Management: European Union
jakovljevicjana
2cFXmrktandEuro1.pptxthe FX-market & Competitiveness - the international market in which currencies can be exchanged.
The exchange rate is the price at which two currencies exchange.
DD
DD shows the demand for
pounds by Americans wanting
to buy UK imports & assets.
Quantity
of pounds
Exchange rate ($/£)
Two countries: UK & USA
SS
SS shows the supply of pounds
by UK residents wishing to buy
US imports & assets.
e0
Equilibrium exchange rate is e0
SS1
If UK residents want more $ (e.g. more
US imports leading to external deficit), the supply of £ rises to SS1
e1
New equilibrium at e1 . The value of
the pound has fallen due to the
excess supply of pounds at e0.
e0
1$=1£
1$=2£
1
See Section 28-1 in the main text, and Figure 28-1.
The foreign exchange market
At the new equilibrium the value of the pound has fallen from:
1$=1£ to 1$=2£
The £ has depreciated (weakened) against the $ or the dollar (strengthened) appreciated against the £.
UK goods have become cheaper for Americans and US goods more expensive for UK citizens. (UK exports are more competitive now)
What next?
When a currency depreciates: exports become cheaper and imports more expensive. Thus, an excessive balance of payments deficit (causing the depreciation) will be checked
When a currency appreciates: exports become more expensive & imports cheaper so an excessive external surplus will be reduced
Implication: When a country has external deficit/surplus there is pressure for currency depreciation/appreciation. This is the automatic market mechanism to control excessive imbalances
Factors determining exchange rates:
In the long term, the relative inflation rates (prices of goods)
In the short term, the relative interest rates (return on assets)
.
2
Exchange rate regimes
Flexible exchange rate regime
the exchange rate is allowed to attain its free market equilibrium without any government intervention.
Fixed or managed exchange rate regime
the government wants to maintain the value of its currency at a fixed rate with respect to another
Intervention in the foreign exchange market is required:
If the UK currency tends to depreciate (e.g. due to rising demand for $ i.e. US imports & assets), the government can use its $-reserves to support (buy) the £ . The UK looses $-reserves. The same might be achieved by raising UK interest rates.
The opposite will need to occur in case of appreciation. The UK will use £ to buy $ (accumulating $-reserves. It is easier to stop appreciation since the government can print money. The same might be achieved by lowering interest rates.
3
See Section 28-2 of the main text.
International competitiveness
The competitiveness of a country’s exports in international markets depends upon:
relative prices or inflation rates.
Competitiveness is measured by the real exchange rate
The relative price of goods across countries when measured in a common currency.
Real ER= nominal ER x (domestic P/ foreign P*)
Real ER= nominal ER x (domestic ULC/foreign ULC*)
ULC=wage/productivity
Law of one price or purchasing power parity theory:
‘The price of the same good, expressed in a common currency, must be equal across countries.’
4
See Section 28-4 of the main text.
The Big Mac & the law of one price
Exchange rate 1$=6.8yuan. In China, a BigMac costs 15Yuan ($2,2) but in US $3,7. The same dollar amount in China buys 1,4 BigMacs instead of 1 in the US. Thus, Yuan is 40% undervalued versus $. Yuan should appreciate versus $ to $1=4 Yuan instead of 6.8 in order to restore law of one price.
Euro is 30% overvalued versus $ instead of 1Eur=1.3$ it should be 1Eur=1$
BigMac $price
$price Brazil Euro Area Canada Japan USA Britain S.Korea S.Africa Mexico Russia China 5.2 4.8 4.2 3.9 3.7 3.6 3 2.8 2.6 2.4 2.2000000000000002% undervalued(-) or overvalued (+)
versus the $US
under(-), over (+) Brazil Euro Area Canada Japan USA Britain S.Korea S.Africa Mexico Russia China 40 30 15 5 0 -2 -20 -23 -27 -37 -40
Unit Labour Cost (wage/Productivity) a key measure of competitiveness. If the ULC of a country is lower than others’ it is more cost competitive i.e. it can charge lower prices. If wages rise faster than productivity it implies a loss in competitiveness
Real Exchange rate
| Greek Prices CPI gr | German prices CPI gy | Nominal Exchange rate | Real Exchange rate | |
| 2002 | 100 | 100 | 1GR Euro =1GYEuro | 1GR Euro =1GY Euro |
| 2010 | 140 | 110 | >> | 1 GR Euro =1*(140/110)=1.27 GY Euros |
2002-10: The Greek price level increased by 40% and the German by 10%, as a result there was a Greek competitiveness loss of 27%. As prices mostly determined by wages we can use AC of labour or ULC (=wage/productivity) instead of prices to measure the RER
Real Exchange Rate {=ER x (Pgr/Pgy*) }.
Germany is the major European export economy. Its Euro is much cheaper than other countries’ Euros e.g. 1 GR Euro buys 1.27 GY Euros or equivalently a loaf of bread that costs 1Eur in Germany would cost 1.27Eur in GR. Germany could gain by exporting it to Greece but Greece could not do the same (too expensive)
Without depreciation, Greek costs of production (prices) would have to fall by 30% to restore law of one price. This requires a wage fall or productivity increase or both
Alternatively, if Greece left the Euro, New Drachma would depreciate by 30% to regain competitiveness (by the amount Greek prices have grown faster than Germany’s). This would automatically translate into a relative decline in Greek living standards.
competitiveness within Europe
Post-euro, countries in catch up process of living standards (GR, PO, SP, IR) borrowed at low interest rate from the banks of surplus countries (North Europe).
Fiscal policies (except GR) were disciplined but the private sector over-borrowed leading to high external deficits & debt. Domestic economic overheating in the South also led to rising wages/ inflation & competitiveness loss versus the North.
This can be corrected via higher spending by the North as the South saves to repay debt thus sustaining overall EU growth. Also generalised wage restraint (internal devaluation) and productivity gains (reforms) in the South or with wage increases (internal appreciation) by the North or a mix of both
Real Exchange Rates (based on ULC = wage/productivity
