Foreign Trade and Exchange Rates

1
Foreign Trade and Exchange Rates

• Lecture 11

2
Foreign Trade and Exchange Rates

• Key Concepts to Master
• Exports and imports within the circular flow of
  the economy
• The key drivers of exports and imports
• Interest rate parity and exchange rates
• The J-Curve

3
Exports and imports within the circular flow of
the economy

• GNP C I G X - M
• Exports are an addition to the flow of spending
  created by domestic income
• i.e. exports are purchases by foreign buyers of
  the same types of goods as C,I,G and add to US
  production (GDP)
• Imports are a subtraction, a leakage, from the
  circular flow
• i.e.imports are all components of C, I, G, and
  even X and substitute for / subtract from US
  production (GDP)

4
The Circular Flow--in a closed economy
Excise Taxes
Production of Goods
Spending on Purchases of Goods
Wages, Profits, Rents
Saving
Payroll Income Tax
5
The Circular Flow--in an open economy
Imported Goods
Export Demands
Excise Taxes
Production of Domestic Goods
Spending on Purchases of Goods
Wages, Profits, Rents
Saving
Payroll Income Tax
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The key drivers of exports and imports

• Imports are all components of C, I, G, and even X
• This countrys income, production and policy
  choices drive our imports--all of the concepts
  discussed in the lectures and reading on these
  domestic sectors
• Exports are simply another countrys imports,
  thus part of its C, I, G, X
• That countrys income and production and policy
  choices drive our exports
• The share of any countrys C,I,G,X grabbed by
  imports depends on relative prices, tastes,
  quotas, and other market restrictions

7
Interest rate parity and exchange rates

• A simple relationship should hold among exchange
  rates and interest rates in any pair of
  countries
• the percentage difference between the exchange
  rate today and the expected future exchange rate
  is the difference between todays interest rates
  in the two countries for the same future time
  horizon
• For example, the number of dollars the market
  will pay for 100 yen today equals the expected
  dollars a yen will cost next year minus the
  percentage difference between todays one-year
  interest rates in Japan and the US. For example,
• If 100 yen are expected to cost 1.05 next year,
  and the US 1-year rate is 6 while the Japanese
  is 1, the market will only pay 1.00 today for
  100 yen thus relatively high interest rates
  produce a strong currency, other factors equal
• 1 invested in the US today will be worth 1.06
  or 101 (1.06 x 100 / 1.05) yen next year
• 100 Yen invested in Japan today will be worth 101
  yen next year

8
Interest rate parity and exchange rates
Complications in the simple story

• But what determines the expected value a year
  from now? Will purchasing power parity for a
  broad range of goods and assets prevail then?
  What is purchasing power parity?
• The expected future exchange rate depends on the
  expected future demand for each currency, hence a
  long list of drivers
• future monetary and fiscal policies affecting
  interest rates at that time
• current goods and asset prices in both countries
  and expected inflation and appreciation rates
• the relative stages of the business cycles hence
  levels of trade deficits and hence the immediate
  flow of a currency in or out of a country versus
  the existing stock
• future trade policies

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More Complications in the simple story

• In some very long run, perhaps ten to twenty
  years out, purchasing power parity might be
  expected to roughly prevail, out of ignorance of
  what other factors would be in force in either
  direction.
• Biases due to uncertainty or irrationality or
  lack of information also can break up the basic
  simple relationship.
• However, the fundamental premise is pretty
  strong the higher a country pushes its interest
  rates today, the stronger will be that countrys
  exchange rate today.
• And, the stronger the exchange rate is, the
  weaker its export quantities and the stronger its
  import quantities, hence the weaker its real
  (inflation-adjusted) net exports .

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Exchange Rate Drivers for Mature Nations

• Relative Inflation Rates / Price Levels Affect
  Long-Run Trends
• Investment Opportunities Drive Short-Run Cycles
• Bond-Yield Differentials Dominate
• Business Cycle Impacts on Equity Returns are also
  Important

11
Historical View of the German Exchange Rate
DM /
12
Real and Nominal Exchange Rates Much of the
Historic DM Appreciation Has Been an Adjustment
for Price Levels
Nominal
Real
DM /
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A Comparison of Wholesale Price Inflation Rates
Reveals a Strong Tendency for Lower German
Inflation, Except in Periods of Exceptional
Dollar Strength
SpreadGermany-US
Germany
United States
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Bond Yields Are Another Substantial Driving Force
SpreadGermany-US
Germany
United States
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The Real Exchange Rate (DM per US) Rises /
Falls with the Bond Yield Spread (US minus German)
Real Exchange Rate
10-Year Bond Yield Spread
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The Correspondence is Near-Perfect if Allowance
is Also Made for Inflation Differentials
Real Exchange Rate
Interest Spread
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Benefits of a strong currency

• But a strong exchange rate does have some
  positive effects in the short- and the long-run.
• It does mean a country can buy other countries
  goods, services, and assets more cheaply, raising
  its own relative and absolute standard of living.
• It may also mean a temporarily higher nominal
  (non-inflation-adjusted) trade deficit.

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The J-Curve

• This name refers to the shape of a graph
  depicting changes through time in a countrys
  nominal net exports after a depreciation of that
  countrys currency

Change in Nominal Net Exports Relative to a
Baseline
0
0
Time Elapsed After Depreciation
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An Example of the J-Curve
Both price elasticities -1
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An Example of the J-Curve
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An Example of the J-Curve
Both price elasticities are small
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An Example of the J-Curve