econ project

Ch04_Macro2e.pptx

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Exam Instructions

Meet in Love Library’s Computing Hub – Not classroom.

You must be able to log into library computer – Know login credentials. Multiple attempts to log-on will result in not being able to take exam.

You will login to Blackboard from library’s computer. You need to know your Blackboard login credentials.

GO TO LIBRARY AND TEST OUT YOUR CREDENTIALS BEFORE THE DAY OF THE EXAM.

The only items allowed in your exam workspace:

Calculators (can’t connect to internet)

Handwritten notes of one 8.5”X11” paper

Scratch (blank) paper, Pencils, pens

Drinks

Any other items in your workspace or line of sight is considered cheating. Everything else must be inside your bag and your bug must be under the desk.

It is a timed exam. 30 questions, 60 minutes. Manage your time.

Go to the bathroom before exam.

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The Global Financial System

Explain how to calculate the balance of payments.

Understand the advantages and disadvantages of different exchange rate policies.

Discuss what factors determine exchange rates.

Use the loanable funds model to analyze the international capital market.

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Learning Objectives
After studying this chapter, you should be able to:
4.1
4.2

4.3
4.4

Did U.S. monetary policy slow Brazil’s growth?

Brazil’s growth slowed in 2012. Brazilian President Dilma Rousseff argued that the Fed was partly to blame:

High value of Brazilian real relative to dollar made Brazilian exports expensive.

Economist magazine: Brazilian currency most overvalued of any big country.

By influencing value of U.S. dollar, Fed affects businesses in U.S., but also overseas.

Especially people and firms wanting to make international financial investments.

We will examine foreign exchange markets to see how they work, and what factors can influence exchange rates.

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Some governments allow the value of their currency to fluctuate in foreign-exchange markets, while other governments fix the value of their currency.

What are the advantages and disadvantages of floating versus fixed exchange rates?

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Key Issue and Question

Issue:

Question:

Explain how to calculate the balance of payments.

4.1

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Learning Objective

Trade imbalances

When one country exports goods to the U.S. they receive U.S. dollars in exchange.

Purchase U.S. goods and services.

Purchase U.S. financial assets.

Exchange dollars for another currency.

The buyer of dollars can either purchase U.S. goods or financial assets.

Open economy An economy in which households, firms, and governments borrow, lend, and trade internationally.

Closed economy An economy in which households, firms, and governments do not borrow, lend, and trade internationally.

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Trade as a percentage of GDP

Trade has been growing as a percentage of GDP since 1960.

Exports plus imports are a measure of economic openness.

Global trade decreased during the global recession, but in 2010 rebounded to 56%

The recession did have a severe effect on Chinese trade, however.

Trade as a percentage of GDP, 1960-2010

Figure 4.1

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Financial flows as a percentage of GDP

International financial flows have also been increasing.

By being more open to financial flows, countries typically increase their opportunities for growth.

Low-income countries have not experienced as large an increase in financial flows as high-income countries.

Financial flows as a percentage of GDP, 1960-2010

Figure 4.2

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The balance of payments

Balance of payments A record of a country’s trade with other countries in goods, services, and assets.

The balance of payments accounts are set up so when one item changes in the accounts, there is an offsetting transaction in another part of the accounts. Therefore the balance of payments is always zero.

Current account The part of the balance of payments that records a country’s net exports, net investment income, and net transfers.

Financial account The part of the balance of payments that records purchases of assets a country has made abroad and foreign purchases of assets in the country.

Capital account The part of the balance of payments that records (generally) minor transactions, such as migrants’ transfers, and sales and purchases of non-produced, non-financial assets.

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The current account

The current account for the U.S. records three items:

Net exports, which are exports minus imports.

Net factor payments which are income received from foreign investments, minus income foreigners received from domestic investments.

Transfers represent the transfer payments made by U.S. residents to foreigners minus the transfer payments foreign residents make to residents of the U.S.

A negative current account is a current account deficit.

The country is a net borrower from foreign countries.

