ECW3121 International Trade and Finance Lecture 10

1
ECW3121International Trade and FinanceLecture
10
2
Heckscher-Ohlin
Stolper-Samuelson
Factor Price Equalisation
Comparative Advantage
Trade Theory Study Guide 1
Rybzcynski
Absolute Advantage
Immiserising Growth
Mercantilism
International Trade and Finance
Balance Of Payments
Foreign Exchange Markets
Non Tariff Barriers
Interest Arbitrage
Tariffs
TradeBlocs
Finance Study Guide 3
Trade Policy Study Guide 2
International Resource Movements
Exchange rate theorems
Tools of the Trade Policy Analysis
3
Reading
International Finance
Foreign Exchange Market

• Salvatore - Chapter 13

4
International Finance
Exchange Rate Theories
What determines the foreign exchange rate????

• Used to explain how the exchange rate works and
• to predict future movements and long term trends.
• based on factors considered to have the most
  influence on the exchange rate.

5
Purchasing Power Parity Theory
International Finance
Exchange Rate Theories

• Law of one price - a commodity will be the same
  price in each country once the exchange rate
  differences are accounted for.
• Therefore, the exchange rate is just the ratio of
  prices that exist in each country.
• P AUD x R P USD
• Therefore R P USD / P AUD

6
International Finance
Exchange Rate Theories
Absolute Purchasing Power Parity

• Law of One Price
• Pair of Jeans costs 100 AUD
• Exchange rate 1 AUD 0.65 USD
• How much will jeans cost in USD?
• 100 AUD x 0.65 65 USD
• P AUD x R P USD
• R PUSD / PAUD
• R 65 / 100
• Inflation is not taken into account

7
International Finance
Exchange Rate Theories
Relative Purchasing Power Parity

• Exchange Rate is a function of the general price
  level and changes in that price level over time
  (inflation).
• R USD/AUD1
• Example Price of Jeans falls to 80 AUD
• R1 0.8125

Inflation is taken into account. Money supply or
economic growth are not taken into account
8
International Finance
Exchange Rate Theories
Monetary Approach

• Postulates that it is the stock of money held at
  any one time by nations that determines the
  exchange rate.
• Based on the Quantity Theory of Money and the
  Quantity Theory Equation
• MV PQ
• Where M- Money Supply
• V - Velocity of Money
• P - General Price Level
• Q- Quantity of Transactions

9
Quantity Theory Equation
International Finance
Exchange Rate Theories
Monetary Approach

• Assume that V and Q fixed in MV PQ
• Then the equation determines the amount of money
  required to service transactions.
• If M increases and output cannot increase then
  inflation occurs.
• Therefore, the equation gives a direct
  relationship between the money supply and price
  variables.
• Assumes that money is only required for
  transactions.

10
Demand For Money
International Finance
Exchange Rate Theories
Monetary Approach

• People need money to finance transactions
• Assume that the aggregate amount of transactions
  is associated with GDP or national income (Y)
• Demand for money balances, therefore, some
  proportion of the value of output (PQ).
• Md k PY which is another form of MV PQ
• where k 1/V and Y is national income output
  (Q).
• Only need to hold a fraction of total output
  value (PY) in money balances (Md).
• In equilibrium Md Ms
• Ms k PY

11
International Finance
Exchange Rate Theories
Monetary Approach

• The equation M k PY can be rearranged in terms
  of price
• P M / kY
• giving a direct relationship with M and an
  inverse relationship with kY. If kY is constant,
  then price is only influenced by the Money Supply.

12
International Finance
Exchange Rate Theories
Monetary Approach

• One of these equations can be derived for each
  nation
• P M / kY for domestic country (AUD)
• P M / kY for foreign country (USD)

13
International Finance
Exchange Rate Theories
Monetary Approach

• Purchasing Power Parity
• P AUD P USD x R
• Therefore R P AUD / P USD P / P
• Substituting in the Monetary Equation
• Note that this exchange rate is AUD per USD, ie
  1.35AUD 1USD

R
14
Predictions
International Finance
Exchange Rate Theories
Monetary Approach

• Assuming k and Y are constant
• Changes in the exchange rate will be a direct
  consequence of changes in the money supply.
• If M then P will and R will
  causing the local currency to depreciate.
• Inflation reduces the purchasing power (value) of
  money, currency now worth less - depreciation.

R
15
Deficiency
International Finance
Exchange Rate Theories
Monetary Approach

• Monetary version of exchange rate determination
  depends upon the purchasing power parity theorem.
• Generally been successful in predicting long run
  exchange rate movements but does not account for
  short run volatility.
• Original version did not regard interest rates as
  an important factor due to perfect capital
  mobility and the resulting interest parity.

16
Interest Parity
International Finance
Exchange Rate Theories
Further Developments

• Assume that behaviour of individuals and firms is
  consistent with profit maximisation.
• Differences in interest rates between nations
  will give an opportunity to make a profit.
• Capital will move around the world seeking the
  highest return.
• This can be in the form of covered or uncovered
  interest arbitrage.
• The profit seeking activity will quickly move to
  close the interest rate differential and return
  the market to interest parity.

17
Interest Parity
International Finance
Exchange Rate Theories
Further Developments

• Adjustments in the exchange rate can come from
  the real sector (goods and services) or the
  financial sector (capital flows)....most likely
  both.
• It is generally recognised that the financial
  sector reacts a lot faster than the real sector.
• Therefore short term volatility in the exchange
  rate is likely to be caused by capital flows
  chasing profit.
• Long term trends in interest rates are likely to
  be as a result of the adjustment of the real
  sector (prices, output).

18
A Generalised Model
International Finance
Exchange Rate Theories
Further Developments

• If the economy is not at full employment, Y
  cannot be held constant.
• Keynesian theory also questioned if k is
  constant.
• Therefore a more acceptable explanation of the
  exchange rate is

19
A Generalised Model
International Finance
Exchange Rate Theories
Further Developments

• M - home country's money supply
• M- foreign countrys money supply
• Y - home countrys real income
• Y- foreign countrys real income
• i - home countrys interest rate
• i - foreign countrys interest rate
• ? - home country's expected inflation
• ?? - foreign countrys expected inflation
• TB - home countrys trade balance
• K - foreign to home country velocity of money
  ratio

20
A Generalised Model
International Finance
Exchange Rate Theories
Further Developments
The price of foreign currency R goes up

• A rise in the home country's money supply (M)
• A drop in the foreign countrys money supply
  (M)
• A rise in the foreign countrys real income (Y)
• A drop in the home countrys real income (Y)
• A rise in the foreign countrys interest rate
  (i)
• A drop in the home countrys interest rate (i)
• A rise in the home country's expected
  inflation(?)
• A drop in the foreign countrys expected
  inflation (??)
• A drop in the home countrys trade balance (TB).