.govt.nz; Statistics New Zealand

Level 5 Economics: Foreign Exchange Rate

-2%

0%

2%

4%

6%

8%

10%

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

perc

ent c

hang

e

New Zealand CPI Annual Inflation: Tradable vs. Non-Tradable Sectors

TWI below 55 Tradable Non-Tradablesource: www.rbnz.govt.nz; Statistics New Zealand

Exchange Rate Systems• Floating rate systems S 433; S&R 402

– "forex" (foreign exchange) market fig 21.1 • $NZ price determined by supply of and demand for $NZ

– clean (pure market) vs. dirty (managed) floats

• Fixed rate systems– gold and gold-exchange standards– 'pegged' to a 'basket' of foreign currencies (NZ 1971-85)

• may be regularly adjusted; eg according to inflation rates

• Currency Union– Eurozone: the Euro (€)– also NZ and Cook Islands; some others and $US– a single ANZAC currency ?

Measuring the Exchange RateMeasuring a Currency's Value

– Trade-Weighted Index (TWI)actual figures: Jan 2003 to Sep 2015

– current weights: rbnz.govt.nz/statistics/twi/5565445.html

example with simplified weights– see ANZ Bank's website [past changes]

http://anz.co.nz/about-us/economic-markets-research/

NZ TWI weight J an-03 Sep-15 % changeTWI Dec-14 60.00 67.22 12.03%

$NZ/$US 0.3123 0.55 0.64 17.43%$NZ/$A 0.2202 0.93 0.89 -4.30%

$NZ/yen¥ 0.1510 64.00 76.80 20.00%$NZ/Euro 0.2532 0.51 0.57 11.76%$NZ/£UK 0.0633 0.33 0.41 24.24%

1.0000

Measuring a Currency's Value– Trade-Weighted Index (TWI)

example

NZ TWI weight period 1 period 2 % changeTWI 50.00 50.00 0.00%

$NZ/$US 0.30 0.70 0.77 10.00%$NZ/$A 0.20 0.80 0.70 -12.50%

$NZ/yen¥ 0.15 70.00 61.85 -11.64%$NZ/Euro 0.25 0.60 0.63 5.00%$NZ/£UK 0.10 0.50 0.50 0.00%

1.00

Measuring the Exchange Rate

Measuring a Currency's Value– Trade-Weighted Index (TWI)

example

NZ TWI weight period 1 period 2 % changeTWI 50.00 51.00 2.00%

$NZ/$US 0.30 0.70 0.77 10.00%$NZ/$A 0.20 0.80 0.70 -12.50%

$NZ/yen¥ 0.15 70.00 61.85 -11.64%$NZ/Euro 0.25 0.60 0.63 5.00%$NZ/£UK 0.10 0.50 0.60 20.00%

1.00

Measuring the Exchange Rate

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TWI

Month:

TWI

last 18 years

Year:

TWI

Year

1986-2004

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Demand for & Supply of $NZ template S; S&R fig 21.2

The $NZ depreciates when:• demand decreases for New Zealand's exports• demand increases for imports• foreign lending decreases to New Zealand

ie New Zealanders borrow less from foreign countries• interest rates decrease in New Zealand

(less foreign borrowing by NZers; more lending to overseas)• higher NZ inflation rates [esp. non-tradable prices]

(exports fall and imports rise; reduced NZ supply of tradables due to higher production costs)

When the reverse happens, the $NZ appreciates.

Appreciation & Depreciation

e2

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Q2

quiz

result of a fall in export or other current receiptsor a decreased

foreign demand for NZ financial

assetsor decreased NZ borrowing from other countries

(TWI)

depreciation

e2

eg result of a rise in import payments

(ie more imports or higher import prices)

or other current payments

or an increased demand by NZers for

foreign assetsor an increased sale

of foreign-held assets in New Zealand

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(TWI)

depreciation

e2

eg NZ interest rates fall, generating

financial outflows or inflation in NZ is higher than in trading partners

backQ2quiz

(TWI)

depreciation

e2

result of a rise in export or other

current receiptsor an increased foreign demand for NZ financial

assets or increased NZ borrowing from other countries

back

Q2

quiz

(TWI)

appreciation

e2

result of a fall in import payments

(ie fewer imports or cheaper imports) or

other current payments

or a decreased demand by NZers for

foreign assetsor a decreased sale of foreign-held assets in

New Zealand

backQ2quiz

(TWI)

appreciation

e2

eg NZ interest rates rise, generating

financial inflows or inflation in NZ is lower than in trading partners

backQ2quiz

(TWI)

appreciation

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Domestic (eg NZ) Markets for Traded Goods

S'of whatever the firms sell

Effect of Domestic Inflation• Less Supply of Traded Goods

due to higher costs – fewer exports.

• Excess Demand for these.• Prices stay at World Prices• More goods purchased will

now be imports.• Exchange rate will fall as

less $NZ demanded andmore $NZ supplied.

Pw

extra imports

D

QDQS

exercise

Q2

Note: "Import Substitution" means to replace imports with domestic production.