A positive current account is a current account surplus.

The country is a net lender to foreign countries.

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U.S. balance of payments

A current account deficit of $473.6 billion means that $473.6 billion more flowed out of the country than flowed into the country.

Countries that run current account surpluses must run financial account deficits.

The U.S. has a current account deficit and hence a financial account surplus.

Balance of payments for the United States, 2011 (billions of dollars)

Table 4.1

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U.S. balance of payments

When the U.S. runs a current account deficit, either foreigners held onto the dollars or decided to purchase assets or financial securities.

Dollars held by foreigners are official reserves and changes in foreign holdings of dollars are official reserve transactions.

Balance of payments for the United States, 2011 (billions of dollars)

Table 4.1

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The financial account

The financial account records the flow of funds into and out of a country.

Capital outflows

American investors or firms purchase foreign financial assets or a U.S. firm builds a factory in another country.

Capital inflows

Foreign investors or firms buy U.S. financial assets or build capital in the U.S.

Net capital outflows Capital outflows minus capital inflows.

Capital here can refer to either physical capital goods, or financial assets such as stocks and bonds.

Foreign direct investment

When firms buy or build capital goods in foreign countries.

Foreign portfolio investment

When investors buy stock or bonds issued in a foreign country.

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The capital account

Least quantitatively important of the balance of payments for the U.S.; though note that prior to 1999, “the capital account” referred to both the financial and capital accounts.

Records generally minor transactions:

Migrants’ transfers of goods and financial assets.

Sales and purchases of non-produced, non-financial assets such as copyrights, patents, trademarks, or natural resource rights.

Generally ignored here since it is a small factor, but plays an important role in some smaller and developing countries.

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Understand the advantages and disadvantages of different exchange rate policies.

4.2

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Learning Objective

Nominal exchange rates

Nominal exchange rate The price of one country’s currency in terms of another country’s currency.

We typically express the nominal exchange rate as units of foreign currency per unit of domestic currency.

Example: 80 Japanese yen per U.S. dollar

Fluctuations in exchange rates can affect the ability of firms to sell their goods in other countries.

Example: If the real/dollar exchange rate is 2.5 reals = $1, then a bag of coffee with a price of 250 reals in Brazil will cost $100. But if the value of the real goes up to 2.0 reals = $1, then the same bag of coffee will cost $125.

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Exchange-rate risk

Suppose Brazilian private jet maker Embraer sells a jet for $50 million, with payment in 6 months.

Embraer is uncertain how many reals that will buy in 6 months; Embraer faces exchange rate risk.

We are assuming Embraer will exchange dollars for reals when it receives the dollars; it will do so at the spot exchange rate.

An alternative is for Embraer to sign a forward exchange contract at a forward exchange rate, “locking in” an exchange rate for the future. This allows them to hedge their risk.

Related product: future exchange contracts are market-traded foreign exchange contracts.

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Trade-weighted exchange rate

Each pair of currencies has a bilateral exchange rate.

Currency appreciation An increase in the market value of one country’s currency relative to another country’s currency.

The trade-weighted exchange rate of the U.S. dollar against an index of major currencies, 1973-2012

Figure 4.3

Currency depreciation A decrease in the market value of one country’s currency relative to another country’s currency.

It is often more useful to examine a multilateral exchange rate, a measure of how a country’s currency is changing relative to a group of other countries’ currencies.

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Real exchange rate

Economists are often interested in the terms of trade, or the rate at which domestic goods can be exchanged for foreign goods.

Real exchange rate The rate at which goods and services in one country can be exchanged for goods and services in another country.

This makes the most sense when comparing “apples to apples”: either a particular good, or more commonly, the price of a basket of goods—a price index.

Example: Suppose a Big Mac costs $4.20 in the U.S., and 10.25 reals in Brazil. If the nominal exchange rate is 1.81 reals = $1, then the real exchange rate is:

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Real exchange rate

Real exchange rates are usually measured in terms of average prices—the price level—in each country, such as the CPI or GDP deflator.

The trade-weighted exchange rate of the U.S. dollar against an index of major currencies, 1973-2012

Figure 4.3

E is the nominal exchange rate, and e is the real exchange rate.

The figure also shows a real trade-weighted exchange rate. Since it doesn’t differ much from the nominal exchange rate, we can tell price levels have changed similarly across countries.

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Foreign-exchange markets

~$4 trillion worth of currency traded daily on foreign-exchange market.

To finance international trade, international financial transactions

Global market, 24 hours a day

Virtual, over-the-counter market

Most trades involve major currencies:

85% of trades involve $U.S.

39% involve Euro

19% involve yen

13% involve British pound

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Exchange rate policy

When countries agree on an exchange rate policy, economists say that there is an exchange rate system, or exchange rate regime.

Exchange rate system An agreement among countries about how exchange rate should be determined.

Three major types of exchange rate systems:

Fixed exchange rate system A system in which exchange rates are set at levels determined and maintained by governments.

Floating exchange rate system A system in which the foreign-exchange value of currency is determined in the foreign exchange market.

Managed float exchange rate system A system in which private buyers and sellers in the foreign exchange market determine the value of currencies most of the time, with occasional government intervention.

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Fixed exchange rate systems

Two historically-important fixed exchange rate systems:

Gold standard

Lasted from 19th century to the 1930s.

Countries committed to redeem paper currency for gold.

Money supply determined by gold holdings.

During Great Depression of the 1930s, many countries abandoned gold standard for more flexibility in exchange rates and money supply.

Bretton Woods system

Lasted from 1944 to early 1970s

U.S. committed to buy/sell gold for $35 per ounce, but only to foreign central banks.

Other countries fixed currencies against the dollar.

Collapsed due to difficulty in maintaining exchange rates with rapidly increasing international trade/finance.

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Floating and managed float exchange rate systems

After the Bretton Woods system collapsed, most countries allowed currencies to float.

But some countries found this produced too much instability.

Current system is a managed float exchange rate system, as some countries try to influence exchange rates, but markets largely determine exchange rates.

Given the amount of foreign exchange, many economists question how effective interventions by governments could be; central banks’ purchases will still be small relative to total amount of buying and selling of currencies.

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Policy choices and the current exchange rate systems

The current exchange rate system reflects three key policy choices:

The United States allows the dollar to float against other major currencies.

Seventeen countries in Europe have adopted the euro as their common currency.

Some developing countries have pegged their exchange rates against the dollar or another major currency.

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Fixed exchange rates

Fixing or pegging exchange rates with a major trading partner helps avoid exchange rate risk for firms.

Also helps as a commitment device for fighting inflation.

During 1980s and 1990s, as international trade expanded, several East Asian countries pegged their exchange rates to the U.S. dollar in order to facilitate trade and financial flows.

Example: Korean won pegged to the dollar during the 1990s.

But there are some drawbacks to the fixed exchange rate, such as:

The inability to conduct monetary policy effectively

The need to support the exchange rate by buying or selling foreign currency.

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Greece experiences a “bank jog”

Before the U.S. enacted federal deposit insurance in 1934, commercial banks were subject to bank runs.

In 2012, depositors began to withdraw funds from Greek banks slowly: a “bank jog”, according to some commentators.

The European Central Bank helped Greece avoid default by buying its bonds directly—and also bonds of Spain, Ireland, and Italy.

The International Monetary Fund and the European Union also helped Greece with aid packages that were contingent upon the enactment of unpopular austerity policies, cutting government spending and raising taxes.

Newly elected politicians vowed to reverse the austerity policies, leading many to believe Greece would abandon the euro. This uncertainty led people to withdraw euros from Greek banks, fearing their euros would be replaced overnight with Greek drachmas.

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Making the Connection

Comparing various exchange rate policies

Advantages and disadvantages of various exchange rate policies

Table 4.2

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Discuss what factors determine exchange rates.

4.3

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Learning Objective

What factors determine exchange rates?