69.0

a

b

c

d

e

ie domestic industries that compete with imports

eg crude oil

Tradable and non-Tradable Sectors• Dividing the NZ economy into 2 parts (PPF)

– the tradable sector produces goods and services that are traded internationally• it is export industries plus the import substitution

industries that compete with imports (eg clothing in NZ)

– importers (eg The Warehouse) are a part of thenon-tradable sector; they provide retail services• importers like the $NZ to appreciate; exporters don't

– consider: oil, electricity, coal, accountancy, music

• Domestic prices of Tradable Products– tradable goods and services sell at world prices– NZ prices of traded goods will rise if $NZ falls quiz +

cartoon

butter example

Example: Butter Prices

Assume Pw (world price) of butter is $US 2.00 per Kg

1. If NZ$ 1.00 = US$ 0.67 then2. If NZ$ 1.00 = US$ 0.50 then

($NZ ↓; butter price ↑)3. If NZ$ 1.00 = US$ 0.80 then

($NZ ↑; butter price ↓)

PbutterNZ = $3.00PbutterNZ = $4.00

PbutterNZ = $2.50

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trade off between tradable and non-tradable sectors

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non-tradable sector

Changes in the exchange rate cause movements along the PPF; eg between A and B.This means resources are transferred between sectors.

tradablesector

Resources move up/left (A) when the TWI falls down/right when the TWI rises

If the exchange rate falls, and we are at point C, will the economy move to A or B?

C

Level 5 Economics Exercise Sheet 5b International

1. The exchange rate is measured by the a) CPI. b) GDP.

c) Terms of Trade. d) TWI.

2. When demand for an imported product is price elastic (eg large TV sets), an increase in its price will lead to a) a rise of a country's terms of trade. b) an increase of a country's imports. c) an increase of a country's exports. d) an appreciation of a country's exchange rate.

3. If the New Zealand dollar depreciates a) New Zealand farmers will spend more. b) farm motorbikes will become less expensive. c) New Zealand school-teachers will take more overseas holidays. d) New Zealand retailers will import a greater proportion of their stock.

4. A New Zealand bank funds new mortgages by borrowing from its Australian parent bank a) New Zealand's TWI (trade-weighted index) will rise in value. b) The Australian dollar will appreciate. c) New Zealand's trade will not be affected. d) New Zealand's government will borrow more. previous

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Level 5 Economics Exercise Sheet 5b International

1. The exchange rate is measured by the a) CPI. b) GDP.

c) Terms of Trade. d) TWI.

2. When demand for an imported product is price elastic (eg large TV sets), an increase in its price will lead to a) a rise of a country's terms of trade. b) an increase of a country's imports. c) an increase of a country's exports. d) an appreciation of a country's exchange rate.

3. If the New Zealand dollar depreciates a) New Zealand farmers will spend more. b) farm motorbikes will become less expensive. c) New Zealand school-teachers will take more overseas holidays. d) New Zealand retailers will import a greater proportion of their stock.

4. A New Zealand bank funds new mortgages by borrowing from its Australian parent bank a) New Zealand's TWI (trade-weighted index) will rise in value. b) The Australian dollar will appreciate. c) New Zealand's trade will not be affected. d) New Zealand's government will borrow more.

S 444;S&R 413

1996 cartoon

Costs and Benefits of a Currency Depreciation

• prices of tradable inputs will rise– this raises the costs of production of all firms– firms' supply curves shift left (supply decreases)

• prices of tradable outputs will rise– raises the revenues of firms in the tradable sector– also,

such firms will raise their quantities supplied to keep maximising their profits

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Effect of $NZ depreciation on all firms' revenues

S'effect of rising price of tradable inputs (S')

of whatever the firm sells

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Effect of $NZ depreciation on dairy revenues

S'

$NZ priceof butter rises

+

+

of buttereffect of rising price of tradable inputs (S')

extra revenueremember:• competitive price = MR• supply = MC• maximum profit Q increases

P

P'

Production, Price and Income Effects• a depreciation (fall) of the $NZ leads to

– a rise in export and import prices– substitution in favour of NZ-made products

• therefore exports ↑, imports ↓– increased total incomes in NZ's tradable sector– a general rise in prices (inflation)

as import and export prices rise– a fall in the real wages (ie inflation-corrected) of

those employed in the non-tradable sector

• the opposite effects apply to an appreciation (rise) in the $NZ value

The Impact of Financial Flows on the Exchange Rate

• At certain times – eg when interest rates are high – interest rate effects outweigh trade impacts, so the exchange rate may move in the opposite direction to that predicted by international trade, or may 'overshoot'.– this is more true for NZ than most countries

• extreme case: Iceland in the mid-2000s like a 'Ponzi scheme'

– New Zealand banks sold bonds overseas• eg Eurokiwi bonds sold in Europe; Uridashi sold in Japan

• Foreign exchange market becomes unstable– demand for a currency becomes self-perpetuating– trade becomes highly unbalanced

RBNZ

1. Use sketch demand/supply diagrams for the $NZ to show each of the following, clearly indicating whether the exchange rate will appreciate or depreciate:

a) New Zealand consumers demand fewer imported computers.

b) New Zealand interest rates fall relative to other countries' interest rates.

c) United States removes its tariffs on agricultural imports.

d) New Zealand experiences a rapid growth of English language schools.

2. Interest rates rise in New Zealand but not in Australia. a) New Zealand's exchange rate will fall. b) The value of the Australian dollar will rise. c) There will be an increased flow of financial capital (loans)

from New Zealand to Australia. d) There will be an increased flow of financial income (interest)

from New Zealand to Australia.

check

check

check

check

check

No. From Australia to NZ

$NZ up$A down

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1. Use sketch demand/supply diagrams for the $NZ to show each of the following, clearly indicating whether the exchange rate will appreciate or depreciate:

a) New Zealand consumers demand fewer imported computers.

b) New Zealand interest rates fall relative to other countries' interest rates.

c) United States removes its tariffs on agricultural imports.

d) New Zealand experiences a rapid growth of English language schools.

2. Interest rates rise in New Zealand but not in Australia. a) New Zealand's exchange rate will fall. b) The value of the Australian dollar will rise. c) There will be an increased flow of financial capital (loans)

from New Zealand to Australia. d) There will be an increased flow of financial income (interest)

from New Zealand to Australia.