In theory, the price discrepancy between Big Macs in the U.S. and Mexico represents a profit opportunity.

Buy Big Macs in Mexico and sell them in the U.S. for profit.

Purchasing power parity The theory that, in the long run, nominal exchange rates adjust to equalize the purchasing power of different currencies.

In the long run, these profit opportunities should disappear.

Otherwise arbitrage profits are possible

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Implications of purchasing power parity

Recall the real exchange rate:

We can write this in terms of percentage changes, with  for the inflation rate:

% change in e = % change in E + Domestic –  Foreign

If purchasing power parity holds, then in the long run e is equal to 1; so its percentage change is zero. Rearranging, we obtain:

% change in E =  Foreign − Domestic

Example: If the inflation rate is higher in Japan than in the U.S., the nominal exchange yen/dollar exchange rate will increase—a depreciating yen, an appreciating dollar.

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Why purchasing power doesn’t hold exactly

Not all goods and services are traded internationally

Why? Transportation costs, perishable goods, local services like doctors

Countries impose barriers to trade

Tariffs, quotas

Products differ across countries

Example: Big Mac in India is different to one in the U.S.

Purchasing power parity is a useful guide to how exchange rates will move, but does not explain all changes.

Better in the long run than the short run.

In part, this is because trade in goods and services is only responsible for a fraction of the buying and selling of currency.

More due to engaging in international financial investments.

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International investments

International capital mobility is greater than for goods and services.

We expect investments to be made where they will receive the greatest return.

Example: If one-year Japanese government bonds paid 5%, while one-year U.S. Treasury bills paid 3%, you would prefer Japanese bonds, ceteris paribus.

But what if the exchange rate changes?

The return that a domestic investor receives on a foreign investment is equal to the interest rate on the foreign investment minus the rate of appreciation of the domestic currency.

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The interest parity condition

Where an investor should invests depends both on what the relative returns are, and the expected movement in the exchange rate.

Hence rates should adjust so that the interest parity condition holds:

Where iD and iF are the domestic and foreign interest rates on similar bonds, Et is the current (spot) nominal exchange rate, and Eet+1 is the nominal exchange rate expected in one year.

Interest parity condition The proposition that differences in interest rates on similar bonds in different countries reflect investors’ expectations of future changes in exchange rates.

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Make a financial killing by buying Brazilian bonds?

When President Obama and Brazilian President Rousseff met in 2012, the interest rate on a one-year U.S. Treasury bill was just 0.2%, while the interest rate on a comparable one-year Brazilian government bond was 7.8%.

With the gap between these interest rates so large, it was easy for an investor to make a high return by borrowing money at the low U.S. interest rate and investing it at the much higher Brazilian interest rate. Or was it?

Evaluate this Investment strategy.

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Solved Problem

Make a financial killing by buying Brazilian bonds?

Step 1 Review the chapter material.

Step 2 Answer the question by using the interest parity condition. If the interest parity condition holds, then we expect the $U.S. to appreciate 7.6% over the year. This would nullify any (expected) gain. Note that while the U.S. government can borrow (sell bonds) at 0.2%, a private investor cannot reasonably expect to borrow at this rate, due to his default risk. Further, the Brazilian bonds likely also have more of a default risk than the U.S. bonds, explaining part of the difference. In addition, there is exchange-rate risk to consider. All in all, the strategy is not as appealing as it first appeared.

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Solved Problem

Does the interest parity condition always hold?

Some reasons why the interest parity condition might not hold:

Differences in default risk and liquidity affect the relative attractiveness (and hence the interest rate) of domestic vs. foreign bonds.

Transaction costs are higher for trading in foreign assets than for domestic assets.

Exchange rate risk is significant also.

But the interest parity condition can give insight into how exchange rates will move if interest rates change.

Example: Suppose the interest rates on one-year government bonds in the U.S. and France are 2% and 4% respectively. If the rate on one-year U.S. Treasuries falls to 1%, we expect the $U.S. to depreciate 1%.

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Brazilian firms and unstable exchange rates

At the beginning of the chapter, we saw some Brazilians were upset about the high value of their currency making their exports uncompetitive.

But the larger problem appears to be that the real is unstable against the dollar, making long-term planning difficult.

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Making the Connection

Use the loanable funds model to analyze the international capital market.

4.4

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Learning Objective

Different interest rates, different models

Last chapter we developed the money market model to explain short-run nominal interest rates.

In this section we will develop the loanable funds model in order to explain long-run real interest rates.

The latter is more relevant for firms and households making long-lived investments, such as in factories or houses.

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Savings in the loanable funds model

The supply of loanable funds come from savings from three sources: households, government, and the foreign sector:

SHouseholds = (Y + TR – T) – C

SGovernment = T – (G + TR)

SForeign = – NX

Adding these up, we get:

S = SHouseholds + SGovernment + SForeign

Note: Y = National income

C = Consumption expenditure

I = Investment expenditure

G = Government purchases

NX = Net exports

T = Household’s taxes

TR = Transfer payments

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Savings in the loanable funds model

S = SHouseholds + SGovernment + SForeign

As interest rates rise:

SHouseholds rises, as households delay consumption

Sforeign rises: capital flows into the U.S. due to the higher interest rates, increasing the demand for dollars; the $U.S. appreciates, causing exports to fall and imports rise; so NX falls.

Then overall, the supply of loanable funds goes up as the interest rate goes up—the supply of loanable funds is upward-sloping.

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Demand and the market for loanable funds

The demand for loanable funds derives from firms and households borrowing money.

They want to borrow more at lower interest rates; demand is downward sloping.

Demand (investment) and supply (saving) determine the equilibrium long-run real interest rate.

The market for loanable funds

Figure 4.4

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Changes in the demand for loanable funds

The demand for loanable funds will change if any of the following change:

Risk

Taxes on businesses

Expectations about the profitability of business projects

The figure shows the effect of expectations about profitability improving.

An increase in the demand of loanable funds

Figure 4.5

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Changes in the supply of loanable funds

The supply of loanable funds would change if any of the following changed:

Taxes on households

Government expenditure

The desire for households to consume today rather than in the future

National income

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Changes in the supply of loanable funds

A budget deficit, for example, crowds out some investment by decreasing the supply of loanable funds.

Crowding out The reduction in private investment that results from an increase in government purchases

The figure shows the effect of the budget deficit.

The effect of a budget deficit on the market for loanable funds

Figure 4.6

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Summary of the loanable funds model

Table 4.3

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Summary of the loanable funds model - continued

Summary of the loanable funds model

Table 4.3

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The international capital market and the interest rate

Most modern economies are relatively open; so borrowing and lending take place in the international capital market.

The world real interest rate, rW, is the corresponding interest rate.

Loanable funds can be supplied to fund projects in the domestic economy or abroad.

The size of the economy matters; so we will separately consider

Small open economies

Large open economies

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Small open economy

In a small open economy:

The quantity of domestic funds is small relative to foreign funds.

So the economy cannot affect the world real interest rate.

The difference between the domestic loanable funds demanded and supplied is made up by international lending or borrowing.

Determining the real interest rate in a small open economy

Figure 4.7

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For example, a small economy like Monaco or Fiji

Large open economy

Simplified model of a large open economy: let the world consist of two large economies, U.S. and “Rest of World”.

Excess lending (borrowing) by U.S. must equal excess borrowing (lending) by rest of world.

Determining the interest rate in a large open economy

Figure 4.8

(a) United States (b) Rest of the world

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Answering the key question

“What are the advantages and disadvantages of floating versus fixed exchange rates?”

Fixed exchange rates make it easier for firms to do business internationally, and easier for the central bank to avoid inflation. But they may require central banks to hold large foreign currency reserves, and hinder monetary policy.

Floating exchange rates require no government intervention, but can make planning difficult for firms.

Managed floating exchange rates allow for more flexibility than a fixed exchange system; but central bank purchases are still small compared with financial market demands.

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